Topic 1 - M. Fouzul Kabir Khan,Ph.D.

Dr. M. Fouzul Kabir Khan
Professor of Economics and Finance
North South University
Requirements and Grading
2 Midterm examination (30%)
Paper (30%)
Final examination (40%)
Class Materials
◦ “Cost-Benefit Analysis: Concepts and Practice,” 2nd Edition, by Anthony E. Boardman,
David H. Greenberg, Aidan R. Vining and David L. Weimer, Prentice Hall, 2001[BGV]
◦ “Capital Budgeting: Financial Appraisal of Investment Projects,” by Don Dayananda,
Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland, Cambridge
University Press, 2008 [DIH].
◦ Guidelines for the Economic Analysis of Projects, Asian Development Bank, 1997 [ADB]
◦ সরকারী খাতে উন্নয়ন প্রকল্প প্রনয়ন, প্রক্রিয়াকরন, অনুত াদন ও সংত াধন পদ্ধক্রে, গণপ্রজােন্ত্রী বাংলাতদ
◦ Web-page:
Office: NAC 751
Office hours: Saturday, 2pm – 3pm, 6-7pm ; Wednesday, 5pm-6:30 pm
26th Jan
2nd February
9th February
16th February
23rd February
2nd March
9th March
16th March
23rd March
30th March
6th April
13th April
Paper Presentation
18th April -28th April
Mid 1
Mid 2
There will be only one make-up for all
examinations (mid-terms, final etc.) towards the
end of the course to accommodate force majeure.
All examination dates are pre-announced. Please
make necessary arrangements with your office.
Historically, the performance of students taking
make-up examinations were always poorer
compared to students taking examinations on
I hope you will appreciate that it is not practical to
offer a customized course for any or group of
individual student(s).
Nature of project appraisal
Overview of cost benefit analysis and capital
Aspects of capital budgeting
Shareholder wealth maximization and NPV
The capital budgeting process
Essentials in cash flow identification
Calculating project cash flows
Investment decisions are important both for
private and public entities.
Goals are different.
Capital budgeting
 Concerned with sizeable investment in long-term
assets by firms
 Various investment criteria
 Choice between projects with different life span,
 Tax and depreciation issues.
Cost benefit analysis
◦ Measurement of economic benefits and cost
◦ Shadow prices
 To correct for distortions in the market prices or put a
price on non-marketed goods
◦ Social discount rate
Financial appraisal
Economic appraisal
Environmental appraisal
of project appraisal
Given the limitation of resources, choices must be made among
the competing uses, and project appraisal is one method of
evaluating alternatives in a convenient and comprehensive
•Project appraisal assesses the benefits and cost of a project and
reduces them to a common yardstick. If benefits exceed costs,
the project is acceptable; if not the project should be rejected
• Society’s objective
–Growth: to increase total national income
–Equity: to improve the distribution of national income
• Projects should be assessed in relation to their net contribution
to both of these objectives
Project and program sometimes used interchangeably
Project: Bridge project, Pharmaceuticals industry
Program: Literacy program
Analysis by whom?
 Investor
 Lender
Government agency
 Public-private partnership
Donor agency
Tools for analysis will vary
Private investor-capital budgeting
Government/donor agency- cost benefit analysis
Cost-benefit analysis
Cost benefit analysis is a program/project
assessment method that quantifies in monetary
terms the value, net social benefits, of all
program /project consequences for all members of
the society
Capital budgeting
Is the process of evaluating and selecting long-term
investments consistent with the firm’s goal of
shareholders wealth maximization
Specify the set of alternative projects
Decide whose benefits and costs counts (standing)
Catalogue the impacts and select measurement
indicators (units)
Predict the impacts quantitatively over the life of the
Monetize (attach dollar/taka values to) all impacts
Discount benefits and costs to obtain present values
Compute the NPV of each alternative
Perform sensitivity analysis
Make a recommendation based on the NPV and
sensitivity analysis
Capital budgeting is primarily concerned with sizeable
investments in
long-term assets.
