2.cashflows

7/25/2019 2.Cashflows

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Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. ll !i"hts

CHAPTER

7

Net Present Value

and CapitalBudgeting


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Chapter Outline

7.1 Incremental Cash Flows

7.2 The Baldwin Company: An !ample

7." The Boein# 777: A $eal-%orld !ample

7.& In'lation and Capital Bud#etin#

7.( In)estments o' *ne+ual ,i)es: The+ui)alent Annual Cost ethod

7. /ummary and Conclusions



7." The Boein# 777: A $eal-%orld !ample

7.& In'lation and Capital Bud#etin#

7.( In)estments o' *ne+ual ,i)es: The+ui)alent Annual Cost ethod

7. /ummary and Conclusions


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Cash 'lows matter0not accountin# earnin#s.

/un costs dont matter.

Incrementalcash 'lows matter.Opportunity costs matter.

/ide e''ects lie canni3alism and erosion matter.

Ta!es matter: we want incremental a'ter-ta! cash'lows.

In'lation matters.

Cash 'lows matter0not accountin# earnin#s.

/un costs dont matter.

Incrementalcash 'lows matter.Opportunity costs matter.

/ide e''ects lie canni3alism and erosion matter.

Ta!es matter: we want incremental a'ter-ta! cash'lows.

In'lation matters.


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Cash Flows04ot Accountin# arnin#s

Consider depreciation e!pense.

5ou ne)er write a chec made out to

6depreciation.

uch o' the wor in e)aluatin# a pro8ect

lies in tain# accountin# num3ers and

#eneratin# cash 'lows.

Consider depreciation e!pense.

5ou ne)er write a chec made out to

6depreciation.

uch o' the wor in e)aluatin# a pro8ect

lies in tain# accountin# num3ers and

#eneratin# cash 'lows.


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Incremental Cash Flows

/un costs are not rele)ant

9ust 3ecause 6we ha)e come this 'ar does not meanthat we should continue to throw #ood money a'ter

3ad.

Opportunity costs domatter. 9ust 3ecause apro8ect has a positi)e 4; that does not mean

that it should also ha)e automatic acceptance./peci'ically i' another pro8ect with a hi#her 4;would ha)e to 3e passed up we should not

proceed.

/un costs are not rele)ant

9ust 3ecause 6we ha)e come this 'ar does not meanthat we should continue to throw #ood money a'ter

3ad.

Opportunity costs domatter. 9ust 3ecause apro8ect has a positi)e 4; that does not mean

that it should also ha)e automatic acceptance./peci'ically i' another pro8ect with a hi#her 4;would ha)e to 3e passed up we should not

proceed.


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Incremental Cash Flows

/ide e''ects matter.

rosion and canni3alism are 3oth 3ad thin#s.

I' our new product causes e!istin# customersto demand less o' current products< we need to

reco#ni=e that.

/ide e''ects matter.

rosion and canni3alism are 3oth 3ad thin#s.

I' our new product causes e!istin# customersto demand less o' current products< we need to

reco#ni=e that.


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stimatin# Cash Flows

Cash Flows 'rom Operations

$ecall that:

Operatin# Cash Flow > BIT ? Ta!es @ epreciation4et Capital /pendin#

ont 'or#et sal)a#e )alue a'ter ta!< o' course.

Chan#es in 4et %orin# Capital$ecall that when the pro8ect winds down< we en8oy a

return o' net worin# capital.

Cash Flows 'rom Operations

$ecall that:

Operatin# Cash Flow > BIT ? Ta!es @ epreciation4et Capital /pendin#

ont 'or#et sal)a#e )alue a'ter ta!< o' course.

Chan#es in 4et %orin# Capital$ecall that when the pro8ect winds down< we en8oy a

return o' net worin# capital.


