Corporate Financial Management 3e Emery Finnerty Stowe Capital Budgeting Cash Flows 10 Corporate Financial Management 3e Emery Finnerty Stowe © Prentice Hall, 2004

An Overview of Estimating Cash Flows Costs and benefits are measured in terms of cash flow—not income. Cash flow timing is critical. Cash flows must be measured on an incremental after-tax basis. Financing costs are included in the discount rate.

Calculating Incremental Cash Flows Costs and benefits associated with a capital budgeting project are measured in terms of cash flows rather than earnings. Cash flows must be on an incremental (or marginal) basis. These are the firm’s cash flows with the project minus the firm’s cash flows without the project. Cash flows must be measured on an after-tax basis.

Incremental Cash Flows for a Project Net initial investment outlay. Future net operating cash flows. Non-operating cash flows required to support the initial investment outlay. Cash flows associated with a major overhaul. Net salvage value received upon termination of the project.

Net Initial Investment Outlay Cash expenditure. Changes in net working capital. Net cash flow from sale of old asset (if any). Investment tax credits.

Cash Expenditure Let I0 be the net expenditure to be capitalized, E0 be the net expenditure to be expensed immediately, and T be the firm’s marginal tax rate. Cash expenditure = – I0 – E0 + T  E0 = – I0 – (1 – T)  E0

Changes in Net Working Capital At the start of a project, an investment of net working capital may be required. Operating cash Inventory Accounts receivable Accounts payable A project could also reduce the net working capital requirements. Asset replacement

Net Cash Flow from Sale of Old Asset If an old asset is to be replaced by a new one, the sale of the old asset generates a cash flow. If the selling price is greater than the book value of the old asset, taxes will have to be paid on this sale. If the selling price is less than the book value of the old asset, a tax credit is generated.

Net Cash Flow from Sale of Old Asset Let S0 be the selling price of the old asset, and B0 be its book value. Net cash flow from sale of old asset = S0 - T  (S0 – B0) = S0  (1 – T) + T B0 Tax on capital gains (a.k.a. depreciation recapture). Tax credit if negative.

Net Initial Outlay Let C0 be the net initial outlay. Let DW be the change in the net working capital. Let Ic be the investment tax credit. Then, C0 = – I0 – DW – (1 – T) E0 + S0 (1 – T) + T B0 + Ic

Net Operating Cash Flow Let DR be the change in periodic revenue and DE be the change in periodic expenses associated with the project. Let DD be the change in the periodic depreciation expense. The Cash Flow After Tax (CFAT) is given by CFAT = (DR – DE) (1 – T) + T  DD

Net Operating Cash Flow By rearranging the terms, we can re-write CFAT as after-tax net income plus depreciation: CFAT = (DR – DE – DD)(1 – T) + DD

Non-Operating Cash Flows These are treated in the same way as initial cash expenditure. The expensed non-operating cash flows are multiplied by (1 - T) to adjust for taxes. Capitalized non-operating cash flows create a cash outflow when they occur and a depreciation tax shield in subsequent years.

Net Salvage Value Let S denote the selling price of the asset and B denote its book value. Let REX denote the cleanup and removal expenses (to be expensed) and DW be the net working capital recovered upon termination of the project. Net salvage value = S (1 – T) + T  B – REX  (1 – T) + DW

Incremental Cash Flow Example New technology can lower production costs by $1.2M a year Current machine was purchased 5 years ago for $3M and is being depreciated using straight-line depreciation to a zero book value over a 10 year period. It’s current market value is thought to be $1.75M There are no investment credits at this time. The cost of the new machine is $5.1M plus $400,000 in shipping and $200,000 installation costs (which can be expensed) New process will result in an initial increase in inventories of $40,000 and accounts payables of $25,000. The tax rate is 40%. The cost of capital is 12%. After 10 years the new machine is expected to be sold off for $350,000 Reclamation costs are expected to be $150,000. INCREMENTAL CASH FLOWS (Asset Replacement) The Perma-Filter Co., a manufacturer of high performance automotive oil filters, is considering replacing an old assembly machine with a new one. The old machine was purchased 5 years ago at a cost of $3 million. It has a useful remaining life of 10 additional years. It is being depreciated to a zero book value using the straight line depreciation method over a 10 year life. It can be sold today for $1.75 million. A new, more efficient machine costs $5.1 million today. It will last for 10 years. At the end of ten years, it is expected to be sold off for $300,000. Removal and cleanup costs are expected to be $150,000. The new machine will require total installation costs of $600,000, of which $400,000 can be capitalized with the rest to be expensed immediately. The new machine will also be depreciated (using the straight line method) over 10 years to a book value of $350,000. If the replacement is made, an additional investment of $40,000 in inventories will be required due to the new manufacturing technology. The purchase of this inventory will create accounts payable of $25,000. The additional investment in net working capital will be recovered at the end of 10 years. While the new machine is not expected to increase sales, its use will result in a reduction of annual cash operating expenses by $1.2 million. The firm’s tax rate is 40%, and no investment tax credit is currently available for this machine. Compute the incremental cash flows if the old machine is replaced by the new one today.

