Financial Economics

WEB-APPENDIX G^*

ESTIMATING CASH FLOWS OF CAPITAL BUDGETING PROJECTS

In Chapter 6 we discussed capital budgeting decisions. As we explained, the firm's managers should invest only to increase the value of the owners’ interests. When a firm invests in new assets, it expects the future cash flows to be greater than without this new investment. The difference between the cash flows of the company with the investment project, compared over the same period of time to the cash flows of the company without the investment project is referred to as the project's incremental cash flows.

The change in the value of the company resulting from an investment can be broken down two components:

1. The cash flows from the project's operating activities (revenues and operating expenses), referred to as the project's operating cash flows (OCF).
2. The investment cash flows; that is, the expenditures needed to acquire the project's assets and any cash flows from disposing the project's assets.

The effect on the value of the company can then be evaluated using the techniques described in Chapter 6 (in the certainty case) and Chapters 25 and 26 in the more realistic case where management is exposed to risk.

G.1 OPERATING CASH FLOWS

In the simplest form of investment, there will be a cash outflow when the asset is acquired and there may be either a cash inflow or an outflow at the end of its economic life. In most cases there are also changes in operating cash flows to take into account—the investment will ...