Transcript Financial Management

Chapter 8 - Cash Flows and Other
Topics in Capital Budgeting
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
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Capital Budgeting Steps
1) Evaluate Cash Flows
Initial
outlay
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Capital Budgeting Steps
1) Evaluate Cash Flows
Initial
outlay
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Annual Cash Flows
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Capital Budgeting Steps
1) Evaluate Cash Flows
Terminal
Cash flow
Initial
outlay
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Annual Cash Flows
...
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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)
+ (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 project’s 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 project’s 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 project’s 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 project’s 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 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:
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
2
3
$
Capital Rationing
 You could rank the projects by IRR:
IRR
25%
20%
15%
10%
5%
1
2
3
4
$
Capital Rationing
 You could rank the projects by IRR:
IRR
25%
20%
15%
10%
5%
1
2
3
4
5
$
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
 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
$X
$
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.
 Let’s 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%
Project B
year
cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%
IRR = 18.10%
IRR = 25.51%
NPV = $9,436
PI = 1.20
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%
Project B
year
cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%
IRR = 18.10%
IRR = 25.51%
NPV = $9,436
PI = 1.20
NPV = $8,455
PI = 1.18
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!
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 
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 doesn’t 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) = -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!