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Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary.

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Presentation on theme: "Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary."— Presentation transcript:

1 Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary

2 CHAPTER 14 Cash Flow Estimation and Capital Budgeting Decisions

3 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Lecture Agenda Learning ObjectivesLearning Objectives Important TermsImportant Terms General Guidelines for Capital Project AnalysisGeneral Guidelines for Capital Project Analysis Estimating and Discounting Cash FlowsEstimating and Discounting Cash Flows Sensitivity to InputsSensitivity to Inputs Replacement DecisionsReplacement Decisions Inflation and Capital Budgeting DecisionsInflation and Capital Budgeting Decisions Summary and ConclusionsSummary and Conclusions

4 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Learning Objectives 1.How to estimate the future cash flows associated with potential investments 2.How to determine whether these investments are the result of expansion or replacement decisions 3.How to conduct a sensitivity analysis to see how the value changes as key inputs vary 4.Why real option valuation techniques have become an important trend in project evaluation 5.How mistakes can easily be made in dealing with inflation

5 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Important Chapter Terms Capital cost (C 0 )Capital cost (C 0 ) Decision treeDecision tree Ending (or terminal) after- tax cash flow (ECF n )Ending (or terminal) after- tax cash flow (ECF n ) Expansion projectsExpansion projects Expected annual after-tax cash flows (CF t )Expected annual after-tax cash flows (CF t ) ExternalitiesExternalities Initial after-tax cash flow (CF 0 )Initial after-tax cash flow (CF 0 ) Marginal or incremental cash flowsMarginal or incremental cash flows NPV break-even pointNPV break-even point Opportunity costsOpportunity costs Real option valuation (ROV)Real option valuation (ROV) Replacement projectsReplacement projects Salvage value (SV n )Salvage value (SV n ) Scenario analysisScenario analysis Sensitivity analysisSensitivity analysis Sunk costsSunk costs

6 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Cash Flows and Capital Budgeting Introduction Decisions are only as good as the information used to make them.Decisions are only as good as the information used to make them. This chapter focuses on approaches used to estimate future cash flows associated with capital project proposalsThis chapter focuses on approaches used to estimate future cash flows associated with capital project proposals

7 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Project Evaluation Techniques Required Information and Estimates All evaluation approaches (NPV, IRR, Discounted Payback, and PI) require the same data:All evaluation approaches (NPV, IRR, Discounted Payback, and PI) require the same data: –Estimate of initial cost (CF 0 ) –Net incremental after-tax cash flows CFBT(1-T) –Cost of Capital (k) –Estimate of useful life (n) –Ending Cash flows (ECF n ) –Corporate tax rate (T) –Capital Cost Allowance Rate (d) This chapter provides you with guidelines for identifying relevant information and testing the decisions sensitivities to variations in those input variables.This chapter provides you with guidelines for identifying relevant information and testing the decisions sensitivities to variations in those input variables.

8 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Cash Flows Estimation General Guidelines Cash flows should be:Cash flows should be: 1.After-tax 2.Incremental or marginal 3.Do not include interest or dividends 4.Adjust initial cash outlay and terminal cash flows for additional working capital requirements 5.Treat sunk costs as irrelevant 6.Opportunity costs should be factored into the cash flow estimates Determine the appropriate time horizon for the projectDetermine the appropriate time horizon for the project Ignore intangible considerationsIgnore intangible considerations Ignore externalitiesIgnore externalities Consider the effect of all project interdependencies on cash flow estimates.Consider the effect of all project interdependencies on cash flow estimates. Treat inflation consistentlyTreat inflation consistently Undertake all social investments required by law.Undertake all social investments required by law.

