Cash Flow And Capital Budgeting Professor XXXXX Course Name / Number

Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know: Incremental cash outflows of the investment (marginal cost of investment), and Incremental cash inflows of the investment (marginal benefit of investment). The timing and magnitude of cash flows and accounting profits can differ dramatically.

Financing Costs Both interest expense from debt financing and dividend payments to equity investors should be excluded. Financing costs should be excluded when evaluating a project’s cash flows. Financing costs are captured in the discounting future cash flows to present.

Cash Flow and Non-Tax Expenses Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits. Capital budgeting analysis focuses on cash inflows and outflows when they occur. Non-cash expenses affect cash flow through their impact on taxes: Compute after-tax net income and add depreciation back, or Ignore depreciation expense but add back its tax savings.

Two Methods of Handling Depreciation to Compute Cash Flow $6,000 Net income $16,000 Cash flow = NI + deprec (4,000) Taxes (40%) $10,000 Pre-tax income (10,000) Depreciation $20,000 Gross profits Cost of goods $30,000 Sales Adding non-cash expenses back to after-tax earnings $4,000 Depreciation tax savings Cash Flow $12,000 Aft-tax income (8,000) Find after-tax profits, add back non-cash charge tax savings Simplest and most common technique: Add depreciation back in. Assume a firm purchases a fixed asset today for $30,000 Plans to depreciate over 3 years using straight-line method Firm will produce 10,000 units/year Costs $1/unit Sells for $3/unit Firm pays taxes at a 40% marginal rate

Depreciation Many countries allow one depreciation method for tax purposes and another for reporting purposes. Accelerated depreciation methods (such as MACRS) increase the present value of an investment’s tax benefits. Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life. For capital budgeting analysis, the depreciation method for tax purposes matters most.

The Initial Investment Initial cash flows: Cash outflow to acquire/install fixed assets Cash inflow from selling old equipment Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability) An example.... Tax rate = 40% New equipment costs $10 million, $0.5 million to install Old equipment fully depreciated, sold for $1 million Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment

Working Capital Expenditures Many capital investments require additions to working capital. Net working capital (NWC) = current assets – current liabilities. Increase in NWC is a cash outflow; decrease a cash inflow. An example… Operate booth from November 1 to January 31 Order $15,000 calendars on credit, delivery by Nov 1 Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan Always want to have $500 cash on hand

Working Capital for Calendar Sales Booth (4,000) +500 NA Monthly  in WC (3,000) 1,000 500 Net WC 5,000 10,000 15,000 Accts payable 1,500 10,500 Inventory $0 $500 Cash Feb 1 Jan 1 Dec 1 Nov 1 Oct 1 +3,000 ($5,000) $0 Payments ($500) Net cash flow $1,500 [10%] $9,000 [60%] $4,500 [30%] Reduction in inventory Jan 1 to Feb 1 Dec 1 to Jan 1 Nov 1 to Dec 1 Oct 1 to Nov 1 Payments and inventory +$4,000 ($3,000)

Construct cash-flow forecasts for 5 to 10 years Terminal Value Terminal value is used when evaluating an investment with indefinite life-span: Construct cash-flow forecasts for 5 to 10 years Forecasts more than 5 to 10 years have high margin of error; use terminal value instead. Terminal value is intended to reflect the value of a project at a given future point in time. Large value relative to all the other cash flows of the project.

JDS Uniphase cash flow projections for acquisition of SDL Inc. Terminal Value Different ways to calculate terminal values: Use final year cash flow projections and assume that all future cash flow grow at a constant rate; Multiply final cash flow estimate by a market multiple, or Use investment’s book value or liquidation value. $3.25 Billion $2.5 Billion $1.75 Billion $1.0 Billion $0.5 Billion Year 5 Year 4 Year 3 Year 2 Year 1 JDS Uniphase cash flow projections for acquisition of SDL Inc.

Terminal Value of SDL Acquisition Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion): Terminal value is $68.2 billion; value of entire project is: $42.4 billion of total $48.7 billion from terminal value Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value Terminal Value = $3.25 x 20 = $65 billion Caveat : market multiples fluctuate over time

Incremental Cash Flow Incremental cash flows versus sunk costs: Capital budgeting analysis should include only incremental costs. An example… Norman Paul’s current salary is $60,000 per year and he expects it to increase at 5% each year. Norm pays taxes at flat rate of 35%. Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programs Room and board expenses are not incremental to the decision to go back to school

What about Norm’s opportunity cost? Incremental Cash Flow At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year Expected tuition, fees and textbook expenses for next two years while studying in MBA: $35,000 If Norm worked at his current job for two years, his salary would have increased to $66,150: Yr 2 net cash inflow: $90,000 - $66,150 = $23,850 After-tax inflow: $23,850 x (1-0.35) = $15,503 Yr 3 cash inflow: MBA has substantial positive NPV value if 30 yr analysis period What about Norm’s opportunity cost?

Opportunity Costs Cash flows from alternative investment opportunities, forgone when one investment is undertaken. First year: $60,000 ($39,000 after taxes) Second Year: $63,000 ($40,950 after taxes) If Norm did not attend MBA program, he would have earned: NPV of a project could fall substantially if opportunity costs are recognized!

