Title: Capital Budgeting
1Capital Budgeting Further Considerations
- For 9.220, Term 1, 2002/03
- 02_Lecture10.ppt
2Lecture Outline
- Introduction
- The input for evaluating projects relevant cash
flows - Inflation real vs. nominal analysis
- Taxes the basics preview this section prior to
the next lecture - This section includes assigned readings make
sure you do them prior to class. - Summary and conclusions
3Introduction
- Up to this point we have examined the methods or
techniques for capital budgeting NPV, IRR, PI,
Payback, AAR. - All, except AAR, use cash flows for the analysis.
AAR is not accepted as a good technique of
analysis. - Now we turn to cash-flow analysis. From where do
we get the cash flows? We need to determine which
cash flows should be included in the analysis and
how to include them properly. Here we bring in
the concepts of relevant cash flows, inflation,
and taxes.
4Relevant cash flows
- The main principles behind which cash flows to
include in capital budgeting analysis are as
follows - Only include cash flows that change as a result
of the project being analyzed. Include all cash
flows that are impacted by the project. This is
often called an incremental analysis looking at
how cash flows change between not doing the
project vs. doing the project.
5Relevant cash flows
- Use projections of cash flows, not accounting
income. - Accounting income ? cash. Accounting income
cannot be spent, a firm can be losing cash but
have positive accounting income, so accounting
income is not necessarily representative of cash.
Cash is what really generates value cash can be
spent! - Depending on arbitrary accounting policies,
income can easily be manipulated, so, by itself,
it is not a reliable input for capital budgeting
analysis.
6Which cash flows are relevant to the project
analysis, which are not?
Examples Type of Cash Flow Is it Relevant to the analysis? Why?
Sunk Costs
Opportunity Costs
Side Effects (or incidental effects)
Interest Expense (or financing charges)
7Working Capital Changes Required by the Project
the cash flow effects
- Working capital (WC) items do not show up as
costs or revenues, however changes to the WC
items either require or free-up cash. - Increases in current assets required for the
project imply that cash is used so a cash outflow
occurs. - To increase inventories requires cash.
- To increase the cash-register float also requires
cash. - An increase in accounts receivable (AR) means
that the cash you may have recognized, through
revenue, hasnt been received yet. In effect, if
your project requires you to increase credit for
your customers (an AR increase), then this uses
up cash that you would otherwise have.
8More on working capital changes
- Increases in current liabilities, on the other
hand, free-up cash, so a cash inflow occurs. - Increasing accounts payable (AP) means that a
cost cash flow you may have recognized elsewhere
has not yet been paid, therefore the increase in
AP is a cash saving or inflow. - For other payables, the analysis is the same.
- Salaries payable, utilities payable, etc.
- Overall, changes in net working capital (NWC)
represent cash flows.
9Working Capital Example
- With the Project (that ends in 2005)
WC item 2003 2004 2005 2006
Inven-tory 10 10 10 10
AR 20 21 26 25
AP 5 5 10 10
NWC 25 26 26 25
WC item 2003 2004 2005 2006
Inven-tory 12 12 14 10
AR 26 26 28 25
AP 8 8 13 10
NWC 30 30 29 25
10NWC Solution
- No project, NWC cash flows are as follows
- With the project, NWC cash flows are as follows
- Change in NWC results in the following
incremental cash flows that should be included in
the project analysis
2003 2004 2005 2006
Cash flow -25 -1 0 1
2003 2004 2005 2006
Cash flow -30 0 1 4
2003 2004 2005 2006
?Cash flow
11Salvage Values and Clean-up Costs Self Study
- The change in salvage value or clean-up costs
represent cash flows related to a project. - Example consider a project to build an ice-cream
stand on some leased land that is currently used
for a parking lot. At the end of the lease, in 5
years, the land must be returned to a natural
state.
12Salvage/Clean-up Analysis Self Study
- Without the Ice-Cream Stand Project
- Year 0 cash flow 0. Nothing needs to be done,
the parking lot can continue for 5 years. - Year 5 cash flows -20,000 to clean up the
parking lot material. Sell the parking lot gate
for scrap for 200.
- With the Ice-Cream Stand Project
- Year 0 cash flows -14,000 to partially clean
up the parking lot material now. Sell parking lot
gate for 1,500. - Year 5 cash flows -16,000 to clean up the
remaining parking lot material and remove ice
cream stand. Sell ice cream stand for scrap for
1,000.
Do the incremental analysis
13Salvage/Clean-up Solution Self Study
No Project New Project Change (incremental cash flow)
Yr.0 0 -14,000 1,500 Net-12,500 -12,500
Yr. 5 -20,000 200 Net-19,800 -16,000 1,000 Net-15,000 4,800
14Inflation
- Sometimes a projected cash flow is given as a
nominal amount (the expected actual amount of
cash to be received or paid). - Sometimes a projected cash flow is given as a
real amount (the current or date 0 purchasing
power of the cash flow. - Note, the real cash flow is not the PV.
