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... 6440 -49000 Nominal cash flow 1 Discount factor Real-Term Cash Flow Estimates for 6 5 4 3 2 1 0 Year 24939 -11587 31224 -13362 -2415 -6314 ... – PowerPoint PPT presentation

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Chapter 8
Cash Flow And Capital Budgeting
Professor John Zietlow MBA 621
Chapter 8 Overview
  • 8.1 Types of Cash Flows
  • Cash flow vs. accounting profit
  • Fixed asset expenditures
  • Working capital expenditures
  • Terminal value
  • Incremental cash flow vs. sunk costs
  • Opportunity costs
  • 8.2 Cash Flow for
  • 8.3 Cash Flows, Discounting, and Inflation
  • 8.4 Special Problems in Capital Budgeting
  • Equipment replacement and equivalent annual cost
  • Excess Capacity
  • 8.5 Summary

Types of Cash Flows
  • First step in capital budgeting determine the
    relevant CFs
  • The incremental after-tax cash outflow
    (investment) and resulting cash flows.
  • Cash flows, rather than accounting values, are
  • The cash flows of any project having simple cash
    flows can include three basic components
  • (1) initial investment, (2) operating CFs, and
    (3) terminal CF
  • All projects have the first two components
  • Initial investment includes all set up costs
  • Also includes incremental working capital
  • Operating cash flows are after-tax net cash flows
    using the firms marginal tax rate
  • CF, not earnings, so add depreciation back in
  • The terminal CF usually related to liquidation of
    the project
  • Include disposal costs and after-tax salvage
    values, if any

Cash Flow Versus Accounting Profit
  • Capital budgeting concerned with cash flow, not
    accounting profit
  • Most important distinction non-cash charges
  • Two ways to treat non-cash charges
  • Can compute net income and add depreciation back
  • Can compute after-tax income, then add tax
  • Demonstrate two methods (next slide) by assuming
    a firm purchases a fixed asset today for 30,000
  • Plans to depreciate over 3 years using
    straight-line method
  • Using machine, firm will produce 10,000
  • Product sells for 3/unit and costs 1/unit
  • Firm pays taxes at a 40 marginal rate

Two Methods Of Handling Depreciation To Compute
Cash Flow
Simplest and most common technique Add
depreciation back in
An Overview Of Depreciation
  • Largest non-cash charge for most projects
  • Firms allowed to charge off portion of assets
    cost each year
  • For tax purposes, depreciation is regulated by
    the IR Code, as laid out most recently in the Tax
    Reform Act of 1986.
  • A firm will often use different depreciation
    methods for financial reporting and tax purposes,
    which is quite legal.
  • Depreciation for tax purposes is determined by
    using the modified accelerated cost recovery
    system (MACRS)
  • In US UK, different depreciation methods can be
    used for taxes and financial reporting
  • MACRS standards, which apply to both new and used
    assets, require a taxpayer to use as an asset's
    depreciable life the appropriate MACRS recovery
  • There are six MACRS recovery periods--3, 5, 7,
    10, 15, and 20 years--excluding real estate (not
  • The first four property classes defined next

The First Four Depreciation MACRS Classes
MACRS Recovery Periods
  • For tax purposes, assets in the first four
    property classes depreciated by the
    double-declining balance (200) method
  • Also computed using the half-year convention and
    switching to straight-line when advantageous.
  • The approximate percentages written off each year
    for the first four property classes are given in
    Table 8.1.
  • Rather than using these, the firm can use either
    straight-line depreciation over the asset's
    recovery period with the half-year convention or
    the alternative depreciation system.
  • We use MACRS figures as these generally provide
    for the fastest writeoff thus the best CF
    effects for profitable firms
  • MACRS requires use of the half-year convention,
    so assets assumed to be acquired in mid-year
  • So only half of first year's deprec is recovered
    in year 1
  • Final half-year of depreciation is recovered in
    the year immediately following the asset's stated
    recovery period.
  • Deprec s for an n-year asset thus given for n
    1 years

Depreciation Percentages By Year
Finding Initial Cost of Fixed Asset Purchase
  • Cap budget decisions usually entail acquiring
    fixed asset.
  • Initial cost typically measured as net cash
  • If new asset, net initial cost fairly simple to
  • Just purchase price plus installation costs
  • If new asset purchased to replace existing asset,
    finding net initial cost much more complicated
  • Must account for purchase and installation cost
    of new asset
  • Plus after-tax inflow or outflow from old asset
    sale price net of removal costs, plus or minus
    tax impact of sale
  • Tax impact from sale of old asset depends on
    assets sale price and book value
  • Sale price below book value ? capital loss (tax
  • Sale price above book value, but below purchase
    price ? firm must pay tax on recaptured
  • Sale price above purchase price ? firm must pay
    tax on recaptured depreciation plus capital gain