Tangible: Property, Plant or equipment
Intangible: R&D, Patents or trademarks
Different from recurring expenditure in two aspects:
Projects are significantly large
Long-lived projects with their benefits or cash flows
spreading over many years.
Capital budgeting is one of the most
significant financial activity of the firm.
Capital budgeting determines the core
activities of the firm over a long term future.
Capital budgeting decisions must be made
carefully and rationally.
The Position of Capital Budgeting
Financial Goal of the Firm :
W ealth Maximisation
Investm ent Decison
Long Term Assets
Capital Budgeting
Short Term Assets
Financing Decision
Dividend Decision
Debt/Equity Mix
Dividend Payout Ratio
Capital budgeting involves:
 Committing significant resources.
 Planning for the long term: 5 to 50 years.
 Decision making by senior management.
 Forecasting long term cash flows.
 Estimating long term discount rates.
 Analyzing risk.
 Emphasizes the firm’s goal of wealth
maximization, which is expressed as maximizing
an investment’s Net Present Value
 Requires calculation of a project’s relevant cash
Capital budgeting uses
• Sophisticated forecasting techniques:• Time series analysis by the application of simple and multiple
regression, and moving averages
• Qualitative forecasting by the application of various techniques,
such as the Delphi method
Capital budgeting requires:
Application of time value of money formulae.
Application of NPV analysis to forecasted cash flows.
Risk analysis – Risk Adjusted Discount Rate(RADR) and certainty
Application of sensitivity and break even analyses to analyze risk.
Application of:
• simulation and Monte Carlo Analysis as extra risk analysis.
• long term forecasting and risk analysis to projects with very long lives.
• optimization techniques to projects which have constrained resources.
• application of generic and specific financial models
• cash flow forecasting, and NPV analysis to all aspects of property
investment projects.
• NPV analysis under the additional risks associated with international
The goal of allocative, or Pareto efficiency provides the conceptual
basis for economic analysis/appraisal of projects
Recall that, allocation of goods is Pareto efficient if no alternative
allocation can make at least one person better off without making
anyone else worse off
Net benefits and Pareto efficiency:
If a policy or a project has positive net benefits, then it is possible to
find a set of transfers, or side payments, that makes at least one
person better off without making anyone else worse off
As long as analysts value all benefits in terms of willingness to
pay and all costs in terms of opportunity costs, then the positive
net benefits indicate the potential for compensation to make
the policy Pareto efficient
The Kaldor criterion
A Kaldor improvement is a change from a given output mix
distributed in a given way to another output-mix which would
enable the gainers to compensate the losers while continuing to
gain themselves. Since compensation need only be hypothetical,
a Kaldor improvement offers only a potential Pareto
of the Kaldor criterion
Scitovsky criterion
Actual compensation is not necessary!
The economic analysis of projects is similar to financial
◦ Both appraise the profit of an investment
◦ Financial analysis is about profit for project entity
◦ Economic analysis is for the national government or the
The economic analysis looks at any investment decision from
the perspective of improving welfare of its citizens
For a project to be economically viable, it must be financially
sustainable, because if project is not financially sustainable,
economic benefits will not be realized.
Financial analysis and economic analysis are therefore two
sides of the same coin and complementary
 Economic
analysis needs to be
undertaken prior to financing of
projects, but should also be carried out
for all stages of project cycle◦
Design and financing, ex-ante
Implementation- in medias res
Comparison of ex-ante and ex-post, or
ex-ante and in medias res
Over people, is Tk 1000 cost to a wealthy person to be
considered equally Tk. 1000 cost to a poor person? How to
compare benefits to criminals and children? How do we
compare benefits to people alive and the unborn
Over goods, costs (concrete for a dam) in one form with
benefits in another (electricity)?
