Chapter 10 - Cash Flows and Other Topics in Capital Budgeting

1
Chapter 10 - Cash Flows and Other Topics in
Capital Budgeting
2
Useful Guidelines

• Use free cash flow rather than accounting profits
• Think incrementally
• Beware of cash flows diverted from existing
  products
• Synergistic effects

3
Useful Guidelines

• Working capital requirements are considered a
  cash flow even though they do not leave the
  company.
• They are tied up over the life of the project.
• When projects terminate, working capital will be
  recovered.

4
Useful Guidelines

• Consider incremental expenses
• Sunk costs are not incremental cash flow
• Ignore interest payments and financing flows
• Free cash flow change in operating cash flow
  change in net working capital change in capital
  spending

5
Useful Guidelines

• Use simple straight line method to calculate
  depreciation expense
• Though depreciation is not a cash flow item, it
  does affect cash flow by lowering profit, so we
  will add it back

6
Useful Guidelines

• Sale of old machine
• Old asset is sold for a price above depreciated
  value
• eg old machine purchased for 15,000, had a book
  value of 10,000, and was sold for 17,000 (34
  tax rate), how much tax the firm should pay?
• (17,000 10,000) 34 2,380

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Useful Guidelines

• Sale of old machine
• 2. Old asset is sold at depreciated value.
• since there is no gain or loss, no tax
• 3. Old asset is sold less than its depreciated
  value.
• eg book value is 10,000 and sold for 7,000,
  what is the tax?
• we have a cash inflow due to loss
• (10,000 7,000) 34 1,020

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Capital Budgeting The process of planning for
purchases of long-term assets.

• For example Our firm must decide whether to
  purchase a new plastic molding machine for
  127,000. How do we decide?
• Will the machine be profitable?
• Will our firm earn a high rate of return on the
  investment?
• The relevant project information follows

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• The cost of the new machine is 127,000.
• Installation will cost 20,000.
• 4,000 in net working capital will be needed at
  the time of installation.
• The project will increase revenues by 85,000 per
  year, but operating costs will increase by 35 of
  the revenue increase.
• Simplified straight line depreciation is used.
• Class life is 5 years, and the firm is planning
  to keep the project for 5 years.
• Salvage value at the end of year 5 will be
  50,000.
• 14 cost of capital 34 marginal tax rate.

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Capital Budgeting Steps

• 1) Evaluate Cash Flows
• Look at all incremental cash flows occurring as
  a result of the project.
• Initial outlay
• Differential Cash Flows over the life of the
  project (also referred to as annual cash flows).
• Terminal Cash Flows

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Capital Budgeting Steps

• 1) Evaluate Cash Flows

Terminal Cash flow
Initial outlay
Annual Cash Flows
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Capital Budgeting Steps

• 2) Evaluate the Risk of the Project
• Well get to this in the next chapter.
• For now, well assume that the risk of the
  project is the same as the risk of the overall
  firm.
• If we do this, we can use the firms cost of
  capital as the discount rate for capital
  investment projects.

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Capital Budgeting Steps

• 3) Accept or Reject the Project

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (Purchase price of the asset)
• (shipping and installation costs)
• (Depreciable asset)
• (Investment in working capital)
• After-tax proceeds from sale of old asset
• Net Initial Outlay

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (127,000) Purchase price of asset
• (20,000) Shipping and installation
• (147,000) Depreciable asset
• (4,000) Net working capital
• 0 Proceeds from sale of old
  asset
• (151,000) Net initial outlay

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Step 1 Evaluate Cash Flows

• b) Annual Cash Flows What incremental cash
  flows occur over the life of the project?

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For Each Year, Calculate

• Incremental revenue
• - Incremental costs
• - Depreciation on project
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000 Revenue
• (29,750) Costs
• (29,400) Depreciation
• 25,850 EBT
• (8,789) Taxes
• 17,061 EAT
• 29,400 Depreciation reversal
• 46,461 Annual Cash Flow

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Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal Cash Flow

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Tax Effects of Sale of Asset

• Salvage value 50,000.
• Book value depreciable asset - total amount
  depreciated.
• Book value 147,000 - 147,000
• 0.
• Capital gain SV - BV
• 50,000 - 0 50,000.
• Tax payment 50,000 x .34 (17,000).

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Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• 50,000 Salvage value
• (17,000) Tax on capital gain
• 4,000 Recapture of NWC
• 37,000 Terminal Cash Flow

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Project NPV

• CF(0) -151,000.
• CF(1 - 4) 46,461.
• CF(5) 46,461 37,000 83,461.
• Discount rate 14.
• NPV 27,721.
• We would accept the project.

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Capital Rationing

• Suppose that you have evaluated five capital
  investment projects for your company.
• Suppose that the VP of Finance has given you a
  limited capital budget.
• How do you decide which projects to select?

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Capital Rationing

• You could rank the projects by IRR

Our budget is limited so we accept only projects
1, 2, and 3.
5
4
2
3
1
X
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Capital Rationing

• Ranking projects by IRR is not always the best
  way to deal with a limited capital budget.
• Its better to pick the largest NPVs.
• Mutually exclusive projects perform same task,
  so accepting one means rejection of the other

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Problems with Project Ranking

• 1) Mutually exclusive projects of unequal size
  (the size disparity problem)
• The NPV decision may not agree with IRR or PI.
• Solution select the project with the largest NPV.

