Transcript Financial Management - University of North Texas

Chapter 10 - Cash Flows
and Other Topics in
Capital Budgeting
Useful Guidelines
 Use free cash flow rather than accounting
profits
 Think incrementally
 Beware of cash flows diverted from
existing products
 Synergistic effects
Useful Guidelines
 Working capital requirements are
considered a cash flow even though they
do not leave the company.
 They are tied up over the life of the
project.
 When projects terminate, working
capital will be recovered.
Useful Guidelines
 Consider incremental expenses
 Sunk costs are not incremental cash flow
 Ignore interest payments and financing
flows
 Free cash flow = change in operating
cash flow – change in net working
capital – change in capital spending
Useful Guidelines
 Use simple straight line method to
calculate depreciation expense
 Though depreciation is not a cash flow
item, it does affect cash flow by lowering
profit, so we will add it back
Useful Guidelines
 Sale of old machine
1. Old asset is sold for a price above
depreciated value
eg: old machine purchased for $15,000, had
a book value of $10,000, and was sold
for $17,000 (34% tax rate), how much
tax the firm should pay?
(17,000 – 10,000) * 34% = 2,380
Useful Guidelines
 Sale of old machine
2. Old asset is sold at depreciated value.
since there is no gain or loss, no tax
3. Old asset is sold less than its
depreciated value.
eg: book value is $10,000 and sold for
$7,000, what is the tax?
we have a cash inflow due to loss
(10,000 – 7,000) * 34% = 1,020
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 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
Terminal
Cash flow
Initial
outlay
0
1
2
3
4
5
6
Annual Cash Flows
...
n
Capital Budgeting Steps
2) Evaluate the Risk of the Project
 We’ll get to this in the next chapter.
 For now, we’ll 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 firm’s 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
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:
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 project’s life?
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 project’s 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
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:
IRR
Our budget is limited
so we accept only
projects 1, 2, and 3.
25%
20%
15%
10%
5%
1
2
3
4
$X
5
$
Capital Rationing
 Ranking projects by IRR is not
always the best way to deal with a
limited capital budget.
 It’s better to pick the largest NPVs.
 Mutually exclusive projects: perform
same task, so accepting one means
rejection of the other
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
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
(48,000)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%
IRR = 18.10%
IRR = 22.78%
NPV = $9,436
PI = 1.20
NPV = $6,955
PI = 1.14
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 can’t be
compared!
 One way is to create replacement
chain
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
project’s 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, we’ve 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
 This doesn’t change the answer, of
course; it just converts EAA to an NPV
that can be compared.
Options in Capital Budgeting
 Option to delay a project
 Option to expand a project
 Option to abandon a project
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 = 420,000 – 3*84,000 =
$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) = -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
(361,200)
23,800
(8,092)
15,708
361,200
376,908 =
Increased sales & cost savings
Extra depreciation
EBT
Taxes (34%)
EAT
Depreciation reversal
Differential Cash Flow
Problem 3
Terminal Cash Flow:
500,000
(170,000)
68,000
398,000
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) = 376,908.
 CF(5) = 376,908 + 398,000 = 774,908.
 Discount rate = 14%.
 NPV = 83,539.
 IRR = 16.18%.
 We would accept the project!