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Interest !pense

,ater chapters will deal with the impact that

the amount o' de3t that a 'irm has in its

capital structure has on 'irm )alue.For now< its enou#h to assume that the

'irms le)el o' de3t hence interest e!pense

is independent o' the pro8ect at hand.

,ater chapters will deal with the impact that

the amount o' de3t that a 'irm has in its

capital structure has on 'irm )alue.For now< its enou#h to assume that the

'irms le)el o' de3t hence interest e!pense

is independent o' the pro8ect at hand.


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Costs o' test maretin# already spent: 2(G


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The %orsheet 'or Cash Flows

o' the Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5In)estments:

1 Bowlin# 3all machine ?1GG.GG 21.7J

2 Accumulated 2G.GG (2.GG 71.2G D2.72 E&.2&depreciation

" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7

machine a'terdepreciation end o' year

& Opportunity cost ?1(G.GG1(G.GGwarehouse

( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 G end o'

year Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22worin# capital

7 Total cash 'low o' ?2G.GG ?."2 ?D.( ".7( 1E2.EDin)estmentK1 @ & @ L

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5In)estments:

1 Bowlin# 3all machine ?1GG.GG 21.7J


" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7

machine a'terdepreciation end o' year

& Opportunity cost ?1(G.GG1(G.GGwarehouse

( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 G end o'

year Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22

worin# capital


J %e assume that the endin# maret )alue o' the capital in)estment at year ( is "G


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The %orsheet 'or Cash Flows o' the Baldwin Company

($ thousands) (All cash flows occur at the endof the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

In)estments:1 Bowlin# 3all machine ?1GG.GG 21.7J


" Ad8usted 3asis o' DG.GG &D.GG 2D.DG 17.2D (.7machine a'ter

depreciation end o' year& Opportunity cost ?1(G.GG

1(G.GGwarehouse

( 4et worin# capital 1G.GG 1G.GG 1."2 2&.E7 21.22 Gend o' year

Chan#e in net ?1G.GG ?."2 ?D.( ".7( 21.22worin# capital


1(G

At the end of the project, the warehouse s unencu!"ered, so we can sell t f we want to.

7


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The %orsheet 'or Cash Flows o' the

Baldwin Company continued


Income:

D /ales $e)enues 1GG.GG 1".GG 2&E.72 212.2G 12E.EG


Income:



$ecall that production in units 3y year durin# (-year li'e o' the machine is#i)en 3y:

(


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The %orsheet 'or Cash Flows o' the Baldwin

Company continued


Income:


E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&


Income:




A#ain< production in units 3y year durin# (-year li'e o' the machine is #i)en3y:

(


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The %orsheet 'or Cash Flows o' the Baldwin

Company continued


Income:



1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2


Income:



1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2

($ thousands) (All cash flows occur at theend

of the year.)

epreciation is calculated usin# the AcceleratedCost $eco)ery /ystem shown at ri#ht

Our cost 3asis is 1GG 1GG 11


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The %orsheet 'or Cash Flows o' the

Baldwin Company continued


Income:


E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2

11 Income 3e'ore ta!es "G.GG &".2G D(."2 7.(D "G.(&KD ? E - 1GL

12 Ta! at "& percent 1G.2G 1&.E 2E.G1 22.ED 1G."D

1" 4et Income 1E.DG 2D.(1 (."1 &&.G 2G.1


Income:


E Operatin# costs (G.GG DD.GG 1&(.2G 1"".1G D7.D&1G epreciation 2G.GG "2.GG 1E.2G 11.(2 11.(2

11 Income 3e'ore ta!es "G.GG &".2G D(."2 7.(D "G.(&KD ? E - 1GL

12 Ta! at "& percent 1G.2G 1&.E 2E.G1 22.ED 1G."D

1" 4et Income 1E.DG 2D.(1 (."1 &&.G 2G.1


7


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Incremental A'ter Ta! Cash Flows

o' the Baldwin Company


1 /ales

$e)enues

1GG.GG 1".GG 2&E.72 212.2G 12E.EG

2 Operatin#

costs

-(G.GG -DD.GG -1&(.2G 1"".1G -D7.D&

" Ta!es -1G.2G -1&.E -2E.G1 -22.ED -1G."D

& OCF

1 ? 2 ? "

"E.DG G.(1 7(.(1 (.12 "1.D

( Total CF o'

In)estment

?2G. ?."2 ?D.( ".7( 1E2.ED

IATCFK& @ (L

?2G. "E.DG (&.1E .D (E.D7 22&.