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Size Disparity Example

• Project B
• year cash flow
• 0 (30,000)
• 1 15,000
• 2 15,000
• 3 15,000
• required return 12
• IRR 23.38
• NPV 6,027
• PI 1.20

• Project A
• year cash flow
• 0 (135,000)
• 1 60,000
• 2 60,000
• 3 60,000
• required return 12
• IRR 15.89
• NPV 9,110
• PI 1.07

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Problems with Project Ranking

• 2) The time disparity problem with mutually
  exclusive projects.
• NPV and PI assume cash flows are reinvested at
  the required rate of return for the project.
• IRR assumes cash flows are reinvested at the IRR.
• The NPV or PI decision may not agree with the
  IRR.
• Solution select the largest NPV.

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Time Disparity Example

• Project B
• year cash flow
• 0 (48,000)
• 1 36,500
• 2 24,000
• 3 2,400
• 4 2,400
• required return 12
• IRR 22.78
• NPV 6,955
• PI 1.14

• Project A
• year cash flow
• 0 (48,000)
• 1 1,200
• 2 2,400
• 3 39,000
• 4 42,000
• required return 12
• IRR 18.10
• NPV 9,436
• PI 1.20

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Mutually Exclusive Investments with Unequal Lives

• Suppose our firm is planning to expand and we
  have to select one of two machines.
• They differ in terms of economic life and
  capacity.
• How do we decide which machine to select?

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• The after-tax cash flows are
• Year Machine 1 Machine 2
• 0 (45,000) (45,000)
• 1 20,000 12,000
• 2 20,000 12,000
• 3 20,000 12,000
• 4 12,000
• 5 12,000
• 6 12,000
• Assume a required return of 14.

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Step 1 Calculate NPV

• NPV1 1,433
• NPV2 1,664
• So, does this mean 2 is better?
• No! The two NPVs cant be compared!
• One way is to create replacement chain

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Step 2 Equivalent Annual Annuity (EAA) method

• If we assume that each project will be replaced
  an infinite number of times in the future, we can
  convert each NPV to an annuity.
• The projects EAAs can be compared to determine
  which is the best project!
• EAA Simply annuitize the NPV over the projects
  life.

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EAA with your calculator

• Simply spread the NPV over the life of the
  project
• Machine 1 PV 1433, N 3, I 14,
• solve PMT -617.24.
• Machine 2 PV 1664, N 6, I 14,
• solve PMT -427.91.

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• EAA1 617
• EAA2 428
• This tells us that
• NPV1 annuity of 617 per year.
• NPV2 annuity of 428 per year.
• So, weve reduced a problem with different time
  horizons to a couple of annuities.
• Decision Rule Select the highest EAA. We would
  choose machine 1.

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Step 3 Convert back to NPV

• Assuming infinite replacement, the EAAs are
  actually perpetuities. Get the PV by dividing
  the EAA by the required rate of return.
• NPV 1 617/.14 4,407
• NPV 2 428/.14 3,057
• This doesnt change the answer, of course it
  just converts EAA to an NPV that can be compared.

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Options in Capital Budgeting

• Option to delay a project
• Option to expand a project
• Option to abandon a project

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Practice ProblemsCash Flows Other Topics in
Capital Budgeting
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Problem 1a

• Project Information
• Cost of equipment 400,000.
• Shipping installation will be 20,000.
• 25,000 in net working capital required at setup.
• 3-year project life, 5-year class life.
• Simplified straight line depreciation.
• Revenues will increase by 220,000 per year.
• Defects costs will fall by 10,000 per year.
• Operating costs will rise by 30,000 per year.
• Salvage value after year 3 is 200,000.
• Cost of capital 12, marginal tax rate 34.

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Problem 1a

• Initial Outlay
• (400,000) Cost of asset
• ( 20,000) Shipping installation
• (420,000) Depreciable asset
• ( 25,000) Investment in NWC
• (445,000) Net Initial Outlay

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For Years 1 - 3
Problem 1a

• 220,000 Increased revenue
• 10,000 Decreased defects
• (30,000) Increased operating costs
• (84,000) Increased depreciation
• 116,000 EBT
• (39,440) Taxes (34)
• 76,560 EAT
• 84,000 Depreciation reversal
• 160,560 Annual Cash Flow

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Problem 1a

• Terminal Cash Flow
• Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal Cash Flow

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Problem 1a

• Terminal Cash Flow
• Salvage value 200,000.
• Book value depreciable asset - total amount
  depreciated.
• Book value 420,000 384,000 168,000.
• Capital gain SV - BV 32,000.
• Tax payment 32,000 x .34 (10,880).