9 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows The Basic Cash Flow Pattern The following slide graphically illustrates the basic cash flow patterns involved in a capital project:The following slide graphically illustrates the basic cash flow patterns involved in a capital project: –There is an initial investment at t = 0 (CF 0 ) –There follows an annual stream of after-tax cash flow benefits (CF t ) –At the end of the useful life, ending cash flow benefits after tax are received (ECF n ) [ 14-5]

10 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows The Basic Cash Flow Pattern Initial After- Tax Cash Flow (CF 0 ) Expected Annual After-Tax Operating Cash Flows (CF tt ) t=123n-1n CF 1 CF 2 CF 3 CF N-1 CF N Terminal Cash Flow (ECF n ) If CF 0 < PV of CF t, then benefits exceeds costs, the NPV is positive. ACCEPT the Project

11 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern The basic cash flow pattern can be deconstructed into:The basic cash flow pattern can be deconstructed into: –Initial investment (CF 0 ) –Annual stream of after-tax cash flows throughout the project life (CF t ) –Ending cash flows (ECF n )

12 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern CF 0 There is an initial investment at t = 0 (CF 0 ) consists of: C 0 the initial capital cost of the assetC 0 the initial capital cost of the asset ΔNWC 0 the change in net working capitalΔNWC 0 the change in net working capital OC the opportunity costs associated with the projectOC the opportunity costs associated with the project [ 14-1]

13 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern CF t There follows an annual stream of after tax cash flow benefits (CF t ) consisting of: Operating after-tax cash flow benefits (OCF t ) = CFBT t (1 – T)Operating after-tax cash flow benefits (OCF t ) = CFBT t (1 – T) Tax shield benefits from CCATax shield benefits from CCA [ 14-2]

14 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern ECF n At the end of the useful life, ending cash flow benefits received (ECF n ) in the absence of tax issues include: SV n the estimated salvage value in year n for the asset purchasedSV n the estimated salvage value in year n for the asset purchased ΔNWC n the net working capital investment released at the end of the projectΔNWC n the net working capital investment released at the end of the project [ 14-4]

15 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern ECF n If there are tax issues the ECF n consists of: SV n the estimated salvage value in year n for the asset purchasedSV n the estimated salvage value in year n for the asset purchased ΔNWC n the net working capital investment released at the end of the projectΔNWC n the net working capital investment released at the end of the project Less any taxes payable on the salvage value (capital gains, recapture of depreciation)Less any taxes payable on the salvage value (capital gains, recapture of depreciation) [ 14-3]

16 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern Putting It All Together Once you have estimated the cash flows you must:Once you have estimated the cash flows you must: –Determine their after-tax values –Discount them back to the present –Sum them in determining the NPV (The following slide graphically illustrates the deconstructed cash flow pattern involved in a capital project)

17 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions The Capital Budgeting Cash Flows Deconstructing the Cash Flows Initial After- Tax Cash Flow (CF 0 ) Expected Annual After-Tax Operating Cash Flows (excluding CCA Tax Shield) (OCF t ) = CFBT(1 – T) t=123n-1n CF 1 CF 2 CF 3 CF N-1 CF N Terminal Cash Flow (ECF n ) CF 0 = C 0 + Δ NWC 0 + OC Expected Tax Shield Benefits from CCA deduction (CdT) Because the CCA tax shield benefit changes each year in a predictable fashion, we can use a formula to calculate their total present value.

18 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Alternative Approaches to Finding the Tax Shield Benefit on CCA You will recall that there are two approaches to determining cash flows.You will recall that there are two approaches to determining cash flows. We will use alternative (2) found on Table 14-1We will use alternative (2) found on Table 14-1 This allows us to deconstruct the analysis, separating operating cash flows from the tax shield benefits of CCA.This allows us to deconstruct the analysis, separating operating cash flows from the tax shield benefits of CCA. (See the following slide)

19 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Determining Cash Flows after CCA

20 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Separating Operating Cash Flows from CCA Tax Shield Benefits t=123n-1n CF 1 CF 2 CF 3 CF N-1 CF N Typically operating cash flow benefits can be treated as an annuity. The CCA Tax Shield benefits are a growing perpetuity with a constant negative growth rate. The only exception to this is the first cash flow. (This is ½ year rule effect.)

