McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 7 Chapter Seven Net Present Value and Capital Budgeting

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-1 Chapter Outline 7.1 Incremental Cash Flows 7.2 The Baldwin Company: An Example 7.3 The Boeing 777: A Real-World Example 7.4 Inflation and Capital Budgeting 7.5 Investments of Unequal Lives: The Equivalent Annual Cost Method

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Cash Flows-Not Accounting Income Only cash flows that are incremental to the project should be used. "Incremental" means the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-3 Sunk Cost –A cost that has already occurred. Not incremental cash outflows. Opportunity Costs –If an asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues are called opportunity costs. Side Effects –Erosion: The cash flow transferred to a new project from customers and sales of other products of the firm. Allocated costs - Should be viewed as a cash outflow of a project only if it is an incremental cost of the project.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Incremental Cash Flows Cash flows matter—not accounting earnings. Sunk costs don’t matter. Incremental cash flows matter. Opportunity costs matter. Side effect like erosion matters. Taxes matter: we want incremental after-tax cash flows. Inflation matters.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-5 Estimating Cash Flows Cash Flows from Operations –Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation Net Capital Spending –Don’t forget salvage value (after tax, of course). Changes in Net Working Capital –Recall that when the project winds down, we enjoy a return of net working capital.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Baldwin Company: An Example Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Working Capital: initially $10,000 changes with sales.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-7 The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5)Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] * We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is $24,240 (= $30,000 – $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 [0.34  ($30,000 – $5,760)]. The after-tax salvage value is $30,000 – [0.34  ($30,000 – $5,760)] = 21,760. ($ thousands) (All cash flows occur at the end of the year.)

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-8 The Worksheet for Cash Flows of the Baldwin Company At the end of the project, the warehouse is unencumbered, so we can sell it if we want to. ($ thousands) (All cash flows occur at the end of the year.) Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5)Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)]

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 7-9 The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues ($ thousands) (All cash flows occur at the end of the year.) Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000×[$20×(1.02) 2 ] = 12,000×$20.81 = $249,720.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues (9) Operating costs ($ thousands) (All cash flows occur at the end of the year.) Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Production costs during first year (per unit) are $10 and (increase 10% per year thereafter). Production costs in year 2 = 8,000×[$10×(1.10) 1 ] = $88,000

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues (9) Operating costs (10) Depreciation ($ thousands) (All cash flows occur at the end of the year.) Depreciation is calculated using the Accelerated Cost Recovery System (shown at right) Our cost basis is $100,000 Depreciation charge in year 4 = $100,000×(.1152) = $11,520. YearACRS % % % % % % 65.76% Total100.00%

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues (9) Operating costs (10) Depreciation (11) Income before taxes [(8) – (9) - (10)] (12) Tax at 34 percent (13) Net Income ($ thousands) (All cash flows occur at the end of the year.)

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Incremental After Tax Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4Year 5 (1) Sales Revenues $100.00$163.00$249.72$212.20$ (2) Operating costs (3) Taxes (4) OCF (1) – (2) – (3) (5) Total CF of Investment –260. –6.32– (6) IATCF [(4) + (5)] –

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Which Set of Books –Our purpose is to determine net cash flow, and tax payments are cash outflows. The FASB regulations determine the calculation of accounting income, not cash flow.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved A Note on Net Working Capital –An investment in net working capital arises whenever raw material and other inventory are purchased prior to the sale of finished goods cash is kept in the project as a buffer against unexpected expenditures credit sales are made. The investment is offset to the extent that purchases are made on credit. –The working capital numbers result from a meticulous forecast of the components.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Interest Expense –Firms typically calculate a project's cash flows under the assumption that the project is financed only with equity. Any adjustments for debt financing are reflected in the discount rate, not the cash flows.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship: (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate) For low rates of inflation, this is often approximated as Real Rate  Nominal Rate – Inflation Rate When accounting for inflation in capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Investments of Unequal Lives: The Equivalent Annual Cost Method Suppose a firm must choose between two machines of unequal lives. Both machines can do the same job, but they have different operating costs and will last for different time periods. Revenues per year are assumed to be the same, regardless of machine, so they are ignored in the analysis. Which one should we choose?

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Two final remarks: Always convert cash flows to real terms when working through problems of this type. The above analysis applies only if one anticipates that both machines can be replaced. If no replacement were possible, both revenues and costs should be included.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The General Decision to Replace (Advanced) More typically, firms must decide when to replace an existing machine with a new one. One should replace if the annual cost of the new machine is less than the annual cost of the old machine.

McGraw-Hill/Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Two final points: It is assumed that both old machine and the replacement machine generate the same revenues. However, sometimes revenues will be greater with a new machine. Applications of the above approach are pervasive in business, since every machine must be replaced at some point.