Professor John ZietlowMBA 621

Professor John ZietlowMBA 621

Cash Flow And Capital BudgetingCash Flow And Capital Budgeting

Chapter 8Chapter 8

Chapter 8: OverviewChapter 8: Overview

• 8.1 Types of Cash Flows– Cash flow vs. accounting profit– Fixed asset expenditures– Working capital expenditures– Terminal value– Incremental cash flow vs. sunk costs– Opportunity costs

• 8.2 Cash Flow for Classicaltunes.com• 8.3 Cash Flows, Discounting, and Inflation• 8.4 Special Problems in Capital Budgeting

– Equipment replacement and equivalent annual cost– Excess Capacity

• 8.5 Summary

Types of Cash FlowsTypes of Cash Flows

• First step in capital budgeting: determine the relevant CFs– The incremental after-tax cash outflow (investment) and

resulting cash flows. – Cash flows, rather than accounting values, are used.

• The cash flows of any project having simple cash flows can include three basic components: – (1) initial investment, (2) operating CFs, and (3) terminal CF – All projects have the first two components

• Initial investment includes all set up costs– Also includes incremental working capital investment

• Operating cash flows are after-tax net cash flows – using the firm’s marginal tax rate– CF, not earnings, so add depreciation back in

• The terminal CF usually related to liquidation of the project– Include disposal costs and after-tax salvage values, if any

Cash Flow Versus Accounting Profit Cash Flow Versus Accounting Profit

• Capital budgeting concerned with cash flow, not accounting profit– Most important distinction: non-cash charges

• Two ways to treat non-cash charges– Can compute net income and add depreciation back– Can compute after-tax income, then add tax savings

• Demonstrate two methods (next slide) by assuming a firm purchases a fixed asset today for $30,000– Plans to depreciate over 3 years using straight-line method– Using machine, firm will produce 10,000 units/year– Product sells for $3/unit and costs $1/unit– Firm pays taxes at a 40% marginal rate

Two Methods Of Handling Depreciation To Compute Cash Flow

Two Methods Of Handling Depreciation To Compute Cash Flow

$6,000Net income

$16,000Cash flow = NI + deprec

(4,000)Taxes (40%)

$10,000Pre-tax income

(10,000)Depreciation

$20,000Gross profits

(10,000)Cost of goods

$30,000Sales

Adding non-cash expenses back to after-tax earnings

$4,000Depreciation tax savings

$16,000Cash Flow

$12,000Aft-tax income

(8,000)Taxes (40%)

$20,000Pre-tax income

(10,000)Cost of goods

$30,000Sales

Find aft-tax profits, add back non-cash charge tax savings

Simplest and most common technique:Add depreciation back in

An Overview Of DepreciationAn Overview Of Depreciation

• Largest non-cash charge for most projects: depreciation – Firms allowed to charge off portion of asset’s cost each year

• For tax purposes, depreciation is regulated by the IR Code, as laid out most recently in the Tax Reform Act of 1986. – A firm will often use different depreciation methods for

financial reporting and tax purposes, which is quite legal.• Depreciation for tax purposes is determined by using the

modified accelerated cost recovery system (MACRS) – In US & UK, different depreciation methods can be used for

taxes and financial reporting • MACRS standards, which apply to both new and used

assets, require a taxpayer to use as an asset's depreciable life the appropriate MACRS recovery period. – There are six MACRS recovery periods--3, 5, 7, 10, 15, and

20 years--excluding real estate (not depreciable). – The first four property classes defined next slide.

The First Four Depreciation MACRS ClassesThe First Four Depreciation MACRS Classes

Property class

Definition

3-year

Research equipment & certain tools

5-year Computers, typewriters, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets

7-year Office furniture, fixtures, most mfg equipment, railroad track, single-purpose agricultural and horticultural structures

10-year Equipment used in petroleum refining or in the manufacture of tobacco and certain food products

