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PPT – Chapter 7: Capital Budgeting Cash Flows PowerPoint presentation | free to download - id: 3c3d75-NDc2N

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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 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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

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.

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.

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.

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.

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).

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

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.

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.

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?

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.