Calculating Net Initial Cost Of New Computers For
Electrocom Mfg
  • Electrocom Mfg wants to replace computers
    purchased three years ago for 100,000 with
    newer, faster machines
  • Old computers have been deprec with 5-year MACRS
  • Accum deprec 71,200 (71.20) so book value
  • If Electrocom sells its old computers for
    10,000, what is net after-tax cash flow from
    sale? Assume tax rate 40
  • Capital loss, sale of old computer book value -
    sale price 28,800 - 10,000 18,800
  • Tax benefit of capital loss (assuming firm has
    other profits) capital loss x tax rate
    18,800 x 0.40 7,520
  • Net inflow from sale sale price tax benefit
  • Net initial cost of new computers thus the
    purchase and installation cost of new computers
    minus 17,520

Working Capital Expenditures
  • Many cap investments require additions to working
  • Net working capital (NWC) curr assets curr
  • Increase in NWC is a cash outflow decrease a
    cash inflow
  • Some curr assets (A/R) can be acquired thru trade
    credit, but curr liab will go up if credit
    extended (A/P)
  • Demonstrate impact of WC investment on cash flow
    with calendar sales booth in mall over Christmas
  • Operate booth from November 1 to January 31
    (close Feb1)
  • Order 15,000 calendars on credit, delivery by
    Nov 1
  • Must pay suppliers 5,000/month, beginning Dec 1
  • Expect to sell 30 of inventory (for cash) in
    Nov 60 in Dec 10 in Jan close up shop Feb 1
  • Always want to have 500 cash on hand invest
    cash Nov 1, receive it back Jan 31.

Working Capital For Calendar Sales Booth
Terminal Value
  • Some investments have a well-defined life,
    determined by
  • Physical life of a piece of equipment
  • Period until a patent expires
  • Period of time covered by a leasing or licensing
  • Terminal value used when evaluating an investment
    with indefinite life-span
  • 1. Construct cash-flow forecasts for 5 to 10
  • 2. Forecasts more than 5 to 10 years high
    margin of error use terminal value instead
  • Terminal value intended to reflect the value of
    a project at a given future point in time
  • Large value relative to all the other cash flows
    of the project

Terminal Value of SDL Acquisition
  • JDS Uniphase projections for acquisition of SDL
  • Different ways to calculate terminal values
    assumptions used to calculate terminal value are
    very important
  • Use final year cash flow projections and assume
    that all future cash flow grow at a constant rate
  • Multiply final cash flow estimate by a market
  • Use investments book value or liquidation value
  • Estimate recovery of no more than 20 50 percent
    of original purchase cost (Asplund, 2002)
  • Possibly negative terminal value if high disposal

Terminal Value of SDL Acquisition (Continued)
  • If assume that cash flow continues to grow at 5
    per year (g 5, r 10, cash flow for year 6
    is 3.41 billion)
  • Terminal value is 68.2 billion value of entire
    project is
  • 42.4 billion of total 48.7 billion from
    terminal value
  • Using price-to-cash-flow ratio of 20 for
    companies in the same industry as SDL to compute
    terminal value
  • Terminal Value 3.25 x 20 65 billion
  • Caveat market multiples fluctuate over time

Incremental Cash Flow
  • Incremental cash flows vs. sunk costs
  • Cap budgeting analysis should include only
    incremental costs
  • For example, decision to pursue MBA can be based
    on incremental cash flows
  • Norman Pauls current salary is 60,000 per year
    and expect to increase at 5 each year
  • Assume that Norm pays taxes at flat rate of 35
  • Sunk costs 1,000 for GMAT course and 2,000 for
    visiting various programs
  • Room and board expenses not incremental to the
    decision to go back to school (assume the same
    expenses for room and board in both cases)

Incremental Cash Flow (Continued)
  • At end of two years assume that Norm receives a
    salary offer of 90,000, which increases at 8
    per year
  • Expected tuition, fees and textbook expenses for
    next two years while studying in MBA 35,000
  • If Norm worked at his current job for two years,
    his salary would have increased to 66,150
  • Yr 2 net cash inflow 90,000 - 66,150 23,850
  • After-tax inflow 23,850 x (1-0.35) 15,503
  • Yr 3 cash inflow
  • MBA has substantial positive NPV value if 30 yr
    analysis period
  • Unwanted incremental cash outflow
    cannibalization (sales of new products may come
    at expense of firms existing products