◦ It is easier when there are markets for the goods, harder when
there aren’t
Over time, How to compare costs now with benefits in the
future? Discount rate
Aggregation over the sates of the world: How to deal with
uncertainty and risk?
Who has standing in relation to the project?
◦ Whose benefits and costs should be counted?
Geographical jurisdiction, foreigners
Legal, security system for Baridhara
Future generation
Flora and fauna, mosquito eradication
 Only willingness-to-pay of humans count
◦ A person who does not have standing will not have their costs
and benefit recognized in the analysis
A transfer from a person with standing to another
person with standing is neither a cost nor a benefit
◦ Taxes, except in case of negative externality
The shareholder wealth maximization goal requires that
management should endeavor to maximize net present value
(NPV) of expected future cash flows to the shareholders of the
NPV represents discounted sum of the expected net cash
• Cash outflows: capital outlays
• Cash inflows: proceeds from sales
Net cash flows are determined by subtracting a given
period’s cash outflows from that period’s cash inflows.
The discount rate takes into account the timing and risk
of the future cash flows resulting from the investment.
• The longer it takes to receive a cash flow, the lower the
present value to the investor.
• The greater the risk associated with receiving a future cash
flow, the lower the value investors place on that cash flow.
Shareholder wealth depends on magnitude, timing and
risk associated with the cash flows expected to be
received in future by the shareholders
Project Alpha requires an initial capital outlay
of Tk. 45,000 and will have net cash inflows
of Tk. 15,000, Tk. 20,000 and Tk. 30,000 at
the end of years 1,2, and 3 respectively. The
discount rate is 8% per annum.
How much project Alpha will add to the firm’s
An independent project is one the acceptance or
rejection of which does not directly eliminate other
projects from consideration or affect likelihood of their
Mutually exclusive projects- cannot be pursued
simultaneously-the acceptance of one prevents the
acceptance of the alternative proposal
A contingent project is one the acceptance or rejection
of which is dependent on the decision to accept or
reject one or more other projects
◦ Complementary projects, pharmacy and doctor’s clinic
◦ Substitute projects, Thai or Fast-food restaurant
Project rationale
◦ What is the rationale for public sector
◦ What is the rationale of the project: what market
or government failure does it address?
◦ What is the main alternative to the project?
Macroeconomic and sectoral context
◦ How does the project relate to the overall
development strategy?
◦ What is the policy environment for the project:
taxes and subsidies, trade controls, exchange rate
and interest rate policy?
◦ How does the project relate to sectoral strategy?
◦ What is the sectoral policy context in terms of
market structure and regulation?
◦ Is the project a priority public investment?
Project alternatives
◦ Have project alternatives been considered in terms of
location, scale, timing?
◦ How has the best alternative been chosen?
◦ Has the least cost alternative been identified for the
project or major subprojects?
◦ Real options
 Options to defer
 Option to scale up and down
 Option to abandon
◦ Is it possible to import services?
Demand analysis
◦ What is the basis for projecting the demand for
project output?
◦ How will demand be affected by income growth?
◦ What other sources of supply are there for
meeting the demand?
◦ How will demand be affected by an increase in
price or user charge?
Identification of costs and benefits
◦ Have the without and with project situations both
been described?
◦ Have all project costs, comparing the with and
without project situations, been identified?
◦ Have all project benefits, comparing the with and
without project situations, been identified?
Use of shadow prices
◦ Which numeraire has been used in the application of
shadow prices? Has it been used consistently?
◦ Have project outputs been identified as nonincremental*?
◦ Have benefits and especially costs been broken down into
traded and non-traded items?
◦ What value of the SERF/SCF has been used: has it been
correctly applied?
◦ Have more specific conversion factors been used for some
items: how were they derived?
◦ What discount rate has been used: to choose between
alternatives, and to assess economic viability?
A project would supply additional 50MW of
Graphically show incremental and nonincremental output of the project.
Incremental output is
additional output
produced by a project
over and above what
would be available and
demanded in the without
project situation.