21 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Tax Shield Benefit of CCA The tax shield benefit from CCA is equal to the corporate tax rate (T) × CCA amount.The tax shield benefit from CCA is equal to the corporate tax rate (T) × CCA amount. As demonstrated in the following slide, assuming the firm will have taxable operating income in the future, we can predict the maximum amount of CCA the firm can claim from the year of acquisition through to infinity.As demonstrated in the following slide, assuming the firm will have taxable operating income in the future, we can predict the maximum amount of CCA the firm can claim from the year of acquisition through to infinity. You will note:You will note: –½ rule effect in the first year –We assume we claim the maximum CCA in each subsequent year. –We forecast the tax shield benefit by: T× CCA t –Tax shield benefits will be a perpetual stream of cash flows that are going a constant negative compound growth rate (d) where d is the CCA rate

22 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield Over Time (Assume a corporate Tax Rate T of 40%) $100,000 asset is acquired in year 1. No asset pool disposals. CCA rate (d) = 10% Tax Shield = T(CCA) Lets graph this series of tax shield benefits the firm is forecast to receive.

23 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield Over Time (A Graphical Representation) Asymptotic Curve

24 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Observations In the foregoing you can now readily see:In the foregoing you can now readily see: CCA provides large tax shields in the early years of the assets life CCA provides large tax shields in the early years of the assets life residual values remain in the pool long after the asset was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firms asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset. residual values remain in the pool long after the asset was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firms asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset. Now we can learn how to find the present value of a perpetual stream of forecast cash flows.Now we can learn how to find the present value of a perpetual stream of forecast cash flows.

25 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of the CCA Tax Shield (Assume a corporate Tax Rate T of 40% and Discount rate of 12%) This is the sum of the first 8 years of tax savings…it would be an infinitely long process to find the actual sum of an infinite stream of cash flows. We must develop a formula-based solution to this problem. Multiplying T(CCA) by the PVIF we can estimate the present value of the tax shield benefit for each year into the future.

26 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of the CCA Tax Shield In Chapter 7 you learned about the constant growth DDM:In Chapter 7 you learned about the constant growth DDM: This model assumes the first dividend becomes the base amount and all future cash flows grow at a constant compound rate from t =1 through infinity:This model assumes the first dividend becomes the base amount and all future cash flows grow at a constant compound rate from t =1 through infinity: [ 7-7] [ 7-6]

27 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of the CCA Tax Shield The constant growth DDM:The constant growth DDM: The Tax Shield benefit to CCA (ignoring the ½ year rule for a moment) is the same except:The Tax Shield benefit to CCA (ignoring the ½ year rule for a moment) is the same except: –Cash flow at time one is the CCA tax shield at t = 1 and is calculated as (TdC 0 ) – this is the numerator –The growth is negative (declining balance) – two negatives equal a positive!

28 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of Tax Savings Lost on Salvage Value – an ECF We will use this version of the formula to calculate the present value of tax savings lost on the salvage value of the asset (when the ½ net addition rule does not apply)We will use this version of the formula to calculate the present value of tax savings lost on the salvage value of the asset (when the ½ net addition rule does not apply) The PV of tax savings lost at time n =The PV of tax savings lost at time n =

29 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of Tax Savings Lost on Salvage Value – an ECF The PV of tax savings lost at time n =The PV of tax savings lost at time n = The last step in finding the Present value of this amount is to discount the value back to t = 0.The last step in finding the Present value of this amount is to discount the value back to t = 0. So…the equation becomes:So…the equation becomes:

30 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of the Tax Savings on CCA Assuming the ½ Year Rule Adjusting the Formula for the ½ year Net Addition Rule We multiply the first factor by (1+.5k) / (1+ k) to produce a formula that will estimate the present value of tax savings from CCA (time 1 through infinity) assuming ½ year net addition rule.We multiply the first factor by (1+.5k) / (1+ k) to produce a formula that will estimate the present value of tax savings from CCA (time 1 through infinity) assuming ½ year net addition rule. For a graphical depiction of this formula see the following slide.For a graphical depiction of this formula see the following slide.

