Capital Budgeting II

Professor: Burcu Esmer

1

Cash Flows

Last chapter introduced valuation techniques based on discounted cash flows.

This chapter develops criteria for properly identifying and calculating cash flows.

2

Capital Budgeting

• Remember:

• Estimate project cash flows (CFs)

• Estimate a discount rate, if needed

• Discount the cash flows

• Select the projects with positive NPV

• Question: How do we forecast the cash flows?

3

Cash Flow vs. Accounting Income

• Discount actual cash flows (not accountingprofits! )

• Using accounting income, rather than cash flow,could lead to erroneous decisions.

Example

A project costs $2,000 and is expected to last 2 years,

producing cash income of $1,500 and $500

respectively. The cost of the project can be

depreciated at $1,000 per year. Given a 10% required

return, compare the NPV using cash flow to the NPV

using accounting income. 4

500 +1,500+2,000-FlowCash Free

2,000-CostProject

500 $ $1,500 InflowCash

2Year 1Year Today

14.223$)10.1(

500

)10.1(

500,12,000=NPVCash

2

Cash Flow vs. Accounting Income

5

500 -500 +Income Accounting

$1,000-$1,000-onDepreciati

500 $ $1,500 InflowCash

2Year 1Year

32.41$)10.1(

500

1.10

500=NPVApparent

2

Cash Flow vs. Accounting Income

Recognize investment expenditures when they occur!

6

Incremental Cash Flows

• Discount incremental cash flows• Include All Indirect Effects

• Forget Sunk Costs

• Include Opportunity Costs

• Recognize the Investment in Working Capital

• Beware of Allocated Overhead Costs

• Remember Shutdown Cash Flows

Incremental

Cash Flow

cash flow with

project

cash flow without

project= -7

Include all Indirect Effects

Indirect Effect Rule: You must include all

indirect effects in your analysis.

8

Indirect EffectAs CFO of Hidden Valley you are considering building a new salad

dressing factory. The new bottled salad dressing will have sales of $1.25

million, but some of those sales (equivalent to $10,000 in FCFF) will come

from consumers who switch from buying Hidden Valley's existing dry

packet salad dressing. Does this affect our decision to produce bottled

dressing?

0 5321 4

-10,000 -10,000 -10,000 -10,000 -10,000

This type of externality is known as : Product cannibalization9

Sunk CostsSunk Cost

– A cost that cannot be recovered

Sunk Cost Rule: Always ignore sunk costs.

10

Sunk Costs

Hidden Valley plans to use a building that it owns for its

new factory. The building was built at a cost of $250,000

which we did not include in the initial cost of the project.

Should we include it?

NO! Whether we accept or reject the project this cost is

sunk. I.e. the cost of the building has been incurred and

does not depend on whether we accept or reject the

project. It is not an incremental cash flow!

11

Opportunity Costs

Opportunity Cost – Benefit or cash flow foregone as a result of an action.

Opportunity Cost Rule: Be sure to recognize the opportunity cost (that which is foregone).

12

Opportunity Costs

Hidden Valley plans to use a building it owns for its new factory. It could rent

the building instead for $15,000 per year (FCFF equivalent). Does this affect

our project decision?

Yes! If the project is taken then we lose the opportunity to rent the building.

So,

0 5321 4

-15,000 -15,000 -15,000 -15,000 -15,000

13

Investments in Working Capital

Working Capital Rule: Investments in working capital, just like investments in plant and equipment, result in cash outflows.

Common ways working capital is overlooked:

1. Forgetting about working capital entirely.

2. Forgetting that working capital may change during the life of the project.

3. Forgetting that working capital is recovered at the end of the project. 14

Additional Considerations

1) Remember Terminal Cash Flows

2) Beware of Allocated Overhead Costs

3) Separation of Investment &Financing Decisions

15

Separation of Investment &Financing Decisions

• When valuing a project, ignore how the project is financed.

