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Chapter 7: Capital Budgeting Cash Flows

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Chapter 7: Capital Budgeting Cash Flows In this chapter, we forecast the annual cash flows for a project. After all the cash flows are forecasted, then we can ... – PowerPoint PPT presentation

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Title: Chapter 7: Capital Budgeting Cash Flows


1
Chapter 7 Capital Budgeting Cash Flows
  • In this chapter, we forecast the annual cash
    flows for a project. After all the cash flows
    are forecasted, then we can calculate the NPV or
    IRR (as covered in Chapter 6) and recommend that
    the project be either accepted or rejected.
  • As in Chapter 6, the relevant cash flows that we
    consider are always after-tax cash flows.
  • Note the similarity between project after-tax
    cash flows and the Free Cash Flow model that is
    covered in Chapter 5.

2
Issues associated with capital budgeting cash
flows
  • The key to analyzing a new project is to always
    think incrementally. We calculate the
    incremental cash flows that are associated with
    the project, i.e., how will the corporations
    total after-tax cash flows change if this project
    is accepted.
  • Dont forget about future inflation when
    estimating future cash flows!
  • Include all side effects within the corporation
    the project may either cannibalize or enhance
    existing operations.
  • Do not include sunk costs any money spent in
    the past is irrelevant. The only cash flows that
    matter are those that occur now and in the
    future.
  • Include any opportunity costs. Any asset used
    for a project might have a higher value in some
    alternative use.

3
The two types of investment in business assets
  • Business investment requires investment in two
    types of assets long-term and short-term
    assets.
  • The long-term assets are the plant, property, and
    equipment, i.e., assets that will be depreciated
    over the coming years.
  • The short-term assets include the increased cash,
    accounts receivable, or inventory that are
    necessary to support a project.
  • Any increase in short-term assets that is funded
    or financed with investors (debt or equity)
    capital is called Net Working Capital and must be
    included in the calculation of a projects NPV.

4
An Example Analysis of a proposed five-year
project
  • If accepted today (t0), the project is expected
    to generate positive net cash flows for each of
    the following five years (t1 through t5).
  • A new machine will be put into operation. The
    new machine costs 1,000,000. Shipping and
    installation will cost an additional 500,000.
    Thus the Installed Cost is 1,500,000.
  • This new machine will be sold five years from
    today when this project is completed. We believe
    that it can be sold for an estimated 100,000
    salvage value in five years (t5).
  • The project will increase annual revenues and
    operating expenses (before depreciation) by
    800,000 and 300,000 in each year, for years 1
    through 5.
  • Continued on next slide.

5
Analysis of a proposed five-year project,
continued
  • More information
  • A 50,000 initial increase in Net Working Capital
    (NWC) is required today and this amount will be
    recovered in 5 years when the project is
    terminated. No other changes in NWC will be
    required during the projects life.
  • If project is accepted, then an old, fully
    depreciated machine must be removed and sold. It
    can be sold today for 50,000.
  • This projects Installed Cost will be depreciated
    using an IRS 5-year MACRS schedule year 1, 20
    year 2, 32 year 3, 19.2 year 4, 11.52 year
    5, 11.52 and year 6, 5.76. Note that this
    schedule actually covers a sixth year.
  • The projects cost of capita is r11. The
    corporate tax rate is 40.

6
Calculating the annual depreciation of the
projects Installed Cost of 1,500,000
  • This projects Installed Cost must be depreciated
    using a 5-year MACRS schedule (schedule actually
    covers 6 years). Below are the annual
    depreciation amounts.
  • The year 6 depreciation amount of 86,400 will
    never be realized, since the project will
    terminate with year 5.

7
Issues related to the projects depreciation and
projects liquidation
  • The project has a five year life. However, the
    IRS MACRS depreciation schedule spills over into
    a sixth year.
  • When the project is liquidated at year 5, the
    remaining accounting book value of the machine
    will be 86,400, the amount that would have been
    expensed in year 6.
  • Today, we believe the asset can be sold for an
    estimated 100,000 salvage value in five years.
    The estimated tax on the sale of the asset at t5
    years is estimated as follows
  • TAX tax ratesale price remaining book
    value 0.40100,000 86,400 5400, paid
    at year t5.

8
Issues related to the t0 disposal of the old,
fully depreciated machine
  • If project is accepted today, then an existing,
    fully depreciated machine must immediately be
    removed and sold. This existing machine can be
    sold today for 50,000.
  • The estimated tax on the sale of the (fully
    depreciated) asset today is estimated as follows
  • TAX tax ratesale price remaining book
    value 0.4050,000 0 20,000, paid at
    today at t0.

9
Estimating the projects Initial Investment or
Capital Expenditure
  • We estimate of the new projects initial cost.
    There are two asset costs Installed Cost and Net
    Working Capital.

10
Estimating the projects annual incremental
operating Cash Flows for years 1 through 5
  • These are essentially incremental Free Cash Flows
    (FCF). Free Cash Flow estimation was covered
    earlier in Chapter 5 (in Addendum 2).
  • The project Net Cash Flows must always ignore the
    interest costs associated with any debt
    financing. Thus these Free Cash Flows appear as
    if the project were all equity financed. The
    actual interest cost of any debt financing is
    actually reflected in the cost of capital r that
    is used to calculate the NPV.
  • The project cost of capital r11 represents a
    weighted average of the equity and debt costs of
    financing this project.