Perma-Filter Co. Annual depreciation on old machine is Current book value of old machine is $3,000,000 - 5×($300,000) = $1,500,000 = B0 Selling price of old machine is $1,750,000 = S0 Investment tax credit is not available. Ic = 0

Perma-Filter Co. If the replacement is made, the investment in net working capital is Increase in Inventory - Increase in Accounts Payable = $40,000 - $25,000 = $15,000 = DW Net expenditure to be capitalized is I0 = $5,100,000 + $400,000 = $5,500,000 Installation cost to be expensed immediately is $200,000 ( = E0).

Perma-Filter Co. The net initial outlay is $3,985,000. C0 = – I0 – DW – (1 – T) E0 + S0 (1 – T) + T B0 + Ic C0 = – $5,500,000 – $15,000 – (1 – .40)$200,000 + $1,750,000×(1 – .40) + .40×$1,500,000 + 0

Perma-Filter Co. Annual depreciation expense on the new machine is In the first five years after the replacement, the firm will “lose” the depreciation expense on the old machine. In the last five years, the depreciation on the old machine (if kept) would be $0.

Perma-Filter Co. The change in depreciation (DD) in years 1 through 5 is Depreciation on new – depreciation on old = $515,000 – $300,000 = $215,000 The change in depreciation (DD) in years 6 through 10 is simply $515,000. Since sales do not increase, DR = 0. Since cash expenses decline, DE = –$1.2 million.

Perma-Filter Co. CFAT1–5 = $806,000 CFAT = (DR – DE – DD)(1 – T) + DD

Perma-Filter Co. CFAT6–10 = $926,000 CFAT = (DR – DE – DD)(1 – T) + DD CFAT1–5 = (0 – –$1,200,000 – $215,000)(1 – .40) + $215,000

Perma-Filter Co. After 10 years, the new machine is expected to be sold off for $350,000 (= S). The book value of this machine will be $350,000 (= B). Removal expenses are $150,000 (= REX). Net working capital of $15,000 will be recovered (= DW).

S (1 – T) + T B – REX  (1 – T) + DW Perma-Filter Co. Net Salvage Value = $275,000 S (1 – T) + T B – REX  (1 – T) + DW $350,000(1 – .40) + .4× $350,000 – 150,000  (1 – .40) +$15,000

Perma-Filter Co. - Summary of Cash Flows

Net Present Value Accept the project if the NPV is positive, and reject it if the NPV is negative.

Perma-Filter Co. Assume that the replacement project being considered by Perma-Filter Co. has a cost of capital of 12%. Should the firm make the replacement? NPV = $903,076

Adding Value per Share Since the NPV of the replacement project is positive, Perma-Filter should make the replacement. Assuming Perma-Filter has 500,000 shares outstanding, making the replacement will add about $1.81 to each share’s value:

The Internal Rate of Return (IRR) The IRR is the discount rate that makes the NPV equal to zero. For Perma-Filter’s replacement project, IRR = 16.95%

Inflation Inflation effects can be complex because asset value is a function of both the required return and the expected future cash flows. The changes can cancel each other out, leaving the project’s NPV unchanged.

Inflation Inflation affects the cash flows from a project. Effect on revenues Effect on expenses Inflation also affects the cost of capital. The higher the expected inflation, the higher the return required by investors. Thus, the effects of inflation must be properly incorporated in the NPV analysis.

Effect of Inflation on the Cost of Capital Notation: rr = cost of capital in real terms rn = cost of capital in nominal terms i = expected annual inflation rate (1 + rn) = (1 + rr) (1 + i) rn = rr + i + i ×rr

Effect of Inflation on the Cost of Capital Inflation affects both revenues and expenses. However, depreciation expense is based on historical cost. Depreciation tax credits do not inflate.

