1. Estimating Cash Flows and Refinements to Capital Budgeting 11 CHAPTER Copyright © 1999 Addison Wesley Longman

2. 2 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Objectives 1.Show how cash flows are estimated 2.Rank investment options 3.Adjust for risk 4.Evaluate projects with different lives 5.Use sensitivity analysis

3. Copyright © 1999 Addison Wesley Longman 3 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Rules for Estimating Cash Flow 1.Include only increment cash flows 2.Include indirect costs 3.Disregard sunk costs 4.Include opportunity costs 5.Adjust for taxes 6.Ignore financing costs

4. Copyright © 1999 Addison Wesley Longman 4 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Estimating Cash Flows Three elements to be estimated: 1.Initial cash flow 2.Annual cash flow 3.Terminal cash flow

5. Copyright © 1999 Addison Wesley Longman 5 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting TABLE 11.1Calculating Initial Cash Flow –Initial purchase price of new asset –Installation/shipping cost of new asset =Net purchase price +Proceeds from sale of old asset +/–Tax on sale of old asset +/–Change in net working capital =Initial cash flow

6. Copyright © 1999 Addison Wesley Longman 6 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting To calculate the tax on the sale:  Compute the accumulated depreciation on the old machine  Compute the book value: –BV = Initial cost – Accumulated depreciation

7. Copyright © 1999 Addison Wesley Longman 7 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Tax is computed as: (Sales price – BV)  Tax Rate There can be tax savings as well as tax losses.

8. Copyright © 1999 Addison Wesley Longman 8 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Change in net working capital:  Equals the change in current assets minus the change in current liabilities.

9. Copyright © 1999 Addison Wesley Longman 9 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Calculation of Annual Cash Flows +(New sales revenue – Old sales revenue) –(New operating expenses – Old operating expenses) =Gross profit –(New depreciation – Old depreciation) =Net profit before taxes –Taxes =Net profit after taxes +(New depreciation) Estimating Annual Cash Flows

10. Copyright © 1999 Addison Wesley Longman 10 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Solution Logan’s Roadhouse Inc. (millions) 1999 2000 2001 2002 2003 New revenues – Old revenues$2.500$2.875$3.306$3.802$4.373 New expenses – Old expenses 2.250 2.588 2.976 3.422 3.935 Gross Profit 0.250 0.287 0.330 0.380 0.438 –(New depr. – Old depr.) 0.070 0.070 0.070 0.070 0.070 Net profit before tax 0.180 0.217 0.260 0.310 0.368 –Taxes (40%) 0.072 0.087 0.104 0.124 0.147 Net profit 0.108 0.130 0.156 0.186 0.221 +Depreciation 0.070 0.070 0.070 0.070 0.070 Net cash flow 0.178 0.200 0.226 0.256 0.291

11. Copyright © 1999 Addison Wesley Longman 11 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Table 11.2Calculation of Terminal Cash Flow +(New sales revenue – Old sales revenue) –(New operating expenses – Old operating expenses) =Gross profit –(New depreciation – Old depreciation) =Net profit before taxes –Taxes =Net profit after taxes +(New depreciation – Old depreciation) =Operating cash inflows +Sale of new asset +/–Tax on sale of new asset +/–Change in net working capital =Terminal cash flow

12. Copyright © 1999 Addison Wesley Longman 12 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Tax  The tax on the sale of the new asset is computed the same way as the tax in the initial cash flow was computed.

13. Copyright © 1999 Addison Wesley Longman 13 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Example Due to unexpectedly high demand, Pizzas-by-Mail finds that it may need a larger oven. The old oven cost $20,000 new and has been in use for 1 year. It has a 3-year life for depreciation and can be sold today for $12,000. The new oven

14. Copyright © 1999 Addison Wesley Longman 14 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting costs $30,000 but will require $5,000 in remodeling to fit the restaurant. Shipping costs are $1,000. The new oven also has a 3- year class life. The larger oven will require that an additional inventory of $500 be held. Revenues will increase $5,000 (from $25,000 per year to $30,000

15. Copyright © 1999 Addison Wesley Longman 15 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting per year) and costs will increase $2,000. Management expects to replace the larger oven after 5 years. It will have a salvage value of $4,000. Assume a 40% tax rate and discount rate of 15% and compute the NPV.

16. Copyright © 1999 Addison Wesley Longman 16 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Calculation of Initial Cash Flow – Initial purchase price of new asset–$30,000 – Installation/shipping cost of new asset–$ 6,000 = Net Purchase Price–$36,000 + Proceeds from the sale of old asset+$12,000 +/– Tax on sale of old asset (see below)+$ 560 +/– Change in net working capital–$ 500 = Initial cash flow–$23,940

17. Copyright © 1999 Addison Wesley Longman 17 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Tax on Sale of Old Asset Accumulated Depreciation = 20,000 .33 = $6,600 (From MACRS tool) Book Value= Initial Cost – Accumulated Depreciation Book Value= $20,000 – $6,600 Book Value= $13,400 Tax on Sale= (Sales Price – Book Value)  Tax Rate = ($12,000 – $13,400) .40 = ($–1,400 .40) = $–560 Add tax savings since this reduction in tax reduces our initial cash flow.

