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Cash Flow And Capital Budgeting. Professor XXXXX Course Name / Number. To evaluate a capital investment we must know:. What cash outflows will occur as a result of the investment?. What cash inflows will the investment produce?.

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cash flow and capital budgeting

Cash Flow And Capital Budgeting

Professor XXXXX

Course Name / Number

cash flow versus accounting profit

To evaluate a capital investment we must know:

  • What cash outflows will occur as a result of the investment?
  • What cash inflows will the investment produce?
  • The timing and magnitude of cash flows and accounting profits can differ dramatically
Cash Flow Versus Accounting Profit

Capital budgeting concerned with cash flow, not accounting profit

cash flow and non tax expenses
Cash Flow and Non-Tax Expenses
  • Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits
  • Capital budgeting analysis focuses on cash inflows and outflows when they occur
  • Non-cash expenses affect cash flow through their impact on taxes
    • Compute after-tax net income and add depreciation back
    • Ignore depreciation expense but add back its tax savings
two methods of handling depreciation to compute cash flow

Assume a firm purchases a fixed asset today for $30,000

Adding non-cash expenses back to after-tax earnings

Find after-tax profits, add back non-cash charge tax savings

Sales

$30,000

Sales

$30,000

Cost of goods

(10,000)

Cost of goods

(10,000)

Plans to depreciate over 3 years using straight-line method

Gross profits

$20,000

Pre-tax income

$20,000

Depreciation

(10,000)

Taxes (40%)

(8,000)

Costs $1/unit

Pre-tax income

$10,000

Aft-tax income

$12,000

Firm will produce 10,000 units/year

Taxes (40%)

(4,000)

Depreciation tax savings

$4,000

Sells for $3/unit

Net income

$6,000

Cash Flow

$16,000

Cash flow

= NI + deprec

$16,000

Firm pays taxes at a 40% marginal rate

Simplest and most common technique:

Add depreciation back in

Two Methods Of Handling Depreciation To Compute Cash Flow
depreciation
Depreciation
  • Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes
  • Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits
  • Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life

Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements?

For capital budgeting analysis, it is the depreciation method for tax purposes that matters

the initial investment

New equipment costs $10 million,

$0.5 million to install

An example....

Tax rate = 40%

Old equipment has been fully depreciated, sold for $1 million

  • The initial investment would then be an outflow of $10.5 million, and an after-tax inflow of $0.60 million from selling the old equipment
The Initial Investment
  • Many capital budgeting problems begin with an initial outflow to acquire/install fixed assets. Must also consider:
    • Cash inflow from selling old equipment
    • Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability)
working capital expenditures
Working Capital Expenditures
  • Many capital investments require additions to working capital
    • Net working capital (NWC) = current assets minus current liabilities
    • Increase in NWC is a cash outflow; decrease a cash inflow
  • An example…
    • Operate booth from November 1 to January 31
    • 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
    • Always want to have $500 cash on hand
working capital for calendar sales booth

Oct 1

Nov 1

Dec 1

Jan 1

Feb 1

Cash

$0

$500

$500

$500

$0

Inventory

$0

$15,000

$10,500

$1,500

$0

Accts payable

$0

$15,000

$10,000

$5,000

Net WC

$0

$500

$1,000

($3,000)

Monthly  in WC

NA

+$500

+$500

($4,000)

Payments and

inventory

Oct 1 to Nov 1

Nov 1 to Dec 1

Dec 1 to Jan 1

Jan 1 to Feb 1

Reduction in inventory

$0

$4,500

[30%]

$9,000

[60%]

$1,500

[10%]

Payments

$0

($5,000)

($5,000)

($5,000)

($500)

+$4,000

($3,000)

Net cash flow

($500)

Working Capital For Calendar Sales Booth

$0

$0

+$3,000

terminal value
Terminal Value

Terminal value used when evaluating an investment with indefinite life-span

Construct cash-flow forecasts for 5 to 10 years

Forecasts more than 5 to 10 years have high margin of error; use terminal value instead

  • Terminal value is 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 value1

Different ways to calculate terminal values

Year 1

Year 2

Year 3

Year 4

Year 5

$0.5 Billion

$1.0 Billion

$1.75 Billion

$2.5 Billion

$3.25 Billion

  • Use final year cash flow projections and assume that all future cash flows grow at a constant rate
  • Multiply final cash flow estimate by a market multiple
  • Use investment’s book value or liquidation value

JDS Uniphase cash flow projections for acquisition of SDL Inc.