15Nominal/Real Cash Flow Examples
- Freds contract with his employer states that he
will be paid 100,000 three years from now. - Currently, the basket of goods used to measure
the consumers price index costs 125. Sue
expects to receive a cash flow in four years that
will allow her to purchase 100 of these baskets. - This can be represented by a real cash flow.
16Are real cash flows the same as present values?
- No!
- Which would you prefer to receive, 1,250 today
(which can buy 10 baskets of goods) or a dollar
amount in 5 year that will buy 10 baskets of
goods then? - The 1,250 today is preferred even though, in
terms of purchasing power, both payments give the
same purchasing power. - Since the 1,250 today is preferred, the two cash
flows cannot have the same present value.
17How do we discount real cash flows?
- Consider the basket of goods that costs 125
today. Suppose inflation is expected to be 5
each year for the next 5 years. - How much, in real dollars, do we need to be able
to purchase 10 baskets in 5 years? - Let this be our real cash flow
- How much, in nominal dollars do we need to be
able to purchase the same 10 baskets in 5 years? - This must be the equivalent nominal cash flow
- What is the relation between the real and nominal
cash flow? (be exact formula?)
18Discounting real vs. nominal cash flows
(continued)
- If the relevant discount rate for the nominal
cash flow is 12, then what is its PV today? - What discount rate applied to the real cash flow
would get the same PV today? - What is the relation between the real discount
rate and the nominal discount rate? (be exact
formula?)
19Conclusions on real and nominal cash flows
- It is possible to express any cash flow as either
a real amount or a nominal amount. - Since the real and nominal amounts are
equivalent, the PVs must be equivalent, so
remember the rule
20Use of real cash flows
- If a projects cash flows are expected to grow
with inflation, then it may be more convenient to
express the cash flows as real amounts rather
than trying to predict inflation and the nominal
cash flows.
21Taxes the basics
- Unfortunately, in most civilized countries both
corporations and individuals must pay tax on
income and profits. - Tax is a cash outflow (yes, really). So we must
include taxes in our capital budgeting analysis.
22Calculating tax effects from non-financing
components of the income statement.
- Recall the income statement you learned about in
accounting - Whatever affects the income statement amounts
will also affect the taxes paid. - Assume depreciation here is what is recognized
for tax purposes. In Canada, this is called
capital cost allowance, CCA. - The interest expense is financing related, so
interest and its tax effect should be removed
from our analysis.
Revenues 1,000
Cost of goods sold 600
Gross Margin 400
Selling, general, and admin expenses 125
RD expense 50
Depreciation Expense 100
Interest Expense 25
Earnings Before Tax 100
Tax (at 40) 40
Earnings after Tax (Net Income) 60
23Tax consequences and after tax cash flows (assume
a tax rate, Tc, of 40)
Item Before-tax amount Before-tax cash flow After-tax cash flow
Revenue Rev 10 Rev 10 Rev(1-Tc) 10(1-.4) 6
Expense Exp 10 -Exp -10 -Exp(1-Tc) -10(1-.4) -6
CCA CCA 10 0 CCA?Tc 10 ?0.4 4
24Yearly cash flows after tax
- Normally we project yearly cash flows for a
project and convert them into after-tax amounts. - CCA deductions are due to an asset purchase for a
project. CCA is calculated as a of the
Undepreciated Capital Cost (UCC). Since a
amount is deducted each year, the UCC will never
reach zero so CCA deductions can actually
continue even after the project has ended (and
thus shelter future income from taxes). All
CCA-caused tax savings should be recognized as
cash inflows for the project that caused them.
25CCA Preview read thoroughly for next class
- Read the assigned sections of Chapter 7, then pay
particular attention to the following - See table 7.3 and accompanying text in the
chapter for an example of CCA and UCC
calculations. See table 7.7 and accompanying text
in the chapter for the corresponding CCA tax
shields and the PV of the tax savings due to CCA. - Equation 7.6, p. 203, allows us to calculate the
sum of the present values of all CCA tax shields
and includes an adjustment in case the asset is
sold (and reduces future CCA deductions). This
equation, although complicated looking, is
nothing more than the PV of one declining
perpetuity minus the PV of a second declining
perpetuity.
26Summary and Conclusions
- All relevant cash flows for a project must be
included in the capital budgeting analysis for a
project. - Relevant cash flows are those that change as a
result of accepting the project. - We exclude things that dont change. We also
exclude interest charges or financing expenses
because these are accounted for in the discount
rate. - Tax effects must also be included. CCA is a
special case to consider because the tax savings
may continue beyond the end of the project. - Once we have all after-tax cash flow effects
projected, we can conduct our analysis of a
project using our preferred methods NPV, IRR, or
PI Payback may also be used but its
oversimplification should be recognized.