Incremental inputs are
inputs that are supplied
from an increase in
production of the input
over and above what
would be produced and
supplied in the without
project situation
Source: Guidelines for the Economic Analysis of Projects, ADB
Financial and fiscal sustainability
◦ Has the FIRR for the project been calculated?
◦ Have the financial returns to different project participants
been calculated?
◦ What is the level of charges for goods and services? Is the
economic analysis related to the charge level?
◦ What is the difference between the FIRR and EIRR, and
what accounts for the difference?
◦ Have the average incremental financial and economic
costs been calculated?
Financial and fiscal sustainability (continued)
◦ What is the level of cost recovery?
◦ Is there any explicit or implicit subsidy to the
project? What is the justification for the subsidy?
◦ Has the fiscal impact on the capital and recurrent
budget been calculated?
◦ What will be the source of funds to meet net fiscal
requirements: extra taxation, extra borrowing, or
a reallocation of expenditure?
Environmental sustainability
◦ Have the environmental effects of the project been
identified: costs and benefits?
◦ How have they been quantified and valued?
◦ Are they expressed in the same numeraire as the basic
economic analysis?
◦ Have they been integrated into the economic analysis: for
choosing between project alternatives; for assessing
economic viability?
◦ Have required mitigatory and monitoring expenditures
been identified and included in economic costs?
Benefit monitoring and evaluation
◦ What are the key variables necessary to identify
project impact during implementation &
◦ Does this include key performance variables,
physical or financial, for the implementing agency?
◦ Is a system in place to collect data on all the key
Distribution analysis
◦ Has a distribution analysis been undertaken for
the project?
◦ Has the effect of different levels of charges for
goods and services been assessed for operators,
customers and government?
◦ Has the distribution of costs, especially on the
poor, been identified?
◦ Has the distribution of benefits, especially to the
poor, been identified?
Distribution analysis (continued)
◦ What proportion of net benefits will go to poor
◦ Is the distribution of costs and benefits analyzed
by gender?
◦ Is there a substantial foreign involvement in
investment and operation?
◦ Has the proportion of incomes and revenues going
to foreign investors, lenders and workers been
Have the major conclusions of the economic
analysis been clearly spelt out?
Does the project incorporate the best
Is the project economically viable?
Are any policy changes necessary to
complement project implementation?
Are any capacity building measures necessary:
to provide incentives or training to the executing
agency and other participants?
What type of sensitivity analysis has been
Does it relate to underlying benefit and cost
Have the key variables been identified?
Have switching values been calculated?
What measures are proposed to monitor the
key variables?
Is there a quantitative risk analysis?
Have probabilities been attached to any of
the key sensitivity variables?
Have institutional risks been assessed?
Are there sufficient incentives for
government participants in the project?
What measures have been proposed for
reducing project risks?
Identification and measurement of consumers
Assume a linear demand curve and a price
without the project Pwo and a lower price with
Pw with the project.
Identify and measure consumers surplus from
incremental and non-incremental output
Graphically show gross benefits of the project
Figure 1. Estimating Gross Benefits
Gross Revenue = (b + c)
Consumer Surplus = (a + d)
Gross Benefits = (a + b + c + d)
Defining project objectives and economic rationale;
Forecasting effective demand for project outputs;
Choosing the least-cost design for meeting demand or
the most cost-effective way of attaining the project
Determining whether economic benefits exceed
economic costs;
Assessing whether the project's net benefits will be
sustainable throughout the life of the project;
Testing for risks associated with the project;
Identifying the distributional effects of the project
on each participating country;
Enumerating the non-quantifiable effects of the
project that may influence project design and the
investment decision.
Bureaucratic and political lenses
◦ Guardians, revenue-expenditure analysis, ignores nonfinancial social benefits
◦ Spenders, favor large, irreversible, capital intensive projects,
treats expenditure as benefits, use low discount rates
◦ Disingenuous or strategic errors resulting from self interest,
overestimation of benefits and underestimate costs
Omission errors
Forecasting errors
Measurement errors,
Valuation errors, shadow prices
Cash flows, and not accounting estimates, are
used in project analysis because:
◦ They measure actual economic wealth.
