Making Capital Investment Decisions Estimating Cash Flows Special cases

Overview We are mainly concerned with how to arrive at correct measure of cash flows in numerator of NPV calculations We are mainly concerned with how to arrive at correct measure of cash flows in numerator of NPV calculations What are relevant and irrelevant cash flows? What are relevant and irrelevant cash flows? We will also look at some special cases of Discounted Cash Flow (DCF) methods We will also look at some special cases of Discounted Cash Flow (DCF) methods

Special Applications of DCF Evaluating Cost Cutting Proposals Evaluating Cost Cutting Proposals Evaluating Equipment with Different Lives Evaluating Equipment with Different Lives We will ignore ‘setting bid price’ example in text We will ignore ‘setting bid price’ example in text

Relevant Cash Flows Only INCREMENTAL after-tax cash flows are relevant: Only INCREMENTAL after-tax cash flows are relevant: Incremental cash flows: Incremental cash flows: Changes in cash flows with and without the project Changes in cash flows with and without the project NOT the same as cash flows before and after the project!! NOT the same as cash flows before and after the project!!

Indentifying cash flows Look For: Look For: Changes in sales and operating costs Changes in sales and operating costs Changes in net working capital Changes in net working capital Opportunity costs and capital spending Opportunity costs and capital spending Effect on tax payments Effect on tax payments

Example Manufacturing operation that uses land that could be sold for $100,000 Manufacturing operation that uses land that could be sold for $100,000 With project: (own and use land)CF = $0 With project: (own and use land)CF = $0 Without project (sell land)CF = +$100,000 Without project (sell land)CF = +$100,000 Incremental CF = -$100,000 (due to project) Incremental CF = -$100,000 (due to project)

Do Not Include... Sunk Costs and unavoidable expenses Sunk Costs and unavoidable expenses Depreciation Depreciation but include effect of depreciation on taxes but include effect of depreciation on taxes Financing payments Financing payments e.g. dividends and interest e.g. dividends and interest financing is captured in denominator ‘r’ financing is captured in denominator ‘r’

Examples: Include/Ignore? Market value of land and existing buildings Market value of land and existing buildings Costs of demolishing and clearing land Costs of demolishing and clearing land Cost of new access road put in last year Cost of new access road put in last year Lost earnings from other products due to managers’ time spent on the new plant Lost earnings from other products due to managers’ time spent on the new plant Part of the cost of leasing the president’s airplane Part of the cost of leasing the president’s airplane Future depreciation of the new plant Future depreciation of the new plant Initial investment on inventories and raw materials Initial investment on inventories and raw materials Payments already made for engineering of the new plant Payments already made for engineering of the new plant

Definitions of Operating CF OCF = operating cash flow OCF = operating cash flow S = sales S = sales C = operating costs C = operating costs D = depreciation D = depreciation EBIT = earnings before interest and taxes EBIT = earnings before interest and taxes = S - C - D = S - C - D T = corporate tax rate T = corporate tax rate OCF = EBIT + D - Taxes

Example: S = $1,000C = $600D = $200T = 34% EBIT = S - C - D = = $200 Taxes = EBIT x T = 200 x.34 = $68 OCF = EBIT + D - Taxes = $332 Use alternative approaches to arrive at the same answer S = $1,000C = $600D = $200T = 34% EBIT = S - C - D = = $200 Taxes = EBIT x T = 200 x.34 = $68 OCF = EBIT + D - Taxes = $332 Use alternative approaches to arrive at the same answer

Alternative Definitions of OCF Bottoms-up approach OCF = N.I. (without interest expense) + D Bottoms-up approach OCF = N.I. (without interest expense) + D Top-down approach OCF = S - C - Taxes Top-down approach OCF = S - C - Taxes Tax-shield approach OCF = (S - C) x (1-T) + D x T Tax-shield approach OCF = (S - C) x (1-T) + D x T

Notice... In all the alternatives of computing cash flows, taxes must be taken into account In all the alternatives of computing cash flows, taxes must be taken into account Payment of taxes is a cash outflow Payment of taxes is a cash outflow Savings of taxes is a cash inflow Savings of taxes is a cash inflow Cash flows are computed on an after-tax basis Cash flows are computed on an after-tax basis