31 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield Over Time (A Graphical Representation) This formula calculations the PV of tax savings on CCA from time 1 through infinity assuming the ½ year net addition rule.

32 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Present Value of the Tax Savings on CCA Adjusting for ½ Year Rule – An Example We can now use the formula to solve for the present of the tax savings on CCA for an asset that is never sold (no salvage value):We can now use the formula to solve for the present of the tax savings on CCA for an asset that is never sold (no salvage value): This formula assumes:This formula assumes: –C 0 = $100,000 (Initial cost of a depreciable asset) –d = 10%(CCA rate) –k = 12%(Cost of capital or discount rate) –T = 40%(Corporate tax rate) Notice the answer is greater than the spread sheet example ($13,871) because the spreadsheet summed only the first 8 cash flows whereas the formula finds the sum of the present values of the tax shield benefits for an infinite stream.Notice the answer is greater than the spread sheet example ($13,871) because the spreadsheet summed only the first 8 cash flows whereas the formula finds the sum of the present values of the tax shield benefits for an infinite stream.

33 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Formula for PV of Tax Savings on CCA Assuming a Salvage Value at t = n Finally we can incorporate planned disposal of the asset we will acquire.Finally we can incorporate planned disposal of the asset we will acquire. Disposal value is the salvage value (SV) at t = nDisposal value is the salvage value (SV) at t = n (See the following two slides for graphical depiction of the effect of a salvage value) [ 14-7]

34 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield Over Time (A Graphical Representation) By selling the asset after the end of the 10 th fiscal year, we lose CCA in years 11 through infinity.

35 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield Over Time (A Graphical Representation) We subtract the PV of tax savings lost on the Salvage Value from the PV of tax saving from t = 1 through infinity to get the PV of tax savings benefits years 1 – 10.

36 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Expected Annual After-Tax Cash Flows (CF t ) As illustrated in Equation 14-2 expected Annual After-Tax Cash Flows are: –The cash flows that are estimated to occur as a result of the investment decision, comprising the associated expected incremental increase in after-tax operating income andthe associated expected incremental increase in after-tax operating income and Any incremental tax savings (or additional taxes paid) that result from the initial investment outlay.Any incremental tax savings (or additional taxes paid) that result from the initial investment outlay. [ 14-2]

37 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Forecasting Expected Annual After-Tax Cash Flows (CF t ) Spreadsheets can be useful in making detailed forecasts of the incremental operating cost and benefits associated with the project. Operating cash flows are an annuity where as net cash flow is not.

38 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Decomposing Expected Annual After-Tax Cash Flows (CF t ) We have already seen that since the CCA tax shield (CCA t )(T) changes each year and potentially involve an infinite series, we separately calculate its present value using a formula. [ 14-2]

39 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Decomposing Expected Annual After-Tax Cash Flows (CF t ) Since the operating cash flow benefits after-tax are often equal each year, we can find their present value simply using the Present Value Factor of an Annuity:Since the operating cash flow benefits after-tax are often equal each year, we can find their present value simply using the Present Value Factor of an Annuity: [ 14-6]

40 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Decomposing Expected Annual After-Tax Cash Flows (CF t ) Example of the PV of the Operating Cash Flow Annuity Using Example 14 – 2: –Operating income excluding CCA before tax = $125,000 –Tax rate = 45% –Useful life = 5 years –Discount rate (k) = 10% –The present vale of the operating income annuity =

41 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Ending (or Terminal) After-Tax Cash Flows (ECF n ) Ending cash flows include:Ending cash flows include: –Salvage value of the asset (SV n ) –Recovery of the net investment in working capital (NWC n ) –Less any taxes payable in the event of a capital gain on the sale of the asset or a recapture of depreciation. [ 14-3]

