cash flow and capital budgeting professor thomson fin 3013
TRANSCRIPT
Cash Flow And Capital Budgeting
Professor ThomsonFin 3013
2
Cash Flow Versus Accounting Profit
Capital budgeting concerned with cash flow, not accounting profit.
To evaluate a capital investment, we must know:
Incremental cash outflows of the investment (marginal cost of investment), and
Incremental cash inflows of the investment (marginal benefit of investment).
The timing and magnitude of cash flows and accounting profits can differ dramatically.
3
Financing Costs
Financing costs are captured in the discounting future cash flows to present
i.e. use the correct discount rate to adjust for the systematic risk of the project.
Both interest expense from debt financing and dividend payments to equity investors
should be excluded.
Financing costs should be excluded when evaluating a project’s cash flows (can separate
the investment decision from the financing decision).
4
Capital Investment Decisions• The with and without principle – Capital
project evaluation should be done by assessing the cash flows with and without undertaking the project. I.e. We need to consider the INCREMENTAL cash flows due to the project.
• Stand Alone Basis – another way of stating this principle is to consider the project on a stand alone basis (by looking only at the incremental cash flows that result from this project).
5
Other Considerations
• Sunk Costs - A sunk cost is a cost that has been expended in the past, and whether you do or do not undertake the project, these costs no longer effect the incremental cost of the project.
• Opportunity cost – There is no such thing as a free lunch. If a firm already owns something that can be applied to a new project – it could also be sold on Ebay. The amount you could sell it for on Ebay represents the opportunity cost of using an existing asset on a new project.
• Side effects – In considering the incremental costs, one has to consider any side effects. If additional advertising of our new product, also increases sales of our other products, these sides effects must be part of the incremental costs (also cannibalization).
6
Net Working Capital
• New or expanded projects often require additional working capital (such as additional inventory) that must be considered as part of the incremental cost of the project.
• For project analysis, the simplest case is when additional working capital is required at the beginning of the project that will be brought back to base line levels at the end of the project.
7
Investment Pro Forma
• A pro forma is the standard analysis of cash flows that one does to determine if a proposed capital project is a good investment.
• A pro forma includes listing the expected cash flows over time, and computing of the investment criteria such as NPV, IRR, PI, and Payback.
8
Investment Pro Forma (simplified)
Source Time 0 1 2 3
OCF OCF1 OCF2 OCF3
NWC -NWC NWC
Investment -Invest Salvage (ATCF)
Total ATCF ATCF0 ATCF1 ATCF2 ATCF3
All numbers are ATCF’s
9
Investment Pro Forma (simplified)
Source Time 0 1 2 3
OCF 60 60 60
NWC -20 20
Investment -100 15
Total ATCF -120 60 60 95
A project that costs 100 and requires 20 of new net working capital will provide incremental operating cash flows of $60 for the next three years. The after tax cash flow from salvaging the equipment will be 15. What are the project’s ATCF? What is the IRR?
10
Investment Cash Flows
Cash Flows from Investment Projects are commonly separated into 3 components
1. Operating Cash Flows (OCF) OCF = EBIT – Taxes + Depreciation
2. Change in Net Working Capital (NWC)3. Investment Cost
Initial Investment at time period zero At the end of the project you may recover
some of your investment cost if you can sell (salvage) your capital goods.
All of the above are presented on an after tax cash basis (i.e. they are ATCF’s)
11
The Idea of Depreciation
• Some people think of depreciation as the wearing out of capital equipment (your car gets old and unreliable)
• From an accounting viewpoint, depreciation has a different interpretation
• Example: You can by a new TV for $1095 that you think will last you 3 years (1095 days). What is the daily cost of watching TV?
12
Depreciation (continued)
• Depreciation assigns the cost of a capital good over the period you receive benefits from it.
• Warning: The cash flow occurred when you bought the TV. If we consider the Depreciation Expense as $1 per day for the three years we watch TV, we have a depreciation expense each day, but not a cash flow each day. We had a big negative cash flow the day we bought the TV.
13
Depreciation (continued)
• When you pay someone wages to work on a given day, you take a labor expense that day, and you have a cash flow that day.
• We pay taxes on our profit, not on our revenues. We deduct our costs from our revenue to determine the profit that we are taxed on.
14
Depreciation (continued)
• For capital goods, depreciation is a recognized expense, but the cash flow occurred in the past when the capital good was purchased.
• When the good was purchased, no tax deduction for the expense of the good is allowed. Instead, we use depreciation to smear out the capital good cost over time. In other words, we will get our tax deduction in the future in response to a cost (cash flow) incurred today.
