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CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting 2005, Pearson Prentice Hall

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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:

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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.

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Capital Budgeting Steps 1) Evaluate Cash Flows Look at all relevant 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

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IDENTIFYING RELEVANT CASH FLOWS A) PROJECT CASH FLOW vs ACCOUNTING INCOME 1) COST OF FIXED ASSETS -Asset purchases represent negative cash flows. - Full cost of the asset includes shipping and installation costs, used as the depreciable basis to calculate depreciation charges. - The fixed assets are often sold at the end of project’s life, giving after-tax cash proceeds which represents a +ve cash flow.

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2) NON CASH CHARGES - Depreciation is subtracted from revenues. Depreciation shelters income from taxation, has an impact on cash flow, but it is NOT a cash flow, thus MUST be added back to net income when estimating project’s CF. 3) CHANGES IN NET OPERATING WORKING CAPITAL - When sales expand, accounts receivable increase. Payables and accruals spontaneously increase, and this reduces the cash to finance inventories and receivables. - At end of project’s life, inventories will be used but not replaced, receivables will be collected without replacement, bringing cash inflows. NOWC will be returned and added back to the cash flow.

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4) INTEREST EXPENSES NOT included in project cash flow for 2 reasons. Firstly because they are already accounted for in the cost of capital (Required rate of return). 2ndly, project cash flow is the cash flow available to ALL investors, bondholders AND shareholders, so interest expenses are NOT subtracted.

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B) INCREMENTAL CASH FLOWS (NET CASH FLOW IN AN INVESTMENT PROJECT) 1) Sunk Costs: (EXCLUDE from CF) A cash outlay that has ALREADY been incurred, cannot be recovered regardless of whether the project is accepted or rejected. Examples: Consultant fees, fees for marketing surveys. A cash outlay that has ALREADY been incurred, cannot be recovered regardless of whether the project is accepted or rejected. Examples: Consultant fees, fees for marketing surveys. 2)Opportunity costs: (INCLUDE in CF) The return on the best ALTERNATIVE use of an asset, that will NOT be earned if funds are invested in a particular project. Example he use of a land for the project site which could be sold, or the use of space/floor which could have been rented out.

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3) Effects on Other Parts of the Firm: (either INCLUDED or EXCLUDED) Externalities - Effects of a project on cash flows in other parts of the firm. Often difficult to quantify. Cannibalization - Occurs when the introduction of a new product causes sales of existing products to decline. (Example: IBM for years refused to provide full support for its PC division because it did not want to steal sales from its highly profitable mainstream business. Huge strategic error, because it allowed Intel, Microsoft, Compaq and others to become dominant forces in the computer industry.

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Capital Budgeting Steps 1) Evaluate Cash Flows 012345n6...

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Capital Budgeting Steps 1) Evaluate Cash Flows 012345n6... Terminal Cash flow Annual Cash Flows Initial outlay

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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

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3) Accept or Reject the Project Capital Budgeting Steps

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Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay Net Initial Outlay

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Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay ($151,000) Net initial outlay

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Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay ($151,000) Net initial outlay

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Step 1: Evaluate Cash Flows b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

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Incremental revenue Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes Incremental earnings after taxes + Depreciation reversal Annual Cash Flow Annual Cash Flow For Each Year, Calculate:

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Incremental revenue Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes Incremental earnings after taxes + Depreciation reversal Annual Cash Flow Annual Cash Flow For Years 1 - 5:

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85,000Revenue 85,000Revenue (29,750)Costs (29,750)Costs (29,400) Depreciation (29,400) Depreciation 25,850EBT 25,850EBT (8,789) Taxes (8,789) Taxes 17,061EAT 17,061EAT 29,400Depreciation reversal 29,400Depreciation reversal 46,461 =Annual Cash Flow 46,461 =Annual Cash Flow For Years 1 - 5:

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Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow Terminal Cash Flow

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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 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow Terminal Cash Flow

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Tax Effects of Sale of Asset: Salvage value = $50,000. Book value = depreciable asset - total amount depreciated. Book value = $147,000 - $147,000 = $0. = $0. Capital gain = SV - BV = 50,000 - 0 = $50,000. = 50,000 - 0 = $50,000. Tax payment = 50,000 x.34 = ($17,000).

