CASH FLOWS IN CAPITAL BUDGETING CHAPTER 10 CASH FLOWS IN CAPITAL BUDGETING

The process of planning for purchases of long-term assets. 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? SITI AISHAH BINTI KASSIM (FM2)

IDENTIFYING RELEVANT CASH FLOWS 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. SITI AISHAH BINTI KASSIM (FM2)

3) CHANGES IN NET OPERATING WORKING CAPITAL 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. SITI AISHAH BINTI KASSIM (FM2)

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. INCREMENTAL CASH FLOWS (NET CASH FLOW IN AN INVESTMENT PROJECT) 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. SITI AISHAH BINTI KASSIM (FM2)

Effects on Other Parts of the Firm: (either INCLUDED or EXCLUDED) 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. 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. SITI AISHAH BINTI KASSIM (FM2)

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 SITI AISHAH BINTI KASSIM (FM2)

Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay 1 2 3 4 5 n 6 . . . Annual Cash Flows SITI AISHAH BINTI KASSIM (FM2)

Capital Budgeting Steps 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. 3) Accept or Reject the Project SITI AISHAH BINTI KASSIM (FM2)

Capital Budgeting Steps (EXAMPLE): 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. SITI AISHAH BINTI KASSIM (FM2)

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay SITI AISHAH BINTI KASSIM (FM2)

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay SITI AISHAH BINTI KASSIM (FM2)

Step 1: Evaluate Cash Flows b) Annual Cash Flows: What incremental cash flows occur over the life of the project? For Each Year, Calculate: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow SITI AISHAH BINTI KASSIM (FM2)

For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789) Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow SITI AISHAH BINTI KASSIM (FM2)

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow SITI AISHAH BINTI KASSIM (FM2)

Tax Effects of Sale of Asset: Salvage value = $50,000. Book value = depreciable asset - total amount depreciated. Book value = $147,000 - $147,000 = $0. Capital gain = SV - BV = 50,000 - 0 = $50,000. Tax payment = 50,000 x .34 = ($17,000). SITI AISHAH BINTI KASSIM (FM2)

Step 1: Evaluate Cash Flows So, the terminal cash flow: 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 = Terminal Cash Flow SITI AISHAH BINTI KASSIM (FM2)

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! SITI AISHAH BINTI KASSIM (FM2)

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? SITI AISHAH BINTI KASSIM (FM2)

Capital Rationing IRR 5% 10% 15% 20% 25% $ 1 2 3 4 5 $X You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ Our budget is limited so we accept only projects 1, 2, and 3. 1 2 3 4 5 $X SITI AISHAH BINTI KASSIM (FM2)

You could rank the projects by IRR: Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ Our budget is limited so we accept only projects 1, 2, and 3. 1 2 3 $X SITI AISHAH BINTI KASSIM (FM2)

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. SITI AISHAH BINTI KASSIM (FM2)

Problems with Project Ranking 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. SITI AISHAH BINTI KASSIM (FM2)

Problems with Project Ranking 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. SITI AISHAH BINTI KASSIM (FM2)

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? SITI AISHAH BINTI KASSIM (FM2)

Example: The after-tax cash flows are: Year Machine 1 Machine 2 0 (45,000) (45,000) 1 20,000 12,000 2 20,000 12,000 3 20,000 12,000 4 12,000 5 12,000 6 12,000 Assume a required return of 14%. SITI AISHAH BINTI KASSIM (FM2)

Step 1: Calculate NPV NPV1 = $1,433 NPV2 = $1,664 So, does this mean #2 is better? No! The two NPVs can’t be compared! SITI AISHAH BINTI KASSIM (FM2)

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! Simply annuitize the NPV over the project’s life. SITI AISHAH BINTI KASSIM (FM2)

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. Machine 2: PV = 1664, N = 6, I = 14, solve: PMT = -427.91. SITI AISHAH BINTI KASSIM (FM2)

NPV1 = annuity of $617 per year. NPV2 = annuity of $428 per year. EAA1 = $617 EAA2 = $428 This tells us that: NPV1 = annuity of $617 per year. NPV2 = 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. SITI AISHAH BINTI KASSIM (FM2)

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. SITI AISHAH BINTI KASSIM (FM2)

The end SITI AISHAH BINTI KASSIM (FM2)