Investment Decision and Cash Flows

20 Pages Posted: 12 Jun 2009

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

John Pringle

University of Virginia - Darden School of Business

Abstract

A positive net present value (NPV) is a direct estimate of value creation for shareholders and is an operational way of carrying through on the strategy of trying to maximize shareholder wealth. To calculate NPV, however we need to estimate the cash costs and benefits of any decision at hand. In this note we discuss the evaluation of investment proposals.

Excerpt

UVA-F-0915

INVESTMENT DECISION AND CASH FLOWS

A positive net present value (NPV) is a direct estimate of value creation for shareholders and is an operational way of carrying through on the strategy of trying to maximize shareholder wealth. To calculate NPV, however we need to estimate the cash costs and benefits of any decision at hand. In this note we discuss the evaluation of investment proposals.

Cash Flows: Basic Concepts

The cash flows that we will use in our analysis are incremental after-tax cash flows. The incremental-cash-flow rule is that the cash flows relevant in analyzing an investment opportunity are those after-tax cash flows and only those after-tax cash flows directly attributable to the investment.

The words incremental, after-tax and cash are critical. The term cash calls attention to the fact that we are interested in cash flow and not accounting profits. Ultimately, financial transactions must be carried out with cash, not profits, so we look to cash as the source of value. As we will see, we are interested in all cash flows affected by a decision under evaluation, no matter how those cash flows are classified for accounting purposes. The term after-tax emphasizes that we are able to keep the cash only after payment of taxes.

. . .

Keywords: valuation

Suggested Citation

Harris, Robert S. and Pringle, John, Investment Decision and Cash Flows. Darden Case No. UVA-F-0915, Available at SSRN: https://ssrn.com/abstract=1417856

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

John Pringle

University of Virginia - Darden School of Business

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

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