Assume interest expense is equal to zero. Which one of the following calculations shows the correct method for computing the operating cash flow of a project?

Question

BlackTom AI · Accepted Answer

To analyze the options, start by identifying what the operating cash flow (OCF) for a project typically involves. OCF is meant to capture cash generated by core operations, incorporating non-cash charges like depreciation as addbacks and adjusting for taxes when applicable. Now evaluate each choice one by one:

Option 1: Net income + Depreciation. Net income already reflects tax effects and interest (if any). Adding back depreciation does not correctly isolate operating cash flow in the usual formulation, because net income is after-tax and after financing effects. This combination misses the proper pre-tax operating income concept and may double-count or omit other cash components, so it’s not the standard OCF expression.

Option 2: EBIT + Depreciation. EBIT is earnings before interest and taxes, i.e., operating income. If we add back depreciation, which is a non-cash expense, we capture the cash generated by operations without financing considerations. In many textbook treatments, when interest expense is zero (no financing costs) and we are focusing on operating cash generation, OCF can be represented as EBIT + Depreciation. This aligns with the idea of converting accruals to cash by adding back non-cash charges to operating profit.

Option 3: EBIT(1 + Taxes). Multiplying EBIT by (1 + Taxes) is not meaningful for OCF and does not reflect cash flow; it would artificially scale operating income by a factor tied to the tax rate, which does not correspond to how cash flows are computed.

Option 4: (Sales − Costs)(1 − Depreciation)(1 − Taxes). This form misuses depreciation inside a multiplicative term with taxes. Depreciation is a non-cash expense that should be added back, not embedded multiplicatively with after-tax sales. The expression also confuses operating profit with after-tax cash effects, making it inappropriate for OCF.

Option 5: (Sales − Costs)(1 − Taxes). This gives after-tax operating cash flow excluding any non-cash adjustments like depreciation. It ignores the depreciation addition that converts accounting income to cash flow, so it generally understates OCF when depreciation is significant.

In summary, the most appropriate representation among the given options, under the stated assumption of zero interest expense, is EBIT + Depreciation, because it starts from operating income and back-adds the non-cash depreciation to reflect actual cash generation from operations.

33:390:300:13 FINANCIAL MANAGEMENT Exam 2- Requires Respondus LockDown Browser

Assume interest expense is equal to zero. Which one of the following calculations shows the correct method for computing the operating cash flow of a project?

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