fnce101-wk05

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Finance (FNCE 101)Capital Budgeting (II)

Chapter 10

Professor WANG Rong


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Today’s Agenda Identifying Cash Flows

Discounted Cash Flows, Not Profits Incremental Cash Flows

Calculating Cash Flows Cash flow from capital investment Cash flow from investment in working capital Cash flow from operations

Case Study: Blooper Industries Exercise: Project Evaluation – A New Fad Product Exercise: Projects with Unequal Lives (EAC)


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Capital Budgeting: NPV Approach

Only Cash Flow and Time Value of Money matter: CF matters, not accounting profit or Net Income CF must be relevant and incremental to the new project:

Does CF occur when project is accepted or rejected? In discounting CF, treat inflation consistently The separation of financing and investment

Estimate project cash flows

andcost of capital

Financial analysisand

Project selection

Project Implementation

Project ReviewPost Audit


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Incremental Cash Flows The cash flows that should be included in a capital

budgeting analysis are those that will only occur if the project is accepted – incremental cash flows.

Ask yourself “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.


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Some Types of Cash Flows Sunk Costs (yes / no)

Sunk costs have accrued in the past and do not affect project NPV.

Example: A firm want to re-evaluate a project. The project already cost the firm $50K. A further investment $40K is required. The PV of future cash flows is $60K. Should the firm continue the project?

Indirect effects (yes / no) Example: A new product will generate a cash flow of

$10million a year. However, the introduction of the new product will reduce the cash flow of the existing projects by $4 million. What is the cash flow we should use when evaluating the new product?


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Some Types of Cash Flows Opportunity Costs (yes / no)

Opportunity costs are costs of lost options. Example: A firm owns a land. The firm can either use the

land for a project or sell it for $100K. Suppose the NPV of the project is $80K. Should the firm accept the project?

Don’t forget Net Working Capital (NWC or WC) WC=current assets–current liability

Non-cash working capital Examples of current assets are, accounts receivable

(unpaid bills), inventories Example of current liabilities are accounts payable.


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Examples of Project Cash Flows

BMW evaluates the NPV of establishing a new line of sport cars: It spent $250,000 to work on a preliminary version of the car. It

also spent $150,000 performing a test-marketing analysis to determine consumer interests. Which of these costs should be included in the project cash

flow calculations? It also has an empty warehouse in which it can store the new line

of sports cars. Should the cost of the warehouse be included in the NPV?

The firm is currently producing an existing line of compact cars. Some of the potential customers for its sports cars will come from the customer base for its compact cars. Do we need to take this into account when we calculate the

NPV of the new line of sport cars?


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Calculating Project Cash Flows Total cash flow = cash flow from capital investment (fixed assets) + cash flow from investments in working capital + cash flow from operations


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Component 1: Capital Investment

Two types of cash flows related to the initial investments. The costs of fixed assets The cash flow from selling off the fixed assets, or the after

tax salvage value of fixed assets.

Salvage value is the estimated value of an asset at the end of its useful life (how much the assets can be sold), and can be different from the book value of the asset.

Book value = initial cost – accumulated depreciation After-tax salvage = salvage – tax rate × (salvage – book value)

Note: only pay tax on the difference between salvage and book value.


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Component 1: Capital Investment

Example: A project requires an investment of $1000K in equipment. The project last 5 years. Suppose that at the end of the five years, the equipment can be sold for $500K. The book value of the equipment is $300K. The tax rate is 40%. What are the cash flows?

Year 0: Year 5:

Salvage value: Book value: After-tax salvage value:


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Exercise - Investment in Fixed Assets Question: what if the equipment is only sold

for $200K at the end of year 5? Year 5:

Salvage value: Book value: After-tax salvage value:

Selling at a loss


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Depreciation A non-cash expense, which only affects taxes

(both after-tax salvage value and after-tax operating cash flows)

Straight-line depreciation Depreciation expense = (initial cost-residual

value)/number of years MACRS (modified accelerated cost recovery system)

Depreciation expense = Multiply percentage given in table by the initial cost

Depreciate to zero


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MACRS Depreciation Allowances Property ClassYear 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%

2 44.44 32.00 24.49

3 14.82 19.20 17.49

4 7.41 11.52 12.49

5 11.52 8.93

6 5.76 8.93

7 8.93

8 4.45


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Depreciation

Example (Depreciation and After-tax Salvage) You purchase equipment for $100,000 and it costs

$10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. What is the depreciation expense each year and the after-tax cash flow in year 6?


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Depreciation

Answer: Suppose the appropriate depreciation schedule is

straight-line and we depreciate the equipment to $17,000 in 6 years. Depreciation expense = Book Value in year 6 = After-tax salvage value =


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Exercise - MACRS Depreciation Allowances

Example – cont. Answer the previous questions by assuming that the firm will use MACRS with a 3-year tax life.

Year MACRS percent

Depreciation Expense

1 .33332 .44443 .14824 .0741

BV in year 6 =After-tax Salvage Value =


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Component 2: Investment in Working Capital

For most projects, working capital =inventories + accounts receivable - accounts payable.

The cash flow is measured by the change in working capital, not the level of working capital.

Increase (Decrease) in working capital=negative (positive) cash flow


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Component 2: Investment in Working Capital

Example: Calculate the CF from investment in working capital in the following example.

Cash flow from investment in WC at year t = - change in WC at year t

0 1 2 31.Total WC 10 30 25 0

2.Change in WC3. CF from Invest. in WC


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Component 3: Cash Flow from OperationsCF from Operations = Net Income + Depreciation

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) 125,000Gross profit $ 75,000

Fixed costs 12,000Depreciation ($90,000 / 3) 30,000EBIT $ 33,000

Taxes (34%) 11,220Net Income $ 21,780


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Component 3: Cash Flow from Operations Example A project generates revenues of $1,000,

cash expenses of $600, and depreciation charges of $200 in a particular year. Tax rate is 35%. Calculate the cash flow from operations.


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Summary - Calculating Cash Flows Three steps to calculate a project’s CFs1. CF from investment in fixed assets:

initial investment and after-tax salvage value 2. CF from Investment in working capital

Change in the level of working capital Don’t forget the recovery of working capital.

3. CF from operations Calculate the net income Adjust for the depreciation


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In-Class Examples – Blooper Industries

The project requires an investment of $10 million. The equipment may be sold for $2 million by the end of year 5.

The company applies straight-line depreciation over 5 years. (Depreciation exp. is $10/5=2 million per year)

The company expects to sell 750,000 pounds of product a year at a price of $20 a pound in year 1. Total expense is $10 million in year 1.

The inflation rate is 5%. (Revenue and expense go up with inflation.)

Account receivables are 1/6 of revenues. Inventories are 15% of following year’s expense.

The company’s tax rate is 35%. The discount rate is 12%.


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In-Class Examples 2. Evaluating a new fad product 3. Compare projects with unequal lives

(EAC)


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Homework Assignments Problems are posted at eLearn.

For problem 3: Invest. In WC is made today and will be recovered in year 5.

Note: All problems in the textbook assume that WC is recovered in the last year of the project.

Next Week Chapter 7 - Valuing Bonds

fnce101-wk05

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