• Depreciation expense, thus affects future taxes, not current taxes.
15
Cash Flow and Non-Tax Expenses • Accountants charge depreciation to spread a
fixed asset’s costs over time to match its benefits.
• Capital budgeting analysis focuses on cash inflows and outflows when they occur.
• Non-cash expenses affect cash flow through their impact on taxes – the investment cash flow made at time period zero, reduced future taxes when you are allowed to take a deduction for the depreciation expense.
16
Depreciation
• Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits.
• Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life.
For capital budgeting analysis, the depreciation method for tax purposes matters
most.
Many countries allow one depreciation method for tax purposes and another for reporting
purposes.
17
Depreciation: 1. Straight Line1. Straight Line
Example: Purchase a truck for $20,000 that you will use for 5 years and then sell for $4000
Investment Cost-SalvageAnnual Depreciation=
Years Of Service
20000 4000$3200 /
5AnnualDepreciation yr
18
Depreciation: 2. MACRS
2. MACRS – Modified Accelerated Cost Recovery SystemInvestments are classified into MACRS classes
such as 3 year, 5 year, etc.When using MACRS, salvage value is not
considered (implicitly assumed to be zero).The annual depreciation percent for each class is
stated such as shown below for the 3-year asset class.
Year 1 2 3 4Allowance 33.33
%44.44 14.82 7.41
19
Example MACRS Depreciation
You purchase a new capital asset that fits into the 3 year MACRS class. The cost of the asset is $1 million and you believe you can sell it for $200,000 after three years of service. What is your depreciation expense in year 3?
Answer: Year 3 Depreciation = $1,000,000 x 0.1482 = 148,200.
Year 1 2 3 4Allowance 33.33
%44.44 14.82 7.41
20
Useful FormulasProject ATCF = OCF – NWC – Investment
(Note: These are all ATCF’s)OCF = EBIT – Taxes + Depreciation
(EBIT = Sales – Operating Costs – Depreciation)Taxes = t*EBIT, where t = tax rate
Straight Line (Annual) Depreciation = (Investment – Est. Salvage)/Years
ATCF from Salvage = Salvage – tax (Salvage is the Sale Price of salvaged
equipment)tax = t(Salvage – BookVal) where t= tax rate,BookVal = Investment – Accumulated
Depreciation
21
Ex 9.1 ATCF from Salvage(Straight Line Depreciation)
• You purchased a new lawnmower for your Landscape business for $5000 that you expected to use for 3 years, and then sell for $500. After 2 years you saw a great deal on another mower so you decided to replace your mower, and sold your old mower for $1500. What is your ATCF from selling your old mower (tax rate = 30%)?
22
Example 9.2 Computing OCF• Noble’s Best Doughnuts is considering
buying a dough machine for $150,000 that it will depreciate (straight line) over its expected 3 year life. It expects to sell the machine for $30,000 at that time. Doughnut sales are projected to increase $100,000 per year. Operating costs are 30% of sales. Noble pays a 34% tax on its income. What are the incremental OCF’s Noble can expect from this project over the next 3 years?
23
Example 9.3 OCF with MACRS• Same as 9.1, but use MACRS for
computing the depreciation, i.e. what are the OCF’s?Year 1 2 3 4
Allowance 33.33% 44.44 14.82 7.41
24
Example 9.4: NWC simplified• Noble’s Best Doughnuts will need
additional supplies of doughnut mix and sprinkles to feed this machine. It estimates it will need to keep an additional $10,000 of baking supplies on hand during the life of the project. What are the ATCF’s associated with the change in NWC to support this project?
25
Example 9.5 Investment CF’s• As noted earlier, Noble’s Best
Doughnuts will invest $150,000 on the new doughnut machinery, and expects to sell the used machinery after 3 years for $30,000.
1. What is the ATCF from Salvage using straight line depreciation?
2. What is the ATCF from Salvage using MACRS?
3. What are the ATCF’s from investment?
26
Example 9.6
• What will Noble’s pro forma look like for:
1. Straight Line depreciation2. MACRS depreciation
• For each case above, what is the IRR of the project?
27
Incremental Cash Flow
Capital budgeting analysis should include only incremental costs.