G(.(DD


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4; Baldwin Company

1

"E.DG

(1


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7." In'lation and Capital Bud#etin#

In'lation is an important 'act o' economic li'e and must 3e considered incapital 3ud#etin#.

Consider the relationship 3etween interest rates and in'lation< o'tenre'erred to as the Fisher relationship:

1 @ 4ominal $ate > 1 @ $eal $ate M 1 @ In'lation $ate

For low rates o' in'lation< this is o'ten appro!imated as

$eal $ate 4ominal $ate ? In'lation $ate

%hile the nominal rate in the *./. has 'luctuated with in'lation< most o'

the time the real rate has e!hi3ited 'ar less )ariance than the nominalrate.

%hen accountin# 'or in'lation in capital 3ud#etin#< one must comparereal cash 'lows discounted at real rates or nominal cash 'lowsdiscounted at nominal rates.

In'lation is an important 'act o' economic li'e and must 3e considered incapital 3ud#etin#.

Consider the relationship 3etween interest rates and in'lation< o'tenre'erred to as the Fisher relationship:

1 @ 4ominal $ate > 1 @ $eal $ate M 1 @ In'lation $ate

For low rates o' in'lation< this is o'ten appro!imated as

$eal $ate 4ominal $ate ? In'lation $ate

%hile the nominal rate in the *./. has 'luctuated with in'lation< most o'

the time the real rate has e!hi3ited 'ar less )ariance than the nominalrate.

%hen accountin# 'or in'lation in capital 3ud#etin#< one must comparereal cash 'lows discounted at real rates or nominal cash 'lowsdiscounted at nominal rates.

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!ample o' Capital Bud#etin# under In'lation

/ony International has an in)estment opportunity to produce a newstereo color T;.

The re+uired in)estment on 9anuary 1 o' this year is "2 million. The'irm will depreciate the in)estment to =ero usin# the strai#ht-linemethod. The 'irm is in the "& ta! 3racet.

The price o' the product on 9anuary 1 will 3e &GG per unit. Theprice will stay constant in real terms.

,a3or costs will 3e 1( per hour on 9anuary 1. The will increase at2 per year in real terms.

ner#y costs will 3e ( per T;H they will increase " per year inreal terms.

The in'lation rate is ( $e)enues are recei)ed and costs are paid atyear-end.

/ony International has an in)estment opportunity to produce a newstereo color T;.

The re+uired in)estment on 9anuary 1 o' this year is "2 million. The'irm will depreciate the in)estment to =ero usin# the strai#ht-linemethod. The 'irm is in the "& ta! 3racet.

The price o' the product on 9anuary 1 will 3e &GG per unit. Theprice will stay constant in real terms.

,a3or costs will 3e 1( per hour on 9anuary 1. The will increase at2 per year in real terms.

ner#y costs will 3e ( per T;H they will increase " per year inreal terms.

The in'lation rate is ( $e)enues are recei)ed and costs are paid atyear-end.

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The risless nominal discount rate is &.

The real discount rate 'or costs and re)enues is D.Calculate the 4;.

The risless nominal discount rate is &.

The real discount rate 'or costs and re)enues is D.Calculate the 4;.

