10. cash flow in capital budgeting

Copyright © 2011 Pearson Prentice Hall.All rights reserved.

Chapter 11

Cash Flows and Other Topics

in Capital Budgeting

11-2 © 2011 Pearson Prentice Hall. All rights reserved.

Learning Objectives

1. Identify guidelines by which we measure cash flows.

2. Explain how a project’s benefits and costs – that is, its free cash flows –are calculated.

3. Explain the importance of options or flexibility in capital budgeting.

4. Explain what the appropriate measure of risk is for capital-budgeting purposes.


Learning Objectives

5. Determine the acceptability of a new project using the risk-adjusted discount method of adjusting for risk.

6. Explain the use of simulating for imitating the performance of a project under evaluation.

7. Explain why a multinational firm faces a more difficult time estimating cash flows along with increased risks.


Slide Contents

Guidelines for Capital Budgeting

Free Cash Flow calculations

Options in Capital Budgeting

Risk and the Investment Decision

Measurement of Systematic Risk

The Multinational Firm


1. Guidelines for Capital Budgeting

To evaluate investment proposals, we must first set guidelines by which we measure the value of each proposal.

In effect, we are deciding what is and what isn’t relevant cash flow.



1. Use free cash flows, not accounting profits

2. Think Incrementally

3. Beware of cash flows diverted from existing products

4. Look for incidental or synergistic effects

5. Work in working-capital requirements



6. Consider incremental expenses

7. Sunk costs are not incremental cash flows

8. Account for opportunity costs

9. Decide if overhead costs are truly incremental cash flows

10. Ignore interest payments and financing flows


Use Free Cash Flows

Free cash flow accurately reflects the timing of benefits and costs—when money is received, when it can be reinvested, and when it must be paid out.

Accounting profits do not reflect actual money in hand.


Incremental Cash Flows

After-tax free cash flows must be measured incrementally.

Determining incremental free cash flow involves determining the cash flows with and without the project. Incremental is the “additional cash flows” (inflows or outflows) that occur due to the project.


Beware of Diverted Cash Flows

Not all incremental free cash flow is relevant.

Thus new product sales achieved at the cost of losing sales from existing product line are not considered a benefit.

However, if the new product captures sales from competitors or prevents loss of sales to new competing products, it would be a relevant incremental free cash flows.


Incidental or Synergistic Effects

Although some projects may take sales away from a firm’s current projects, in other cases new products may add sales to the existing line. This is called synergistic effect and is a relevant cash flow.


Working Capital Requirement

New projects require infusion of working capital (such as inventory to stock the shelves), which would be an outflow.

Generally, when the project terminates, working capital is recovered and there is an inflow of working capital.


Sunk Costs

Sunk costs are cash flows that have already occurred (such as marketing research) and cannot be undone. Sunk costs are considered irrelevant to decision making.

Managers need to ask two basic questions: Will this cash flow occur if the project is accepted?

Will this cash flow occur if the project is rejected?

If the answer is “Yes” to #1 and “No” to #2, it will be an incremental cash flow.


Opportunity Costs

Opportunity cost refers to cash flows that are lost because of accepting the current project.

For example, using the building space for the project will mean loss of potential rental revenue.


Overhead Costs

Must include incremental overhead costs or costs that were incurred as a result of the project and relevant to capital budgeting

Note, not all overhead costs may be relevant (example, utilities bill may have been the same with or without the project)


Interest Payments and Financing Costs

Interest payments and other financing cash flows that might result from raising funds to finance a project are not relevant cash flows.

Reason: Required rate of return implicitly accounts for the cost of raising funds to finance a new project.


2. Free Cash Flow Calculations

Three components of free cash flows:

The Initial outlay

The differential flows over the project’s life

The Terminal cash flow


2.1 Initial Cash Outlay

The initial cash outlay is the immediate cash outflow necessary to purchase the asset and put it in operating order.

This includes: (1) Purchase cost, Set-up cost, Installation, Shipping/Freight (2) increased working-capital requirements (3) sale of existing asset and tax implications (if the project replaces an existing project/asset)


Sale and Taxes

If Sale = Book Value ==> No tax effect

If sale > BV (but less than cost) ==> recaptured depreciation, taxed as ordinary income

If sale > BV (greater than cost) ==> anything above cost, taxed as capital gain, rest taxed as recaptured depreciation

If sale < BV ==> capital loss ==> tax savings


2.2 Annual Free Cash Flows

Annual free cash flows is the incremental after-tax cash flows resulting form the project being considered.

Free Cash flow considers the following:

Cash flow from operations

Cash flows from working capital requirements

Cash flows from capital spending


Calculating Operating Cash Flows

Step 1: Measure the project’s change in after-tax operating cash flows

Operating cash flows= Changes in EBIT– Changes in taxes+ Change in depreciation

Note, depreciation is a non-cash expense but influences the cash flows through impact on taxes (see next two slides).


Depreciation and Cash Flow

Earnings before Tax and Dep. 40,000

Depreciation 25,000

Earnings before tax (EBT) 15,000

If the corporation is taxed at 30%, taxes = .3*15000 = $4,500

If the depreciation was $0, EBT = $40,000 and taxes = .3*40000 = $12,000


Depreciation and Cash Flow

==> Depreciation is a “non-cash expense” BUT affects Cash Flow through its impact on “taxes”;

Depreciation ==> in Expense ==> in taxes => CF


Change in Net Working Capital

Step 2: Calculate the cash flows from the change in net working capital

This refers to additional investment in current assets minus any additional short-term liabilities that were generated.