◦ They occur at identifiable time points.
◦ They have identifiable directional flow: inflow and
◦ They are free of accounting definitional problems.
A relevant cash flow is one which will change
as a direct result of the decision about a
A relevant cash flow is one which will occur in
the future. A cash flow incurred in the past is
irrelevant. It is sunk.
A relevant cash flow is the difference in the
firm’s cash flows with the project, and
without the project.
Project cash flows may be separated into two categories:
 Capital cash flows
 The initial investment
 Outflows, purchasing assets and initial working
 Additional middle-way investments such as upgrades and
increases in working capital investments
 Terminal cash flows
 Inflows, proceeds from sale, salvage value of the
asset net of tax, recovery of remaining working
 Outflows, cost of asset disposal, environmental
rehabilitation, redundancy payment to employees
Operating cash flows: cash inflows from sales, cash
outflows for marketing and advertising, payments for
wages, utilities, raw materials
Principle of the stand-alone project
◦ Evaluation of the proposed project purely on its
own merits, in isolation from any other activities
or the projects of the firm
Indirect of synergistic effects
◦ Negative effects, new model of car, lower sales of
existing model, must be deducted from future
cash flows
◦ Positive effects, pharmacy adjacent to doctor’s
clinic, favorable impact on clinics cash flows to be
added to pharmacy project’s cash flows
Opportunity cost principle: the most valuable
alternative that is given up if the proposed
investment project is undertaken
– Use of existing resources, space, building,
rental value, market value
Sunk cost, is an amount spent in the past in
relation to the project, but which cannot now
be recovered or offset by the current decision
– Past consulting expenses
Overhead costs
– Utilities, executive salaries
– With or without the project, incremental costs
to be included
Treatment of working capital
◦ Current assets (inventories, accounts
receivables) minus current liabilities
(accounts, wages payable)
◦ Increases in working capital is treated as cash
outflows even though there is no actual cash
outflow, opportunity cost
◦ Capital flows, not operational flows, it is a
After-tax cash flows
◦ Must be accounted for as a cash outflow, not
based on net cash flow but on taxable income
Treatment of depreciation
◦ Is not a cash flow
◦ In project appraisal, what is relevant is not
the accounting depreciation but tax allowable
depreciation to measure the tax effect
Investment allowance, enhances NPV
Financing flows, excluded. double counting,
included in the discount rate
Within-year timing of cash flows
◦ Occurs at various points of time in a year
◦ Standard practice is to assume that capital
expenditure occur at the beginning of the year and all
other cash flows occur at the end of the year
◦ Points in cash flow timing is are set at the end of each
year. An initial outlay of Tk. 50,000 at the start of year
1will be timed as occurring at the end of year zero.
Inflation and consistent treatment of cash flows and
discount rates
◦ Nominal returns, incorporating the inflationary effect
is preferred over cash flow forecasts in real terms,
excluding the inflationary effects
◦ Fisher effect
◦ Consistency, cash flow in nominal terms- use nominal
discount rate; cash flow in real terms- use real
discount rate
YES:- these are relevant cash flows: Incremental
future sales revenue.
 Incremental initial outlay.
 Incremental future salvage value.
 Incremental working capital outlay.
 Incremental future taxes.
NO:- these are not relevant cash flows:
 Changed future depreciation.
 Reallocated overhead costs.
 Adjusted future accounting profit.
 The cost of unused idle capacity.
 Outlays incurred in the past.
Depreciation is NOT a cash flow.
Depreciation is simply the accounting
amortization of an initial capital cost.
Depreciation amounts are only accounting
journal entries.
Depreciation is measured in project analysis
only because it reduces taxes.
Tax payable: if the project changes tax
liabilities, those changed taxes are a flow of
the project.
