Transcript FI3300 Corporation Finance

FINC3131
Business Finance
Chapter 12:
Cash Flow Estimation in Capital
Budgeting
1
Learning Objectives
1. Know the guidelines by which cash flows
should be measured.
2. Calculate a project’s incremental after-tax cash
flows.
3. Describe the difference between independent
and mutually exclusive projects.
4. Compare projects with different lives using the
equivalent annual series technique.
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Estimating project cash flows
1. For this chapter, we focus on the NPV,
IRR capital budgeting rules.
2. To apply these rules, we need the
project’s cash flows and the appropriate
discount rate.
3. In this chapter, you will learn how to
estimate a project’s cash flows. The
discount rate will still be given to you.
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3-steps to estimate cash flows
1. Estimate the initial investments at t=0
2. Estimate the operating cash flows for t=1
through t=n
3. Estimate the non-operating cash flows at
t=n
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Guidelines for step 1
1. Ignore sunk costs
2. Include opportunity costs
3. Include costs used to purchase fixed assets in
the project
4. Include the cost due to the increase in net
working capital
5. Include other costs directly related to the
project
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Sunk costs
Sunk (irrecoverable) costs: costs which cannot be
recovered regardless of whether the firm
undertakes the project.
Examples: R&D expenses occurred before t=0,
consultant fees occurred before t=0
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Opportunity costs
Suppose the project requires the use of some
assets already owned by the firm, such as land or
machine. If the asset is not used by the project, the
firm can sell the asset for $X. This $X is the
opportunity cost of the asset. An asset’s
opportunity cost is the money that the firm can
receive if the asset is put to the next best use. The
‘next best’ use may be to sell the asset.
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Net working capital 1
In general, the change in net working capital
= change in current assets – change in current liabilities.
1. Very often, adopting a project will require an initial
increase in net working capital that the firm currently
invested. This increase in net working capital must be
added to the project’s initial costs (outflow) (change in
NWC=changes in AR, Inv, AP, accruals, and minimum
cash balance)
2.
When the project ends, the NWC will decrease back to
the original level. So at t=n, there is cash inflow of the
same amount.
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Net working capital 2
Investment in land and building: 200,000. Changes in
net working capital: 8,000 increase in inventory,
3,500 increase in minimum cash balance, 18,000
increase in account receivable, 2,500 increase in
account payable, 500 increase in accruals. The total
amount will be recovered at the end of life of project.
What is the initial change in net working capital?
Answer: 8000+3500+18000-2500-500=26,500 (outflow)
Hints: 8000, 3500, 18,000 are cash outflows
2500, 500 are cash inflows
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Guidelines for step 2
1. Construct Net Income Statement for
each year.
2. All project cash flows (such as sales)
must be incremental.
3. Ignore allocated costs
4. Ignore interest expense.
5. Add back depreciation to net income.
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All project cash flows
must be incremental
 To evaluate a project, we look at the cash
flows which it contributes towards the firm’s
existing cash flows. In other words, we look at
project’s incremental cash flows.
How to determine incremental cash flows?
1. Look at the firm’s cash flows without the
project.
2. Look at the firm’s cash flows with the project.
3. The difference is the incremental cash flows.
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Example
Suppose currently the firm produces and sales
classic coke. The project is to produce and sale
diet coke. If diet code is on the market, it will grab
some market share (sales) from classic code. So,
the incremental sales is not 5, 7,10, 15. Instead, it
should be 3, 5, 7, 11.
sales in $ million
classic coke
diet coke
estimated
incremental
t=1
10
t=2
15
t=3
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t=4
20
2
2
3
4
5
3
7
5
10
7
15
11
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Allocated costs
Allocated costs: rent, supervisory salaries,
administrative costs, and various overhead
expenses. When a project is adopted, usually the
accounting department will allocate some
percentage of the existing cost to the new project.
These costs are not incremental. They don’t
change if the project is undertaken or not. Thus,
they should not be considered in estimating the
project’s incremental cash flows.
