Objectives Discuss relevant cash flows and the three major cash flow components. Calculate the initial investment, operating cash inflows, and terminal cash flow associated with a proposed capital expenditure. Understand the importance of recognizing risk in the analysis of capital budgeting projects, and discuss risk and cash inflows and break-even analysis as a behavioral approach for dealing with risk. Describe the determination and use of risk-adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs. Select the best of a group of projects using the procedures for capital rationing. © 2012 Pearson Prentice Hall. All rights reserved.

Relevant Incremental Cash Flows To evaluate investment opportunities, financial managers must determine the relevant cash flows—the incremental cash flows that are expected to occur only if an investment is undertaken. Incremental cash flows are the changes in cash flows— outflows or inflows—that occur when the firm makes a new capital expenditure. © 2012 Pearson Prentice Hall. All rights reserved.

Relevant Cash Flows: Major Cash Flow Components The cash flows of any project may include three basic components: Initial investment: the relevant incremental cash outflow for a proposed project at time zero. Operating cash inflows: the incremental after-tax net cash inflows resulting from implementation of a project during its life. Terminal cash flow: the after-tax nonoperating cash flow occurring in the final year of a project. It is usually attributable to liquidation of the project. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: Installed Cost of New Asset The cost of new asset is the net outflow necessary to acquire a new asset. Installation costs are any added costs incurred to place an asset into operation. The installed cost of new asset is the cost of new asset plus its installation costs; equals the asset’s depreciable value. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset The after-tax proceeds from sale of old asset is the cash flow associated with selling an old asset which includes the old asset’s selling price as well as any taxes or tax refunds triggered by the sale. The tax on sale of old asset is tax that depends on the relationship between the old asset’s sale price and book value and on existing government tax rules. Book value is the strict accounting value of an asset, calculated by subtracting its accumulated depreciation from its installed cost. Book value = Installed cost of asset – Accumulated depreciation © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.) Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. Under MACRS for a 5-year recovery period, 20% and 32% of the installed cost would be depreciated in years 1 and 2, respectively. In other words, 52% (20% + 32%) of the $100,000 cost, or $52,000 (0.52  $100,000), would represent the accumulated depreciation at the end of year 2. The book value of Hudson’s asset at the end of year 2 is therefore $100,000 – $52,000 = $48,000. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.) If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 – $48,000). This gain is made up of two parts—a capital gain and recaptured depreciation, which is the portion of an asset’s sale price that is above book value and below its initial purchase price. The capital gain is $10,000 ($110,000 sale price – $100,000 initial purchase price); recaptured depreciation is $52,000 (the $100,000 initial purchase price – $48,000 book value). The total gain above book value of $62,000 is taxed as ordinary income at the 40% rate, resulting in taxes of $24,800 (0.40  $62,000). © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset (cont.) However, if the asset is sold for $48,000, its book value, the firm breaks even. Since no tax results from selling an asset for its book value, there is no tax effect on the initial investment in the new asset. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: After-Tax Proceeds from Sale of Old Asset If Hudson sells the asset for $30,000, it experiences a loss of $18,000 ($48,000 – $30,000). If this is a depreciable asset used in the business, the firm may use the loss to offset ordinary operating income. If the asset is not depreciable or is not used in the business, the firm can use the loss only to offset capital gains. In either case, the loss will save the firm $7,200 (0.40  $18,000) in taxes. If current operating earnings or capital gains are not sufficient to offset the loss, the firm may be able to apply these losses to prior or future years’ taxes. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Initial Investment: Change in Net Working Capital Net working capital is the amount by which a firm’s current assets exceed its current liabilities. The change in net working capital is the difference between a change in current assets and a change in current liabilities. Generally, current assets increase by more than current liabilities, resulting in an increased investment in net working capital. This increased investment is treated as an initial outflow. If the change in net working capital were negative, it would be shown as an initial inflow. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Terminal Cash Flow Terminal cash flow is the cash flow resulting from termination and liquidation of a project at the end of its life. It represents the after-tax cash flow, exclusive of operating cash inflows, that occurs in the final year of the project. The proceeds from sale of the new and the old asset, often called “salvage value,” represent the amount net of any removal or cleanup costs expected upon termination of the project. If the net proceeds from the sale are expected to exceed book value, a tax payment shown as an outflow (deduction from sale proceeds) will occur. When the net proceeds from the sale are less than book value, a tax rebate shown as a cash inflow (addition to sale proceeds) will result. © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Terminal Cash Flow Example Powell Corporation expects to be able to liquidate a new $400,000 machine at the end of its 5-year usable life and will have $20,000 book value in year 6 using MACRS depreciation. They will be able to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. The firm pays taxes at a rate of 40%. The terminal cash flow is calculated: © 2012 Pearson Prentice Hall. All rights reserved.

Finding the Terminal Cash Flow Example After-Tax Gain on proposed machine is $50,000 - $20,000 = $30,000 Tax on sale of proposed machine = $30,000 x 0.40 = $12,000 © 2012 Pearson Prentice Hall. All rights reserved.