42 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions CCA Tax Shield with a Recapture of Depreciation Equation Is used when the salvage value of the asset is greater than the UCC of the pool of assets at the time of disposal.Equation Is used when the salvage value of the asset is greater than the UCC of the pool of assets at the time of disposal. A recapture of depreciation must be included in income in the year it occurs and is subject to tax at the firms tax rate (T )A recapture of depreciation must be included in income in the year it occurs and is subject to tax at the firms tax rate (T ) [ 14-8]

43 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Capital Gain on Asset Disposal Equation 14 – 9 is used when you expect to sell the asset for a price that is greater than its original cost.Equation 14 – 9 is used when you expect to sell the asset for a price that is greater than its original cost. The difference between the SV and C 0 is the capital gain.The difference between the SV and C 0 is the capital gain. 50% of a realized capital gain is subject to tax at the corporate tax rate (T )50% of a realized capital gain is subject to tax at the corporate tax rate (T ) [ 14-9]

44 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions NPV Using the Decomposed Components Equation 14-10, on the following slides, shows how the decomposed components are recombined to determine the projects NPVEquation 14-10, on the following slides, shows how the decomposed components are recombined to determine the projects NPV Remember NPV =Remember NPV = + Present value of after-tax operating cash flows + Present value of CCA tax shield + Present value of the salvage value (ECF) + Present value of the recovery of net working capital investment (ECF) - Taxes payable on realized capital gain and/or recapture of depreciation (ECF) - Initial investment in the asset (CF 0 ) - Initial investment in net working capital (CF 0 )

45 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions NPV Using the Decomposed Components [ 14-10]

46 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs Stress testing NPV models to determine the sensitivity of the decision to input variables is an important part of risk assessmentStress testing NPV models to determine the sensitivity of the decision to input variables is an important part of risk assessment There are two common approaches:There are two common approaches: –Sensitivity analysis – an examination of how an investments NPV changes as the value of one input at a time is changed –Scenario analysis – an examination of how an investments NPV changes in response to varying scenarios in terms of one or more estimates, such as sales or costs

47 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs Scenario Analysis Input variables are often given discrete forecast ranges: –Best case –Most likely –Worst case The analyst will be interested in what the NPV might be in the worst combination of cases for example: –Worst case operating cash flows (low) –Worst case initial cost (high) –Worst case new working capital investment (high)

48 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs Real Option Valuation (ROV) ROV and decision tree analysis have dramatically increased understanding of corporate decision-making and the value of flexibility and strategic considerations.ROV and decision tree analysis have dramatically increased understanding of corporate decision-making and the value of flexibility and strategic considerations. Decision trees are a schematic way to represent alternative decisions and the possible outcomes.Decision trees are a schematic way to represent alternative decisions and the possible outcomes. Table 14-2 (next slide) gives a real options example of three alternative ore-price scenarios for a mine. (The most important variable in mining projects.)Table 14-2 (next slide) gives a real options example of three alternative ore-price scenarios for a mine. (The most important variable in mining projects.) This table illustrates that the highest expected cash flows occur when ore prices are most volatile (have the greatest range of prices).This table illustrates that the highest expected cash flows occur when ore prices are most volatile (have the greatest range of prices). This illustrates an option that is often overlooked in traditional project analysis…the possibility of shutting down the mine when prices make it uneconomic. (Remember, the mine can be returned to production when economic conditions turn more favourable.)This illustrates an option that is often overlooked in traditional project analysis…the possibility of shutting down the mine when prices make it uneconomic. (Remember, the mine can be returned to production when economic conditions turn more favourable.)

49 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Real Option Valuation (ROV) Comparing NPV and IRR

50 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs NPV Break-Even Analysis Operating Cash Flow NPV Break-even Point Solving for the annual operating after-tax cash flows that cause NPV = 0.Solving for the annual operating after-tax cash flows that cause NPV = 0. –PV (Operating CFs) is the source of value creation –The most important part of the viability analysis.

