Chapter 10: Cash Flows and Other Topics in Capital Budgeting

2002, Prentice Hall, Inc.

Capital Budgeting: the process of planning for purchases of long-term assets.

example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows:

 The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate.

Capital Budgeting Steps

1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. Initial outlay Differential Cash Flows over the life of the project (also referred to as annual cash flows). Terminal Cash Flows

Capital Budgeting Steps

1) Evaluate Cash Flows

...

Capital Budgeting Steps

1) Evaluate Cash Flows
Initial outlay

...

Capital Budgeting Steps

1) Evaluate Cash Flows
Initial outlay

...

Annual Cash Flows

Capital Budgeting Steps

1) Evaluate Cash Flows
Initial outlay Terminal Cash flow

...

Annual Cash Flows

Capital Budgeting Steps

2) Evaluate the risk of the project. well assume that the risk of the project is the same as the risk of the overall firm. If we do this, we can use the firms cost of capital as the discount rate for capital investment projects.

Capital Budgeting Steps 3) Accept or Reject the Project.

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (147,000) + ( 4,000) + 0 Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (147,000) + ( 4,000) + 0 ($151,000) Purchase price of asset shipping and installation depreciable asset net working capital proceeds from sale of old asset net initial outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + ( 20,000) (147,000) + ( 4,000) + 0 ($151,000) Purchase price of asset shipping and installation depreciable asset net working capital proceeds from sale of old asset net initial outlay

Step 1: Evaluate Cash Flows

b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

For Each Year, Calculate:

Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 46,461 = Revenue Costs Depreciation EBT Taxes EAT Depreciation reversal Annual Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Tax Effects of Sale of Asset:

Salvage value = $50,000 Book value = depreciable asset - total amount depreciated. Book value = $147,000 - $147,000 = $0. Capital gain = SV - BV = 50,000 - 0 = $50,000 Tax payment = 50,000 x .34 = ($17,000)

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 (17,000) Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 (17,000) 4,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 (17,000) 4,000 37,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Project NPV:
CF(0) = -151,000 CF(1 - 4) = 46,461 CF(5) = 46,461 + 37,000 = 83,461 Discount rate = 14% NPV = $27,721 We would accept the project.

Capital Rationing
Suppose that you have evaluated 5 capital investment projects for your company. Suppose that the VP of Finance has given you a limited capital budget. How do you decide which projects to select?

Capital Rationing
You could rank the projects by IRR:

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

10% 5%
1 $

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

10% 5%
1

2
$

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

10% 5%
1

3
$

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

10% 5%
1

4 $

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

10% 5%
1

5 $

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

Our budget is limited so we accept only projects 1, 2, and 3.

10% 5%
1

4 $X

5 $

Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%

Our budget is limited so we accept only projects 1, 2, and 3.

10% 5%
1

3
$X $

Capital Rationing
Ranking projects by IRR is not always the best way to deal with a limited capital budget. Its better to pick the largest NPVs. Lets try ranking projects by NPV.

Problems with Project Ranking

1) Mutually exclusive projects of unequal size (the size disparity problem) The NPV decision may not agree with IRR or PI. Solution: select the project with the largest NPV.

Size Disparity example

Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07

Size Disparity example

Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Project B year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20

Size Disparity example

Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Project B year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20

Problems with Project Ranking

2) The time disparity problem with mutually exclusive projects. NPV and PI assume cash flows are reinvested at the required rate of return for the project. IRR assumes cash flows are reinvested at the IRR. The NPV or PI decision may not agree with the IRR. Solution: select the largest NPV.

Time Disparity example

Project A year cash flow 0 (48,000) 1 1,200 2 2,400 3 39,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20

Time Disparity example

Project A year cash flow 0 (48,000) 1 1,200 2 2,400 3 39,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20 Project B year cash flow 0 (46,500) 1 36,500 2 24,000 3 2,400 4 2,400 required return = 12% IRR = 25.51% NPV = $8,455 PI = 1.18

Time Disparity example

Project A year cash flow 0 (48,000) 1 1,200 2 2,400 3 39,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20 Project B year cash flow 0 (46,500) 1 36,500 2 24,000 3 2,400 4 2,400 required return = 12% IRR = 25.51% NPV = $8,455 PI = 1.18

Mutually Exclusive Investments with Unequal Lives Suppose our firm is planning to expand and we have to select 1 of 2 machines. They differ in terms of economic life and capacity. How do we decide which machine to select?

 The after-tax cash flows are: Year Machine 1 Machine 2 0 (45,000) (45,000) 1 20,000 12,000 2 20,000 12,000 3 20,000 12,000 4 12,000 5 12,000 6 12,000 Assume a required return of 14%.

Step 1: Calculate NPV

NPV1 = $1,433 NPV2 = $1,664

So, does this mean #2 is better? No! The two NPVs cant be compared!

Step 2: Equivalent Annual Annuity (EAA) method

If we assume that each project will be replaced an infinite number of times in the future, we can convert each NPV to an annuity. The projects EAAs can be compared to determine which is the best project! EAA: Simply annuitize the NPV over the projects life.

EAA with your calculator:

Simply spread the NPV over the life of the project Machine 1: PV = 1433, N = 3, I = 14, solve: PMT = -617.24.

Machine 2: PV = 1664, N = 6, I = 14, solve: PMT = -427.91.

EAA1 = $617 EAA2 = $428 This tells us that: NPV1 = annuity of $617 per year. NPV2 = annuity of $428 per year. So, weve reduced a problem with different time horizons to a couple of annuities. Decision Rule: Select the highest EAA. We would choose machine #1.