#ear #ear % #ear & #ear '

Physcal

Producton

(unts)

, %, %, ,

*a"or +nput(hours)

%,, %,, %,, %,,

Enery nput,

physcal unts

%, %, %, %,

7


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CFG

!ample o' Capital Bud#etin#

under In'lation

The depreciation ta! shield is a ris-'ree nominal cash 'low< and isthere'ore discounted at the nominal risless rate.

Cost o' in)estment today > "2 & years

Annual depreciation e!pense:

epreciation ta! shield > D


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5ear 1 A'ter-ta! $eal $isy Cash Flows

$isy $eal Cash Flowsrice: &GG per unit with =ero real price increase

,a3or: 1( per hour with 2 real wa#e increase

ner#y: ( per unit with " real ener#y cost increase

5ear 1 A'ter-ta! $eal $isy Cash Flows:A'ter-ta! re)enues >

&GG M 1GG 2G

2 2

( M 2


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5ear 2 A'ter-ta! $eal $isy Cash Flows





&GG M 1GG 2G

2

&GG M 1GG 2G

2


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5ear " A'ter-ta! $eal $isy Cash Flows





&GG M 1GG 721

1( M 2

2


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5ear & A'ter-ta! $eal $isy Cash Flows





&GG M 1GG 21

1( M 2

2


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$(


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!ample o' Capital Bud#etin#

under In'lation

The pro8ectNPVcan now 3e computed as thesum o' thePVo' the cost< thePVo' the risycash 'lows discounted at the risy rate and thePVo' the ris-'ree cash 'lows discounted at the ris-'ree discount rate.

NPV> ?"2


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7." The Boein# 777:A $eal-%orld !ample

In late 1EEG< the Boein# Company announced its

intention to 3uild the Boein# 777< a commercial

airplane that could carry up to "EG passen#ersand 'ly 7


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Ta3le 7.( Incremental Cash Flows: Boein# 777

#ear -nts

ales

Re/enue

0peratn

Costs 1ep. Ta2es

34C

Captal

pendn

+n/est5

!ent

3et Cash

6low

$89. $'. $(&7.7) $'. $'. $(7.&)

% ,&'. 9. ('88.%') 9. 9. (,'.79)

& ,%'. 9.' ('9.8) &. &. (,78.8%)

' 8'. %'.79 (&%8.%) %. %. (7.8)

' $,8'7. ,79.9 %.%8 (8%.8) 181 06

.8 8%. (%%.7)

9 ' ,'8.9 7,89.' .9 '&.8& 1 722 00 .'% ,7'.'% 98.7'

7 ' ,%''.%& 9,.' . 88. (7.%) .'% %.& ,89.7

4et Cash Flow can 3e determined in three steps:

Ta!es 1E DD(.1G

In)estment ?17.12 @ 1E.&2 > 2."G

4CF 1E 1


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1EE1 $ (7.&) 2GG2 1


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7." The Boein# 777: A $eal-%orld!ample

rior to 1EEG< Boein# had in)ested se)eralhundred million dollars in research andde)elopment.

/ince these cash out'lows were incurred prior tothe decision to 3uild the plane< they aresunkcosts.

The rele)ant costs were the at the time thedecision was made were the 'orecasted 4et CashFlows

rior to 1EEG< Boein# had in)ested se)eralhundred million dollars in research andde)elopment.

/ince these cash out'lows were incurred prior tothe decision to 3uild the plane< they aresunkcosts.

The rele)ant costs were the at the time thedecision was made were the 'orecasted 4et CashFlows

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4; ro'ile o' the Boein# 777 ro8ect

This #raph shows 4; as a 'unction o' the discount rate.

Boein# should accept this pro8ect at discount rates less than 21

percent and re8ect the pro8ect at hi#her discount rates.

This #raph shows 4; as a 'unction o' the discount rate.

Boein# should accept this pro8ect at discount rates less than 21

percent and re8ect the pro8ect at hi#her discount rates.

I$$ > 21.12

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""


Boein# 777

As it turned out< sales 'ailed to meet

e!pectations.