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Ignore interest expense
WACC includes the cost of interest
expenses already. So we do not want to
double count.
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Add back depreciation
Depreciation is a non-cash charge and must
be added to net income to estimate cash
flow.
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Guidelines for step 3
1. Include inflows of salvage value.
2. Include the cash inflow from the recovery
of NWC.
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Question
Thompson Company has to decide whether to build a new factory.
Management has collected various cost data to use to make the
decision. Some of the items collected are listed below. Which of the
following should Thompson consider as being relevant for
computing cash flows for the new factory project?
A. $500,000 was spent last year to upgrade a piece of property on which the
company is planning to build the new factory.
B. It will cost $10,000,000 to construct the factory and new equipment costing
$3,250,000 will need to be purchased and installed to begin production of
the product to be sold.
C. The factory construction costs of $10,000,000 will be financed entirely with
new long-term debt (specifically a new bond issue). The company estimates
that the interest costs of this new debt will be $850,000 per year.
D. The variable cost of production is estimated to be 65% of annual sales.
E. The accounting department plans to allocate supervisory and management
costs of $25,000 per year to the project. No new supervisory or
management personnel will be required.
Answer: B, D.
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Capital budgeting example 1
You are given the responsibility of conducting
the project selection analysis in your firm. You
have to calculate the NPV of a given project.
The appropriate cost of capital is 12 percent
and the firm is in the 30 percent tax bracket.
You are provided the following pieces of
information regarding the project:
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Details
1. The project is going to be built on a piece of
land that the firm already owns. The market
value of the land is $1 million.
2. If the project is undertaken, prior to
construction, an amount of $100,000 would
have to be spent to make the land usable for
construction purposes.
3. In order to come up with the project concept,
the company had hired a marketing research
firm for $200,000.
4. The firm has spent another $250,000 on R&D
for this project.
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Details
5. The project will require an initial outlay of $20
million for plant and machinery.
6. The sales from this project will be $15 million
per year of which 20 percent will be from lost
sales of existing products.
7. The variable costs of manufacturing for this
level of sales will be $9 million per year.
8. The company uses straight-line depreciation.
The project has an economic life of ten years
and will have a salvage value of $3 million at
the end.
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Details
9. Because of the project the company will need
additional working capital of $1 million which
can be liquidated at the end of ten years.
10. The project will require additional supervisory
and managerial manpower that will cost
$200,000 per year.
11. The accounting department has allocated
$350,000 as allocated overhead cost for
supervisory and managerial salaries.
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Calculate initial cost
 Initial cost is the sum of:
•
•
•
•
Market value of land: $1 mil (opportunity cost)
Land improvement $100 k
Plant & machinery: $20 mil
Incremental working capital: $1 mil
Initial cost
= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
= $22,100,000
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Calculate the annual incremental
cash flow: step 1
Calculate the annual depreciation expense
For this project, fixed assets refer to $20mil plant &
machinery. Therefore,
Depreciation
= (20,000,000 – 3,000,000)/10
= $1,700,000
Calculate incremental sales
Incremental sales = 0.8 x 15,000,000 = $12,000,000
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Calculate the annual incremental
cash flow: step 2
Draw up the incremental income statement
Incremental sales
12,000,000
Less Incremental variable cost
9,000,000
Less Incremental managerial salaries
200,000
Less Incremental depreciation
Equals Incremental taxable income
Less Incremental tax @30%
Equals Incremental net income
Add back depreciation
Incremental cash flow
1,700,000
1,100,000
330,000
770,000
1,700,000
$2,470,000
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Consider other cash flows
 At the end of project’s life (t=10), company
• Recovers $1 mil additional working capital
(item 9)
• Receives $3 mil salvage value from plant &
machinery (item 8)
Additional cash flows at end of project
= 1,000,000 + 3,000,000
= $4,000,000
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Let’s bring all the
cash flows together 1
1. CF0 (initial cost) = $22,100,000
2. Annual incremental after-tax cash flow (Year 1
through Year 10) = $2,470,000
3. Additional cash flow in Year 10 = $4,000,000
 So in year 10, the company receives a total of
= 2,470,000 + 4,000,000 = $6,470,000
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Let’s bring all the
cash flows together 2
To compute NPV, enter cash flows in this way:
CF0 = -22,100,000
C01 = 2,470,000, F01=9
C02 = 6,470,000, F02=1
Then press NPV, enter I = 12, press CPT and NPV.