• An example…Should Norman Paul pursue an MBA?• Norman Paul’s current salary is $60,000 per year
and he expects it to increase at 5% each year.• Norm pays taxes at flat rate of 35%.• Sunk costs: $1,000 for GMAT course and $2,000
for visiting various programs (IGNORE)• Room and board expenses are not incremental to
the decision to go back to school
28
Incremental Cash Flow
• At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year• Expected tuition, fees and textbook expenses for next
two years while studying in MBA: $35,000 for 2 years• If Norm worked at his current job for two years, his
salary would have increased to $66,150:• Yr 2 net cash inflow: $90,000 - $66,150 = $23,850• After-tax inflow: $23,850 x (1-0.35) = $15,503• Yr 3 cash inflow:• MBA has substantial positive NPV value if 30 yr analysis
period
150,66$05.1000,60$ 2
032,18$35.0105.1000,60$08.1000,90$ 3
What about Norm’s opportunity cost?
29
Opportunity Costs
Cash flows from alternative investment opportunities, forgone when one investment is
undertaken.
NPV of a project could fall substantially if opportunity costs are recognized!
First year: $60,000 ($39,000 after taxes)
Second Year: $63,000 ($40,950 after taxes)
If Norm did not attend MBA program, he would have
earned:
30
Capital Rationing
Can a firm accept all investment projects with positive NPV?
Reasons why a company would not accept all projects:
Limited availability of skilled personnel to be involved with all the projects;
Financing may not be available for all projects.
Companies are reluctant to issue new shares to finance new projects because of the
negative signal this action may convey to the market.
31
Capital Rationing
Capital rationing: project combination that maximizes shareholder wealth subject to
funding constraints
1. Rank the projects using the Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds still available, select the second-highest PI, and so on, until the capital is
exhausted.
1. Rank the projects using the Profitability Index (PI)
The steps above helps managers select the combination of projects with the highest NPV.
32
Equipment Replacement and Unequal Lives• A firm must purchase an electronic control
device:• First alternative is a cheaper device, higher maintenance
costs, shorter period of utilization• Second device is more expensive, smaller maintenance
costs, longer life span• Expected cash outflows:
• Maintenance costs are constant over time. Use real discount rate of 7% for NPV
-15001500150012000A120012001200120014000B
43210Device
$15,936A$18,065B
NPVDevice
Cash outflow device A < cash outflow device B select A?
33
Approach 1: Lowest Common Time Frame
• Each could be evaluated on a 12 year time table with the noted CF’s
• PV of A (@7% discount rate) is $48233
• PV of B is $42360• B is cheaper, in a
DCF context, over time
Year A B
0 12000 14000
1 1500 1200
2 1500 1200
3 13500 1200
4 1500 15200
5 1500 1200
6 13500 1200
7 1500 1200
8 1500 15200
9 13500 1200
10 1500 1200
11 1500 1200
12 1500 1200
34
Approach 2: Equivalent Annual Cost (EAC)• EAC converts lifetime costs to a level annuity;
eliminates the problem of unequal lives • 1. Compute NPV for operating devices A and B for
their lifetime:• NPV device A = $15,936• NPV device B = $18,065
• 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device:
$6,072 X 071071071
93615321
...
,$XXX
Device A
$5,333Y 071071071071
065184321
....
,$YYYY
Device B
35
Calculator Approach (Device A)• P/YR = 1• Enter CF’s• Type 7, press I/YR• Press NPV • Press +/-• Press PV• Type 3, press N• Press PMT
Year CF for A
0 12000
1 1500
2 1500
3 1500
36
The Human Face of Capital Budgeting
• Managers must be aware of optimistic bias in these assumptions made by project supporters.
• Companies should have control measures in place to remove bias:• Investment analysis should be done by a group
independent of individual or group proposing the project.
• Project analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential.
• Storytelling: Best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.
Certain types of cash flows are common to many investments
Opportunity costs should be included in cash flow projections
Consider human factors in capital budgeting
Cash Flow and Capital Budgeting
38
39
Excess Capacity
• Excess capacity is not a free asset as traditionally regarded by managers.• Company has excess capacity in a
distribution center warehouse.• In two years, the firm will invest
$2,000,000 to expand the warehouse.• The firm could lease the excess space for
$125,000 per year for the next two years.• Expansion plans should begin immediately
in this case to hold inventory for stores that will come on line in a few months.
• Incremental cost: investing $2,000,000 at present vs. two years from today
• Incremental cash inflow: $125,000
40
Excess Capacity
• NPV of leasing excess capacity (assume 10% discount rate):
• NPV negative: reject leasing excess capacity at $125,000 per year.
• The firm could compute the value of the lease that would allow break even.
• X = $181,818• Leasing the excess capacity for a price above
$181,818 would increase shareholders wealth.