Opportunity Costs
  • Opportunity cost cash flows from alternative
    investment opportunities that are forgone when
    one investment is undertaken
  • If Norm did not attend MBA, he would have earned
  • First year 60,000 (39,000 after taxes)
  • Second Year 63,000 (40,950 after taxes)
  • Norms opportunity cost 39,000 40,950
  • NPV of a project could fall substantially if
    opportunity costs are recognized
  • MBA applications are countercyclical because
    applicants take into consideration opportunity
  • A firm that bought land for an expansion
    opportunity, for example, should factor into the
    NPV of firms expansion plans the opportunity
    cost of selling or leasing the land

Initial Investment for Jazz CD
  • Company is considering adding jazz recordings to
    its offerings
  • Firm uses 10 discount rate to calculate NPV and
    40 tax rate
  • The average selling price of Classicaltunes CDs
    is 13.50 price is expected to increase at 2
    per year
  • Initial investment transactions
  • 50,000 for computer equipment (MACRS 5-year
    asset class)
  • 4,500 for inventory (2,500 of which purchased
    on credit)
  • 1,000 increase in cash balances
  • Sales expected to begin when new fiscal year
  • Expanding sales volume require increases in
    current assets and additional spending on fixed
  • Any additional financing (besides trade credit)
    for the project from funds generated by
    classical-music CD side of the business

Projections for Jazz CD Proposal
Projections for Jazz CD Proposal (Continued)
Annual Cash Flow Estimates
Year Zero Cash Flow
  • Initial cash outlay of 50,000 for computer
  • Even though sales begin when new fiscal year
    begins, half-year of MACRS depreciation can be
    taken in year zero
  • 20 x 50,000 10,000 non cash expense
  • Depreciation expense can be deducted from the
    firms classical-music CD profits. The company
    saves 4,000 (40 x 10,000) in taxes
  • Changes in working capital are result of
    following transactions
  • Purchase of 4,500 in inventory and 1000 cash
  • Accounts payable of 2,500 partially finance the
    5,500 outlay
  • Net Cash Flow
  • Increase in gross fixed assets -
    50,000 Change in working capital -
    3,000 Tax savings 4,000
  • Net cash flow - 49,000

Year One Cash Flow
  • Purchase of additional 10,000 in fixed assets
  • 2nd year depreciation expenses for MACRS 5-year
    asset class is 32. An additional 20
    depreciation deduction for assets purchased this
  • 32 x 50,000 20 x 10,000 18,000
  • Non cash expense has to be added back when
    computing cash flow for the year
  • Net working capital for year one is
  • NWC Current Assets Current Liabilities
    13,934 - 4,320 9,614
  • Increase in NWC cash outflow of 6,614

Year One Cash Flow (Continued)
  • Pretax loss of 13,043 in year 1 of Jazz CD
    project generates tax savings for other
    operations of
  • Tax savings 40 x 13,043 5,217
  • Net operating cash inflow pretax loss tax
    savings depreciation
  • Operating cash inflow -13,043 5,217
    18,000 10,174
  • Net cash flow
  • Increase in gross fixed assets -
    10,000 Change in working capital -
    6,614 Operating cash inflow
  • Net cash flow - 6,440

Year Two Cash Flow
  • Purchase of additional 5,000 in fixed assets
  • Assets purchased at the onset of the project
    allowable depreciation of 19.2 (19.2 x 50,000
  • An additional 32 depreciation deduction for
    assets purchased in year 1 and 20 depreciation
    of assets purchased this year
  • Total depreciation 9,600 32 x 10,000 20
    x 5,000 4,200 13,800
  • Changes in working capital are result of
    following transactions
  • Increases in current assets
  • 500 increase in cash balance
  • 7,115 increase in accounts receivables
  • 11,383 increase in inventory
  • Increase in current liabilities
  • 6,696 increase in account payables
  • Change in NWC 18,998 - 6,696 12,302 (cash

Year Two Cash Flow (Continued)
  • Pretax profit in year two is 1,649
  • The company must pay taxes of 660 (40 x
    1,649) cash outflow
  • Net operating cash inflow pretax profit tax
  • Operating cash inflow 1,649 - 660 13,800
  • Net cash flow
  • Increase in gross fixed assets -
    5,000 Change in working capital -
    12,302 Operating cash inflow
  • Net cash flow - 2,512

Terminal Value for Jazz CD Investment
  • If assume that cash flow continue to grow at 2
    per year (g 2, r 10,)
  • Second approach used by to
    compute terminal value for the project use the
    book value at end of year six
  • Plant and Equipment (PE) at end of year six is
  • The firm liquidates total current assets and pays
    off current debts
  • 85,850 - 29,810 56,040
  • Terminal value 31,328 56,040 87,368