In 'airness to the 'inancial analysts atBoein#< there is an important distinction

3etween a #ood decisionand a #ood

outcome.

As it turned out< sales 'ailed to meet

e!pectations.

In 'airness to the 'inancial analysts atBoein#< there is an important distinction

3etween a #ood decisionand a #ood

outcome.

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7.& In)estments o' *ne+ual ,i)es: The

+ui)alent Annual Cost ethod

There are times when application o' the 4; rule can

lead to the wron# decision. Consider a 'actory which

must ha)e an air cleaner. The e+uipment is mandated 3y

law< so there is no 6doin# without.There are two choices:

The 6Cadillac cleaner costs &


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AC with a Calculator

At 'irst #lance< the Cheapsate cleaner has a lower 4;At 'irst #lance< the Cheapsate cleaner has a lower 4;

1G

?1GG

?&


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7.& In)estments o' *ne+ual ,i)es:

The +ui)alent Annual Cost ethod

This o)erloos the 'act that the Cadillac

cleaner lasts twice as lon#.

%hen we incorporate that< the Cadillaccleaner is actually cheaper.

This o)erloos the 'act that the Cadillac

cleaner lasts twice as lon#.

%hen we incorporate that< the Cadillaccleaner is actually cheaper.

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The Cadillac cleaner time line o' cash 'lows:The Cadillac cleaner time line o' cash 'lows:

7.& In)estments o' *ne+ual ,i)es: The

+ui)alent Annual Cost ethod

-$4,000 100 -100 -100 -100 -100 -100 -100-100 -100 -100

0 1 2 3 4 5 6 7 8 10

-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500

-500 -500

0 1 2 3 4 5 6 7 8 10

The Cheapsate cleaner time line o' cash 'lows over ten years:

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%hen we mae a 'air comparison< the Cadillac is cheaper:%hen we mae a 'air comparison< the Cadillac is cheaper:

1G

?1GG

?&


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In)estments o' *ne+ual ,i)es

$eplacement Chain$epeat the pro8ects 'ore)er< 'ind thePVo' that

perpetuity.

Assumption: Both pro8ects can and will 3e repeated.

atchin# Cycle

$epeat pro8ects until they 3e#in and end at the same

time0lie we 8ust did with the air cleaners.

ComputeNPV'or the 6repeated pro8ects.


$eplacement Chain$epeat the pro8ects 'ore)er< 'ind thePVo' that

perpetuity.

Assumption: Both pro8ects can and will 3e repeated.

atchin# Cycle

$epeat pro8ects until they 3e#in and end at the same

time0lie we 8ust did with the air cleaners.

ComputeNPV'or the 6repeated pro8ects.


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In)estments o' *ne+ual,i)es: AC

The +ui)alent Annual Cost ethodApplica3le to a much more ro3ust set o' circumstancesthan replacement chain or matchin# cycle.

The +ui)alent Annual Cost is the )alue o' the le)el

payment annuity that has the samePVas our ori#inal seto' cash 'lows.

NPV !"# $ "r%

%here"r% is the present )alue o' 1 per period 'or %periods when the discount rate is r.

For e!ample< the AC 'or the Cadillac air cleaner is 7(G.ED

The AC 'or the cheaper air cleaner is 7".DG which con'irmsour earlier decision to re8ect it.

The +ui)alent Annual Cost ethodApplica3le to a much more ro3ust set o' circumstancesthan replacement chain or matchin# cycle.

The +ui)alent Annual Cost is the )alue o' the le)el

payment annuity that has the samePVas our ori#inal seto' cash 'lows.

NPV !"# $ "r%

%here"r% is the present )alue o' 1 per period 'or %periods when the discount rate is r.

For e!ample< the AC 'or the Cadillac air cleaner is 7(G.ED

The AC 'or the cheaper air cleaner is 7".DG which con'irmsour earlier decision to re8ect it.