11
Estimating the projects annual incremental
operating Cash Flows for years 1 through 5
  • For each operating year of this project (years 1
    through 5), the annual net after-tax incremental
    cash flows ?CF1 through ?CF5 must be estimated.
    The general formula follows
  • ?CFi ?NOPAT ?depreciation ?NWC / Salvage
    or Terminal cash flows, otherwise expressed as
    shown below
  • ?CFi ?revenue ?costs ?depreciation1
    tax rate ?depreciation ?NWC(a) / Salvage
    or Terminal cash flows(b)
  • (a) ?NWC represents changes in Net Working
    Capital. ?NWC is positive when additional
    investment in NWC is needed.
  • (b) The Salvage or Terminal cash flows include
    such items as sale of assets and taxes on the
    sale of those assets, and costs associated with
    the disposal of a project, e.g., environmental
    cleanup costs.

12
Estimating the projects annual incremental
operating Cash Flows for years 1 through 5
  • ?CFi ?revenue ?costs ?depreciation1
    tax rate ?depreciation ?NWC / Salvage or
    Terminal cash flows
  • ?CF1 800,000 300,000 300,0001 0.4
    300,000 0 420,000
  • ?CF2 800,000 300,000 480,0001 0.4
    480,000 0 492,000
  • ?CF3 800,000 300,000 288,0001 0.4
    288,000 0 415,200
  • ?CF4 800,000 300,000 172,8001 0.4
    172,800 0 369,120

13
Estimating the projects annual incremental
operating Cash Flows for years 1 through 5
  • Note that CF5 must include the recovery of the
    original 50,000 of NWC, final sale of machine
    for 100,000, and tax payment of 5440 on the
    sale of the machine.
  • ?CF5 ?revenue ?costs ?depreciation1
    tax rate ?depreciation ?NWC / Salvage or
    Terminal cash flows
  • ?CF5 800,000 300,000 172,8001 0.4
    172,800 (50,000) 100,000 0.40100,000
    86,400 513,680

14
Final NPV and IRR analysis of the five-year
project
  • This five-year project has the following
    estimated after-tax cash flows.The project also
    has a cost of capital r11.
  • Now this example becomes a Chapter 6 NPV/IRR
    analysis.

15
Final NPV and IRR analysis of the five-year
project
  • Using a financial calculator, at a cost of
    capital of r11, the NPV is 109,282. The IRR
    is 13.8, which is greater than r11.
  • If this is an independent project, then it should
    be accepted.

16
A further look at the five-year projects Net
Working Capital
  • 50,000 is initially spent on NWC if the project
    is accepted. This 50,000 is considered to be
    recovered at t5 years, when the project is
    liquidated or terminated.
  • For five years, this 50,000 is tied up for the
    project and cannot be used elsewhere in the firm,
    and thus represents an opportunity cost. This
    50,000 had to be borrowed at r11 for five
    years.
  • Most firms take strong action to minimize
    investment in inventory and other short-term
    assets, as these items represent a use of
    investors capital.

17
Other issues associated with the capital
budgeting process
  • The analysis of the five-year project obviously
    provides a budget for the project, consisting of
    forecasts of future revenue and costs.
  • Over the life of the project, actual performance
    will be evaluated and then compared to the
    original capital budgeting forecast.
  • Be very aware of the games that may be played
    within firms with the capital budgeting process.

18
Investments of unequal lives an example
  • We evaluate a machine, having a four year
    economic life (t0 to t4 years).
  • The machine costs 12,000 today to purchase.
  • The machine costs 3000 per year to maintain.
  • The machine can be sold for 2000 salvage value
    at the end of year 4 (t4).
  • The machine can be replaced with an identical
    machine, having the same annual costs, at t4
    years.
  • The real cost of capital is r6 per year.
  • We will use the Equal Annual Cost Method (EAC).

19
Investments of unequal lives an example,
continued
  • The timeline of costs for the 4-year machine is
    shown below.
  • In order to estimate the Equivalent Annual Cost
    or EAC, a two step procedure is required.
  • Step 1 Calculate the PV0 of all the (net
    annual) costs.
  • Step 2 Express the PV0 from Step 1 as the cash
    flow of an n4 year annuity and calculate the
    annual cash flow of this annuity.

t0
t1
t3
t4
t2
- 3000 2000 -1000
-12,000
-3000
-3000
-3000
20
Investments of unequal lives an example,
continued
  • Below are Steps 1 and 2, as described in the
    previous slide. Step 1 calculate the PV0 of the
    annual net costs, while Step 2 converts the PV0
    into the cash flows of a 4-year annuity.

21
Investments of unequal lives an example,
continued
t0
t1
t3
t4
t2
-6005.92
-6005.92
-6005.92
-6005.92
  • This 4-year machine thus has an Equivalent Annual
    Cost or EAC6005.92 per year.
  • What if the firm had to decide between two
    consecutive 4-year machines versus an 8-year
    machine that has an EAC6500 per year.
  • In such a case, choose the machine with the lower
    EAC, in this case the 4-year machine has the
    lower EAC.

22
The decision to replace an existing asset
  • An existing machine has the annual maintenance
    and salvage costs shown below.
  • This machine performs the same function as the
    4-year machine with an EAC6005.92
  • When should the existing machine be replaced with
    the new 4-year machine?

23
The decision to replace an existing asset,
continued
  • What is the PV0 of keeping the existing machine
    in operation for one more year?
  • PV0 8000 4000/(10.06) 6000/(10.06)
    6113.21
  • This 6113.21 figure still cannot be compared to
    the new 4-year machines EAC6005.92, as the new
    machines EAC falls from t1 to t4 on the
    timeline. The PV0 of the old machine must be
    multiplied by 1r to bring it up to t1 years.
  • FV1 (6113.21)(10.06) 6480
  • The 6005.92 EAC of the new machine is less than
    the FV16480 of allowing the old machine to
    remain for the next year.
  • Replace the existing machine today at t1.
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