Steps in Calculating Operating Cash Flows

Step 3: Determine the cash flows from the change in capital spending

This refers to any capital spending requirements during the life of the project.


Putting it all together

Step 4: Project free cash flows = change in EBIT– changes in taxes+ change in depreciation– change in net working capital– change in capital spending


2.3 Terminal Cash Flow

Terminal cash flows are flows associated with the project at termination.

It may include:

Salvage value of the project

Any taxable gains or losses associated with the sale of any asset


Refer to Example 11.2

Initial outlay = $200,000 + $30,000 = $230,000

∆Operating cash flow = EBIT + Depreciation = $155,600(see Tables 11-1, 11-2)

Terminal free cash flows = ∆Operating cash flow + ∆ net working capital = $185,600 (See Table 11-3)


Table 11-1


Table 11-2


Table 11-3


3. Options in Capital Budgeting

Options add value to capital budgeting project by being able to modify the project based on future developments (that are currently unknown). Some common options are: Option to delay a project

Option to expand a project

Option to abandon a project


Option to Delay

Almost every project has a mutually exclusive alternative—waiting and pursuing at a later time.

It is conceivable that a project with a negative NPV now may have a positive NPV if undertaken later on. This could be due to various reasons such as favorable changes in fashion, technology, economy, or borrowing costs.


Option to Expand

Even if a project is currently unprofitable, it may be useful to determine whether the profitability of the project will change if the company is able to expand in the future.

Example: Firms investing in negative NPV projects to gain access to new markets


Option to Abandon

It may be necessary to abandon the project before its estimated life due to inaccurate project analysis models or cash flow forecasts or due to changes in market conditions.

When comparing two projects with similar NPVs, project that is easier to abandon may be more desirable (example, temporary versus permanent workers, lease versus buy)


4. Risk and the Investment Decision

Two main issues:

What is risk and how should it be measured?

How should risk be incorporated into a capital budgeting analysis?


Three Perspectives on Risk

Project standing alone risk

Project’s contribution-to-firm risk

Systematic risk


Project Standing Alone Risk

This is a project’s risk ignoring the fact that much of the risk will be diversified away as the project is combined with other projects and assets.

This is an inappropriate measure of risk for capital budgeting projects.


Contribution-to-Firm Risk

This is the amount of risk that the project contributes to the firm as a whole;

This measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets but ignores the effects of diversification of the firm’s shareholders.


Systematic Risk

Risk of the project from the viewpoint of a well-diversified shareholder;

This measure takes into account that some of the risk will be diversified away as the project is combined with the firm’s other projects and in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolios.


Relevant risk

Theoretically, the only risk of concern to shareholders is systematic risk.

Since the project’s contribution-to-firm risk affects the probability of bankruptcy for the firm, it is a relevant risk measure.

Thus we need to consider both the project’s contribution-to-firm risk and the project’s systematic risk.


Incorporating Risk into Capital Budgeting

We know that investors demand higher returns for more risky projects.

As the risk of a project increases, the required rate of return is adjusted upward to compensate for the added risk.

This risk adjusted discount rate is then used for discounting free cash flows (in NPV model) or as the benchmark required rate of return (in IRR model)


5. Measurement of Systematic Risk

Estimating risk of a project can be difficult Historical stock return data relates to an entire firm, rather than a specific project or division. Risk must be estimated. Options to estimate risk include: Accounting Beta Pure Play Method Simulation Scenario Analysis Sensitivity Analysis


Beta

Accounting Beta Method Can be estimated via time-series regression

on a division’s return on assets on the market index

Pure Play Method Identifies publicly traded firms engaged

solely in the same business as the project, using that firm’s return data to judge the project.


Simulation

Involves the process of imitating the performance of the project under evaluation (See Figure 11-6) Done by randomly selecting observations

from each of the distributions that affect the outcome of the project and continuing with this process until a representative record of the project’s probable outcome is assembled.


Scenario Analysis

Identifies the range of possible outcomes under the worst, best, and most likely cases.


Sensitivity Analysis

Determining how the distribution of possible net present values or internal rate of return for a particular project is affected by a change in one particular input variable while holding all other input variables constant (also known as what-if analysis).


6. The Multinational Firm

Process of measuring the incremental after-tax cash flows to the company as a whole gets more difficult when dealing with competition from abroad.

Calculating the right base case (i.e. incremental cash flows if project not taken) is difficult

International opportunities come with risks such as currency fluctuations that can distort cash flow projections.


Figure 11-1


Figure 11-2


Figure 11-3


Figure 11-4


Figure 11-5


Figure 11-6


Figure 11-6 (cont.)


Figure 11-7


Table 11-4


Table 11-5


Table 11-5 (cont.)


Key Terms

Contribution-to-firm risk Incremental after-tax free cash flows Initial outlay Project standing alone risk Pure play method


Key Terms

Risk-adjusted discount rate Scenario analysis Sensitivity analysis Simulation Systematic risk

10. cash flow in capital budgeting

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