Multiply by T or (1-T)? When you are calculating the amount of tax, you multiply by T When you are calculating the amount of tax, you multiply by T When you are calculating the amount of tax savings due to an expense (such as depreciation expense or any other expense), you multiply by T When you are calculating the amount of tax savings due to an expense (such as depreciation expense or any other expense), you multiply by T When you are calculating the amount of after- tax cash flow, you multiply by (1-T) When you are calculating the amount of after- tax cash flow, you multiply by (1-T)

Example Before Tax CF:$1000 [= CF] Before Tax CF:$1000 [= CF] 40%: $400 [= CF x T] 40%: $400 [= CF x T] After Tax Income: $600 [= CF x (1-T)] After Tax Income: $600 [= CF x (1-T)]

Example Taking a project increases tax deductible expense by $1,000 Taking a project increases tax deductible expense by $1,000 How much savings in taxes does this result? How much savings in taxes does this result? T = 40% T = 40% Answer: 1000 x.40 = $400 Answer: 1000 x.40 = $400 This is the amount by which the taxes are lower This is the amount by which the taxes are lower

Depreciation Depreciation is a way accountants measure ‘wear and tear’ or ‘using-up’ of assets Depreciation is a way accountants measure ‘wear and tear’ or ‘using-up’ of assets It does not reflect actual cash going out It does not reflect actual cash going out Depreciation is a tax-deductible expense Depreciation is a tax-deductible expense Tax savings due to depreciation is (D x T) Tax savings due to depreciation is (D x T) tax savings is a cash inflow tax savings is a cash inflow tax savings is called depreciation tax shield tax savings is called depreciation tax shield

Example: Depr. Tax Shield The Latte Stand project requires purchasing coffee equipment for $12,000 which will be depreciated on a straight-line basis over 4 years to zero book value. The tax rate is 38%. The Latte Stand project requires purchasing coffee equipment for $12,000 which will be depreciated on a straight-line basis over 4 years to zero book value. The tax rate is 38%. What is the annual depreciation? What is the annual depreciation? What are the cash flow consequences of depreciation? What are the cash flow consequences of depreciation?

Note Equipment can be sold before it is fully depreciated Equipment can be sold before it is fully depreciated The book value (BV) of the machine in any year is the original cost – accumulated depreciation The book value (BV) of the machine in any year is the original cost – accumulated depreciation Example. $1m machine is being depreciated straight line over 10 years to zero book value. What is its BV in year 6? Example. $1m machine is being depreciated straight line over 10 years to zero book value. What is its BV in year 6?

Accelerated Depreciation IRS allows a quicker schedule of depreciation than straight-line depreciation IRS allows a quicker schedule of depreciation than straight-line depreciation This method is called Accelerated Depreciation This method is called Accelerated Depreciation Assets are categorized in different ‘classes’ Assets are categorized in different ‘classes’ e.g. “5-year class” e.g. “5-year class”

Accelerated Depreciation $500,000 investment is depreciated over 4 years as 3-year MACRS to zero book value $500,000 investment is depreciated over 4 years as 3-year MACRS to zero book value What is the annual depreciation? What is the annual depreciation? What is the annual depreciation tax shield? What is the annual depreciation tax shield?

Salvage Value The latte equipment will be sold at the end of 4 years for $5,600. The latte equipment will be sold at the end of 4 years for $5,600. What are the cash flows resulting from salvage at the end of the project? What are the cash flows resulting from salvage at the end of the project?

Salvage Sale of equipment can result in Sale of equipment can result in Taxable gain if BV < MV Taxable gain if BV < MVOR Taxable loss if BV > MV Taxable loss if BV > MVOR Neither if BV = MV Neither if BV = MV

Gain Example Loss Example Book Value of Asset in year of sale (BV) $10,000$10,000 Sale price of asset (MV) $15,000$5,000 Gain (+)/Loss (-) on sale +$5000-$5,000 Cash flow from tax paid/saved on gain/loss from sale -$2,000+$2,000 Here, gain on sale to taxes being paid on the gain (cash outflow) Here, loss on sale leads to taxes being saved (cash inflow)

