Reading: Net Cash Flow Basics

The following table provides a general template for the computation of project specific net cash flows (NCF):

 A few points are noteworthy:

• Depreciation is not a cash outlay. It is an accounting charge to reflect the reduction in the value of the project's assets due to wear and tear. However, depreciation lowers the project's taxable income and therefore has an indirect effect on the project's net cash flow: It lowers the firm's tax bill! To capture this tax effect, we subtract depreciation to compute the taxable income and then add it back to compute the cash flow. 
   
• Free of financing effects: Remember from the introductory remarks that the NCF captures the cash flow that is available for the providers of capital. In computing the NCF, we therefore ignore all cash flows to and from the providers of capital. In particular, we also ignore interest payments (and the associated tax effects). These financing cash flows are a use of the NCF, not a source!
   
• Changes in the Net Working Capital (ΔNWC): The net working capital reflects any current assets and liabilities the firm assumes to run the project. Most intuitively, think of an inventory, which the firm has to build up in order to run the project smoothly. The associated cash is tied up in the project and cannot be used elsewhere.  We are interested in the changes in the net working capital, that is, how much additional cash the firm puts into or frees from the net working capital.
   
• Net Investments: The investments should capture all investment cash flows associated with the project. Most notably, the purchase of property, plant, and equipment. However, it could also be that the firm can sell existing assets because of a new project, so-called divestments or divestitures. Consequently, we are interested in the project's net investments, the difference between all project-related acquisitions and sales of long-term assets.

Let's look at an introductory example.