MACRS Recovery PeriodsMACRS Recovery Periods

• For tax purposes, assets in the first four property classes depreciated by the double-declining balance (200%) method – Also computed using the half-year convention and switching

to straight-line when advantageous.– The approximate percentages written off each year for the

first four property classes are given in Table 8.1. • Rather than using these, the firm can use either straight-line

depreciation over the asset's recovery period with the half-year convention or the alternative depreciation system. – We use MACRS figures as these generally provide for the

fastest writeoff & thus the best CF effects for profitable firms• MACRS requires use of the half-year convention, so assets

assumed to be acquired in mid-year– So only half of first year's deprec is recovered in year 1 – Final half-year of depreciation is recovered in the year

immediately following the asset's stated recovery period. – Deprec %s for an n-year asset thus given for n + 1 years

Depreciation Percentages By YearDepreciation Percentages By Year

Depreciation percentage by recovery year

Recovery year

3-year

5-year

7-year

10-year

1 33% 20% 14% 10%

2 45 32 25 18

3 15 19 18 14

4 7 12 12 12

5 12 9 9

6 5 9 8

7 9 7

8 4 6

9 6

10 6

11 4 Totals 100% 100% 100% 100%

Finding Initial Cost of Fixed Asset PurchaseFinding Initial Cost of Fixed Asset Purchase

• Cap budget decisions usually entail acquiring fixed asset.– Initial cost typically measured as net cash outflow

• If new asset, net initial cost fairly simple to compute– Just purchase price plus installation costs

• If new asset purchased to replace existing asset, finding net initial cost much more complicated– Must account for purchase and installation cost of new asset– Plus after-tax inflow or outflow from old asset = sale price

net of removal costs, plus or minus tax impact of sale• Tax impact from sale of old asset depends on asset’s sale

price and book value– Sale price below book value capital loss (tax benefit)– Sale price above book value, but below purchase price

firm must pay tax on recaptured depreciation– Sale price above purchase price firm must pay tax on

recaptured depreciation plus capital gain

Calculating Net Initial Cost Of New Computers For Electrocom Mfg

Calculating Net Initial Cost Of New Computers For Electrocom Mfg

• Electrocom Mfg wants to replace computers purchased three years ago for $100,000 with newer, faster machines– Old computers have been deprec with 5-year MACRS rule– Accum deprec = $71,200 (71.20%); so book value =

$28,800• If Electrocom sells its old computers for $10,000, what is

net after-tax cash flow from sale? Assume tax rate = 40%– Capital loss, sale of old computer = book value - sale price =

$28,800 - $10,000 = $18,800 – Tax benefit of capital loss (assuming firm has other profits) =

capital loss x tax rate = $18,800 x 0.40 = $7,520– Net inflow from sale = sale price + tax benefit = $17,520

• Net initial cost of new computers thus the purchase and installation cost of new computers minus $17,520

Working Capital ExpendituresWorking Capital Expenditures

• Many cap investments require additions to working capital– Net working capital (NWC) = curr assets – curr liabilities– Increase in NWC is a cash outflow; decrease a cash inflow– Some curr assets (A/R) can be acquired thru trade credit,

but curr liab will go up if credit extended (A/P)• Demonstrate impact of WC investment on cash flow with

calendar sales booth in mall over Christmas season– Operate booth from November 1 to January 31 (close Feb1)– Order $15,000 calendars on credit, delivery by Nov 1– Must pay suppliers $5,000/month, beginning Dec 1 – Expect to sell 30% of inventory (for cash) in Nov; 60% in

Dec; 10% in Jan; close up shop Feb 1– Always want to have $500 cash on hand; invest cash Nov 1,

receive it back Jan 31.

Working Capital For Calendar Sales BoothWorking Capital For Calendar Sales Booth

($4,000)+$500+$500NAMonthly in WC

($3,000)$1,000$500$0Net WC

$5,000$10,000$15,000$0Accts payable

$0$1,500$10,500$15,000$0Inventory

$0$500$500$500$0Cash

Feb 1Jan 1Dec 1Nov 1Oct 1

($5,000)($5,000)($5,000)$0Payments

($500)Net cash flow

$1,500

[10%]

$9,000

[60%]

$4,500

[30%]

$0Sales revenue

[all cash]

Jan 1 to Jan 31

Dec 1 to Dec 31

Nov 1 to Nov 30

Oct 1 to Oct 31

Payments and

sales receipts

($500) +$4,000 ($3,000)