471,108$1.1
000,000,2
10.1
000,125000,000,2000,125
2NPV
01.1
000,000,2
10.1000,000,2
2
XXNPV
41
Assume a firm purchases a fixed asset today for $30,000
Plans to depreciate over 3 years using straight-line method
Firm will produce 10,000 units/year
Costs $1/unit
Sells for $3/unit
Firm pays taxes at a 40% marginal rate
$6,000Net income
$16,000Cash flow = NI + deprec
(4,000)Taxes (40%)
$10,000Pre-tax income
(10,000)Depreciation
$20,000Gross profits
(10,000)Cost of goods
$30,000Sales
Adding non-cash expenses back to after-tax earnings
$4,000Depreciation tax savings
$16,000Cash Flow
$12,000Aft-tax income
(8,000)Taxes (40%)
$20,000Pre-tax income
(10,000)Cost of goods
$30,000Sales
Find after-tax profits, add back non-cash charge tax savings
Simplest and most common technique:Add depreciation back in.
Two Methods of Handling Depreciation to Compute Cash Flow
42
The Initial Investment
• Initial cash flows: • Cash outflow to acquire/install fixed assets• Cash inflow from selling old equipment • Cash inflow (outflow) if selling old
equipment below (above) tax basis generates tax savings (liability)
An example....
Tax rate = 40%
New equipment costs $10 million,
$0.5 million to install
Old equipment fully depreciated, sold for $1
million
Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from
selling the old equipment
43
Working Capital Expenditures
• Many capital investments require additions to working capital.• Net working capital (NWC) = current
assets – current liabilities.• Increase in NWC is a cash outflow;
decrease a cash inflow.
• An example…• Operate booth from November 1 to January 31• Order $15,000 calendars on credit, delivery by
Nov 1• Must pay suppliers $5,000/month, beginning Dec
1 • Expect to sell 30% of inventory (for cash) in Nov;
60% in Dec; 10% in Jan• Always want to have $500 cash on hand
44
Working Capital for Calendar Sales Booth
(4,000)+500+500NAMonthly in WC
(3,000)1,0005000Net WC
5,00010,00015,0000Accts payable
01,50010,50015,0000Inventory
$0$500$500$500$0Cash
Feb 1Jan 1Dec 1Nov 1Oct 1
($5,000)($5,000)($5,000)$0Payments
($500)Net cash flow
$1,500[10%]
$9,000[60%]
$4,500[30%]
$0Reduction in inventory
Jan 1 to Feb 1
Dec 1 to Jan 1
Nov 1 to Dec 1
Oct 1 to Nov 1
Payments and inventory
($500) +$4,000 ($3,000)
0
0
+3,000
45
Terminal Value
Terminal value is used when evaluating an investment with indefinite life-span:
Construct cash-flow forecasts for 5 to 10
years
Forecasts more than 5 to 10 years have
high margin of error; use terminal value
instead.
• Terminal value is intended to reflect the value of
a project at a given future point in time.
• Large value relative to all the other cash flows of the project.
46
Terminal Value
Different ways to calculate terminal values:
• Use final year cash flow projections and assume that
all future cash flow grow at a constant rate;
• Multiply final cash flow estimate by a market multiple, or
• Use investment’s book value or liquidation value.
$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion
Year 5Year 4Year 3Year 2Year 1
JDS Uniphase cash flow projections for acquisition of SDL Inc.
47
Terminal Value of SDL Acquisition
67.48$1.1
2.68$
1.1
25.3$
1.1
5.2$
1.1
75.1$
1.1
1$
1.1
5.0$554321
$68.20.050.10
$3.41PVor ,
grCF
PV 51t
t
• Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):
• Terminal value is $68.2 billion; value of entire project is:
• $42.4 billion of total $48.7 billion from terminal value
• Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value• Terminal Value = $3.25 x 20 = $65 billion• Caveat : market multiples fluctuate over time
48
Initial Investment for Jazz CD ProjectClassicaltunes.com is considering adding jazz
recordings to its offerings.
• Firm uses 10% discount rate to calculate NPV and 40% tax rate.
• The average selling price of Classicaltunes CD’s is $13.50; price is expected to increase at 2% per year.
• Sales expected to begin when new fiscal year begins.