• Following the logic from incremental analysis ask yourself the following question:

Is the project existence dependent on the financing? If no, you must separate financing and investment decisions.

16

Incremental Cash Flows

IMPORTANT

Ask yourself this question

Would the cash flow still exist if the project does not exist?

If yes, do not include it in your analysis.

If no, include it.17

Question

• A firm is considering an investment in a new manufacturingplant. The site already is owned by the company, but existingbuildings would need to be demolished. Which of thefollowing should be treated as incremental cash flows?

a. The market value of the site.

b. The market value of the existing buildings.

c. Demolition costs and site clearance.

d. The cost of a new access road put in last year.

e. Lost cash flows on other projects due to executive time spent on the new facility.

f. Future depreciation of the new plant. 18

Inflation

INFLATION RULE

• Be consistent in how you handle inflation!!

• Use nominal interest rates to discount nominal cash flows.

• Use real interest rates to discount real cash flows.

• You will get the same results, whether you use nominal or real figures

19

Inflation

Example

You own a lease that will cost you $8,000 thisyear increasing at 3% a year (the forecastedinflation rate) for 3 additional years (4 yearstotal). If discount rates are 10% (nominal) what isthe present value cost of the lease?

1 real interest rate =1+nominal interest rate

1+inflation rate20

InflationExample - nominal figures

$29,073

6,5688,742=8000x1.033

7,014487,8=8000x1.032

491,78,240=8000x1.031

00.000,880000

10% @ PVFlowCash Year

3

2

10.1

8742310.1

8487210.1

8240

21

InflationExample - real figures

29,073

6,5688,0003

7,0148,0002

7,4918,0001

8,0008,0000

PV@6.7961%FlowCash Year

3

2

068.1

8,000068.1

8,000068.1

8,000

= $

22

Calculating Cash Flows

• Think of cash flows as coming from three elements

Total cash flow =

+ cash flows from capital investments

+ cash flows from changes in working capital + operating cash flows

23

Calculating Cash Flows

• 1) Cash Flow from Capital Investments

• Almost every project requires some sort of initial investment. Thisis often capitalized from an accounting perspective. In finance,the investment represents a negative cash flow.

• 2) Cash Flow from Working Capital (WC)

• Remember: NWC= CA-CL

• e.g. Slick makes an initial investment of $10 m in inventories ofplastic and steel for its blade plant. In year 1, it accumulates anadditional $20m of raw materials. In year 5, it decides to reduceits inventory from $20 m to $15 m. Show the cash flows fromchanges in working capital.

24

• Cash Flow from Working Capital (cont)

Slick makes an initial investment of $10 m in inventories ofplastic and steel for its blade plant. In year 1, it accumulates anadditional $20 m of raw materials. In year 5, it decides toreduce its inventory from $20 m to $15 m. Show the cash flowsfrom changes in working capital.

• Summary: An increase in WC is an investment a negative cash flow

An decrease in WC a positive cash flow

Year 0 1 2 3 4 5

Total WC 10 30 30 30 30 25

Change in WC

10 20 0 0 0 -5

CF from change in WC

-10 -20 0 0 0 5

25

Calculating Cash Flows (cont.)

• 3) Operating Cash Flow

• Operating cash flow =

+ Revenue

- Costs

- Taxes

• Methods of Handling Depreciation

• Method l: Dollars in Minus Dollars Out (use income statement entries)

• OCF= revenues – cash expenses - taxes

• Method 2: Adjusted Accounting Profits

• OCF= after-tax profit + depreciation

• Method 3: Add Back Depreciation Tax Shield

• OCF= (revenues – cash expenses ) x (1- tax rate) + (tax rate x depreciation)

Depreciation tax shieldNet profit

26

e.g.Methods of Handling Depreciation

• A project generates revenues of $1000, cash expenses of $600and depreciation charges of $200 in a year. The firm’s taxbracket is 35%. What is Net Income ? Calculate the OCF usingall three aproaches.