$0

$0

+$3,000

Terminal ValueTerminal Value

• Some investments have a well-defined life, determined by:– Physical life of a piece of equipment– Period until a patent expires– Period of time covered by a leasing or licensing agreement

• Terminal value used when evaluating an investment with indefinite life-span– 1. Construct cash-flow forecasts for 5 to 10 years– 2. Forecasts more than 5 to 10 years – high margin of error;

use terminal value instead• Terminal value – intended to reflect the value of a project at

a given future point in time– Large value relative to all the other cash flows of the project

Terminal Value of SDL AcquisitionTerminal Value of SDL Acquisition

• JDS Uniphase projections for acquisition of SDL Inc.

• Different ways to calculate terminal values – assumptions used to calculate terminal value are very important– Use final year cash flow projections and assume that all

future cash flow grow at a constant rate– Multiply final cash flow estimate by a market multiple– Use investment’s book value or liquidation value

• Estimate recovery of no more than 20 – 50 percent of original purchase cost (Asplund, 2002)

• Possibly negative terminal value if high disposal costs

$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion

Year 5Year 4Year 3Year 2Year 1

Terminal Value of SDL Acquisition (Continued)Terminal Value of SDL Acquisition (Continued)

• If assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):

• Terminal value is $68.2 billion; value of entire project is

– $42.4 billion of total $48.7 billion from terminal value

• Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value– Terminal Value = $3.25 x 20 = $65 billion– Caveat : market multiples fluctuate over time

7.48$1.1

2.68$

1.1

25.3$

1.1

5.2$

1.1

75.1$

1.1

1$

1.1

5.0$554321

2.68$05.010.0

41.3$or , 5

1

PVgr

CFPV t

t

Incremental Cash FlowIncremental Cash Flow

• Incremental cash flows vs. sunk costs– Cap budgeting analysis should include only incremental costs

• For example, decision to pursue MBA can be based on incremental cash flows– Norman Paul’s current salary is $60,000 per year and expect to

increase at 5% each year– Assume that Norm pays taxes at flat rate of 35%– Sunk costs: $1,000 for GMAT course and $2,000 for visiting

various programs– Room and board expenses – not incremental to the decision to

go back to school (assume the same expenses for room and board in both cases)

Incremental Cash Flow (Continued)Incremental Cash Flow (Continued)

• At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year– Expected tuition, fees and textbook expenses for next two years

while studying in MBA: $35,000– If Norm worked at his current job for two years, his salary would

have increased to $66,150:– Yr 2 net cash inflow: $90,000 - $66,150 = $23,850– After-tax inflow: $23,850 x (1-0.35) = $15,503– Yr 3 cash inflow:– MBA has substantial positive NPV value if 30 yr analysis period

• Unwanted incremental cash outflow – cannibalization (sales of new products may come at expense of firm’s existing products

150,66$05.1000,60$ 2

032,18$35.0105.1000,60$08.1000,90$ 3

Opportunity CostsOpportunity Costs

• Opportunity cost: cash flows from alternative investment opportunities that are forgone when one investment is undertaken– If Norm did not attend MBA, he would have earned:

• First year: $60,000 ($39,000 after taxes)• Second Year: $63,000 ($40,950 after taxes)

– Norm’s opportunity cost: $39,000 + $40,950 = $79,950• NPV of a project could fall substantially if opportunity costs

are recognized– MBA applications are countercyclical because applicants take

into consideration opportunity costs– A firm that bought land for an expansion opportunity, for

example, should factor into the NPV of firm’s expansion plans the opportunity cost of selling or leasing the land

Initial Investment for Classicaltunes.com Jazz CD Project

Initial Investment for Classicaltunes.com Jazz CD Project

• Company is considering adding jazz recordings to its offerings– Firm uses 10% discount rate to calculate NPV and 40% tax rate– The average selling price of Classicaltunes CD’s is $13.50;

price is expected to increase at 2% per year• Initial investment transactions:

– $50,000 for computer equipment (MACRS 5-year asset class) – $4,500 for inventory ($2,500 of which purchased on credit)– $1,000 increase in cash balances

