© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Making Capital Investment Decisions Chapter Ten

10.1 Relevant Cash Flows 10.1  The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted  These cash flows are called incremental cash flows  The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

10.2 Relevant Cash Flows  Relevant Cash Flows – any incremental changes in cash flows related to the project 1- Depreciation is not a cash flow, but does affect taxes which are cash flows. 2- Purchases of fixed assets represents cash outflows. They also produce depreciation. 3- Any working capital changes associated with a capital budgeting project must be recognized as part of the investment at the beginning (and possibly end) of the project. 4- Ignore sunk costs. 5- Include opportunity costs. 6- Include externalities (side effects) from other parts (products) of the firm. 7- Do not include interest expense.

10.3 Asking the Right Question  You should always ask yourself “Will this cash flow occur (or not occur) ONLY if we accept the project?”  If the answer is “yes”, it should be included in the analysis because it is incremental  If the answer is “no”, it should not be included in the analysis because it will occur anyway  If the answer is “part of it”, then we should include the part that occurs (or does not occur) because of the project

10.4 Common Types of Cash Flows 10.2  Sunk costs – costs that have been incurred in the past (& thus must be excluded from the current decision)  Opportunity costs – cost of foregone opportunities  Example – you purchased an asset many years ago for a nominal sum. You now want to use that asset in a current project. How much do you charge to the project, since you already own the asset?  You must charge the project with the amount you could obtain by selling the asset to another user.

10.5 Common Types of Cash Flows  Side effects  Positive side effects – benefits to other projects  Negative side effects – costs to other projects  Issue of erosion or cannibalism  Be sure to only include erosion due to the new project. Erosion can also occur due to competition from other firms.  Example: Air Canada – Tango versus the mainline fleet  Changes in net working capital (NWC)  Increases in NWC are a cost of the project  Decreases in NWC are a benefit of the project  NWC often increases initially and then decreases at the end of the project’s life

10.6 Types of Cash Flows  Three types of cash flows to evaluate 1- Initial Outflows ( CF0): -fixed assets -working capital 2- Annual Cash Flows (CF1→N): -income statement (no interest expense) 3- Terminal Cash Flows (CFN): -fixed assets -working capital

10.7 Example 1  Your firm is contemplating the purchase of a new $700,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $160,000 at the end of that time. You will save $300,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $70,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 35%, what is the IRR for this project? If the required rate of return is 11%, what is the NPV of the project?

10.8 Example 1 (cont.) CF0 -630,000 CF1 244,000 CF2 244,000 CF3 244,000 CF4 244,000 CF5 278,000 IRR = IF I=11% NPV =

10.9 Example 2  A company is evaluating a new acquisition of a milling machine. The machine’s price is $180,000 and it would cost another $25,000 to modify it for special use by the firm. The machine falls into the ACRS three-year class and it will be sold after three years for $80,000. The machine would require an increase in inventory of $7,500. This will be recovered when the machine is sold. The machine would have no effect on revenues, but it is expected to save the firm $75,000 per year in before tax operating costs. The firm’s marginal tax rate is 34%. Find the initial investment and all annual cash flows associated with this project. Find the IRR and PP of the project. If the required rate of return is 10% find the NPV of the project.

10.10 Example 2 (cont.) CF0 -212,500 CF1 72,731 CF2 80,475 CF3 125,295 IRR = If I=10% NPV = PP =

10.11 Example 3  Marsh Mining is considered an expansion project. The proposed project has the following features: -The project has an initial cost of $500,000 and this amount will be fully depreciated using the 3-yrs MACRS class. -If the project is undertaken, at year 0 the company will need to increase its inventories by $50,000, and its accounts payable will rise by $10,000. This net working capital will be recovered at the end of the project’s life of 4 years.

10.12 Example 3 (cont.) -If the project is undertaken, the company will realize an additional $580,000 in sales over each of the next 4 years. The company’s operating costs (excluding depreciation) will increase by $400,000 each year. -The company’s tax rate is 40%. -At the end of 4 yrs, the project will have a salvage value of $50,000. -The project’s required rate of return (WACC) is 10%. What is the project’s NPV? What is the project’s IRR?

10.13 Example 3 (cont.) CF0 -540,000 CF1 174,660 CF2 196,880 CF3 137,640 CF4 192,820 I = 10 NPV = IRR =

10.14 Example 4  Universal Farm Supply’s Management has observed that it can sell as much fertilizer as it can stock and is considering the possibility of purchasing a forklift and expanding warehouse space in order to be able to handle and stock more fertilizer. The forklift costs $42,000 and would be depreciated on a straight-line basis to a salvage value of zero in seven years, even though it will last ten years. The forklift will not be sold. The warehouse expansion would cost $100,000 and would be straight-line depreciated to a salvage value of, and sold for $60,000 in ten years.

10.15 Example 4 (cont.)  The expansion would allow Universal to sell 1,000,000 more pounds per year at $0.20 per pound. The fertilizer costs Universal $0.17 per pound to produce. This increase in sales will also require an increase in accounts receivables of $200,000, in inventory of $50,000, and in accounts payable of $15,000. These will be recovered at the end of ten years. Universal’s marginal tax rate is 34%. Calculate the initial investment and the annual cash flows associated with this project. If the required rate of return (WACC) is 11%, calculate the project’s net present value and internal rate of return.

10.16 Example 4 (cont.) CF0 -197,000 CF1→7 23,200 CF8→9 21,160 CF10 136,160 I = 11 NPV = IRR =

10.17 Common Types of Cash Flows 10.2  Financing costs  Are never included in the cash flows of the project  Financing costs are captured in the discount rate

10.18 More on NWC 10.4  Why do we have to consider changes in NWC separately?  An investment in current assets is exactly the same as an investment in a fixed asset (but it is harder to visualize)  An increase in NWC requires either:  An increase in Current Assets (a use of cash)  A reduction in Current Liabilities (a use of cash)  GAAP requires that sales be recorded on the income statement when made, not when cash is received (recorded as an Account Receivable on the B/S)  GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet (costs recorded as an Account Payable on the B/S)  Finally, we have to buy inventory to support sales although we haven’t collected cash yet (Both inventory and accounts payable rise)