Chapter 11: Cash Flows & Other Topics in Capital Budgeting  2000, Prentice Hall, Inc.

Capital Budgeting: the process of planning for purchases of long-term assets. n example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? n Will the machine be profitable? n Will our firm earn a high rate of return on the investment? n The relevant project information follows:

n The cost of the new machine is $127,000. n Installation will cost $20,000. n $4,000 in net working capital will be needed at the time of installation. n The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. n Simplified straight line depreciation is used. n Class life is 5 years, and the firm is planning to keep the project for 5 years. n Salvage value at year 5 will be $50,000. n 14% cost of capital; 34% marginal tax rate.

Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. n Initial outlay n Differential Cash Flows over the life of the project (also referred to as annual cash flows). n Terminal Cash Flows

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

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

Capital Budgeting Steps 1) Evaluate Cash Flows n6... Annual Cash Flows Initialoutlay

Capital Budgeting Steps 1) Evaluate Cash Flows n6... Terminal Cash flow Annual Cash Flows Initialoutlay

2) Evaluate the risk of the project. n We’ll get to this at the end of this chapter. n For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. n If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects. Capital Budgeting Steps

3) Accept or Reject the Project. Capital Budgeting Steps

Step 1: Evaluate Cash Flows n 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

Step 1: Evaluate Cash Flows n a) Initial Outlay: What is the cash flow at “time 0?” (127,000) (127,000) + (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

Step 1: Evaluate Cash Flows n a) Initial Outlay: What is the cash flow at “time 0?” (127,000) (127,000) + ( 20,000) (Depreciable asset) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay Net Initial Outlay

Step 1: Evaluate Cash Flows n a) Initial Outlay: What is the cash flow at “time 0?” (127,000) (127,000) + ( 20,000) (147,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay Net Initial Outlay

Step 1: Evaluate Cash Flows n a) Initial Outlay: What is the cash flow at “time 0?” (127,000) (127,000) + ( 20,000) (147,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset Net Initial Outlay Net Initial Outlay

Step 1: Evaluate Cash Flows n a) Initial Outlay: What is the cash flow at “time 0?” (127,000) (127,000) + ( 20,000) (147,000) (147,000) + ( 4,000) + 0 Net Initial Outlay Net Initial Outlay

Step 1: Evaluate Cash Flows n 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

Step 1: Evaluate Cash Flows n 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

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

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:

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:

85,000 85,000 - 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:

85,000 85,000 (29,750) (29,750) - 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:

85,000 85,000 (29,750) (29,750) (29,400) (29,400) 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:

85,000 85,000 (29,750) (29,750) (29,400) (29,400) 25,850 25,850 - Tax on incremental EBT Incremental earnings after taxes Incremental earnings after taxes + Depreciation reversal Annual Cash Flow Annual Cash Flow For Years 1 - 5:

85,000 85,000 (29,750) (29,750) (29,400) (29,400) 25,850 25,850 (8,789) (8,789) Incremental earnings after taxes Incremental earnings after taxes + Depreciation reversal Annual Cash Flow Annual Cash Flow For Years 1 - 5:

85,000 85,000 (29,750) (29,750) (29,400) (29,400) 25,850 25,850 (8,789) (8,789) 17,061 17,061 + Depreciation reversal Annual Cash Flow Annual Cash Flow For Years 1 - 5:

85,000 85,000 (29,750) (29,750) (29,400) (29,400) 25,850 25,850 (8,789) (8,789) 17,061 17,061 29,400 29,400 Annual Cash Flow Annual Cash Flow For Years 1 - 5:

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:

Step 1: Evaluate Cash Flows n 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

Step 1: Evaluate Cash Flows n 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

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

Step 1: Evaluate Cash Flows n 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 Recapture of NWC Recapture of NWC Terminal Cash Flow Terminal Cash Flow

Step 1: Evaluate Cash Flows n 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 Terminal Cash Flow Terminal Cash Flow

Step 1: Evaluate Cash Flows n 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

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

Incorporating Risk into Capital Budgeting n Risk-Adjusted Discount Rate

How can we adjust this model to take risk into account? NPV = - IO ACF t ACF t (1 + k) t nt=1 

How can we adjust this model to take risk into account? n Adjust the discount rate (k). NPV = - IO ACF t ACF t (1 + k) t nt=1 

Risk-Adjusted Discount Rate n Simply adjust the discount rate (k) to reflect higher risk. n Riskier projects will use higher risk-adjusted discount rates. n Calculate NPV using the new risk- adjusted discount rate.

