Capital Investment Decisions In corporate finance, cash flows are used, whereas financial accounting generally stresses income or earnings. When valuing the firm as a whole, we discount dividends and not earnings because dividends are cash flows that investors receive. Incremental cash flow is the net cash flow from all inflows and outflows over the investment period. To calculate the incremental value, we account for: . Opportunity cost - The cost of not going forward with the project (the cost of the next best alternative) · Side effects (externalities e.g. erosion) - when a new project takes sales away and hence erodes the cash flow from the existing product. For example, one of Walt Disney Company's main concerns when it built Euro Disney in Paris was that the new park would drain visitors from the Florida park, a popular tourist destination for Europeans · Taxes · Inflation We should not account for sunk costs, because these costs cannot be recovered and therefore don't affect the future cash flows of the project. Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation (Fisher Rule) (1 + Nominal Rate) = (1 + Real Rate) x (1 + Inflation Rate) Rearranging, we get: Real Interest Rate = (1 + Nominal interest rate/1 + Inflation Rate) - 1 For low rates of inflation, this is often approximated as: Real rate ~ Nominal Rate - Inflation Rate