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Topic 5 Making Capital Investment Decisions

Topic 5 Making Capital Investment Decisions. 5 .1. Project Cash Flows: A First Look 5 .2. Incremental Cash Flows 5 .3. Pro Forma Financial Statements and Project Cash Flows 5 .4. More on Project Cash Flow 5 .5. Alternative Definitions of Operating Cash Flow

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Topic 5 Making Capital Investment Decisions

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  1. Topic 5Making Capital Investment Decisions 5.1. Project Cash Flows: A First Look 5.2. Incremental Cash Flows 5.3. Pro Forma Financial Statements and Project Cash Flows 5.4. More on Project Cash Flow 5.5. Alternative Definitions of Operating Cash Flow 5.6. Some Special Cases of Cash Flow Analysis

  2. 5.1. Project Cash Flows: A First Look The effect of taking an investment project is to change the firm’s overall cash flows today and in the future. To evaluate a proposed investment, we must consider these cash flow changes in the firm’s cash flows and then decide whether or not they add value to the firm. The first and most important step is to decide which cash flows are relevant and which are not.

  3. 5.1. Project Cash Flows: A First Look The relevant cash flows are defined in terms of changes in, or increments to, the firm’s existing cash flow. They are called the incremental cash flows associated with the project. The incremental cash flows for the project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.

  4. 5.1. Project Cash Flows: A First Look The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted. These cash flows are called incremental cash flows. The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.

  5. 5.1. Project Cash Flows: A First Look You should always ask yourself “Will this cash flow occur ONLY if we accept the project?” • If the answer is “yes”, it should be included in the analysis because it is incremental; • If the answer is “no”, it should not be included in the analysis because it will occur anyway; • If the answer is “part of it”, then we should include the part that occurs because of the project.

  6. 5.2. Incremental Cash Flows Common Types of Cash Flows: • Sunk costs – costs that have been accrued in the past; • Opportunity costs – costs of lost options; • Side effects: • Positive side effects – benefits to other projects; • Negative side effects – costs to other projects; • Changes in net working capital; • Financing costs; • Taxes.

  7. 5.2. Incremental Cash Flows Sunk Costs. A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. Opportunity Costs. The most valuable alternative that is given up if a particular investment is undertaken.

  8. 5.2. Incremental Cash Flows Side Effects. The incremental cash flows for a project include all the resulting changes in the firm’s future cash flows. It would not be unusual for a project to have side effects, both good and bad. Erosion. The cash flows of a new project that come at the expense of a firm’s existing projects.

  9. 5.2. Incremental Cash Flows Net Working Capital. A project will require that the firm invests in net working capital in addition to long-term assets. For example, a project will need an initial investment in inventories and accounts receivable.

  10. 5.2. Incremental Cash Flows As project winds down, inventories are sold, receivables are collected and cash balances can be drawn down. These activities free up the net working capital originally invested. The firm supplies working capital at the beginning and recovers it towards the end.

  11. 5.2. Incremental Cash Flows Financing costs. In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid, because we are interested in the cash flow generated by the assets of the project. Interest paid is a component of cash flow to creditors, not cash flow from assets.

  12. 5.2. Incremental Cash Flows Our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project in order to estimate NPV. This is not to say that financing arrangements are unimportant. They are just something to be analyzed separately.

  13. 5.2. Incremental Cash Flows Taxes. We are only interested in measuring cash flow when it actually occurs, not when it accrues in an accounting sense. We are always interested in after-tax cash flow because taxes are definitely cash outflow. Remember, however, that after-tax cash flow and accounting profit, or net income, are entirely different things.

  14. 5.3. Pro Forma Financial Statements and Project Cash Flows Capital budgeting relies heavily on pro forma accounting statements, particularly income statements. Pro forma financial statements are a convenient and easily understood means of summarizing much of relevant information for a project. To illustrate, suppose we think we can sell 50,000 cans of shark attractant per year at a price of $4 per can.

  15. 5.3. Pro Forma Financial Statements and Project Cash Flows It costs us about $2.50 per can to make the attractant, and a new product such as this one typically has only a three-year life. We require a 20% return on new products. Fixed costs for the project, including such things as rent on the production facility, will run $12,000 per year. We will need to invest a total of $90,000 in manufacturing equipment.

