The Argument for Incremental Cash Flows

When analyzing investments it is easy to get tunnel vision and focus on the project or investment at hand, and to act as if the objective of the exercise is to maximize the value of the individual investment. There is also the tendency, with perfect hindsight, to require projects to cover all costs that they have generated for the firm, even if such costs will not be recovered by rejecting the project. The objective in investment analysis is to maximize the value of the business or firm taking the investment. Consequently, it is the cash flows that an investment will add on in the future to the business, i.e, the incremental cash flows, that we should focus on.

Illustration 5.4: Estimating Cash Flows for an On-line Book Ordering Service: Bookscape

As described in illustration 5.1, Bookscape is considering an on-line book ordering and information service, which will be staffed by two full-time employees. The following estimates relate to the costs of starting the service and the subsequent revenues from it:

1. The initial investment needed to start the service, including the installation of additional phone lines and computer equipment, will be $ 1 million. These investments are expected to have a life of 4 years, at which point they will have no salvage value. The investments will be depreciated straight line over the 4-year life.

2. The revenues in the first year are expected to be $ 1.5 million, growing 20% in year 2, and 10% in the two years following.

3. The salaries and other benefits for the employees is estimated to be $150,000 in year 1, and grow 10% a year for the following 3 years.

4. The cost of the books is assumed to be 60% of the revenues in each of the 4 years.

5. The working capital, which includes the inventory of books needed for the service and the accounts receivable (associated with selling books on credit) is expected to amount to 10% of the revenues; the investments in working capital have to be made at the beginning of each year. At the end of year 4, the entire working capital is assumed to be salvaged.

6. The tax rate on income is expected to be 40%, which is also the marginal tax rate for Bookscape.

Based upon this information, we estimate the operating income for Bookscape Online in table 5.2:

Table 5.2: Expected Operating Income on Bookscape Online
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