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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 50,000 Salvage value (17,000) Tax on capital gain (17,000) Tax on capital gain 4,000 Recapture of NWC 4,000 Recapture of NWC 37,000 Terminal Cash Flow 37,000 Terminal Cash Flow

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Project NPV: CF(0) = -151,000. CF(1 - 4) = 46,461. Or CF (1-5) = 45,461 CF(5) = 46,461 + 37,000 = 83,461. Or CF (5) = 37,000 Discount rate = 14%. NPV = $27,721. We would accept the project.

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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?

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Capital Rationing You could rank the projects by IRR:

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Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ 1 23 4 5 $X Our budget is limited so we accept only projects 1, 2, and 3.

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Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ 1 23 $X Our budget is limited so we accept only projects 1, 2, and 3.

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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.

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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.

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Size Disparity Example Project B yearcash flow yearcash flow 0 (30,000) 0 (30,000) 1 15,000 1 15,000 2 15,000 2 15,000 3 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20 Project A yearcash flow yearcash flow 0(135,000) 0(135,000) 1 60,000 1 60,000 2 60,000 2 60,000 3 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07

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Size Disparity Example Project B yearcash flow yearcash flow 0 (30,000) 0 (30,000) 1 15,000 1 15,000 2 15,000 2 15,000 3 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20 Project A yearcash flow yearcash flow 0(135,000) 0(135,000) 1 60,000 1 60,000 2 60,000 2 60,000 3 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07

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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.

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Time Disparity Example Project B yearcash flow yearcash flow 0 (46,500) 0 (46,500) 1 36,500 1 36,500 2 24,000 2 24,000 3 2,400 3 2,400 4 2,400 4 2,400 required return = 12% IRR = 25.51% NPV = $8,455 PI = 1.18 Project A yearcash flow yearcash flow 0 (48,000) 0 (48,000) 1 1,200 1 1,200 2 2,400 2 2,400 3 39,000 3 39,000 4 42,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20

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Time Disparity Example Project B yearcash flow yearcash flow 0 (46,500) 0 (46,500) 1 36,500 1 36,500 2 24,000 2 24,000 3 2,400 3 2,400 4 2,400 4 2,400 required return = 12% IRR = 25.51% NPV = $8,455 PI = 1.18 Project A yearcash flow yearcash flow 0 (48,000) 0 (48,000) 1 1,200 1 1,200 2 2,400 2 2,400 3 39,000 3 39,000 4 42,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20

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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?

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The after-tax cash flows are: Year Machine 1 Machine 2 0 (45,000) (45,000) 0 (45,000) (45,000) 1 20,000 12,000 1 20,000 12,000 2 20,000 12,000 2 20,000 12,000 3 20,000 12,000 3 20,000 12,000 4 12,000 4 12,000 5 12,000 5 12,000 6 12,000 6 12,000 Assume a required return of 14%.

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Step 1: Calculate NPV NPV 1 = $1,433 NPV 2 = $1,664 So, does this mean #2 is better? No! The two NPVs can’t be compared!

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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.

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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. solve: PMT = -617.24. Machine 2: PV = 1664, N = 6, I = 14, solve: PMT = -427.91. solve: PMT = -427.91.

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EAA 1 = $617 EAA 2 = $428 This tells us that: NPV 1 = annuity of $617 per year. NPV 2 = 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.

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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

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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.

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Practice Problems: Cash Flows & Other Topics in Capital Budgeting

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Project Information: 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

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Initial Outlay: (400,000)Cost of asset (400,000)Cost of asset + ( 20,000)Shipping & installation (420,000)Depreciable asset (420,000)Depreciable asset + ( 25,000)Investment in NWC ($445,000)Net Initial Outlay ($445,000)Net Initial Outlay

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220,000Increased revenue 220,000Increased revenue 10,000Decreased defects 10,000Decreased defects (30,000)Increased operating costs (30,000)Increased operating costs (84,000) Increased depreciation (84,000) Increased depreciation 116,000EBT 116,000EBT (39,440)Taxes (34%) (39,440)Taxes (34%) 76,560EAT 76,560EAT 84,000Depreciation reversal 84,000Depreciation reversal 160,560 = Annual Cash Flow 160,560 = Annual Cash Flow For Years 1 - 3: Problem 1a

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Terminal Cash Flow: Salvage value Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow Terminal Cash Flow Problem 1a

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Terminal Cash Flow: 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

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Terminal Cash Flow: 200,000 Salvage value 200,000 Salvage value (10,880) Tax on capital gain (10,880) Tax on capital gain 25,000 Recapture of NWC 25,000 Recapture of NWC 214,120 Terminal Cash Flow 214,120 Terminal Cash Flow Problem 1a

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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!

