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Chapter 8 - Cash Flows and Other Topics in Capital Budgeting. 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?
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Chapter 8 - Cash Flows and Other Topics in Capital Budgeting
Capital Budgeting: The process of planning for purchases of long-termassets. 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:
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.
Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. • Initial outlay • Differential Cash Flowsover the life of the project (also referred to as annual cash flows). • Terminal Cash Flows
. . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows
. . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Initial outlay
. . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Initial outlay Annual Cash Flows
. . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay Annual Cash Flows
Capital Budgeting Steps 2)Evaluate the Risk of the Project • We’ll get to this in the next chapter. • For now, we’ll 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 firm’s cost of capital as the discount rate for capital investment projects.
Capital Budgeting Steps 3) Accept or Reject the Project
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
Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay
Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay
Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay
Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (20,000) (147,000) + (4,000) + After-tax proceeds from sale of old asset Net Initial Outlay
Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (20,000) (147,000) + (4,000) + 0 Net Initial Outlay
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
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
Step 1: Evaluate Cash Flows b) Annual Cash Flows: What incremental cash flows occur over the life of the project?
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
For Years 1 - 5: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow
For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow
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
Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
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).
Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow
Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000Recapture of NWC Terminal Cash Flow
Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow
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 acceptthe project.
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?
Capital Rationing • You could rank the projects by IRR:
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 1
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 2 1
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 2 3 1
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 4 2 3 1
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 5 4 2 3 1
IRR 25% 20% 15% 10% 5% $ 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
IRR 25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: Our budget is limited so we accept only projects 1, 2, and 3. 2 3 1 $X
Capital Rationing • Ranking projects by IRR is not always the best way to deal with a limited capital budget. • It’s better to pick the largest NPVs. • Let’s try ranking projects by NPV.
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.
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 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 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 Size Disparity Example