  16. 5.3. Pro Forma Financial Statements and Project Cash Flows For simplicity, we will assume that this $90,000 will be 100% depreciated over the three-year life of the project. The cost of removing the equipment will roughly equal its actual value in three years, so it will be essentially worthless on a market value basis as well. The project will require an initial $20,000 investment in net working capital, and the tax rate is 34%.

  17. 5.3. Pro Forma Financial Statements and Project Cash Flows Pro forma income statement

  18. 5.3. Pro Forma Financial Statements and Project Cash Flows Projected Capital Requirements

  19. 5.3. Pro Forma Financial Statements and Project Cash Flows Computing cash flows – refresher • Operating Cash Flow (OCF) = EBIT + + depreciation – taxes • OCF = Net income + depreciation when there is no interest expense • Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

  20. 5.3. Pro Forma Financial Statements and Project Cash Flows Projected Operating cash Flow Pro forma Income statement

  21. 5.3. Pro Forma Financial Statements and Project Cash Flows Projected Total Cash Flows

  22. 5.3. Pro Forma Financial Statements and Project Cash Flows Now we have cash flow projections and we may apply the various investment criteria. NPV=-110,000 +51,780/1,21+ 51,780/1,22 + +71,780/1,23 = $10,648 IRR = 25.8% NPV=-110,000 +51,780/(1+IRR)1+ + 51,780/(1+IRR)2 + 71,780/(1+IRR)3 = 0

  23. 5.3. Pro Forma Financial Statements and Project Cash Flows Payback = 2.1 years Year ___0________1_________2_________3 -110,000 51,780 51,780 71,780 The average accounting return (AAR) =33.51% The average net income is $21,780. The average of the four book values is ($110+80+50+20)/4=$65 So the AAR is $21,780/65,000 = 33.51%

  24. 5.4. More on Project Cash Flow (Net Working Capital) Why do we have to consider changes in NWC separately? • IAS (GAAP) requires that sales be recorded on the income statement when made, not when cash is received • IAS (GAAP) also requires that we record cost of goods sold when the corresponding sales are made, whether we have not actually paid our suppliers yet • Finally, we have to buy inventory to support sales although we haven’t collected cash yet

  25. 5.4. More on Project Cash Flow (Net Working Capital) Suppose that during a particular year of a project we have the following simplified income statement: Depreciation and taxes are zero. No fixed assets are purchased during the year. We assume that the only components of net working capital are

  26. 5.4. More on Project Cash Flow (Net Working Capital) accounts receivable and payable. The beginning and ending amounts for these accounts are as follows: Operating cash flow in this particular case is the same as EBIT because there are no taxes or depreciation and thus it equals $190.

  27. 5.4. More on Project Cash Flow (Net Working Capital) Net working capital actually declined by $25. There was no capital spending, so the total cash flow for the year is: Total cash flow = Operating cash flow – Change in NWC – Capital spending = = $190 – (– 25) – 0 = $215 The total cash flow is the difference between cash revenues and cash costs. What were cash revenues and cash costs for the year?

  28. 5.4. More on Project Cash Flow (Net Working Capital) We had sales of $500. However, accounts receivable rose by $30. The sales exceeded collections by $30. As a result, our cash inflow is $500 – 30 = $470. Cash outflows can be similarly determined. We had costs of $310, but accounts payable increased by $55 during the year. So cash costs for the period were just $310 – 55 = $255.

  29. 5.4. More on Project Cash Flow (Net Working Capital) Cash flow = Cash inflow – Cash outflow = = ($500 – 30) – (310 – 55) = = ($500 – 310) – (30 – 55) = = Operating cash flow – Change in NWC = = $190 – (– 25) = $215 This example illustrates that including net working capital changes in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments.

  30. 5.4. More on Project Cash Flow (Depreciation) Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes Depreciation tax shield = D×T D = depreciation expense T = marginal tax rate Straight-line depreciation D = (Initial cost – salvage) / number of years Very few assets are depreciated straight-line for tax purposes.

  31. 5.4. More on Project Cash Flow (Depreciation) MACRS (Modified accelerated cost recovery system). A depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications. • Need to know which asset class is appropriate for tax purposes • Multiply percentage given in table by the initial cost • Depreciate to zero • Mid-year convention

  32. 5.4. More on Project Cash Flow (Depreciation) Property Classes Modified ACRS Depreciation Allowances

  33. 5.4. More on Project Cash Flow (Depreciation) A nonresidential real property, such as an office building, is depreciated over 31.5 years using straight-line depreciation. A residential real property, such as an apartment building, is depreciated straight-line over 27.5 years. Land cannot be depreciated. To illustrate, how depreciation is calculated, we consider an automobile costing $12,000. Autos are normally classified as five-year property.