Effect of Inflation on the Cost of Capital If nominal depreciation tax credits are used, then we must use: Nominal values of revenues and other expenses. Nominal cost of capital. If revenues and other expenses are in real terms, we must: Express depreciation tax credits in real terms. Use the real cost of capital. A consistent treatment of NPV will not alter the project’s NPV.

Inflation and NPV Analysis The NPV of the project is unchanged as long as the cash flows and the cost of capital are expressed in consistent terms. Both in real terms Both in nominal terms If inflation is expected to affect revenues and expenses differently, these differences must be incorporated in the analysis.

Inflation and NPV Wildcat Washer Works (WWW) is evaluating a new project which costs $120,000. It has a life of 3 years and no salvage value. Annual revenues, less operating expenses (excluding depreciation) are $55,000 per year in real dollars. WWW will use straight line depreciation to a zero book value over 3 years. Its marginal tax rate is 40%. The real cost of capital is 5% and inflation is expected to be 8% per year. Compute the NPV of the project in real and in nominal dollars.

NPV in Real Dollars Annual after-tax revenues (less expenses), in real dollars are $55,000(1- 0.40) or $33,000 per year. Annual depreciation expense (in nominal dollars) is ($120,000 - $0)/3 or $40,000 per year. Annual depreciation tax credit (in nominal dollars) is $40,000(0.40) or $16,000 per year.

NPV in Real Dollars In real dollars, the first year’s depreciation tax credit is worth $16,000/(1.08) or $14,815. In real dollars, the second year’s depreciation tax credit is worth $16,000/(1.08)2 or $13,717. In real dollars, the third year’s depreciation tax credit is worth $16,000/(1.08)3 or $12,701. The annual after-tax cash flow is the after tax revenues (less expenses) plus the depreciation tax credit.

NPV in Real Dollars Year 0 Year 1 Year 2 Year 3 Initial investment ($120,000) After-tax net rev. $33,000 $33,000 $33,000 Depr. tax credit. $14,815 $13,717 $12,701 Real after-tax cash flow ($120,000) $47,815 $46,717 $45,701 NPV of real after-tax cash flows at the real cost of capital (of 5%) is $7,390.03.

NPV in Nominal Dollars Annual depreciation expense (in nominal dollars) is ($120,000 - $0)/3 or $40,000 per year. Annual depreciation tax credit (in nominal dollars) is $40,000(0.40) or $16,000 per year.

NPV in Nominal Dollars In nominal dollars, revenues net of expenses in year 1 are $55,000(1.08) or $59,400. After-tax net revenues = $59,400(1-0.4) or $35,640. In nominal dollars, revenues net of expenses in year 2 are $55,000(1.08)2 or $64,152 After-tax net revenues = $64,152(1-0.4) or $38,491. After-tax net revenues in year 3 are $41,570.

NPV in Nominal Dollars The nominal cost of capital is

NPV in Nominal Dollars Year 0 Year 1 Year 2 Year 3 Initial investment After-tax net rev. Depr. tax credit. Nominal after- tax cash flow ($120,000) $35,640 $16,000 $51,640 $38,491 $54,491 $41,570 $57,570 NPV of nominal after-tax cash flows at the nominal cost of capital (of 13.40%) is $7,390.02.

A Little More About Taxes Because tax laws change often, it is critical to use the current tax laws to determine after-tax cash flows for a capital budgeting decision. When a choice presents itself, like a choice in depreciation methods, use the method that provides the largest present value of tax credits.

A Note on Tax Considerations Tax laws are constantly changing: Marginal tax rates. Provisions for allowable depreciation of capital assets. Investment tax credit. The marginal tax rate may be higher than the marginal federal income tax rate due to state and local taxes.

A Note on Depreciation The total amount of depreciation tax credits over the life of the project is independent of the depreciation method used. The present value of these tax credits is dependent on the depreciation method. Accelerated versus straight line methods. A firm should use the depreciation method that results in the largest present value of depreciation tax credits.

Evaluating Replacement Cycles Certain assets need to be replaced after the original is worn out. Example: delivery vehicles The initial choice may involve alternative models that essentially do the same job but differ in their costs and usable life. The choice can be made in two ways: Equivalent Annual Cost method Common Horizon method

Unequal Life Projects The Mid-Town Transit Co. is considering the purchase of a special purpose delivery vehicle. Two models are available: Model A Model B Cost Useful life After - tax annual operating expenses $40,000 5 years $12,000 $60,000 9 years $10,500 If the cost of capital is 15%, which one should it choose?

