Note on: The Concept of Cash Flow in Capital Budget
Why is depreciation allowance included in the definition of the Operating
Cash Flow (OCF)?
Students of Corporate Finance, Managerial Finance and Investment always
wonder why is depreciation allowance included in the definition of the
Operating Cash Flow (OCF).
There are four definition of the OCF
Without taxes (if a firm is tax exempted)
1. OCF= EBIT + dep. allow.
2. OCF= EBITDA
Without taxes
3. OCF= (EBIT)(1-t) + dep. allow.
= NOPAT + dep. allow.
where t = tax rate
4. OCF= (EBITDA)(1-t) + dep. (t)
(to acknowledge the tax shield of the cost of debt)
The following example is a very simplified project that has the necessary
required data to calculate the Net Present Value (NPV).
The NPV’s decision rule is to select / reject a project is:
if NPV ≥ 0 select
NPV <0 reject
If NPV = 0 this implies that financiers of this project will get back their initial
investment (contributed fund) plus the required rate of return which is the
cost of finance (Weighted Average Cost of Capital – WACC) for the firm
implementing the project.
To illustrate the concept of returning back the initial investment and the
required rate of return we assumed the following set of data followed by
the solution.