The most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows—the investment outlays and the annual net cash flows after a project goes into operation. Many variables are involved, and many individuals and departments participate in the process. For example, the forecasts of unit sales and sales prices are normally made by the marketing group, based on their knowledge of price elasticity, advertising effects, the state of the economy, competitors’ reactions, and trends in consumers’ tastes. Similarly, the capital outlays associated with a new product are generally obtained from the engineering and product development staffs, while operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing agents, and so forth.

It is difficult to forecast the costs and revenues associated with a large, complex project, so forecast errors can be quite large. For example, when several major oil companies decided to build the Alaska Pipeline, the original cost estimates were in the neighborhood of $700 million, but the final cost was closer to $7 billion. Similar (or even worse) miscalculations are common in forecasts of product design costs, such as the costs to develop a new personal computer. Further, as difficult as plant and equipment costs are to estimate, sales revenues and operating costs over the project’s life are even more uncertain. Just ask Polaroid, which recently filed for bankruptcy, or any of the now-defunct dot-com companies.

A proper analysis includes (1) obtaining information from various departments such as engineering and marketing, (2) ensuring that everyone involved with the forecast uses a consistent set of economic assumptions, and (3) making sure that no biases are inherent in the forecasts. This last point is extremely important, because some managers become emotionally involved with pet projects, and others seek to build empires. Both problems cause cash flow forecast biases which make bad projects look good—on paper.

It is almost impossible to overstate the problems one can encounter in cash flow forecasts. It is also difficult to overstate the importance of these forecasts.

The first step in capital budgeting is to identify the relevant cash flows, defined as the specific set of cash flows that should be considered in the decision at hand. Analysts often make errors in estimating cash flows, but two cardinal rules can help you minimize mistakes: (1) Capital budgeting decisions must be based on cash flows, not accounting income. (2) Only incremental cash flows are relevant.

Free cash flow is the cash flow available for distribution to investors. In a nutshell, the relevant cash flow for a project is the additional free cash flow that the company can expect if it implements the project. It is the cash flow above and beyond what the company could expect if it doesn’t implement the project. The following sections discuss the relevant cash flows in more detail.

Project Cash Flow versus Accounting Income

Free cash flow is calculated as follows: Just as a firm’s value depends on its free cash flows, so does the value of a project. It is important for you to understand that project cash flow differs from accounting income.

Costs of Fixed AssetsMost projects require assets, and asset purchases represent negative cash flows. Even though the acquisition of assets results in a cash outflow, accountants do not show the purchase of fixed assets as a deduction from accounting income. Instead, they deduct a depreciation expense each year throughout the life of the asset.

Note that the full cost of fixed assets includes any shipping and installation costs. When a firm acquires fixed assets, it often must incur substantial costs for shipping and installing the equipment. These charges are added to the price of the equipment when the project’s cost is being determined. Then, the full cost of the equipment, including shipping and installation costs, is used as the depreciable basis when depreciation charges are being calculated. For example, if a company bought a computer with an invoice price of $100,000 and paid another $10,000 for shipping and installation, then the full cost of the computer (and its depreciable basis) would be $110,000. Note too that fixed assets can often be sold at the end of a project’s life. If this is the case, then the after-tax cash proceeds represent a positive cash flow.

Noncash ChargesIn calculating net income, accountants usually subtract depreciation from revenues. So, while accountants do not subtract the purchase price of fixed assets when calculating accounting income, they do subtract a charge each year for depreciation. Depreciation shelters income from taxation, and this has an impact on cash flow, but depreciation itself is not a cash flow. Therefore, depreciation must be added to NOPAT when estimating a project’s cash flow.

Changes in Net Operating Working CapitalNormally, additional inventories are required to support a new operation, and expanded sales tie up additional funds in accounts receivable. However, payables and accruals increase as a result of the expansion, and this reduces the cash needed to finance inventories and receivables. The difference between the required increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. If this change is positive, as it generally is for expansion projects, then additional financing, over and above the cost of the fixed assets, will be needed. Toward the end of a project’s life, inventories will be used but not replaced, and receivables will be collected without corresponding replacements. As these changes occur, the firm will receive cash inflows, and as a result, the investment in net operating working capital will be returned by the end of the project’s life.

Interest Expenses Are Not Included in Project Cash Flows The cost of capital is a weighted average (WACC) of the costs of debt, preferred stock, and common equity, adjusted for the project’s risk. Moreover, the WACC is the rate of return necessary to satisfy all of the firm’s investors—debtholders and stockholders. In other words, the project generates cash flows that are available for all investors, and we find the value of the project by discounting those cash flows at the average rate required by all investors. Therefore, we do not subtract interest when estimating a project’s cash flows.

If you did not take our advice and instead were to subtract interest (or interest plus principal payments), then you would be calculating the cash flows available only for equity investors, which should be discounted at the rate of return required by equity investors. One problem with this approach, though, is that you must adjust the amount of debt each year by exactly the right amount. If you were extremely careful doing this, then you should get the correct result. However, this is a very complicated process, and we do not recommend that you try it. Here is one final caution: If you did subtract interest, you would definitely be wrong to discount that cash flow, which is available only for equity holders, at the project’s WACC, since the project’s WACC is the average rate expected by all investors, not just the equity investors.

