Chapter 66. Estimating Cash Flows of Capital Budgeting Projects

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance and Department Head of Finance and Business Law, James Madison University

Abstract: A company invests in capital projects in order to increase stockholder value by investing in projects that generate cash flows in the future whose present value exceeds the present value of the cash flows needed to make the investment. When it invests in new capital projects, it expects the future cash flows to be greater than without this new investment. Hence, in estimating a project's cash flows, the focus is on incremental cash flows. These cash flows must take into account investment costs (that is, acquisition costs adjusted for the cost of asset disposition) and operating cash flows (that is, changes in revenues, expenses, taxes, and working capital).

Keywords: incremental cash flows, investment cash flows, asset acquisition, asset disposal, sunk cost, tax basis, capital gain, recapture of depreciation, capital loss, tax shield, operating cash flows, tax credit

The value of a particular asset is not always easy to determine. However, financial managers continually face decisions about which assets to invest in. The objective is to make investment decisions that are consistent with the strategic plan of the company and its objectives, evaluating investment opportunities and selecting ...

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