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Problem 1a

• Terminal Cash Flow
• 200,000 Salvage value
• (10,880) Tax on capital gain
• 25,000 Recapture of NWC
• 214,120 Terminal Cash Flow

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Problem 1a Solution

• NPV and IRR
• CF(0) -445,000
• CF(1 ), (2), 160,560
• CF(3 ) 160,560 214,120 374,680
• Discount rate 12
• IRR 22.1
• NPV 93,044. Accept the project!

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Problem 1b

• Project Information
• For the same project, suppose we can only get
  100,000 for the old equipment after year 3, due
  to rapidly changing technology.
• Calculate the IRR and NPV for the project.
• Is it still acceptable?

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Problem 1b

• Terminal Cash Flow
• Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal Cash Flow

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Problem 1b

• Terminal Cash Flow
• Salvage value 100,000.
• Book value depreciable asset - total amount
  depreciated.
• Book value 168,000.
• Capital loss SV - BV (68,000).
• Tax refund 68,000 x .34 23,120.

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Problem 1b

• Terminal Cash Flow
• 100,000 Salvage value
• 23,120 Tax on capital gain
• 25,000 Recapture of NWC
• 148,120 Terminal Cash Flow

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Problem 1b Solution

• NPV and IRR
• CF(0) -445,000.
• CF(1), (2) 160,560.
• CF(3) 160,560 148,120 308,680.
• Discount rate 12.
• IRR 17.3.
• NPV 46,067. Accept the project!

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Problem 2

• Automation Project
• Cost of equipment 550,000.
• Shipping installation will be 25,000.
• 15,000 in net working capital required at setup.
• 8-year project life, 5-year class life.
• Simplified straight line depreciation.
• Current operating expenses are 640,000 per yr.
• New operating expenses will be 400,000 per yr.
• Already paid consultant 25,000 for analysis.
• Salvage value after year 8 is 40,000.
• Cost of capital 14, marginal tax rate 34.

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Problem 2

• Initial Outlay
• (550,000) Cost of new machine
• (25,000) Shipping installation
• (575,000) Depreciable asset
• (15,000) NWC investment
• (590,000) Net Initial Outlay

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For Years 1 - 5
Problem 2

• 240,000 Cost decrease
• (115,000) Depreciation increase
• 125,000 EBIT
• (42,500) Taxes (34)
• 82,500 EAT
• 115,000 Depreciation reversal
• 197,500 Annual Cash Flow

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For Years 6 - 8
Problem 2

• 240,000 Cost decrease
• ( 0) Depreciation increase
• 240,000 EBIT
• (81,600) Taxes (34)
• 158,400 EAT
• 0 Depreciation reversal
• 158,400 Annual Cash Flow

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Problem 2

• Terminal Cash Flow
• 40,000 Salvage value
• (13,600) Tax on capital gain
• 15,000 Recapture of NWC
• 41,400 Terminal Cash Flow

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Problem 2 Solution

• NPV and IRR
• CF(0) -590,000.
• CF(1 - 5) 197,500.
• CF(6 - 7) 158,400.
• CF(10) 158,400 41,400 199,800.
• Discount rate 14.
• IRR 28.13 NPV 293,543.
• We would accept the project!

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Problem 3

• Replacement Project
• Old Asset (5 years old)
• Cost of equipment 1,125,000.
• 10-year project life, 10-year class life.
• Simplified straight line depreciation.
• Current salvage value is 400,000.
• Cost of capital 14, marginal tax rate 35.

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Problem 3

• Replacement Project
• New Asset
• Cost of equipment 1,750,000.
• Shipping installation will be 56,000.
• 68,000 investment in net working capital.
• 5-year project life, 5-year class life.
• Simplified straight line depreciation.
• Will increase sales by 285,000 per year.
• Operating expenses will fall by 100,000 per
  year.
• Already paid 15,000 for training program.
• Salvage value after year 5 is 500,000.
• Cost of capital 14, marginal tax rate 34.

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Problem 3 Sell the Old Asset

• Salvage value 400,000.
• Book value depreciable asset - total amount
  depreciated.
• Book value 1,125,000 - 562,500
• 562,500.
• Capital gain SV - BV
• 400,000 - 562,500 (162,500).
• Tax refund 162,500 x .35 56,875.

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Problem 3

• Initial Outlay
• (1,750,000) Cost of new machine
• ( 56,000) Shipping installation
• (1,806,000) Depreciable asset
• ( 68,000) NWC investment
• 456,875 After-tax proceeds (sold old
  machine)
• (1,417,125) Net Initial Outlay

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For Years 1 - 5
Problem 3

• 385,000 Increased sales cost savings
• (361,200) Extra depreciation
• 23,800 EBT
• (8,092) Taxes (34)
• 15,708 EAT
• 361,200 Depreciation reversal
• 376,908 Differential Cash Flow

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Problem 3

• Terminal Cash Flow
• 500,000 Salvage value
• (170,000) Tax on capital gain
• 68,000 Recapture of NWC
• 398,000 Terminal Cash Flow

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Problem 3 Solution

• NPV and IRR
• CF(0) -1,417,125.
• CF(1 - 4) 376,908.
• CF(5) 376,908 398,000 774,908.
• Discount rate 14.
• NPV 83,539.
• IRR 16.18.
• We would accept the project!