NPV = -$6,856,056.17
Decision: reject the project.
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Capital budgeting example 2
ABC Corp. manufactures television sets and
computer monitors. The company is
considering introducing a new 40” flat
screen television/monitor. The company’s
CFO has collected the following information
about the proposed product.
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Details
1) The project has an anticipated economic life of
5 years.
2) The company will have to purchase a new
machine to produce the screens. The machine
has an up front cost (t = 0) of $4,000,000. The
machine will be depreciated on a straight-line
basis over 5 years. The company anticipates
that the machine will last for five years and then
have no salvage value (that is, it will be
worthless).
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Details
3) If the company goes ahead with the proposed
product, it will have to increase inventory by
$280,000 and accounts payable by $80,000.
At t = 5, the net working capital will be
recovered after the project is completed.
4) The screen is expected to generate sales
revenue of $2,000,000 the first year;
$4,500,000 the second through fourth years
and $3,000,000 in the fifth year. Each year the
operating costs (excluding depreciation) are
expected to equal 50% of sales revenue.
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Details
5) The company’s interest expense each year will
be $350,000.
6) The new screens are expected to reduce the
sales of the company’s large screen TV’s by
$500,000 per year.
7) The company’s cost of capital is 12%.
8) The company’s tax rate is 30%.
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Questions
1. What is the initial investment for the project?
2. What is the 3rd year expected incremental
operating cash flow? (i.e., the incremental after
tax cash flow)
3. What is the 5th year incremental non-operating
cash flow?
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Q1: initial investment
To answer Q1, you need points 2 & 3.
Initial investment
= machine cost + change in net working capital
= 4,000,000 + (change in current assets
– change in current liabilities)
= 4,000,000 + (280,000 – 80,000)
= $4,200,000
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Q2: 3rd incremental operating cash flow
To answer Q2, you need points 2,4,6,8.
Steps:
1) Incremental sales
= 4,500,000 – 500,000 = 4,000,000
2) Annual depreciation = (4,000,000)/5 = 800,000
3) Incremental operating cost for 3rd year
= 0.5 x 4,500,000 = 2,250,000
Next, draw up the incremental income statement
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Q2: 3rd incremental operating cash flow
Draw up the incremental income statement
Incremental sales
Less Incremental operating cost
Less Incremental depreciation
Equals Incremental taxable income
Less Incremental tax @30%
Equals Incremental net income
Add back depreciation
Incremental cash flow
4,000,000
2,250,000
800,000
950,000
285,000
665,000
800,000
$1,465,000
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Q3: 5th year incremental
non-operating cash flow
1. Very simple. The only incremental nonoperating cash flow is the cash flow from
liquidating the increase in net working capital
(point 3).
2. 5th year incremental non-operating cash flow
= $200,000
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Choose among projects
1. When there is only one project, we use
NPV, IRR for capital budgeting.
2. When there are more than one projects,
how should we make decision?
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Independent Projects
1. Projects are independent from each
other if accepting one project or not does
not affect the decision on other projects.
2. When projects are independent, we pick
all projects that have a positive NPV.
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Mutually Exclusive Projects
 Projects are mutually exclusive if accepting
one implies that the other projects will be
foregone.
 When projects are mutually exclusive and
have equal lifespan, we rank the projects based on
their NPVs and choose the project with the highest
positive NPV.
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Question
 Consider the following mutually exclusive
projects of equal lives, for a firm using a
discount rate of 10%:
Project NPV
IRR
A
$100,000 10.2%
B
C
D
$1
$70,000
$24,000
11%
23%
13%
Which project(s) should the firm accept?