Investment allowance: if a taxing authority
offers this ‘extra depreciation’ concession,
then its tax savings are included.
Financing flows: interest paid on debt, and
dividends paid on equity, are NOT cash flows
of the project.
In property investment, ‘property’ cash flows
may be distinguished from ‘equity’ cash
In project analysis, cash inflows are timed as
at the end of a year, and capital outlays are
timed as at the start of a year.
Forecast inflated cash flows must be
discounted at the nominal discount rate, not
the real discount rate.
 All
relevant project cash flows are set out in a
 The cash flow table usually reads across in End of
Years, starting at EOY 0 (now) and ending at the
project’s last year.
 The cash flow table usually reads down in cash
flow elements, resulting in a Net Annual Cash Flow.
This flow will have a positive or negative sign.
Project start date 2001
Capital outlay in year 1 is $ 1 million; year 3 is $0.5
Economic life 8 years
Working capital Y0-2000; Y1-2500; Y2-3100; Y33600; Y4-4000; Y5-4300;Y6-4500; Y7-3000, Y8-0.
Salvage value in Y8: $16,000
Depreciation on initial investment is 12.5% p.a.
upgrade depreciates @$100,000 for years 4-8.
Sales forecasts
After tax salvage value
Accounting income
Workbook 2.1
Initial investment
– Initial investment in plants and working capital
Net operating cash flows
– Add back depreciation
– Exclude depreciation from costs
– Add tax shield of depreciation (tax rate x
Terminal cash flows
– Proceeds from sale of assets minus taxes on sale of
an assets plus recovery of working capital
Initial investment
– Initial investment in plants and working capital
minus proceeds from sale of old asset plus taxes on
sale of old assets
Incremental operating cash flows
Terminal cash flow
– Operating cash flow of new assets minus operating
cash flow of old assets
– Proceeds from sale of new asset- proceeds from
sale of old asset - taxes on sale of old assetstaxes on sale of an assets-taxes on sale of old
assets plus recovery of working capital
future, incremental, cash flows are
Relevant Cash Flows are entered into a yearly
cash flow table.
Net Annual Cash Flows are discounted to give
the project’s Net Present Value.
We only need to estimate cash flows that
change as a result of accepting the project
(incremental cash flows).
The amount of, and the timing of the cash
flow must be estimated, not the
accounting profit/loss by ordinary
accounting methods.
There are generally three kinds of cash flows
that can be affected by a capital budgeting
1) Initial period cash flow
2) Operating cash flow
3) Terminal year cash flow
Since taxes are cash flows, we must include
taxes in our cash flow estimates. All
estimated cash flows should be after-tax
cash flow estimates!
These are simply any cash flows that occur in the
initial period of the project’s life (period 0).
For example, assume that a new investment project
would require spending $20 million for new capital
machines, plus $3 million for additions to working
capital (increases in cash balances, inventory, and
accounts receivable).
The initial period cash flow = -$20 + -$3
= -$23 million.
Accounting income for a period could be a
measure of cash flow, except that
depreciation (an expense, but not a cash
flow) was subtracted in calculating it.
Operating cash flow equals
Net Income + Depreciation
Operating cash flow will be affected
whenever a revenue or expense is changed
on the income statement.
For example, operating cash flow is
increased/decreased if a project results in
increased/decreased sales revenues.
Operating cash flow is decreased/increased
if a project results in increased/decreased
expense of some kind.
Assume the business currently has sales of $95
million and cash operating expenses of $65
million, plus $15 million of depreciation
Assume the tax rate = 30%.
Net income = ($95 - $65 - $15) x (1 - .3)
= $10.5 million.
Operating cash flow = Net income + depreciation
= $10.5 + $15 = $25.5 million per year.
Assume that accepting the new investment project
would increase the business sales by $10 million,
and increase the operating costs by $4 million,
plus increase depreciation expense by $2 million.