Net Working Capital Net working capital (NWC) Net working capital (NWC) = S.T. Assets - S.T. Liabilities Businesses need NWC to conduct business Businesses need NWC to conduct business NWC ties up money (i.e. it is an investment) NWC ties up money (i.e. it is an investment) What are S.T. Assets and Liabilities of a firm? What are S.T. Assets and Liabilities of a firm? Increase in NWC is cash outflow Increase in NWC is cash outflow Decrease in NWC is cash inflow Decrease in NWC is cash inflow

NWC ST Assets ST Assets Cash Cash Marketable securities Marketable securities Accounts Receivables Accounts Receivables Inventory Inventory ST Liabilities ST Liabilities Accounts payable Wages due Taxes due NWC = ST Assets - ST Liabilities

Example: NWC Without Project ($s) Without Project ($s) Acct Rec’v4,500 Acct Rec’v4,500 Inventories6,000 Inventories6,000 Acct Pay’b3,900 Acct Pay’b3,900 With Project ($s) With Project ($s) Acct Rec’v6,700 Acct Rec’v6,700 Inventories9,000 Inventories9,000 Acct Pay’b3,400 Acct Pay’b3,400 What is the change in NWC? What is the cash inflow / outflow?

NWC at Project End When projects have finite life, the money tied up in NWC becomes available when the project ends When projects have finite life, the money tied up in NWC becomes available when the project ends Hence, one typically encounters situations where a drop in NWC occurs at the end of project’s life Hence, one typically encounters situations where a drop in NWC occurs at the end of project’s life This results in a cash inflow This results in a cash inflow

Application: Cost Cutting Buying a new machine press for $350,000 is estimated to result in $145,000 in annual pre-tax savings. MACRS five-year class depreciated to zero book value, and has sale price of $75,000. Also required spare parts of $17,000 and $2,500 in inventory for each succeeding year of the project. T = 34%, r = 15%. Buy new machine? Buying a new machine press for $350,000 is estimated to result in $145,000 in annual pre-tax savings. MACRS five-year class depreciated to zero book value, and has sale price of $75,000. Also required spare parts of $17,000 and $2,500 in inventory for each succeeding year of the project. T = 34%, r = 15%. Buy new machine?

Equivalent Annual Cost (EAC) Useful: Useful: when alternatives have different economic lives when alternatives have different economic lives we will use and replace the equipment indefinitely we will use and replace the equipment indefinitely Trick: Trick: Calculate NPV of alternatives Calculate NPV of alternatives Use NPV as PV of annuity to calculate PMT over the ‘n’ years of useful life Use NPV as PV of annuity to calculate PMT over the ‘n’ years of useful life

EAC Example FiltrationPrecipitation Economic Life5 years8 years Economic Life5 years8 years Installation Cost$1.1 mill$1.9 mill Installation Cost$1.1 mill$1.9 mill Annual Oper. Cost$60,000 $10,000 Annual Oper. Cost$60,000 $10,000 Salvage value$0 $0 Salvage value$0 $0 Depreciable life5 years8 years Depreciable life5 years8 years Discount rate12%12% Discount rate12%12% T =.34, Straight line depreciation T =.34, Straight line depreciation

Notice... The two alternative have different lives The two alternative have different lives Cannot directly compare them Cannot directly compare them We usually assume that the machines are replaced indefinitely at end of their lives We usually assume that the machines are replaced indefinitely at end of their lives Hence we convert NPV to Equivalent Annual Costs (EAC) Hence we convert NPV to Equivalent Annual Costs (EAC)

EAC ex. continued.. Filtr. Precip. After tax oper. cost-$39,600 -$6,600 After tax oper. cost-$39,600 -$6,600 Depr. tax shield$74,800 $80,750 Depr. tax shield$74,800 $80,750 Oper. Cash flow$35,200 $74,150 Oper. Cash flow$35,200 $74,150 PV of Oper. cash flow$126,888 $368,350 PV of Oper. cash flow$126,888 $368,350 Investment -$1,100,000 -$1,900,000 Investment -$1,100,000 -$1,900,000 12%-$973,112 -$1,531,650 12%-$973,112 -$1,531,650 EAC EAC