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Cadillac AC with a Calculator*se the cash 'low menu to 'ind the ; o' the 6lumpy cash 'lows.

Then use the time )alue o' money eys to 'ind a payment with thatpresent )alue.

*se the cash 'low menu to 'ind the ; o' the 6lumpy cash 'lows.


1G

?1GG

?&


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Cheapsate AC with a Calculator

*se the cash 'low menu to 'ind the ; o' the cash 'lows.


*se the cash 'low menu to 'ind the ; o' the cash 'lows.


(

?(GG

?&


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!ample o' $eplacement ro8ects

Consider a Bel#ian entists o''iceH he needs an autocla)e to sterili=e

his instruments. Qe has an old one that is in use< 3ut the

maintenance costs are risin# and so is considerin# replacin# this

indispensa3le piece o' e+uipment.

4ew Autocla)e

Cost > " 2G per year

$esale )alue a'ter years > 1 " 2G per year

$esale )alue a'ter years > 1 -((".2E

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&&



!istin# Autocla)e#ear % & '

aintenance G 2GG 27( "2( &(G (GG

$esale EGG D(G 77( 7GG GG (GG

%otal "nnual #ost

!istin# Autocla)e#ear % & '



%otal "nnual #ostTotal Cost 'or year 1 > EGG M 1.1G ? D(G @ 2GG > "&G

340 435

Total Cost 'or year 2 > D(G M 1.1G ? 77( @ 27( > &"(

4&'

Total Cost 'or year " > 77( M 1.1G ? 7GG @ "2( > &7D

(20

Total Cost 'or year & > 7GG M 1.1G ? GG @ &(G > 2G

Total Cost 'or year ( > GG M 1.1G ? (GG @ (GG > G

((0

Note that the total cost o) kee*in+ an autoclave )or the )irst year includes the ,200

maintenance cost as -ell as the o**ortunity cost o) the )ore+one )uture value o) the ,00

-e didn/t +et )rom sellin+ it in year 0 less the ,'50 -e have i) -e still o-n it at year 1.

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4ew Autocla)e !"#o' new autocla)e > -((".2E

!istin# Autocla)e

#ear % & '



%otal "nnual #ost


340 435 4&' (20 ((0

R%e should eep the old autocla)e until its cheaper to 3uy

a new one.

R$eplace the autocla)e a'ter year ": at that point the new

one will cost ((".2E 'or the ne!t years autocla)in# and

the old one will cost 2G 'or one more year.

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&


7.( /ummary and Conclusions

Capital 3ud#etin# must 3e placed on an incremental3asis.

/un costs are i#nored

Opportunity costs and side e''ects matter

In'lation must 3e handled consistently

iscount real 'lows at real rates

iscount nominal 'lows at nominal rates.

%hen a 'irm must choose 3etween two machines o'une+ual li)es:

the 'irm can apply either the matchin# cycle approach

or the e+ui)alent annual cost approach.

Capital 3ud#etin# must 3e placed on an incremental3asis.

/un costs are i#nored

Opportunity costs and side e''ects matter

In'lation must 3e handled consistently

iscount real 'lows at real rates

iscount nominal 'lows at nominal rates.

%hen a 'irm must choose 3etween two machines o'une+ual li)es:

the 'irm can apply either the matchin# cycle approach

or the e+ui)alent annual cost approach.

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&7


orm Beds !ample

Consider a pro8ect to supply the *ni)ersity o' issouriwith 1G


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orm Beds !ample

The pro8ect will last 'or " years. Annual 'i!ed costs will 3e2(


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orm Beds !ample #G

%hat is the OCF in year =ero 'or this pro8ectCost o' 4ew +uipment G


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$e)enue 1G 2


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(2orm Beds !ampleNPV

First< set your calculator to 1 payment per year.Then< use the cash 'low menu:First< set your calculator to 1 payment per year.Then< use the cash 'low menu:

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CF1

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