51 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs Operating Cash Flow NPV Break-Even Point Example: CF 0 = $100,000 PV(CCA Tax Shield) = $20,453 PV(ECF n ) = $12,834 Approach: –Set NPV = 0 and solve for the PV of the operating CF s : –Now solve for the annual after- tax CF Conclusion: –The operating cash flows could fall to $10,770 without destroying value. –Now the decision makers can assess the threats to this key forecast and determine the likelihood of this occurring.

52 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs Operating Cash Flow NPV Break-Even Point NPV $ $20,000 Operating Cash Flow Break-even cash flow 0 $50,000$40,000$30,000$20,000$10,000$0 It is possible to vary the cash flow assumptions and test the sensitivity of NPV to those changes. NPV is the dependent variable.

53 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs NPV Break-Even Discount Rate Break Even Discount Rate IRR of the projectIRR of the project NPV profile illustrates the range of discount rates that produce a positive NPV.NPV profile illustrates the range of discount rates that produce a positive NPV. (See the following two slides as a review of NPV profiles from Chapter 13)

54 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs NPV Break-Even Discount Rate NPV $ $260,000 Discount Rate (%) IRR = 55.8% 0 0% 5%10% 20%40%50%60% Required rates of return can change if: The general level of interest rates rise in the economy, or The risk of the project increases.

55 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Sensitivity to Inputs NPV Break-Even Discount Rate NPV $ $260,000 $146,684 Discount Rate (%) IRR = 55.8% 0 0% 5%10% 20%40%50%60% Even if your estimate of the projects required return (RADR) is wrong, the projects NPV remains positive over a wide range of values for k (from 0% to 55%)

56 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Expansion Decisions Expansion projects add something extra to the firm in terms of sales or cost savings; their new cash flows are incremental cash flowsExpansion projects add something extra to the firm in terms of sales or cost savings; their new cash flows are incremental cash flows

57 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Involve the replacement of an existing asset (or assets) with a new one.Involve the replacement of an existing asset (or assets) with a new one. –In such cases we must clearly identify the incremental cash flows paying particular attention to: The effect on the incremental capital cost (C 0 )The effect on the incremental capital cost (C 0 ) The effect on the CCA tax shieldThe effect on the CCA tax shield

58 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Incremental Capital Cost Incremental Capital Cost (C 0 ) = the difference between the purchase price of the new equipment and the salvage price of the old machine.Incremental Capital Cost (C 0 ) = the difference between the purchase price of the new equipment and the salvage price of the old machine. The equipment to be replaced is normally sold. Normally there are no tax consequences on disposal, except when assets are sold at a price greater than their original cost (which triggers capital gains taxes on the difference)The equipment to be replaced is normally sold. Normally there are no tax consequences on disposal, except when assets are sold at a price greater than their original cost (which triggers capital gains taxes on the difference)

59 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Effects on Capital Cost Allowance Tax Shield When an asset is removed from the Capital Cost Allowance Class: There is no CCA in the year of disposalThere is no CCA in the year of disposal The UCC of the pool/class is reduced by the disposal valueThe UCC of the pool/class is reduced by the disposal value When an asset is added to the Capital Cost Allowance Class: There is ½ of the normal CCA on the net additions to the pool in that yearThere is ½ of the normal CCA on the net additions to the pool in that year The UCC of the pool is increased by half of the net addition in the first year, and half of the net additions in the second yearThe UCC of the pool is increased by half of the net addition in the first year, and half of the net additions in the second year In replacement decisions we must modify the PV of Tax Shield formula to account for the change () in C 0 and () in SV (See the following slide for the new formula)

60 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Effects on Capital Cost Allowance Tax Shield The replacement of old with new results in a change in the tax shield and affects both the net cost of the new as well as the salvage value.

61 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Simple Example Ignoring CCA – Formula Approach Problem: Cost of new machine = $12,000Cost of new machine = $12,000 Disposal value of old machine = $2,000Disposal value of old machine = $2,000 After-tax cash flow benefits:After-tax cash flow benefits: –Year 1 = $5,000 –Year 2 = $5,000 –Year 3 = $8,000 Discount rate (k) = 15%Discount rate (k) = 15% Incremental capital cost is the price of the new machine less the price of the old.

