18 Changes in Net Working Capital NWC NWC current assets current liabilities A

18 Changes in Net Working Capital (NWC) ° NWC = current assets – current liabilities ° A new project typically requires an investment in NWC ± Extra cash (e.g. to provide change to customers) ± Inventories (e.g. spare parts) ° These investments are often recovered at the end of the project ° Decision: ± include initial NWC investment, changes in NWC, recovery of NWC ± investment in NWC and its recovery do not affect taxes ° Example: You provide $200 in NWC at the beginning of a project and recover $200 at the end of the project.

10 19 Depreciation ° Straight-line ± D = (asset price + installation – salvage value) / useful life ° MACRS (Modified Accelerated Cost Recovery System) ± D = (% value in the table) * (asset price + installation) ± MACRS depreciates all assets to the book value of zero ° Depreciation is a non-cash expense but it affects cash flows by reducing taxes ± Tax Shield = (depreciation expense)*(tax rate) 20 Capital Investment (CapEx) ° An asset purchase reflects capital expenditures (CapEx) and represents a cash outflow ° An asset sale has the following effects: ± 1. Record the sale price as an inflow (i.e. as negative CapEx) ± 2. Record the tax effect from the sale: ± Tax effect = tax rate * (sale price – book value) ± If the asset is sold at a gain ´ subtract taxes on gain ± If the asset is sold at a loss ´ add tax savings from loss

11 Revenues – costs – depreciation = Taxable income from operations – taxes = Net operating income + depreciation – capital expenditures – taxes from gain on asset sale (or + tax savings from loss) – increases in working capital (or + decreases in working capital ) + after-tax synergy effects (or – after-tax cannibalization effects ), if any – opportunity costs today, + opportunity costs after project ends = Free Cash Flow 21 Free Cash Flow for a Project - Recipe 22 Example 1: Comprehensive Cash Flow Problem ° We are evaluating an investment project in the production of shampoo at a consumer products factory that we currently manage. The project requires purchasing new equipment for $3,400,000 and preparing it for operation, which costs another $60,000. The equipment will be depreciated based on the 5-year MACRS schedule and is expected to be sold for $200,000 at the end of project’s life (end of year 6). In addition to the fixed assets, the project requires an immediate investment in working capital in the amount of $200,000, which will be recovered at the end of year 6. ° Our company regularly incurs annual overhead expenses of $1 million for legal counsel and administration. These expenses are allocated to products based on products’ share in total sales, and this share for the new shampoo is 10%.