  34. 5.4. More on Project Cash Flow (Depreciation)

  35. 5.4. More on Project Cash Flow (Depreciation) If the salvage value is different from the book value of the asset, then there is a tax effect. Book value = initial cost – accumulated depreciation After-tax salvage = salvage – – T×(salvage – book value)

  36. 5.4. More on Project Cash Flow (Depreciation) In calculating depreciation under current tax law, the economic life and future market value of the asset are not an issue. As a result, a book value of an asset can differ substantially from its actual market price. Suppose that we wanted to sell the car after five years. Based on historical averages, it would be worth 25% of the purchase price, or 0.25 × $12,000 = $3,000 If we actually sold it for this, then we would have

  37. 5.4. More on Project Cash Flow (Depreciation) to pay taxes at the ordinary income tax rate on the difference between the sale price of $3,000 and the book value of $691.20. For a corporation the tax liability would be 0.34 × $2,308.80 = $784.99 Finally, if the book value exceeds the market value, then the difference is treated as a loss for tax purposes. For example, if we sell the car after two years for $4,000, then the book value exceeds the market value by $1,760. A tax saving of 0.34 × 1,760 = $598.40 occurs.

  38. 5.4. More on Project Cash Flow (An example MMCC) The Majestic Mulch and Compost Company (MMCC) is investigating the feasibility of a new line of power mulching tools aimed at the growing number of home composters. MMCC projects unit sales as follows:

  39. 5.4. More on Project Cash Flow (An example MMCC) The new power mulcher will be priced to sell at $120 per unit to start. MMCC anticipates that after three years the price will drop to $110. The project will require $20,000 in net working capital at the start. Subsequently, total net working capital at the end of each year will be about 15% of sales for that year. The variable cost per unit is $60, and total fixed costs are $25,000 per year.

  40. 5.4. More on Project Cash Flow (An example MMCC) It will cost about $800,000 to buy the equipment necessary to begin production. This investment is primarily in industrial equipment, which qualifies as seven-year MACRS property. The equipment will actually be worth 20% of its cost in eight years, or 0.20×$800,000=$160,000. The relevant tax rate is 34%, and the required return is 15%. Based on this information, should MMCC proceed?

  41. 5.4. More on Project Cash Flow (An example MMCC) Projected revenues

  42. 5.4. More on Project Cash Flow (An example MMCC) Annual Depreciation

  43. 5.4. More on Project Cash Flow (An example MMCC) Projected Income Statement

  44. 5.4. More on Project Cash Flow (An example MMCC) Changes in Net Working Capital

  45. 5.4. More on Project Cash Flow (An example MMCC) Projected Cash Flows

  46. 5.4. More on Project Cash Flow (An example MMCC) Change in NWC NWC starts out at $20,000 and then rises to 15% of sales. During the first year, net working capital grows from $20,000 to 0.15×$360,000=$54,000 The increase in net working capital for this year is thus $54,000-20,000=$34,000. The remaining figures are calculated in the same way.

  47. 5.4. More on Project Cash Flow (An example MMCC) Capital Spending MMCC invests $800,000 at year 0. By assumption, this equipment will be worth $160,000 at the end of the project. It will have a book value of zero at that time. As we discussed earlier, this $160,000 excess of market value over book value is taxable, so after tax proceeds will be $160,000×(1-0.34)=$105,600

  48. 5.4. More on Project Cash Flow (An example MMCC) Projected Total Cash Flow

  49. 5.4. More on Project Cash Flow (An example MMCC) Total Cash Flow and Value If we sum the discounted flows and the initial investment, the net present value (at 15%) works out to be $65,488. This is positive, so the power mulcher project is acceptable. The internal rate of return is grater than 15% because the NPV is positive. It works out to be 17.24%, again indicating that the project is acceptable.

  50. 5.5. Alternative Definitions of Operating Cash Flow Tax Shield Approach • OCF = (Sales – Costs) × (1 – Tc) + + Depreciation × Tc Bottom-Up Approach • Works only when there is no interest expense • OCF = NI + Depreciation Top-Down Approach • OCF = Sales – Costs – Taxes • Don’t subtract non-cash deductions

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