Note that this differs from the procedures used to calculate accounting income. Accountants measure the profit available for stockholders, so interest expenses are subtracted. However, project cash flow is the cash flow available for all investors, bondholders as well as stockholders, so interest expenses are not subtracted.

Incremental Cash Flows

In evaluating a project, we focus on those cash flows that occur if and only if we accept the project. These cash flows, called incremental cash flows, represent the change in the firm’s total cash flow that occurs as a direct result of accepting the project. Three special problems in determining incremental cash flows are discussed next.

Sunk CostsA sunk cost is an outlay that has already occurred, hence is not affected by the decision under consideration. Since sunk costs are not incremental costs, they should not be included in the analysis. To illustrate, in 2002, Northeast BankCorp was considering the establishment of a branch office in a newly developed section of Boston. To help with its evaluation, Northeast had, back in 2001, hired a consulting firm to perform a site analysis; the cost was $100,000, and this amount was expensed for tax purposes in 2001. Is this 2001 expenditure a relevant cost with respect to the 2002 capital budgeting decision? The answer is no—the $100,000 is a sunk cost, and it will not affect Northeast’s future cash flows regardless of whether or not the new branch is built. It often turns out that a particular project has a negative NPV if all the associated costs, including sunk costs, are considered. However, on an incremental basis, the project may be a good one because the future incremental cash flows are large enough to produce a positive NPV on the incremental investment.

Opportunity Costs A second potential problem relates to opportunity costs, which are cash flows that could be generated from an asset the firm already owns provided it is not used for the project in question. To illustrate, Northeast BankCorp already owns a piece of land that is suitable for the branch location. When evaluating the prospective branch, should the cost of the land be disregarded because no additional cash outlay would be required? The answer is no, because there is an opportunity cost inherent in the use of the property. In this case, the land could be sold to yield $150,000 after taxes. Use of the site for the branch would require forgoing this inflow, so the $150,000 must be charged as an opportunity cost against the project. Note that the proper land cost in this example is the $150,000 market-determined value, irrespective of whether Northeast originally paid $50,000 or $500,000 for the property. (What Northeast paid would, of course, have an effect on taxes, hence on the after-tax opportunity cost.)

Effects on Other Parts of the Firm: ExternalitiesThe third potential problem involves the effects of a project on other parts of the firm, which economists call externalities. For example, some of Northeast’s customers who would use the new branch are already banking with Northeast’s downtown office. The loans and deposits, hence profits, generated by these customers would not be new to the bank; rather, they would represent a transfer from the main office to the branch. Thus, the net income produced by these customers should not be treated as incremental income in the capital budgeting decision. On the other hand, having a suburban branch would help the bank attract new business to its downtown office, because some people like to be able to bank both close to home and close to work. In this case, the additional income that would actually flow to the downtown office should be attributed to the branch. Although they are often difficult to quantify, externalities (which can be either positive or negative) should be considered.

When a new project takes sales from an existing product, this is often called cannibalization. Naturally, firms do not like to cannibalize their existing products, but it often turns out that if they do not, someone else will. To illustrate, IBM for years refused to provide full support for its PC division because it did not want to steal sales from its highly profitable mainframe business. That turned out to be a huge strategic error, because it allowed Intel, Microsoft, Dell, and others to become dominant forces in the computer industry. Therefore, when considering externalities, the full implications of the proposed new project should be taken into account.

A few young firms, including Dell Computer, have been successful selling their products only over the Internet. Many firms, however, had established retail channels long before the Internet became a reality. For these firms, the decision to begin selling directly to consumers over the Internet is not a simple one. For example, Nautica Enterprises Inc. is an international company that designs, sources, markets, and distributes sportswear. Nautica sells its products to traditional retailers such as Saks Fifth Avenue and Parisian, who then sell to consumers. If Nautica opens its own online Internet store, it could potentially increase its profit margin by avoiding the substantial markup added by dealers. However, Internet sales would probably cannibalize sales through its retailer network. Even worse, retailers might react adversely to Nautica’s Internet sales by redirecting the marketing effort and display space they now provide Nautica to other brands that do not compete over the Internet. Nautica, and many other producers, must determine whether the new profits from Internet sales will compensate for lost profits from existing channels. Thus far, Nautica has decided to stay with its traditional retailers.

Rather than focusing narrowly on the project at hand, analysts must anticipate the project’s impact on the rest of the firm, which requires imagination and creative thinking. As the IBM and Nautica examples illustrate, it is critical to identify and account for all externalities when evaluating a proposed project.

Timing of Cash Flow

We must account properly for the timing of cash flows. Accounting income statements are for periods such as years or months, so they do not reflect exactly when during the period cash revenues or expenses occur. Because of the time value of money, capital budgeting cash flows should in theory be analyzed exactly as they occur. Of course, there must be a compromise between accuracy and feasibility. A time line with daily cash flows would in theory be most accurate, but daily cash flow estimates would be costly to construct, unwieldy to use, and probably no more accurate than annual cash flow estimates because we simply cannot forecast well enough to warrant this degree of detail. Therefore, in most cases, we simply assume that all cash flows occur at the end of every year. However, for some projects, it may be useful to assume that cash flows occur at mid-year, or even quarterly or monthly.