Initial investment transaction
s:
$50,000 for computer equipment (MACRS 5-year)
$4,500 for inventory ($2,500 of which purchased on credit)
$1,000 increase in cash balances
49
Projections for Jazz CD Proposal
6543210Year
28057
120646
39840
105160
145000
80806
47696
29810
3300
25214
122903
50048
79952
130000
72855
42864
26790
3200
29810179781101643202500Accounts Payable
11717986585561324593445500Total assets
3132833920232003200040000Net P&E
123672
56080418002800
010000
Accumulated Depreciation
15500090000650006000050000Gross P&E
8585152665329321393
45500
Current Assets
50677305631872773444500Inventory
31673191021170545900Accounts Receivable
35003000250020001000Cash
Abbreviated Project Balance Sheet6543210Year
24,000
$14.91
22,000
$14.61
25,00016,00010,0004,0000Units
$15.20$14.33$14.05$13.77$13.50Price per unit
37393
25208
35772
98374
259349
357722
27565
23872
35363
86800
234682
321482
49903155191649-13043-10000Pretax profit
1851214280138001800010000Depreciation
38008297991966482620SG&A Expense
1064225959735114 13219 0Gross profit
273657
169623
105341
418610Cost of goods sold
380080229221140454550800Revenue
Abbreviated Project Income Statement
Annual Cash Flow Estimates for Classicaltunes.com
-3291-5109-
12953-
12771-
12302-6614-3000
Change in working capital
-10000-15000-
40000-
25000-5000
-10000
-50000
New Fixed Assets
6543210Year
27535
47644
-12542
40411
35163-14180-2512-6440-49000Net cash flow
484542359114790101744000Operating cash flow
50
Year Zero Cash Flow
• Initial cash outlay of $50,000 for computer equipment• Half-year of MACRS depreciation can be taken in year zero:
• 20% x $50,000 = $10,000; non cash expense• Depreciation expense are deducted from the firm’s classical-music
CD profits. Savings of $4,000 (40% x $10,000) in taxes• Changes in working capital are result of following transactions:
• Purchase of $4,500 in inventory and $1000 cash balance• Accounts payable of $2,500 partially finance the $5,500 outlay
Increase in gross fixed assets - $50,000
Change in working capital - $3,000
Operating cash inflow + $4,000
Net cash flow - $49,000
Net Cash Flow:
51
Year One Cash Flow
• Purchase of additional $10,000 in fixed assets• 2nd year depreciation expenses for MACRS 5-year
asset class is 32%. An additional 20% depreciation deduction for assets purchased this year• 32% x $50,000 + 20% x $10,000= $18,000• Non cash expense; has to be added back when
computing cash flow for the year• Net working capital for year one is:
• NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614
• Increase in NWC; cash outflow of $6,614
614,6$000,3$614,9$ NWC– NWC NWC 0year 1year
52
Year One Cash Flow
• Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com.• Tax savings = 40% x $13,043 = $5,217
• Net operating cash inflow = pretax loss + tax savings + depreciation• Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174
Increase in gross fixed assets - $10,000
Change in working capital - $6,614
Operating cash inflow + $10,174
Net cash flow - $6,440
Net Cash Flow:
53
Year Two Cash Flow
• Purchase of additional $5,000 in fixed assets• Assets purchased at the onset of the project have allowable
depreciation of 19.2% (19.2% x $50,000 = $9,600)• An additional 32% depreciation deduction for assets
purchased in year 1 and 20% depreciation of assets purchased this year
• Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000= $4,200 = $13,800
• Changes in working capital are result of following transactions:• Increases in current assets:
• $500 increase in cash balance• $7,115 increase in accounts receivables• $11,383 increase in inventory
• Increase in current liabilities:• $6,696 increase in account payables
• Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)
54
Year Two Cash Flow
Increase in gross fixed assets
- $5,000
Change in working capital - $12,302
Operating cash inflow +$14,790
Net cash flow - $2,512
• Pretax profit in year two is $1,649.• The company must pay taxes of $660 (40% x $1,649-- cash
outflow.• Net operating cash inflow = pretax profit + tax + depreciation
• Operating cash inflow = $1,649 - $660 + $13,800 = $14,789
Net Cash Flow:
55
Terminal Value for Jazz CD Investment
• If we assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,):
• Second approach used by Classicaltunes.com to compute terminal value for the project: use the book value at end of year six:• Plant and Equipment (P&E) at end of year six is
$31,328.• The firm liquidates total current assets and pays off
current debts:• $85,850 - $29,810 = $56,040
• Terminal value = $31,328 + $56,040 = $87,368.
325,448$02.010.0
866,35$or ,
866,35$163,35$02.11
61
1
PVgr
CFPV
CFgCF
tt
tt
56
NPV for Jazz CD Project
• Using assumption that cash flow grow at a steady rate past year 6:
• Using book value assumption for terminal value:
• NPV is positive with both methods: investing in Jazz CD project increases shareholders wealth.
862,213$1.1
325,448$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV
111,10$1.1
368,87$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV