Prepared by Ingrid McLeod-Dick Schulich School of Business © 2015 McGraw–Hill Ryerson Limited All Rights Reserved Net Present Value and Capital Budgeting Chapter Eight

2-1 © 2015 McGraw–Hill Ryerson Limited 8-1 Chapter Outline 8.1 Incremental Cash Flows 8.2 The Majestic Mulch and Compost Company: An Example 8.3 Inflation and Capital Budgeting 8.4 Alternative Definitions of Operating Cash Flows 8.5 Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project 8.6 Investments of Unequal Lives: The Equivalent Annual Cost Method 8.7 Summary and Conclusions

2-2 © 2015 McGraw–Hill Ryerson Limited 8-2 Incremental Cash Flows Cash flows matter—not accounting earnings. Sunk costs don’t matter. Taxes matter: After - tax Incremental cash flows matter. Opportunity costs matter. Side effects like cannibalism and erosion matter. Allocate costs only matter if incremental to the project Inflation matters. LO 8.1

2-3 © 2015 McGraw–Hill Ryerson Limited 8-3 Cash Flows—Not Accounting Earnings Much of the work in evaluating a project lies in taking accounting numbers and calculating the cash flows. –Consider non-cash costs such as depreciation expense. Incremental cash flows – those cash flows that change as a direct consequence of accepting a project. LO 8.1

2-4 © 2015 McGraw–Hill Ryerson Limited 8-4 Incremental Cash Flows Sunk costs are not relevant –A past cost that has already been incurred and is not changed by accepting or rejecting a project. Opportunity costs do matter. –Look at other opportunities that have been forgone if the project is accepted –Example – forgone revenues from an asset that is used in the project. LO 8.1

2-5 © 2015 McGraw–Hill Ryerson Limited 8-5 Incremental Cash Flows (cont.) Side effects are the impact of the project on other areas of the business May be either erosion or synergy –Erosion and cannibalism - reduce cash flows in other business areas –Synergies – increase cash flows in other business areas Allocated costs – only include in the analysis if an incremental cost of the project LO 8.1

2-6 © 2015 McGraw–Hill Ryerson Limited 8-6 Estimating Cash Flows Initial Investments (after-tax) After-tax Cash Flows from Operations –Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation Changes in Net Working Capital –Initial investments; and –a return of net working capital when the project I completed. Salvage values (after-tax) at end of project LO 8.1

2-7 © 2015 McGraw–Hill Ryerson Limited 8-7 Interest Expense Interest expense is excluded from the cash flows related to a project. –The cost of financing is represented in the discount rate. –Later chapters will deal with the determination of this discount rate. LO 8.1

2-8 © 2015 McGraw–Hill Ryerson Limited 8-8 The Majestic Mulch and Compost Company (MMCC): An Example Costs of test marketing (already spent): $250,000 – Is this a sunk cost? The proposed factory site (which we own) has no resale value - Any opportunity cost? Initial cost of the tool making machine: $800,000 (CCA calculations are based on a class 8, 20-percent rate). –Salvage value at end is $150,000 Working capital: initially $40,000, then 15% of sales at the end of each year. Falls to $0 by the project’s end. LO 8.2

2-9 © 2015 McGraw–Hill Ryerson Limited 8-9 The MMCC: An Example (cont.) Production (in units) by year during 8-year life of the machine: 6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, and 6,000. Selling price during first year is $100; price increases 2% per year thereafter. Production costs during first year are $64 per unit and increase at the annual inflation rate of 5% per year thereafter. Tax rate is 40% Fixed production costs are $50,000 each year. LO 8.2

2-10 © 2015 McGraw–Hill Ryerson Limited 8-10 The Worksheet for Cash Flows of the MMCC Recall that production (in units) by year during 8-year life of the machine is given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000). Price during first year is $100 and increases 2% per year thereafter. Sales revenue in year 5 = 12,000×[$100×(1.02) 4 ] = $1,298,919. (All cash flows occur at the end of the year.) LO 8.2

2-11 © 2015 McGraw–Hill Ryerson Limited 8-11 The Worksheet for Cash Flows of the MMCC (cont.) – Table 8.1 Again, production (in units) by year during 8-year life of the machine is given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000). Variable costs during first year (per unit) are $64 and (increase 5% per year thereafter). Fixed costs are $50,000 each year. Production costs in year 5 = 12,000×[$64×(1.05) 4 ] + 50,000= $983,509. (All cash flows occur at the end of the year.) LO 8.2

2-12 © 2015 McGraw–Hill Ryerson Limited 8-12 CCA calculations are based on a class 8, 20% rate (shown at right) (Table 8.3) The machine cost $800,000. CCA charge in year 5 =$368,640×(.20) = $73,728. Annual CCA The Worksheet for Cash Flows of the MMCC (cont.) – Table 8.1 (All cash flows occur at the end of the year.) LO 8.2

2-13 © 2015 McGraw–Hill Ryerson Limited 8-13 The Worksheet for Cash Flows of the MMCC (cont.) – Table 8.1 (All cash flows occur at the end of the year.) LO 8.2

2-14 © 2015 McGraw–Hill Ryerson Limited 8-14 The Worksheet for Cash Flows of the MMCC (cont.) – Table 8.1 (All cash flows occur at the end of the year.) LO 8.2

2-15 © 2015 McGraw–Hill Ryerson Limited 8-15 Incremental After Tax Cash Flows (IATCF) of the MMCC – Table 8.4 (All cash flows occur at the end of the year.) 4% $500,135 $188,042 $2,280 IRR15.07% If the project’s discount rate is above 15.07%, it should not be accepted (since NPV < 0). LO 8.2

2-16 © 2015 McGraw–Hill Ryerson Limited 8-16 NPV of the MMCC 1 81, ,042 –840,000 CF1 F1 CF0 I NPV ,820 CF2 F ,564 CF3 F ,056 CF4 F ,835 CF5 F ,175 CF6 F ,228 CF7 F ,570 CF8 F8 LO 8.2

2-17 © 2015 McGraw–Hill Ryerson Limited 8-17 Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship: (1 + Nominal Rate) = (1 + Real Rate)×(1 + Inflation Rate) For low rates of inflation, this is often approximated as Real Rate  Nominal Rate – Inflation Rate When accounting for inflation in capital budgeting either calculate: –real cash flows and discount at real rates; or –nominal cash flows and discount at nominal rates. LO 8.3