• Method 1: OCF = revenues – cash expenses – tax = 1000- 600 – 70= 330

• Method 2: OCF = after-tax profit + depreciation = 130 + 200 = 330

• Method 3 : OCF = = (revenues – cash expenses ) x (1- tax rate) + (tax rate xdepreciation) = (1000-600) x (0.65) x (0.35 x 200) = 330

Revenues 1000

- Cash expense 600

- Depreciation 200

Profit before tax 200

- Tax at 35% 70

Net profit 130

27

Recall, Operating Cash Flows

Firm Approach: FCFF

Free Cash

Flow to Firm

Need measure of

the actual cash flow

created by the

project available to

pay the debt,

preferred, and

common stock their

required rates of

return.

Note: Many different

books use different

acronyms but the

process for

estimating free cash

flow is the same

Revenues

- Costs

- Dep

EBIT

- Tax

EBIT(1-t)

+ DEP

OPCF

- CapExp

- DWC

FCFF

DO FCFF in 3-Steps:

a - operating cash flow

b - additional cap. exp.

c - change in noncash

working capital

28

FCFFFCFF

v Cost Dep t Dep CapExp WC

v Cost t t Dep Dep CapExp WC

v Cost t t Dep CapExp WC

(Re )( )

(Re )( ) ( )

(Re )( ) ( )

1

1 1

1

D

D

D

After tax cash flow Depreciation tax shield

Note: from previous slide OPCF=After tax cash flow + Dep. tax shield

29

Example –Blooper Industries (BI) • BI is analyzing a proposal for mining and seeling a small deposit of high-grade

magnoosium ore. A consulting study which cost $800 million has been completed toassess the costs and benefits of the project. The data have been simplified in thefollowing terms:

• The global unified tax rate is 35%. The inflation rate is 5%.

• The global unified after-tax cost of capital is 12% for projects with this level of risk.The project life is 5 years.

• The project would require the purchase of a $10 million mining equipment . Thisequipment would be depreciated (straight-line) over 5 years to a zero salvagevalue. However, experts argue that the equipment could be sold for as much as$2 million after 5 years.

• Annual maintenance expenses will be $10 million in year 1.

• The working capital requirements will be $1.5 million starting immediately) , then$ 4.075 m, $ 4.279 m , $4.493 m, $4.717 m , $3.039 m.

• The consultants estimate that BI will be able to sell 750,000 pounds ofmagnoosium a year at a price of $20 a pound in year 1.

• (For all practical purposes, you can assume that the venture has sufficient profitsto immediately take advantage of potential tax shields)

30

Blooper IndustriesCash Flow From Operations (,000s) in year 1

Revenues

- Expenses

Depreciation

= Profit before tax

.-Tax @ 35 %

= Net profit

+ Depreciation

= CF from operations

15 000

10 000

2 000

3 000

1 050

1 950

2 000

3 950

,

,

,

,

,

,

,

,

or $3,950,000 31

Blooper Industries

650,2462,2283,2113,2950,1Profit

427,1326,1230,1137,1050,1(35%).Tax

078,4788,3513,3250,3000,3ProfitPretax

000,2000,2000,2000,2000,2onDepreciati

155,12576,11025,11500,10000,10Expenses

233,18364,17538,16750,15000,15Revenues

039,3679,1225214204575,2500,1in WC Change

0039,3717,4493,4279,4075,4500,1WC

00010Invest Cap

6543210Year

,

(,000s)

32

Blooper IndustriesNet Cash Flow (entire project) (,000s)

4,3396,3294,2384,0693,9091,37511,500-FlowCash Net

4,6514,4624,2834,1133,950Op from CF

039,31,679225-214-204-2,575-1,500-in WC Change

300,1

10,000-

valueSalvage

Invest Cap

6543210Year

NPV @ 12% = $4,222,350 33