Initial Investment for Jazz CD Project Classicaltunes.com is considering adding jazz recordings to its offerings. Firm uses 10% discount rate to calculate NPV and 40% tax rate. The average selling price of Classicaltunes CD’s is $13.50; price is expected to increase at 2% per year. Sales expected to begin when new fiscal year begins. Initial investment transactions: $50,000 for computer equipment (MACRS 5-year) $4,500 for inventory ($2,500 of which purchased on credit) $1,000 increase in cash balances

Projections for Jazz CD Proposal 6 5 4 3 2 1 Year 28057 120646 39840 105160 145000 80806 47696 29810 3300 25214 122903 50048 79952 130000 72855 42864 26790 3200 17978 11016 4320 2500 Accounts Payable 117179 86585 56132 45934 45500 Total assets 31328 33920 23200 32000 40000 Net P&E 123672 56080 41800 28000 10000 Accumulated Depreciation 155000 90000 65000 60000 50000 Gross P&E 85851 52665 32932 13934 5500 Current Assets 50677 30563 18727 7344 4500 Inventory 31673 19102 11705 4590 Accounts Receivable 3500 3000 2000 1000 Cash Abbreviated Project Balance Sheet Annual Cash Flow Estimates for Classicaltunes.com -3291 -5109 -12953 -12771 -12302 -6614 -3000 Change in working capital -10000 -15000 -40000 -25000 -5000 -50000 New Fixed Assets 6 5 4 3 2 1 Year 27535 47644 -12542 40411 35163 -14180 -2512 -6440 -49000 Net cash flow 48454 23591 14790 10174 4000 Operating cash flow 6 5 4 3 2 1 Year 24,000 $14.91 22,000 $14.61 25,000 16,000 10,000 4,000 Units $15.20 $14.33 $14.05 $13.77 $13.50 Price per unit 37393 25208 35772 98374 259349 357722 27565 23872 35363 86800 234682 321482 49903 15519 1649 -13043 -10000 Pretax profit 18512 14280 13800 18000 10000 Depreciation 38008 29799 19664 8262 SG&A Expense 106422 59597 35114 13219 Gross profit 273657 169623 105341 41861 Cost of goods sold 380080 229221 140454 55080 Revenue Abbreviated Project Income Statement

Year Zero Cash Flow Initial cash outlay of $50,000 for computer equipment Half-year of MACRS depreciation can be taken in year zero: 20% x $50,000 = $10,000; non cash expense Depreciation expense are deducted from the firm’s classical-music CD profits. Savings of $4,000 (40% x $10,000) in taxes Changes in working capital are result of following transactions: Purchase of $4,500 in inventory and $1000 cash balance Accounts payable of $2,500 partially finance the $5,500 outlay Net Cash Flow: Increase in gross fixed assets - $50,000 Change in working capital - $3,000 Operating cash inflow + $4,000 Net cash flow - $49,000

Year One Cash Flow Purchase of additional $10,000 in fixed assets 2nd year depreciation expenses for MACRS 5-year asset class is 32%. An additional 20% depreciation deduction for assets purchased this year 32% x $50,000 + 20% x $10,000= $18,000 Non cash expense; has to be added back when computing cash flow for the year Net working capital for year one is: NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614 Increase in NWC; cash outflow of $6,614

Year One Cash Flow Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com. Tax savings = 40% x $13,043 = $5,217 Net operating cash inflow = pretax loss + tax savings + depreciation Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174 Net Cash Flow: Increase in gross fixed assets - $10,000 Change in working capital - $6,614 Operating cash inflow + $10,174 Net cash flow - $6,440

Year Two Cash Flow Purchase of additional $5,000 in fixed assets Assets purchased at the onset of the project have allowable depreciation of 19.2% (19.2% x $50,000 = $9,600) An additional 32% depreciation deduction for assets purchased in year 1 and 20% depreciation of assets purchased this year Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000= $4,200 = $13,800 Changes in working capital are result of following transactions: Increases in current assets: $500 increase in cash balance $7,115 increase in accounts receivables $11,383 increase in inventory Increase in current liabilities: $6,696 increase in account payables Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)

Year Two Cash Flow Pretax profit in year two is $1,649. The company must pay taxes of $660 (40% x $1,649-- cash outflow. Net operating cash inflow = pretax profit + tax + depreciation Operating cash inflow = $1,649 - $660 + $13,800 = $14,789 Net Cash Flow: Increase in gross fixed assets - $5,000 Change in working capital - $12,302 Operating cash inflow +$14,790 Net cash flow - $2,512

Terminal Value for Jazz CD Investment If we assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,): Second approach used by Classicaltunes.com to compute terminal value for the project: use the book value at end of year six: Plant and Equipment (P&E) at end of year six is $31,328. The firm liquidates total current assets and pays off current debts: $85,850 - $29,810 = $56,040 Terminal value = $31,328 + $56,040 = $87,368.

NPV for Jazz CD Project Using assumption that cash flow grow at a steady rate past year 6: Using book value assumption for terminal value: NPV is positive with both methods: investing in Jazz CD project increases shareholders wealth.

Can a firm accept all investment projects with positive NPV? Capital Rationing Can a firm accept all investment projects with positive NPV? Reasons why a company would not accept all projects: Limited availability of skilled personnel to be involved with all the projects; Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market.

Capital Rationing Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints 1. Rank the projects using the Profitability Index (PI) 1. Rank the projects using the Profitability Index (PI) 2. Select the investment with the highest PI 3. If funds still available, select the second-highest PI, and so on, until the capital is exhausted. The steps above ensure that managers select the combination of projects with the highest NPV.

The Human Face of Capital Budgeting Managers must be aware of optimistic bias in these assumptions made by project supporters. Companies should have control measures in place to remove bias: Investment analysis should be done by a group independent of individual or group proposing the project. Project analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential. Storytelling: Best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.

Cash Flow and Capital Budgeting Certain types of cash flows are common to many investments Opportunity costs should be included in cash flow projections Consider human factors in capital budgeting