Answer:A
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Another question
Your company is considering 5 projects: A, B, C, D, & E. Project A and
Project B are independent projects. Project C, Project D and Project E
are mutually exclusive (to each other, but independent from Project A
and Project B). Your company’s cost of capital is 16%.
1.The IRR of Project A is 14.4% (the NPV of Project A was not
provided)
2.The NPV of Project B is $3,286 (the IRR of Project B was not
provided)
3.The NPV of Project C is $1,812 (the IRR of Project C was not
provided)
4.The IRR of Project D is 15.2% (the NPV of Project D was not
provided)
5.The NPV of Project E is $2,436 (the IRR of Project F was not
provided)
Which project(s) should be chosen?
Answer: B, E.
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Mutually exclusive projects with
unequal lives:
 When projects are mutually exclusive but have
unequal lifespan
a. We construct the equivalent annual series (EAS) of
each project and
b. We choose the project with the highest EAS
 A project’s EAS is the payment on an annuity
whose life is the same as that of the project
and whose present value, using the discount
rate of the project, is equal to the project’s
NPV.
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Calculating EAS
 Consider Projects J & K, with the following
cash flows. The discount rate is 10%.
Project
C0
C1
C2
C3
J
-12000
6000
6000
6000
K
-18000
7000
7000
7000
C4
7000
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EAS for Project J
 To compute Project J’s EAS, do the following:
1. Compute Project J’s NPV
•
Verify that NPV(J) = $2,921.11
2. Find the payment on the 3-year (life of project J)
annuity whose PV is equal to $2,921.11.
Enter the following values:
N=3, I/Y=10, PV=-2921.11, FV=0, Then CPT, PMT.
PMT = 1,174.62, which is Project J’s EAS.
So, finding EAS is nothing more than finding the payment of
an annuity.
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EAS for Project K
1. Verify that Project K’s NPV= $4,189.06
2. Find the payment on the 4-year (life of project K)
annuity whose PV is equal to $ 4,189.06.
Enter the following values:
N=4, I/Y=10, PV=- 4,189.06, FV=0, Then CPT, PMT.
PMT = 1,321.53, which is Project K’s EAS.
Recall that Project J’s EAS=1174.62
So, choose Project K since it has the higher EAS.
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Another application of EAS
 We can use the EAS concept to choose
between two machines that do the same job
but have different costs and lives.
 Example: you go to a grocery store to buy
apples. Apple A and B have the same color,
shape, smell, and taste, but A is cheaper.
Which apple will you buy?
I will buy A as it produces the same benefit with lower cost.
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EAC example
 Suppose that your firm is trying to decide
between two machines, that will do exactly the
same job. Machine A costs $90,000, will last
for ten years and will require operating costs of
$5,000 per year. At the end of ten years it will
be scrapped for $10,000. Machine B costs
$60,000, will last for seven years and will
require operating costs of $6,000 per year. At
the end of seven years it will be scrapped for
$5,000. Which is a better machine? (discount
rate is 10 percent)
Hints: we use only cash flows that are different between the two
projects.
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Step 1: compute the PV of the costs of
each machine
PV of costs (A)
= $90,000 + PV of $5,000 annuity for ten years
- PV of $10,000
= 90000 + 30722.84 – 3855.43 = $116,867.41
PV of costs (B)
= $60,000 + PV of $6,000 annuity for seven years
- PV of $5,000
= $60,000 + $29,210.51 - $2,565.79 =$86,644.72
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Step 2: compute equivalent annual cost
(EAC) series of each machine

The equivalent annual cost series is the payment of
an annuity that has the same present value as the PV
of the machine’s cost.
EAC of machine A, EAC(A):
 N = 10, I/Y = 10, PV = -116867.41, FV = 0. Then
CPT, PMT. This yields EAC(A) = $19,019.63.
EAC of machine B, EAC(B):
 N = 7, I/Y = 10, PV = -86644.72, FV = 0. Then CPT,
PMT. This yields EAC(B) = $17,797.30.
 Choose machine B because it has the lower cost.
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Assignment
Problems: 1 2 3
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