You are here:

Economics/cash flows for npv calculation

Advertisement


Question
I've read several answers posted regarding removing the financing from the cash flows for npv calculations.  I know you recommend excluding interest payments from cash flow, but do you also recommend removing any tax benefits from those interest payments in the net income after taxes?

right now i'm using cash flow for a given year by taking net income after taxes and adding back depreciation and interest expense.  

The purpose of this is to create an example for students on how to use NPV function properly.. after having created a cash flow worksheet.  

thanks.

Answer
Hi, Debby--

Sorry to be slow in responding. I'm up to my eyeballs on a deadline for a client. That's not an excuse, of course. . .but I hope it qualifies as a reason for my tardiness. Let me offer some comments about why both interest expense and the 'tax benefit' associated with it is excluded from the NPV or the IRR calculations.

1.  The irony here, Debby, is that your number--which adds back interest expense from Net Income--will get you to EXACTLY the same number as tax-effecting EBIT (earnings before interest and taxes). Do the math, and you'll see exactly what I'm talking about. We're really on the same page from a computational standpoint, but I believe that your approach has a sky-high probability of really confusing students by forcing them through convoluted extra steps that obscure the objective of capital budgeting.

2. That objective is to identify which projects are economic and which are not. By 'economic', I mean projects that generate a positive NPV (although I'll have more to say about one of NPV's major weaknesses momentarily) and/or an IRR in excess of the firm's weighted-average cost of capital (WACC). The WACC measures free cash flow to the firm (FCFF); it is a return on assets. If interest expense and the tax deduction it provides is included in the mix, then (a) FCFF become FCFE (free cash flow to equity), (b) the WACC must change to the discount rate for equity (which is higher than the WACC, so fewer projects will get done), and (c) the cash flow forecast must also include debt service. What matters is economics, not accounting. The use of the WACC implicitly assumes a mix of debt and equity financing. By including interest expenses and the so-called 'tax benefit' that comes with it, you are double-counting.

3. The primary weakness of NPV is that it is static. It allows for no mid-course decisions. For instance, some complex capital projects take years to implement. Others offer companies the choice to opt-out of the project. After all, stuff happens that directly impacts the economics of a given project. NPV is static: it offers no way to account for any post-decision changes. In the last twenty years or so, an approach to capital budgeting called 'real options' has emerged. It is sufficiently complex--and I'm still time-constrained here--that I'm not going to try to explain it here. There are plenty of books available on the subject; look for ones by Trigeoris, Mun, Dixit & Nalebuff, Amram & Kulatilaka, and Boer, among others. In no particular order, here are some links that will help you learn more about real options:

Using Real Options in Decision-Making

YouTube Video: Real Options and You

Widipedia: Real Options Valuation

YouTube Video: Real Options and You

Real Options - Basic Concepts (MIT PPT from Prof. Robert Pindyck)

The Promise and Peril of Real Options

I hope that these links are helpful and that I've explained why you and I are on the same page. . .but I think that your computation makes things unnecessarily complicated. Please do me the favor of completing the 'Rate-the-Expert' email you'll receive on the heels of my reply here. Your ratings and, especially, your comments help me do a better job of helping folks like you who ask such interesting questions.

You should also feel free to e-mail me directly--cfa2005@gmail.com--if you'd like to discuss these issues further.

Take care, and thanks for this opportunity to elaborate in what I hope is a clearer and more convincing way on what I've said before. And I hasten to add that what I've said here is said in any authoritative text on corporate finance and/or in any course on capital budgeting.

Warren

Economics

All Answers


Answers by Expert:


Ask Experts

Volunteer


Warren D. Miller, CFA, CPA, ASA

Expertise

My expertise in economics is limited to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Questions dealing with macroeconomics and other sub-disciplines of the subject should be submitted to those who have the appropriate expertise. N.B.: I DO NOT ANSWER QUESTIONS MARKED 'PRIVATE' because I believe that knowledge should not be hoarded. I also believe that such questions are likely to come those trying to cheat. Also, as one who was a full-time academic for half a decade, I can recognize test/homework questions several time zones away. Do not demean yourself by submitting such questions to me. Those who do so are cheating; I WILL call you out publicly. I have a zero-tolerance policy for cheating and dishonesty. In addition, please don't emulate the businessman who posted a request for help in August 2008. He expressly denied that he was seeking "investment advice" and said that his query was for, and I quote, "educational and informational purposes." Later, he allowed as how his questions related to the possible purchase of a $500K piece of equipment. I said I thought he had misrepresented himself. Bottom line: high-end business consulting is how I make my living. I am the sole support for my family. Please respect that fact and don't try to get for free what our clients pay for. If your company is big enough to have a sophisticated problem, it can afford to pay for the expert advice we and others provide. Beckmill Research, LLC, is a 95-octane firm. We're small, but we've been at this for nearly 20 years. We know what we're doing. Segue: Early on, some asked me for career advice; I gave it. I now get many such requests. The demand for a valuable good that is free is unlimited, so I now charge for that advice. Email me: cfa2005@gmail.com. Finally, PLEASE DO NOT ASK FOR INVESTMENT ADVICE. I am not licensed to provide such advice. If you want such counsel, talk to your financial planner or other financial adviser.

Experience

I work with Austrian economics (which differs in major respects from the traditional economics), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) every day in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and solutions to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.

Organizations
CFA Institute, Strategic Management Society, American Society of Appraisers, Academy of Management, Culver Legion, National Association of Scholars.

Publications
CFA Magazine, Strategic Finance, Valuation Strategies, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, Business Valuation Review, among others

Education/Credentials
Chartered Financial Analyst designation (2006); Accredited Senior Appraiser in Business Valuation (2006); Certified Public Accountant (1992); MBA - Oklahoma State University (1991); Completed all of my Ph.D. coursework in strategic management - Oklahoma State University (1983-87); BBA in finance and accounting - U. of Oklahoma (1975)

Awards and Honors
Business Valuation Volunteer of the Year (2001) - American Institute of CPAs; Winner - Oklahoma Humorous-Speaking Contest - Toastmasters International (1971)

Past/Present Clients
Names are confidential. However, the "sweet spot" of our target market is companies that are too big to be small and too small to be big. Usually, those are companies with employees in the 15-to-100 range. At the low end of that range is where companies can first take advantage of the specialization of labor. However, having everyone do everything is a tough habit for many--most, I would argue--small enterprises. That is why they not only remain small, but also fail to survive beyond a second generation. Only 5% (one in twenty) companies make it to the third generation of ownership.

©2016 About.com. All rights reserved.