• Sales expected to begin when new fiscal year begins• Expanding sales volume require increases in current assets and

additional spending on fixed assets• Any additional financing (besides trade credit) for the project

from funds generated by classical-music CD side of the business

Projections for Jazz CD ProposalProjections for Jazz CD Proposal

6543210Year

24,000

$14.91

22,000

$14.61

25,00016,00010,0004,0000Units

$15.20$14.33$14.05$13.77$13.50Price per unit

37393

25208

35772

98374

259349

357722

27565

23872

35363

86800

234682

321482

49903155191649-13043-10000Pretax profit

1851214280138001800010000Depreciation

38008297991966482620SG&A Expense

1064225959735114 13219 0Gross profit

273657 169623105341418610Cost of goods sold

380080229221140454550800Revenue

Abbreviated Project Income Statement

Projections for Jazz CD Proposal (Continued)Projections for Jazz CD Proposal (Continued)

6543210Year

28057

120646

39840

105160

145000

80806

47696

29810

3300

25214

122903

50048

79952

130000

72855

42864

26790

3200

29810179781101643202500Accounts Payable

11717986585561324593445500Total assets

3132833920232003200040000Net P&E

12367256080418002800010000Accumulated Depreciation

15500090000650006000050000Gross P&E

858515266532932139345500 Current Assets

50677305631872773444500Inventory

31673191021170545900Accounts Receivable

35003000250020001000Cash

Abbreviated Project Balance Sheet

Annual Cash Flow EstimatesAnnual Cash Flow Estimates

Annual Cash Flow Estimates for Classicaltunes.com

-3291-5109-12953-12771-12302-6614-3000Change in working capital

-10000-15000-40000-25000-5000-10000-50000New Fixed Assets

6543210Year

27535

47644

-12542

40411

35163-14180-2512-6440-49000Net cash flow

484542359114790101744000Operating cash flow

Year Zero Cash FlowYear Zero Cash Flow

• Initial cash outlay of $50,000 for computer equipment• Even though sales begin when new fiscal year begins, half-year

of MACRS depreciation can be taken in year zero:– 20% x $50,000 = $10,000; non cash expense– Depreciation expense can be deducted from the firm’s classical-

music CD profits. The company saves $4,000 (40% x $10,000) in taxes

• Changes in working capital are result of following transactions:– Purchase of $4,500 in inventory and $1000 cash balance– Accounts payable of $2,500 partially finance the $5,500 outlay

• Net Cash Flow: Increase in gross fixed assets - $50,000

Change in working capital - $3,000 Tax savings + $4,000

Net cash flow - $49,000

Year One Cash FlowYear One Cash Flow

• Purchase of additional $10,000 in fixed assets• 2nd year depreciation expenses for MACRS 5-year asset class

is 32%. An additional 20% depreciation deduction for assets purchased this year– 32% x $50,000 + 20% x $10,000= $18,000– Non cash expense; has to be added back when computing cash

flow for the year• Net working capital for year one is:

– NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614

– Increase in NWC; cash outflow of $6,614

614,6$000,3$614,9$ NWC– NWC NWC 0year 1year

Year One Cash Flow (Continued)Year One Cash Flow (Continued)

• Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com– Tax savings = 40% x $13,043 = $5,217

• Net operating cash inflow = pretax loss + tax savings + depreciation– Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174

• Net cash flow:

Increase in gross fixed assets - $10,000 Change in working capital - $6,614 Operating cash inflow + $10,174

Net cash flow - $6,440

Year Two Cash FlowYear Two Cash Flow

• Purchase of additional $5,000 in fixed assets– Assets purchased at the onset of the project – allowable

depreciation of 19.2% (19.2% x $50,000 = $9,600)– An additional 32% depreciation deduction for assets purchased

in year 1 and 20% depreciation of assets purchased this year– Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000=

$4,200 = $13,800• Changes in working capital are result of following transactions:

– Increases in current assets:• $500 increase in cash balance• $7,115 increase in accounts receivables• $11,383 increase in inventory

– Increase in current liabilities:• $6,696 increase in account payables

– Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)

