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## Cash Flows and Other Topics in Capital Budgeting

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Cash Flows in General

Measure Incremental Cash Flows

- Measure cash flows that change if a project is undertaken
- Sunk cost is irrelevant
- Opportunity cost is relevant
- Do not include allocation of existing overhead
- Do subtract lost sales of other products
- Include cost savings as a positive cash flow.

Cash Flows in General

- New Project vs. Replacement Project
- New project – simply addition to company
- Replacement – replace and existing old machine or plant.
- Financing costs - Interest and Dividend payments. are not considered operating cash flows. Financing cost are used to discount the cash flows to find NPV,etc.
- Only include CASH inflows and outflows.

0 1 2 3 N

Estimating Cash FlowsThree Types of Cash Flows

- Initial Outlay
- Operating (Differential) Cash Flows

Initial Outlay

Operating Cash Flows

0 1 2 3 N

Estimating Cash FlowsThree Types of Cash Flows

- Initial Outlay
- Operating (Differential) Cash Flows
- Terminal Cash Flow

Initial Outlay

Terminal Cash Flow

Operating Cash Flows

Estimating Cash Flows

Initial Outlay

- Cost of Assets
- Installation and Shipping
- Non-Expense Outlays (i.e. Working Capital)
- Expense Outlays after tax (i.e. Training Expenses)

Estimating Cash Flows

Initial Outlay

- Cost of Assets
- Installation and Shipping
- Non-Expense Outlays (i.e. Working Capital)
- Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

- Sale of Old Machine

Estimating Cash Flows

Initial Outlay

- Cost of Assets
- Installation and Shipping
- Non-Expense Outlays (i.e. Working Capital)
- Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

- Sale of Old Machine
- Taxes on Machine

Estimating Cash Flows

Initial Outlay

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%.

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

4,000(1-0.40)

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

Tax rate x (Salvage Value-Book Value)

.4(10,000 – 0)

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

Initial Outlay +49,400

0 1 2 3 4 5

Estimating Cash FlowsInitial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

Initial Outlay +49,400

-49,400

Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Sell “New” Machine 15,000

Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Sell “New” Machine 15,000

Tax on Sale -6,000

.4(15,000-0)

Estimating Cash FlowsGasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Terminal Cash Flow

Example:

Recover Working Capital +3,000

Sell “New” Machine 15,000

Tax on Sale -6,000

Terminal Cash Flow +12,000

Capital Rationing

- In large companies, many projects are evaluated each year
- Management often imposes a limit that can be spent on new projects adopted during the year–Capital Rationing
- In order to allocate scarce resources, choose the group of projects whose initial outlays are within the capital spending limit while at the same time maximizing NPV of the group of projects.

Capital Rationing

Example

The following independent projects are subject to a

$100,000 capital budget.

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

All Projects have NPV > 0, PI > 1

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital RationingExample

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital RationingExample

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital RationingExample

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital RationingExample

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

1,3 & 4 50,000 1,500

30,000 2,500

20,000 1,000

100,000 5,000

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital RationingExample

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

1,3 & 4 50,000 1,500

30,000 2,500

20,000 1,000

100,000 5,000

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