Terminal Value
terminal value of sdl acquisition
Terminal Value of SDL Acquisition
  • If we 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 versus sunk costs

  • Capital budgeting analysis should include only incremental costs
  • An example…
    • Norman Paul’s current salary is $60,000 per year and expect increases of 5% each year
    • 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 are not incremental to the decision to go back to school
Incremental Cash Flow
incremental cash flow1
Incremental Cash Flow
  • 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

What about Norm’s opportunity cost?

opportunity costs

If Norm did not attend MBA, he would haveearned:

First year: $60,000 ($39,000 after taxes)

Second Year: $63,000 ($40,950 after taxes)

Opportunity Costs

Cash flows from alternative investment opportunities, forgone when one investment is undertaken

NPV of a project could fall substantially if opportunity costs are recognized

initial investment for jazz cd project

$50,000 for computer equipment (MACRS 5-year)

Initial investment transactions:

$4,500 for inventory ($2,500 of which purchased on credit)

$1,000 increase in cash balances

Initial Investment for Jazz CD Project

Classicaltunes.com 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 CD’s is $13.50; price is expected to increase at 2% per year
  • Sales expected to begin when new fiscal year begins
projections for jazz cd proposal

Abbreviated Project Balance Sheet

Year

0

1

2

3

4

5

6

Annual Cash Flow Estimates for Classicaltunes.com

Year

0

1

2

3

4

5

6

Price per unit

$13.50

$13.77

$14.05

$14.33

$14.61

$14.91

$15.20

Year

0

1

2

3

4

5

6

Cash

1000

2000

2500

3000

3200

3300

3500

Units

0

4,000

10,000

16,000

22,000

24,000

25,000

New Fixed Assets

-50000

-10000

-5000

-25000

-40000

-15000

-10000

Accounts Receivable

0

4590

11705

19102

26790

29810

31673

Abbreviated Project Income Statement

Change in working capital

-3000

-6614

-12302

-12771

-12953

-5109

-3291

Inventory

4500

7344

18727

30563

42864

47696

50677

Revenue

0

55080

140454

229221

321482

357722

380080

Current Assets

5500

13934

32932

52665

72855

80806

85851

Cost of goods sold

0

41861

105341

169623

234682

259349

273657

Operating cash flow

4000

10174

14790

23591

40411

47644

48454

Gross P&E

50000

60000

65000

90000

130000

145000

155000

Gross profit

0

13219

35114

59597

86800

98374

106422

Accumulated Depreciation

10000

28000

41800

56080

79952

105160

123672

Net cash flow

-49000

-6440

-2512

-14180

-12542

27535

35163

SG&A Expense

0

8262

19664

29799

35363

35772

38008

Net P&E

40000

32000

23200

33920

50048

39840

31328

Depreciation

10000

18000

13800

14280

23872

25208

18512

Total assets

45500

45934

56132

86585

122903

120646

117179

Pretax profit

-10000

-13043

1649

15519

27565

37393

49903

Accounts Payable

2500

4320

11016

17978

25214

28057

29810

Projections for Jazz CD Proposal
year zero cash flow
Year Zero Cash Flow
  • Initial cash outlay of $50,000 for computer equipment
  • Half-year of MACRS depreciation can be taken in year zero:
    • 20% x $50,000 = $10,000; non cash expense
    • Depreciation expense are deducted from the firm’s classical-music CD profits. Savings of $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 balance
    • Accounts payable of $2,500 partially finance $5,500 outlay

Net Cash Flow:

year one cash flow
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 year
    • 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 flow1
Year One Cash Flow
  • Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com
    • 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:

year two cash flow
Year Two Cash Flow
  • Purchase of additional $5,000 in fixed assets
    • Assets purchased at the onset of the project have allowable depreciation of 19.2% (19.2% x $50,000 = $9,600)
    • 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 outflow)
year two cash flow1
Year Two Cash Flow
  • 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 + depreciation
    • Operating cash inflow = $1,649 - $660 + $13,800 = $14,789

Net Cash Flow:

terminal value for jazz cd investment
Terminal Value for Jazz CD Investment
  • If assume that cash flow continues to grow at 2% per year (g = 2%, r = 10%,)
  • Second approach used by Classicaltunes.com to compute terminal value for the project – use the book value at end of year six:
    • Plant and Equipment (P&E) at end of year six is $31,328
    • 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
NPV for Jazz CD Project
  • Using assumption that cash flow grows 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
capital budgeting and inflation
Capital Budgeting and Inflation

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 CD’s investment, assumption that price of a CD increases by 2% per year on average
  • 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 Classicaltunes.com 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
equipment replacement and unequal lives

Device

0

1

2

3

4

A

12000

1500

1500

1500

-

B

14000

1200

1200

1200

1200

Device

NPV

A

$15,936

B

$18,065

Equipment Replacement and Unequal Lives
  • A firm must purchase an electronic control device
    • First alternative is a cheaper device, higher maintenance costs, shorter period of utilization
    • Second device is more expensive, smaller maintenance costs, longer life span
  • Expected cash outflows
    • Maintenance costs are constant over time. Use real discount rate of 7% for NPV

Cash outflow device A < cash outflow device B  select A?

equivalent annual cost eac

Device A

Device B

Equivalent Annual Cost (EAC)
  • EAC converts lifetime costs to a level annuity; eliminates the problem of unequal lives
    • 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
excess capacity
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
  • 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 capacity1
Excess Capacity
  • 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
The Human Face of Capital Budgeting
  • Managers must be aware of optimistic bias in these assumptions made by supporters of the project
  • 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 project
    • Analysts of the project must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential
  • Storytelling
    • Best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense
cash flow and capital budgeting1

Cash Flow and Capital Budgeting

Certain types of cash flows are common to many investments

Opportunity costs should be included in cash flow projections

Discount nominal cash flows at a nominal rate and real cash flows at a real rate

Consider human factors in capital budgeting