Initial Investment and Managing Earnings

Relevant cash flows – cash flows that occur (or do not occur) because a project is undertaken. Cash flows that will occur whether or not we accept a project are not relevant.

Incremental cash flows – any and all changes in the firm’s future cash flows that are a direct consequence of taking the project Accounting income is only relevant in that it is used as a starting point for generating cash flows. Use after-tax cash flows, not pretax (the tax bill is a cash outlay, even though it is based on accounting numbers).

Remember, a project’s cash flows imply changes in future firm cash flows and, therefore, in the firm’s future financial statements. Consider the tax shelter provided by depreciation: What is the relevant depreciation effect if we replace an old machine with a three-year remaining life and $5,000 per year depreciation? Suppose the new machine will cost $45,000 and will be depreciated over a 5-year life with straight-line depreciation. The depreciation expense on the new machine would be $9,000 per year. Assume a tax rate of 40%. Therefore, the incremental depreciation expense for the first three years is $4,000, leading to a depreciation tax shield of $4,000(.4) = $1,600. The incremental depreciation tax shield for years 4 and 5 is $9,000(.4) = $3,600. Viewing projects as “mini-firms” with their own assets, revenues, and costs allows us to evaluate the investments separately from the other activities of the firm.

Incremental Cash Flows

Sunk cost – a cash flow already paid or accrued. These costs should not be included in the incremental cash flows of a project. From an emotional standpoint, it does not matter what investment has already been made. We need to make our decision based on future cash flows, even if it means abandoning a project that has already had a substantial investment.

Personal examples might help to clarify the meaning. For instance, consider a hypothetical situation in which a college student purchased a computer for $1,500 while in high school. A better computer is now available that also costs $1,500. The relevant factors to the decision are what benefits would be provided by the better computer to justify the purchase price. The cost of the original computer is irrelevant. On the other hand, opportunity costs represent any cash flows lost or forgone by taking one course of action rather than another. It applies to any asset or resource that has value if sold, or leased, rather than used.

What about the ethical side of the coin? An episode of the old “L.A. Law” television series presented an interesting example of the ethical aspects of capital budgeting. According to the show, an automobile manufacturer knowingly built cars that had a tendency to explode when involved in accidents of a certain type. Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car. Many would say that the example is an inappropriate (to say the least) and unrealistic application of cost-benefit analysis. Yet, history suggests that it is not so unrealistic. Manufacturers make similar decisions on a daily basis. The recall of 6.5 million Firestone tires on some Ford cars in the fall of 2000 is an excellent example.

The companies involved knew that there were problems with the treads separating from the tire long before the recall. As problems and criticisms mounted, Ford voluntarily recalled an additional 13 million tires in May of 2001 (Greenwald, 2001). Firestone was forced to recall an additional 3.5 million tires in October of 2001 after refusing to do so in July (Greenwald). The cost of the various recalls is astronomical and has substantially lowered the profits for both Ford and Bridgestone/Firestone. In fact, Ford cut its dividend in October, 2001 (a sure sign that things were not going to get better soon).

Additionally, Firestone settled state lawsuits in the amount of $41.5 million in November of 2001 and class-action status was given to approximately 3.5 million “economic loss” lawsuits filed against both Ford and Firestone (Greenwald). These lawsuits do not count the numerous lawsuits filed by the families of the individuals that were either killed or injured in accidents. As of July 2001, the death toll stood at 203, and the number of injured was over 700. And, the cost does not stop with the direct costs of the recalls and lawsuits; business dropped dramatically for both companies because of a lack of trust from the public. It is easy to say that the cost is irrelevant, given the potential loss of human life. However, we know that estimation error exists in all parts of the decision making process. What happens when a company underestimates the potential danger? (This is not meant to imply that Firestone and Ford made the correct decision initially. Too much information is still unavailable and it will be years before it all comes out.) The point is that sometimes the “side effects” of many decisions are complex, but very important.

Greenwald, J. “Inside the ford/firestone fight.” Time Magazine, p. 20-23.