Unequal Life Projects First, compute the total present value of the costs (TC) over the life of the project. Next, determine the annual cash flow that, if it occurred every year, would have a present value = TC. This annual cash flow is called the Equivalent Annual Cost (EAC). Now choose the project that has the lowest EAC. If both projects have the same EAC, choose the one with the shorter life.

Computing the EAC

EAC for Mid-Town Transit Co.’s Projects Model A Model B Cost $40,000 $60,000 Useful life 5 years 9 years After-tax annual operating expenses $12,000 $10,500 Total Present Value ($80,226) ($110,102) Equivalent Annual Cost ($23,933) ($23,074)

Optimal Replacement Frequency Fisher Plastics uses an extruding machine in its manufacturing process. The machine costs $50,000, and annual after-tax operating expenses are $12,000 per year. If used for 4 years, it can be sold off for an after-tax salvage value of $5,000. If used for 6 years, the after-tax salvage value would be only $3,000. If the cost of capital is 15%, should Fisher use this machine for 4 or 6 years?

Optimal Replacement Frequency By replacing the machine every 4 years, the firm incurs the cost of the new machine sooner. However, it receives the benefit of a higher salvage value. By replacing the machine every 6 years, the firm incurs the cost of the new machine later. However, it receives a lower salvage value. The optimal replacement frequency takes into account these opposing effects.

Optimal Replacement Frequency 4 Years 6 years Cost $50,000 $50,000 Annual Operating Expenses $12,000 $12,000 Salvage Value (after tax) $5,000 $3,000 Total Present Value ($81,401) ($94,117) Equivalent Annual Cost ($28,512) ($24,869)

Equivalent Annual Annuity The EAC annualizes the cost of the project over its life. This concept can be applied to annualize any amount: A project’s NPV A project’s total revenues The general term is called the Equivalent Annual Annuity (EAA).

Equivalent Annual Annuity The EAA can be used to choose between two or more mutually exclusive projects with unequal lives. Choose the project with the highest EAA. If two projects have the same EAA, choose the project with the shorter life.

Equivalent Annual Annuity Fisher Plastics is considering a new 6-year project which has an NPV of $2,650 at a cost of capital of 15%. What is the project’s Equivalent Annual Annuity (EAA)? EAA = $700. (Solve for PMT on your calculator.)

Break-Even Analysis (Ch. 11 App.) Hancock Cabinets, Inc. is considering a new project which costs $1.0 million, has a life of 6 years with no salvage value. The unit selling price is $18, unit variable costs are $8, and annual fixed costs are $500,000. The cost of capital is 12% and Hancock’s marginal tax rate is 40%. What is the accounting break-even level of sales? What is the financial break-even level of sales?

Accounting Break-Even Contribution Margin = c = Selling Price - Variable Cost = $18 - $8 = $10 per unit. Break-Even Sales = Fixed Costs / c = $500,000 / $10 = 50,000 units. At a sales level of 50,000 units, the firm will make zero profits.

Financial Break-Even Analysis First find the cash flows necessary to make the NPV equal to zero. Annual depreciation = $1.0million / 6 or $166,667. Annual depreciation tax credit = $166,667(0.40) = $66,667. Present value of these tax credits (at 12%) is $274,095.

Financial Break-Even Analysis NPV = 0 = initial investment + PV tax shield of depreciation + PV after-tax cash flow on final sale of asset + cash flow before tax times 1 minus tax rate times present value annuity factor NPV = 0 = -$1,000,000 + 274,095 + (cQ - F) (1-T) PVIFA6 years, 12% PVIFAn,r =

Financial Break-Even Analysis NPV = 0 = -$1,000,000 + 274,095 + (cQ - F) (1-T) PVIFA6 years, 12% $725,905 = ($10Q - $500,000)(.6)(4.1114) $725,905/(.6)(4.1114) +$500,000 = $10Q $794,265 = $10Q Q = 79,427 units

Break-Even Analysis Note that the accounting break-even level of sales (50,000 units) is less than the financial break-even quantity (79,427). If Hancock sells 50,000 units per year for 6 years, its accounting income will be zero in each year. However, the project will have a negative NPV.

Capital Budgeting in Practice Most firms used more than one method for capital budgeting project evaluation. The NPV profile is the most useful item. It provides the most complete view of the project. A process for appropriating capital after the projects have been selected must be created by the firm. Review of project performance must be done periodically.