18. Copyright © 1999 Addison Wesley Longman 18 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Calculation of Annual Cash Flows 1999 2000 2001 2002 2003 New revenues – Old revenues$5,000 $5,000 $5,000$5,000 $5,000 New expenses – Old expenses$2,000 $2,000 $2,000$2,000 $2,000 Gross Profit$3,000 $3,000 $3,000$3,000 $3,000 –(New depr. – Old depr.)$2,880 $13,200 $4,000$2,520 0 Net profit before tax $120–$10,200–$1,000 $480 $3,000 –Taxes (40%) –$48 +$4,080 +$400 –$192 –$1,200 Net profit +$72 –$6,120 –$600 +$288 +$1,800 +Depreciation$2,880 $13,200 $4,000$2,520 0 Net cash flow$2,952 $7,080 $3,400$2,808 $1,800

19. Copyright © 1999 Addison Wesley Longman 19 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Calculation of Terminal Cash Flow Net cash flow (year 2003 from solution to annual cash flow table)+$1,800 + Proceeds from the sale of new asset+$4,000 +/– Tax on sale of new asset (see below)–$1,600 +/– Change in net working capital +$500 = Terminal cash flow+$4,700

20. Copyright © 1999 Addison Wesley Longman 20 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Tax on Sale of New Asset The new asset will be fully depreciated by the end of the project so its book value is zero. Tax= (Sales Price – Book Value)  Tax Rate Tax= ($4,000 – $0) .40 = $1600 Since this is the tax that must be paid on the gain, it is a cash out flow and is subtracted.

21. Copyright © 1999 Addison Wesley Longman 21 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Computing NPV

22. Copyright © 1999 Addison Wesley Longman 22 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Selecting Projects under Capital Rationing  Capital Rationing occurs when there are more positive NPV projects available than a firm can accept.  One method is to plot projects on a graph.

23. Copyright © 1999 Addison Wesley Longman 23 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting An Alternative Method:  Maximize the sum of the NPVs of the projects accepted. –Compute the NPV of each possible project. –Put them in order from largest PI to smallest.

24. Copyright © 1999 Addison Wesley Longman 24 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting –Compute the total NPV of those selected. –Make sure the alternative selections do not decrease total NPV.

25. Copyright © 1999 Addison Wesley Longman 25 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Project CostTotal CostNPVTotal NPV PI B$1.50 $1.50$0.30 $0.301.20 E 0.75 2.25 0.15 0.451.20 F 0.50 2.75 0.10 0.551.20 A 1.50 4.25 0.20 0.751.13 D 2.50 6.75 0.25 1.001.10 C 2.00 8.75 0.10 1.101.05

26. Copyright © 1999 Addison Wesley Longman 26 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Adjusting for Risk  Certainty equivalent method  Risk adjusted discount rate

27. Copyright © 1999 Addison Wesley Longman 27 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Certainty Equivalent Method  Reduce the cash flows to an amount you believe will occur with near certainty.  Compute the NPV by discounting the cash flows at a risk free rate of interest.

28. Copyright © 1999 Addison Wesley Longman 28 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Rate Adjusted Discount Rate  Identify a firm similar to yours with respect to risk and size that is in the business you are evaluating.

29. Copyright © 1999 Addison Wesley Longman 29 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting  Use this surrogate firm’s beta and CAPM to estimate a new discount rate.  Use this discount rate to compute the project’s NPV.

30. Copyright © 1999 Addison Wesley Longman 30 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Differing Lives  Replacement Chain Approach: –Repeat the short project until it matches the length of the longer one.

31. Copyright © 1999 Addison Wesley Longman 31 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting –If the short one is not an even multiple of the long one this requires repeating the longer one as well until a common length is achieved.

32. Copyright © 1999 Addison Wesley Longman 32 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Example Project A =Invest $10 million and receive $3.75 million for five years. Project B =Invest $10 million and receive $2.5 million for ten years. Assume a 12% discount rate.

33. Copyright © 1999 Addison Wesley Longman 33 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting NPV A = $3.75 (PVIFA 5,12% ) - $10 = $3.518 million NPV B = $3.75 (PVIFA 10,12% ) - $10 = $4.123 million Solution

34. Copyright © 1999 Addison Wesley Longman 34 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Repeat project A NPV short = $3.75(PVIFA 10 yr,12% ) – $10(PVIF 5 yr,12% ) – $10 NPV short = $21.188 – $5.674 – $10 = $5.514 million Select Project A 0 1 2 3 4 5 6 7 8 9 10 -10 3.75 3.75 3.75 3.75 3.75 -10

35. Copyright © 1999 Addison Wesley Longman 35 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Differing Lives  Equal Annual Annuity Method: Convert the cash flows from each project into an annuity. –Compute the NPV of each option.

36. Copyright © 1999 Addison Wesley Longman 36 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting –Compute the value of the annuity that has a PV = NPV given the discount rate and number of periods.

37. Copyright © 1999 Addison Wesley Longman 37 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Example 1.In the previous example NPV A = $3.518 million NPV B = $4.123 million 2.NPV a = Pmt (PVIFA 5,12% ) 3.518 = Pmt (3.6048) Pmt = $.9759 million

38. Copyright © 1999 Addison Wesley Longman 38 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting 3. NPV b = Pmt (PVIFA 10,12% ) $4.123 = Pmt (5.6502) Pmt = $.7297 million We assume that each project could be repeated indefinitely, so the annuity payments would go on forever. Clearly, we would select the one with the largest payment— Project A.

39. Copyright © 1999 Addison Wesley Longman 39 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting Sensitivity Analysis Before accepting a project it is critical that you understand how sensitive it is to changes in the assumptions. This is best done using spreadsheet software.

40. Copyright © 1999 Addison Wesley Longman 40 Chapter 11: Estimating Cash Flows and Refinements to Capital Budgeting –Prepare cash flow schedule using spreadsheet. –Use build-in functions to compute NPV. –Vary each input and record the new NPV. –Graph results to help interpretation.