Year Two Cash Flow (Continued)Year Two Cash Flow (Continued)

• Pretax profit in year two is $1,649– The company must pay taxes of $660 (40% x $1,649); cash

outflow• Net operating cash inflow = pretax profit + tax + depreciation

– Operating cash inflow = $1,649 - $660 + $13,800 = $14,789

• Net cash flow:

Increase in gross fixed assets - $5,000 Change in working capital - $12,302 Operating cash inflow + $14,790

Net cash flow - $2,512

Terminal Value for Jazz CD InvestmentTerminal Value for Jazz CD Investment

• If assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,)

• Second approach used by Classicaltunes.com to compute terminal value for the project – use the book value at end of year six:– Plant and Equipment (P&E) at end of year six is $31,328– The firm liquidates total current assets and pays off current

debts

$85,850 - $29,810 = $56,040– Terminal value = $31,328 + $56,040 = $87,368

325,448$02.010.0

866,35$or ,

866,35$163,35$02.11

61

1

PVgr

CFPV

CFgCF

tt

tt

NPV for Jazz CD ProjectNPV for Jazz CD Project

• Using assumption that cash flow grow at a steady rate past year 6

• Using book value assumption for terminal value

• NPV is positive with both methods – investing in Jazz CD project increases shareholders wealth

862,213$1.1

325,448$

1.1

163,35$

1.1

535,27$1.1

562,12$

1.1

180,14$

1.1

513,2$

1.1

440,6$000,49$

665

4321

NPV

111,10$1.1

368,87$

1.1

163,35$

1.1

535,27$1.1

562,12$

1.1

180,14$

1.1

513,2$

1.1

440,6$000,49$

665

4321

NPV

Nominal and Real ReturnNominal and Real Return

• Nominal return vs. real return– Nominal return reflects the actual dollar return; real return

measures the increase in purchasing power gained by holding a certain investment

• Common in capital budgeting is the use of market rates of return at the time of the analysis– Market interest rates have embedded an assumption about

inflation– In this case, use nominal cash flows to reflect the same inflation

rate as that embedded in discount rate

1inf1

nom1rate real or,

rate), real(1rate)inflation (1rate) nominal1(

Inflation RulesInflation Rules

• Inflation Rule 1 – if nominal rate used to discount cash flow of a project, the embedded inflation expectation in the nominal rate must be used to construct the cash flows– In analysis of Jazz CD’s investment, assumption that price of a

CD increases by 2% per year on average– Revenues expressed in nominal terms– Discount rate used (10%) must reflect current market returns to

account for inflation rate• Inflation Rule 2 – when project cash flows are stated in real rather

than nominal terms, the appropriate discount rate is the real rate– Cash flows projections for Classicaltunes.com could be

expressed in real terms– Use current price for CDs of $13.50, current-year labor costs,

current-year prices for fixed assets for projections of cash flows

Real-Term Cash Flows for Jazz CD Investment

Real-Term Cash Flows for Jazz CD Investment

• To obtain cash flow in real terms – discount nominal cash flow at inflation rate– First year cash flow of -$6,440 restated in real terms

314,6$02.01

440,6$

3516327535-12542-14180-2512-6440-49000Nominal cash flow

1Discount factor

Real-Term Cash Flow Estimates for Classicaltunes.com

6543210Year

24939-11587 31224-13362-2415-6314-49000Real-term cash flow

02.1 202.1 302.1 402.1 502.1 602.1

NPV of Jazz CD ProjectNPV of Jazz CD Project

• Real rate for Classicaltunes.com

• NPV of the project – discount real-term cash flow at real rate

0784.0102.01

10.011

inf1

nom1rate Real

862,213$0784.1

100,398224,310784.1

939,24

0784.1

587,11

0784.1

362,13

0784.1

415,2

0784.1

314,6000,49

6

5432

NPV

Discounting real cash flows at real interest rate yields the same NPVas discounting nominal cash flows at nominal rate

Capital Budgeting and InflationCapital Budgeting and Inflation

NPV Overstated

NPV UnderstatedNominal Discount Rate

Real Discount Rate

Nominal Cash Flows Real Cash Flows

• If discount nominal cash flows at real discount rate:

overstated NPV $213,862 552,248$0784.1

325,448$163,35$0784.1

535,27$

0784.1

562,12$

0784.1

180,14$

0784.1

513,2$

0784.1

440,6$000,49$

6

54321

NPV

• If discount real cash flows at nominal discount rate:

detatsrednu NPV 862,213$ 138,183$1.1

100,398224,311.1

939,24

1.1

587,11

1.1

362,13

1.1

415,2

1.1

314,6000,49

6

5432

NPV

Equipment ReplacementEquipment Replacement

• A firm must purchase an electronic control device– First alternative – cheaper device, higher maintenance costs,

shorter period of utilization– Second device – more expensive, smaller maintenance costs,

longer life span• Expected cash outflows

– Maintenance costs – constant over time – use real discount rate of 7% for NPV

• Cash outflow device A < cash outflow device B select A

-15001500150012000A120012001200120014000B

43210Device

$15,936A$18,065B

NPVDevice

Equipment Replacement (Continued)Equipment Replacement (Continued)

   

         Year   A   B

0   12,000   14,0001   1,500   1,2002   1,500   1,2003   13,500   1,2004   1,500   15,2005   1,500   1,2006   13,500   1,2007   1,500   1,2008   1,500   15,2009   13,500   1,200

10   1,500   1,20011   1,500   1,20012   1,500   1,200

         NPV(7%) $48,233 $42,360

• Previous approach ignores the fact that device A will be replaced in year 4– Different approach – use cash flows for 12 years select B

Equivalent Annual Cost (EAC)Equivalent Annual Cost (EAC)

• EAC method approximates NPV for operating device with NPV of annuity– 1. Compute NPV for operating devices A and B for their lifetime

• NPV device A = $15,936• NPV device B = $18,065

– 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device

• Device A

• Device B

$6,072 X 07.107.107.1

936,15$321

XXX

$5,333Y 07.107.107.107.1

065,18$4321

YYYY

Equivalent Annual Cost (Continued)Equivalent Annual Cost (Continued)

• The firm chooses device B – replacing device B every four years is equivalent to a perpetuity of $5,333– The firm assumes that will keep using device B for a long period

of time• Assume the firm will use in three years new, less expensive

technology that makes current technology obsolete– In this case, choose the device that has the smallest cash outflow

for three years – choose A (assume salvage value zero)

926,15$07.1

500,1

07.1

500,1

07.1

500,1000,12$

321ANPV

674,18$07.1

200,1

07.1

200,1

07.1

200,1000,14$

321BNPV

Excess CapacityExcess Capacity

• Excess capacity – not a free asset as traditionally regarded by managers– Company has excess capacity in a distribution center warehouse– In two years the firm will invest $2,000,000 to expand the

warehouse as new stores are built in the region• The firm could lease the excess space for $125,000 per year for

the next two years– Expansion plans should begin immediately in this case to hold

inventory for stores that will come on line in a few months– Incremental cost – investing $2,000,000 at present vs. two years

from today– Incremental cash inflow - $125,000

Excess Capacity (Continued)Excess Capacity (Continued)

• NPV of leasing excess capacity (assume 10% discount rate)

• NPV negative – reject to lease excess capacity at $125,000 per year

• The firm could compute the value of the lease that would allow to break even

– X = $181,818– Leasing the excess capacity for a price above $181,818 would

increase shareholders wealth

471,108$1.1

000,000,2

10.1

000,125000,000,2000,125

2NPV

01.1

000,000,2

10.1000,000,2

2

XXNPV

The Human Face of Capital BudgetingThe Human Face of Capital Budgeting

• NPV of a project is based on a number of assumptions– Managers must be aware of optimistic bias in these assumptions

made by supporters of the project• Companies should have control measures in place to remove

bias– Analysis of an investment done by a group independent of

individual or group proposing the project– Analysts of the project must have a sense of what is reasonable

when forecasting a project’s profit margin and its growth potential• Another side of determining which projects receive funding –

storytelling– Best analysts not only provide numbers to highlight a good

investment, but also can explain why this investment makes sense