Step 3: Convert back to NPV

Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.

Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.

NPV 1 = 617/.14 = $4,407

Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.

NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057

Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.

NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057 This doesnt change the answer, of course; it just converts EAA to a NPV that can be compared.

Practice Problems: Cash Flows & Other Topics in Capital Budgeting

Project Information:

Problem 1a

Cost of equipment = $400,000 Shipping & installation will be $20,000 $25,000 in net working capital required at setup 3-year project life, 5-year class life Simplified straight line depreciation Revenues will increase by $220,000 per year Defects costs will fall by $10,000 per year Operating costs will rise by $30,000 per year Salvage value after year 3 is $200,000 Cost of capital = 12%, marginal tax rate = 34%

Problem 1a
Initial Outlay: (400,000) + ( 20,000) (420,000) + ( 25,000) ($445,000) Cost of asset Shipping & installation Depreciable asset Investment in NWC Net Initial Outlay

For Years 1 - 3:
220,000 10,000 (30,000) (84,000) 116,000 (39,440) 76,560 84,000 160,560 =

Problem 1a

Increased revenue Decreased defects Increased operating costs Increased depreciation EBT Taxes (34%) EAT Depreciation reversal Annual Cash Flow

Problem 1a
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

 Terminal Cash Flow:

Problem 1a

Salvage value = $200,000 Book value = depreciable asset - total amount depreciated. Book value = $168,000. Capital gain = SV - BV = $32,000 Tax payment = 32,000 x .34 = ($10,880)

Problem 1a
Terminal Cash Flow: 200,000 (10,880) 25,000 214,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 1a Solution: NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 214,120 = 374,680 Discount rate = 12% IRR = 22.1% NPV = $93,044. Accept the project!

Problem 1b
Project Information: For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology.
Calculate the IRR and NPV for the project. Is it still acceptable?

Problem 1b
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

 Terminal Cash Flow:

Problem 1b

Salvage value = $100,000 Book value = depreciable asset - total amount depreciated. Book value = $168,000. Capital loss = SV - BV = ($68,000) Tax refund = 68,000 x .34 = $23,120

Problem 1b
Terminal Cash Flow: 100,000 23,120 25,000 148,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 1b Solution NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 148,120 = 308,680 Discount rate = 12% IRR = 17.3% NPV = $46,067. Accept the project!

Automation Project: Problem 2 Cost of equipment = $550,000 Shipping & installation will be $25,000 $15,000 in net working capital required at setup 8-year project life, 5-year class life Simplified straight line depreciation Current operating expenses are $640,000 per yr. New operating expenses will be $400,000 per yr. Already paid consultant $25,000 for analysis. Salvage value after year 8 is $40,000 Cost of capital = 14%, marginal tax rate = 34%

Problem 2
Initial Outlay: (550,000) + (25,000) (575,000) + ( 15,000) (590,000) Cost of new machine Shipping & installation Depreciable asset NWC investment Net Initial Outlay

For Years 1 - 5:
240,000 (115,000) 125,000 (42,500) 82,500 115,000 197,500 =

Problem 2

Cost decrease Depreciation increase EBIT Taxes (34%) EAT Depreciation reversal Annual Cash Flow

For Years 6 - 8:
240,000 ( 0) 240,000 (81,600) 158,400 0 158,400 =

Problem 2

Cost decrease Depreciation increase EBIT Taxes (34%) EAT Depreciation reversal Annual Cash Flow

Problem 2
Terminal Cash Flow:

40,000 (13,600) 15,000 41,400

Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 2 Solution: NPV and IRR: CF(0) = -590,000 CF(1 - 5) = 197,500 CF(6 - 7) = 158,400 CF(10) = 158,400 + 41,400 = 199,800 Discount rate = 14% IRR = 28.13% NPV = $293,543 We would accept the project!

Problem 3
Replacement Project:
Old Asset (5 years old): Cost of equipment = $1,125,000 10-year project life, 10-year class life Simplified straight line depreciation Current salvage value is $400,000 Cost of capital = 14%, marginal tax rate = 35%

Replacement Project:

Problem 3

New Asset: Cost of equipment = $1,750,000 Shipping & installation will be $56,000 $68,000 investment in net working capital. 5-year project life, 5-year class life Simplified straight line depreciation Will increase sales by $285,000 per year Operating expenses will fall by $100,000 per year Already paid $15,000 for training program Salvage value after year 5 is $500,000 Cost of capital = 14%, marginal tax rate = 34%

Problem 3: Sell the Old Asset: Salvage value = $400,000 Book value = depreciable asset - total amount depreciated. Book value = $1,125,000 - $562,500 = $562,500. Capital gain = SV - BV = 400,000 - 562,500 = ($162,500) Tax refund = 162,500 x .35 = $56,875

 Initial Outlay:
(1,750,000) + ( 56,000) (1,806,000) + ( 68,000) + 456,875

Problem 3

Cost of new machine Shipping & installation Depreciable asset NWC investment After-tax proceeds (sold old machine) (1,417,125) Net Initial Outlay

Problem 3 For Years 1 - 5:

385,000 (248,700) 136,300 (47,705) 88,595 248,700 337,295 = Increased sales & cost savings Extra depreciation EBT Taxes (35%) EAT Depreciation reversal Differential Cash Flow

Problem 3
Terminal Cash Flow: 500,000 (175,000) 68,000 393,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 3 Solution: NPV and IRR: CF(0) = -1,417,125 CF(1 - 4) = 337,295 CF(5) = 337,295 + 393,000 = 730,295 Discount rate = 14% NPV = (55,052.07) IRR = 12.55% We would not accept the project!