62 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions Simple Example Ignoring CCA – Formula Approach Problem: Cost of new machine = $12,000 Disposal value of old machine = $2,000 After-tax cash flow benefits: Year 1 = $5,000 Year 2 = $5,000 Year 3 = $8,000 Discount rate (k) = 15%

63 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Replacement Decisions The Formula Approach The deconstructed NPV model can be used in replacement decisions. Again, in replacement decisions, the focus in on the net change in operating cash flows, net change in CCA tax shield, and net changes in ending and initial cash flows.

64 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Inflation and Capital Budgeting Decisions The Impact of Inflation Even small rates of inflation over time can have considerable effects on the economic viability of a project.Even small rates of inflation over time can have considerable effects on the economic viability of a project. Although inflation is often measured by aggregate changes in prices at the retail (CPI consumer price index) or wholesale level, these measures often do not reflect price changes specific to one company or one project.Although inflation is often measured by aggregate changes in prices at the retail (CPI consumer price index) or wholesale level, these measures often do not reflect price changes specific to one company or one project. Inflation MUST be treated consistently in our project evaluation models (NPV, IRR, PI)Inflation MUST be treated consistently in our project evaluation models (NPV, IRR, PI)

65 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Inflation and Capital Budgeting Decisions Two Basic Approaches Inflation can be consistently incorporated by:Inflation can be consistently incorporated by: 1.Removing it from the nominal discount rate and using nominal cash flow forecasts 2.Leaving the discount rate with an expected inflation component and estimating real (inflation-adjusted) cash flows

66 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Inflation and Capital Budgeting Decisions Removing Expected Inflation from the Discount Rate As illustrated on the following slide, all discount rates used have embedded into them an expected rate of inflation.As illustrated on the following slide, all discount rates used have embedded into them an expected rate of inflation. If we use non-inflation adjusted cash flow forecasts, and then discount using a nominal discount rate, we are over discounting because we are using a higher rate…but not using inflated forecast cash flows.If we use non-inflation adjusted cash flow forecasts, and then discount using a nominal discount rate, we are over discounting because we are using a higher rate…but not using inflated forecast cash flows. You can use the Fisher equation to estimate the embedded inflationary expectations, and then reduce the nominal discount rate by that amount.You can use the Fisher equation to estimate the embedded inflationary expectations, and then reduce the nominal discount rate by that amount. Then you are free to discount nominal cash flows.Then you are free to discount nominal cash flows.

67 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Risk Adjusted Discount Rates Using the CAPM β Market = 1 Required Return RF β M ER M β Project = 1.5 ER Project Risk Premium for project systematic risk Real rate of return Premium for expected inflation

68 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Required Rates of Return (RADR) Components The risk-free rate is equal to the real rate of return plus expected inflation (Fisher Equation)The risk-free rate is equal to the real rate of return plus expected inflation (Fisher Equation) The risk premium is based on an estimate of the risk associated with the project.The risk premium is based on an estimate of the risk associated with the project. Beta of the Project Required Return (%) RF Risk Risk Adjusted Discount Rate Risk Premium Real Return Expected Inflation Rate

69 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Inflation and Capital Budgeting Decisions The Inflation Adjustment Process The key thing to remember is: –If you use WACC unadjusted, then you must use inflation-adjusted cash flow estimates for operating cash flows –If you remove inflation from the discount rate (WACC), you can use nominal cash flow estimates The key is consistency.

70 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Summary and Conclusions In this chapter you have learned: –Several approaches and guidelines for estimating future cash flows associated with an investment –The equations used to estimate the present value of future cash flows –How to differentiate between expansion and replacement decisions –How to use sensitivity analysis, scenario analysis, what-if decision tree analysis and NPV break-even analysis. –How to incorporate inflation into capital budgeting analysis.

71 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.


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