What is the incremental operating cash flow for the
Operating cash flow with the new project = ($105 $69 - $17) x (1-.3) + $17 = $30.3 million.
The incremental operating cash flow for the
project equals the change in cash flows from
before accepting the project to after accepting it =
$30.3 - $25.5 = $4.8 million per year. (Assume
these benefits continue the same each year for 10
It is usually easiest to compute this incremental cash flow
by just using the incremental numbers themselves.
The relevant incremental operating cash flow for the
example project =
+ Inc. in sales revenue ……… $10 million
- Inc. in op. costs (expenses) ….. 4 million
- Inc. in depreciation expense … 2 million
= Inc. in EBT …………………. 4 million
- Inc. in taxes (@ 30%) …..…... 1.2 million
= Inc. in EAT …………….…..
2.8 million
+ Inc. in depreciation expense … 2 million
= Inc. in operating cash flow ….. $ 4.8 million
Notice that this method of calculating the
incremental operating cash flow requires you to
simply identify every item in the company’s income
statement that changes, and then to calculate the
change in net income that results. Finally, the
operating cash flow equals the change in net
income plus the change in depreciation.
These cash flows consist of any residual
values (salvage values) recovered from the
project at the end of its useful life.
For our example, assume that at the end of
project’s life, the machines could be
sold to net $100,000 after taxes, and that
the working capital ($3 million) is recovered
in full.
Thus, the terminal year cash flow (year 10)
for the project = $3.1 million.
The complete cash flows for the example
project are:
Periods: 0
- $23
+ $ 4.8
+ $ 3.1
Assume that the cost of capital for the
project equals 10%, the NPV is calculated to
be $7.69 million.
Since the NPV > 0 we know the project is a good one
 We could alternatively have made the decision
using the IRR method. IRR of the project can be
calculated to be 17%. Since this is > the 10% cost
of capital, the project should be accepted.
We could also have (alternatively) made the
decision using the PI method. PI = 1.33, which is
> 1.00.
Assume the Widget Company is considering an
investment to replace a production machine with a
more efficient one.
Assume the new machine costs $100,000, and the
old machine has a book value of $15,000 and a
current salvage value of $25,000.
Assume the tax rate is 30%.
What are the relevant cash flows for the project
analysis, and should the replacement be accepted?
The total initial period (period 0) incremental
cash flows for the replacement project are:
 -$100,000 + $25,000 - $3,000 = -$78,000.
Next, we calculate the operating cash flows:
 Assume the new machine would reduce operating
costs by $35,000 per year for the next 8 years,
compared to using the old machine. Depreciation
expense would also increase by $12,500 per year
for 8 years.
 Net income will increase by ($35,000 - 12,500) x
(1-.3) = $15,750.
 Op. CF = Net Income + Depreciation = $15,750 +
$12,500 = $28,250 per year, for 8 years.
 Note that this is an annuity of benefits.
Assume that both the old machine and the new one
would be fully depreciated after 8 years.
 With the new machine, sale in year 8 for $5,000
=> taxable gain on the sale equal to the
salvage value minus the book value = ($5,000 – 0)
= $5,000. Tax on this gain = $5,000 x .3 =
 With the old machine, sale in year 8 for $500 =>
taxable gain on the sale equal to the salvage
value minus the book value = ($500 – 0) =
$500.Tax on this gain = $500 x .3 = $150.
Altogether, then, the total terminal year cash
flow equals
 = incremental salvage value of $4,500 incremental taxes of $1,350
 = $4,500 - $1,350 = $3,150.
 This cash flow in year 8 is in addition to the
regular $28,250 operating cash flow
that year (already computed).
While in general, any cash flow affected by a
project is relevant, we do not include any
cash flows that are financing costs.
For example, we do not include interest
expense or lease payments.
The reason for this is that all financial cash
flows are implicitly included in the cost of
capital used to find NPV (or used to compare
to IRR). To include the financial cash flows
and then discount them to PV would be to
double count their impact.

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