Risk in Capital Budgeting (Behavioral Approaches) Thus far we have assumed that all projects are equally risky, and the acceptance of any project would not change the firm’s overall risk. In fact, all projects are not equally risky, and the acceptance of a project can affect the firm’s overall risk. Now we relax these assumptions and focus on how managers evaluate the risks of different projects. © 2012 Pearson Prentice Hall. All rights reserved.

Risk in Capital Budgeting (Behavioral Approaches): Breakeven Analysis Risk (in capital budgeting) refers to the uncertainty surrounding the cash flows that a project will generate or, more formally, the variability of cash flows. In many projects, risk stems almost entirely from the cash flows that a project will generate several years in the future, because the initial investment is generally known with relative certainty. Breakeven cash inflow is the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV > $0. © 2012 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates The Risk-adjusted discount rates (RADR) is the rate of return that must be earned on a given project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price. © 2012 Pearson Prentice Hall. All rights reserved.

Bennett Company’s Risk Classes and RADRs © 2012 Pearson Prentice Hall. All rights reserved.

Risk-Adjusted Discount Rates: RADRs in Practice Assume that the management of Bennett Company decided to use risk classes to analyze projects and so placed each project in one of four risk classes according to its perceived risk. The classes ranged from I for the lowest-risk projects to IV for the highest-risk projects. The financial manager of Bennett has assigned project A to class III and project B to class II. The cash flows for project A would be evaluated using a 14% RADR, and project B’s would be evaluated using a 10% RADR. The NPV of project A at 14% is now calculated to be $6,063 instead of $11,074 at 10%, while the NPV for project B which maintains a 10% RADR is $10,924. © 2012 Pearson Prentice Hall. All rights reserved.

Relevant Cash Flows and NPVs for Bennett Company’s Projects © 2012 Pearson Prentice Hall. All rights reserved.

Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives Using RADRs NPV is now $6,063 @ a 14% RADR © 2012 Pearson Prentice Hall. All rights reserved.

Capital Rationing Firm’s often operate under conditions of capital rationing—they have more acceptable independent projects (with positive NPV) than they can fund. In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs. However, in practice, most firms operate under capital rationing. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management. © 2012 Pearson Prentice Hall. All rights reserved.

Capital Rationing Specific targets set on the usage of funds that can be invested in a given period: Reasons why rationing may be adopted include: Fear of too much spending growth Hesitation to use external sources of funding Economic uncertainty Justification for management approval process May constrain a firm’s ability to achieve maximum profitability

Capital Rationing (cont.) Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000. © 2012 Pearson Prentice Hall. All rights reserved.

Investment Opportunities Schedule © 2012 Pearson Prentice Hall. All rights reserved.

Capital Rationing Example ($K) Priority Description Q1 ’06 Q2 ’06 Q3 ’06 Q4 ’06 Total Cum 1 Loading Equipment $25 $25 $25 $25 $100 $100 1 Epoxy Oven $200 $200 $125 $125 $650 $750 1 Trolley Carrier $50 $50 $50 $50 $200 $950 1 Test Equipment $300 $0 $300 $0 $600 $1,550 2 Metrology Lab $100 $100 $100 $100 $400 $1,950 2 CMT Tester $250 $250 $250 $250 $1,000 $2,950 2 Finish Equipment $75 $75 $75 $75 $300 $3,250 2 Computer Servers $100 $100 $50 $50 $300 $3,550 3 Network Storage $400 $200 $400 $250 $1,250 $4,800 4 Optical Infrared Test $300 $300 $300 $100 $1,000 $5,800 4 Burn In Oven $450 $450 $450 $450 $1,800 $7,600 4 Chasis System $500 $500 $500 $500 $2,000 $9,600 4 SAN Laser Equip $100 $100 $100 $100 $400 $10,000 Target = $5M 1 = Strategic Support, 2 = Required to support existing Capability, 3 = Needed but can be pushed to ’07, 4 = Pushed to‘07

Chapter Summary The relevant cash flows for capital budgeting decisions are the incremental cash outflow (investment) and resulting subsequent inflows associated with a proposed capital expenditure. The three major cash flow components of any project can include: (1) an initial investment, (2) operating cash inflows, and (3) terminal cash flow. The initial investment occurs at time zero, the operating cash inflows occur during the project life, and the terminal cash flow occurs at the end of the project. For replacement decisions, the relevant cash flows are the difference between the cash flows of the new asset and the old asset. Expansion decisions are viewed as replacement decisions in which all cash flows from the old asset are zero. When estimating relevant cash flows, ignore sunk costs and include opportunity costs as cash outflows. The initial investment is the initial outflow required, taking into account the installed cost of the new asset, the after-tax proceeds from the sale of the old asset, and any change in net working capital. The operating cash inflows are the incremental after-tax cash inflows expected to result from a project. © 2012 Pearson Prentice Hall. All rights reserved.