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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

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Terminal Cash Flow: Salvage value Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow Terminal Cash Flow Problem 1b

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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

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Terminal Cash Flow: 100,000 Salvage value 100,000 Salvage value 23,120 Tax on capital gain 23,120 Tax on capital gain 25,000 Recapture of NWC 25,000 Recapture of NWC 148,120 Terminal Cash Flow 148,120 Terminal Cash Flow Problem 1b

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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!

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Automation Project: 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

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Initial Outlay: (550,000)Cost of new machine (550,000)Cost of new machine + (25,000)Shipping & installation (575,000)Depreciable asset (575,000)Depreciable asset + (15,000)NWC investment (590,000)Net Initial Outlay (590,000)Net Initial Outlay

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240,000 Cost decrease 240,000 Cost decrease (115,000) Depreciation increase (115,000) Depreciation increase 125,000EBIT 125,000EBIT (42,500)Taxes (34%) (42,500)Taxes (34%) 82,500EAT 82,500EAT 115,000Depreciation reversal 115,000Depreciation reversal 197,500 = Annual Cash Flow 197,500 = Annual Cash Flow For Years 1 - 5: Problem 2

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240,000 Cost decrease 240,000 Cost decrease ( 0) Depreciation increase ( 0) Depreciation increase 240,000EBIT 240,000EBIT (81,600)Taxes (34%) (81,600)Taxes (34%) 158,400EAT 158,400EAT 0Depreciation reversal 0Depreciation reversal 158,400 = Annual Cash Flow 158,400 = Annual Cash Flow For Years 6 - 8: Problem 2

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Terminal Cash Flow: 40,000 Salvage value 40,000 Salvage value (13,600) Tax on capital gain (13,600) Tax on capital gain 15,000 Recapture of NWC 15,000 Recapture of NWC 41,400 Terminal Cash Flow 41,400 Terminal Cash Flow Problem 2

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Problem 2 Solution NPV and IRR: CF(0) = -590,000. CF(years 1 - 5) = 197,500. CF(years 6 - 7) = 158,400 (no depreciation) CF(terminal year 8) = 158,400 + 41,400 = 199,800. Discount rate = 14%. ANSWER IRR = 28.13% NPV = $293,543. We would accept the project!

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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%. Problem 3

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Replacement Project: 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

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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. = $562,500. Capital gain = SV - BV = 400,000 - 562,500 = ($162,500). = 400,000 - 562,500 = ($162,500). Tax refund = 162,500 x.35 = $56,875.

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Problem 3 Initial Outlay: (1,750,000)Cost of new machine (1,750,000)Cost of new machine + ( 56,000)Shipping & installation (1,806,000)Depreciable asset (1,806,000)Depreciable asset + ( 68,000)NWC investment + 456,875After-tax proceeds (sold old machine) (1,417,125)Net Initial Outlay (1,417,125)Net Initial Outlay

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385,000Increased sales & cost savings 385,000Increased sales & cost savings (248,700) Extra depreciation (248,700) Extra depreciation 136,300EBT 136,300EBT (47,705)Taxes (35%) (47,705)Taxes (35%) 88,595EAT 88,595EAT 248,700Depreciation reversal 248,700Depreciation reversal 337,295 = Differential Cash Flow 337,295 = Differential Cash Flow For Years 1 - 5: Problem 3

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Terminal Cash Flow: 500,000 Salvage value 500,000 Salvage value (175,000) Tax on capital gain (175,000) Tax on capital gain 68,000 Recapture of NWC 68,000 Recapture of NWC 393,000 Terminal Cash Flow 393,000 Terminal Cash Flow Problem 3

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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!

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Capital Budgeting Problems

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