Risk-Adjusted Discount Rate NPV = - IO ACF t ACF t (1 + k*) t nt=1 

Risk-Adjusted Discount Rates n How do we determine the appropriate risk-adjusted discount rate (k*) to use? n Many firms set up risk classes to categorize different types of projects.

Risk Classes Risk RADR Class (k*) Project Type 1 12% Replace equipment, 1 12% Replace equipment, Expand current business Expand current business 2 14% Related new products 2 14% Related new products 3 16% Unrelated new products 3 16% Unrelated new products 4 24% Research & Development 4 24% Research & Development

Summary: Risk and Capital Budgeting You can adjust your capital budgeting methods for projects having different levels of risk by: n Adjusting the discount rate used (risk- adjusted discount rate method), n Measuring the project’s systematic risk, n Computer simulation methods, n Scenario analysis, n Sensitivity analysis.

Practice Problems: Cash Flows & Other Topics in Capital Budgeting

Project Information: n Cost of equipment = $400,000 n Shipping & installation will be $20,000 n $25,000 in net working capital required at setup n 3-year project life, 5-year class life n Simplified straight line depreciation n Revenues will increase by $220,000 per year n Defects costs will fall by $10,000 per year n Operating costs will rise by $30,000 per year n Salvage value after year 3 is $200,000 n Cost of capital = 12%, marginal tax rate = 34% Problem 1a

n 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

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

n 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

n Terminal Cash Flow: n Salvage value = $200,000 n Book value = depreciable asset - total amount depreciated. n Book value = $168,000. n Capital gain = SV - BV = $32,000 n Tax payment = 32,000 x.34 = ($10,880) Problem 1a

n 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

Problem 1a Solution: n NPV and IRR: n CF(0) = -445,000 n CF(1 ), (2), = 160,560 n CF(3 ) = 160, ,120 = 374,680 n Discount rate = 12% n IRR = 22.1% n NPV = $93,044. Accept the project!

Project Information: n For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. n Calculate the IRR and NPV for the project. n Is it still acceptable? Problem 1b

n 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

n Terminal Cash Flow: n Salvage value = $100,000 n Book value = depreciable asset - total amount depreciated. n Book value = $168,000. n Capital loss = SV - BV = ($68,000) n Tax refund = 68,000 x.34 = $23,120 Problem 1b

n 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

Problem 1b Solution n NPV and IRR: n CF(0) = -445,000 n CF(1 ), (2), = 160,560 n CF(3 ) = 160, ,120 = 308,680 n Discount rate = 12% n IRR = 17.3% n NPV = $46,067. Accept the project!

Automation Project: n Cost of equipment = $550,000 n Shipping & installation will be $25,000 n $15,000 in net working capital required at setup n 8-year project life, 5-year class life n Simplified straight line depreciation n Current operating expenses are $640,000 per yr. n New operating expenses will be $400,000 per yr. n Already paid consultant $25,000 for analysis. n Salvage value after year 8 is $40,000 n Cost of capital = 14%, marginal tax rate = 34% Problem 2

n 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

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

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

n 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

Problem 2 Solution: n NPV and IRR: n CF(0) = -590,000 n CF(1 - 5) = 197,500 n CF(6 - 7) = 158,400 n CF(10) = 158, ,400 = 199,800 n Discount rate = 14% n IRR = 28.13% NPV = $293,543 n We would accept the project!

Replacement Project: Old Asset (5 years old): n Cost of equipment = $1,125,000 n 10-year project life, 10-year class life n Simplified straight line depreciation n Current salvage value is $400,000 n Cost of capital = 14%, marginal tax rate = 35% Problem 3

Replacement Project: n New Asset: n Cost of equipment = $1,750,000 n Shipping & installation will be $56,000 n 5-year project life, 5-year class life n Simplified straight line depreciation n Will increase sales by $285,000 per year n Operating expenses will fall by $100,000 per year n Already paid $15,000 for training program n Salvage value after year 5 is $500,000 n Cost of capital = 14%, marginal tax rate = 34% Problem 3

Problem 3: Sell the Old Asset: n Salvage value = $400,000 n Book value = depreciable asset - total amount depreciated. n Book value = $1,125,000 - $562,500 = $562,500. = $562,500. n Capital gain = SV - BV = 400, ,500 = ($162,500) = 400, ,500 = ($162,500) n Tax refund = 162,500 x.35 = $56,875

Problem 3 n 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

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

n 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

Problem 3 Solution: n NPV and IRR: n CF(0) = -1,417,125 n CF(1 - 4) = 337,295 n CF(5) = 337, ,000 = 730,295 n Discount rate = 14% n NPV = (55,052.07) n IRR = 12.55% n We would not accept the project!