CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting

2005, Pearson Prentice Hall

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

For 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 relevant 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

IDENTIFYING RELEVANT CASH FLOWS

A) PROJECT CASH FLOW vs ACCOUNTING

INCOME
1) COST OF FIXED ASSETS

- Asset purchases represent negative cash flows. - Full cost of the asset includes shipping and installation costs, used as the depreciable basis to calculate depreciation charges. - The fixed assets are often sold at the end of projects life, giving after-tax cash proceeds which represents a +ve cash flow.

2) NON CASH CHARGES - Depreciation is subtracted from revenues. Depreciation shelters income from taxation, has an impact on cash flow, but it is NOT a cash flow, thus MUST be added back to net income when estimating projects CF.
3) CHANGES IN NET OPERATING WORKING CAPITAL - When sales expand, accounts receivable increase. Payables and accruals spontaneously increase, and this reduces the cash to finance inventories and receivables. - At end of projects life, inventories will be used but not replaced, receivables will be collected without replacement, bringing cash inflows. NOWC will be returned and added back to the cash flow.

4) INTEREST EXPENSES
NOT included in project cash flow for 2 reasons. Firstly because they are already accounted for in the cost of capital (Required rate of return). 2ndly, project cash flow is the cash flow available to ALL investors, bondholders AND shareholders, so interest expenses are NOT subtracted.

B) INCREMENTAL CASH FLOWS (NET CASH FLOW IN AN INVESTMENT PROJECT)

1) Sunk Costs: (EXCLUDE from CF)
A cash outlay that has ALREADY been incurred, cannot be recovered regardless of whether the project is accepted or rejected. Examples: Consultant fees, fees for marketing surveys. 2) Opportunity costs: (INCLUDE in CF) The return on the best ALTERNATIVE use of an asset, that will NOT be earned if funds are invested in a particular project. Example he use of a land for the project site which could be sold, or the use of space/floor which could have been rented out.

3) Effects on Other Parts of the Firm: (either INCLUDED or

EXCLUDED) Externalities Effects of a project on cash flows in other parts of the firm. Often difficult to quantify. Cannibalization Occurs when the introduction of a new product causes sales of existing products to decline. (Example: IBM for years refused to provide full support for its PC division because it did not want to steal sales from its highly profitable mainstream business. Huge strategic error, because it allowed Intel, Microsoft , Compaq and others to become dominant forces in the computer industry.

Capital Budgeting Steps

1) Evaluate 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 get to this in the next chapter. For now, 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) + (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 (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) 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.

Or CF (1-5) = 45,461 CF(5) = 46,461 + 37,000 = 83,461. Or CF (5) = 37,000 Discount rate = 14%. NPV = $27,721. We would accept the project.

Capital Rationing

Suppose that you have evaluated

five 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% 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 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% 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

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% 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

IRR = 18.10%
NPV = $9,436 PI = 1.20

Mutually Exclusive Investments with Unequal Lives

Suppose our firm is planning to

expand and we have to select one of two 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

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 an 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

Problem 1b
Terminal Cash Flow:

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) CF(years 1 - 5) CF(years 6 - 7) = -590,000. = 197,500. = 158,400 (no depreciation) = 158,400 + 41,400 = 199,800.

CF(terminal year 8)
Discount rate = 14%.

ANSWER 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!