NPV for Jazz CD Project
  • Using assumption that cash flow grow at a steady
    rate past year 6
  • Using book value assumption for terminal value
  • NPV is positive with both methods investing in
    Jazz CD project increases shareholders wealth

Nominal and Real Return
  • Nominal return vs. real return
  • Nominal return reflects the actual dollar return
    real return measures the increase in purchasing
    power gained by holding a certain investment
  • Common in capital budgeting is the use of market
    rates of return at the time of the analysis
  • Market interest rates have embedded an assumption
    about inflation
  • In this case, use nominal cash flows to reflect
    the same inflation rate as that embedded in
    discount rate

Inflation Rules
  • Inflation Rule 1 if nominal rate used to
    discount cash flow of a project, the embedded
    inflation expectation in the nominal rate must be
    used to construct the cash flows
  • In analysis of Jazz CDs investment, assumption
    that price of a CD increases by 2 per year on
  • Revenues expressed in nominal terms
  • Discount rate used (10) must reflect current
    market returns to account for inflation rate
  • Inflation Rule 2 when project cash flows are
    stated in real rather than nominal terms, the
    appropriate discount rate is the real rate
  • Cash flows projections for
    could be expressed in real terms
  • Use current price for CDs of 13.50, current-year
    labor costs, current-year prices for fixed assets
    for projections of cash flows

Real-Term Cash Flows for Jazz CD Investment
  • To obtain cash flow in real terms discount
    nominal cash flow at inflation rate
  • First year cash flow of -6,440 restated in real

NPV of Jazz CD Project
  • Real rate for
  • NPV of the project discount real-term cash flow
    at real rate

Discounting real cash flows at real interest rate
yields the same NPV as discounting nominal cash
flows at nominal rate
Capital Budgeting and Inflation
Nominal Cash Flows
Real Cash Flows
Nominal Discount Rate
Real Discount Rate
  • If discount nominal cash flows at real discount
  • If discount real cash flows at nominal discount

Equipment Replacement
  • A firm must purchase an electronic control device
  • First alternative cheaper device, higher
    maintenance costs, shorter period of utilization
  • Second device more expensive, smaller
    maintenance costs, longer life span
  • Expected cash outflows
  • Maintenance costs constant over time use real
    discount rate of 7 for NPV
  • Cash outflow device A lt cash outflow device B ?
    select A

Equipment Replacement (Continued)
  • Previous approach ignores the fact that device A
    will be replaced in year 4
  • Different approach use cash flows for 12 years
    ? select B

Equivalent Annual Cost (EAC)
  • EAC method approximates NPV for operating device
    with NPV of annuity
  • 1. Compute NPV for operating devices A and B for
    their lifetime
  • NPV device A 15,936
  • NPV device B 18,065
  • 2. Compute annual expenditure to make NPV of
    annuity equal to NPV of operating device
  • Device A
  • Device B

Equivalent Annual Cost (Continued)
  • The firm chooses device B replacing device B
    every four years is equivalent to a perpetuity of
  • The firm assumes that will keep using device B
    for a long period of time
  • Assume the firm will use in three years new, less
    expensive technology that makes current
    technology obsolete
  • In this case, choose the device that has the
    smallest cash outflow for three years choose A
    (assume salvage value zero)

Excess Capacity
  • Excess capacity not a free asset as
    traditionally regarded by managers
  • Company has excess capacity in a distribution
    center warehouse
  • In two years the firm will invest 2,000,000 to
    expand the warehouse as new stores are built in
    the region
  • The firm could lease the excess space for
    125,000 per year for the next two years
  • Expansion plans should begin immediately in this
    case to hold inventory for stores that will come
    on line in a few months
  • Incremental cost investing 2,000,000 at
    present vs. two years from today
  • Incremental cash inflow - 125,000

Excess Capacity (Continued)
  • NPV of leasing excess capacity (assume 10
    discount rate)
  • NPV negative reject to lease excess capacity at
    125,000 per year
  • The firm could compute the value of the lease
    that would allow to break even
  • X 181,818
  • Leasing the excess capacity for a price above
    181,818 would increase shareholders wealth

The Human Face of Capital Budgeting
  • NPV of a project is based on a number of
  • Managers must be aware of optimistic bias in
    these assumptions made by supporters of the
  • Companies should have control measures in place
    to remove bias
  • Analysis of an investment done by a group
    independent of individual or group proposing the
  • Analysts of the project must have a sense of what
    is reasonable when forecasting a projects profit
    margin and its growth potential
  • Another side of determining which projects
    receive funding storytelling
  • Best analysts not only provide numbers to
    highlight a good investment, but also can explain
    why this investment makes sense