Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 11 Cash Flows and Other Topics in Capital Budgeting.

11-1 © 2011 Pearson Prentice Hall. All rights reserved. Learning Objectives 1.Identify guidelines by which we measure cash flows. 2.Explain how a project’s benefits and costs – that is, its free cash flows –are calculated. 3.Explain the importance of options or flexibility in capital budgeting. 4.Explain what the appropriate measure of risk is for capital-budgeting purposes.

11-2 © 2011 Pearson Prentice Hall. All rights reserved. Learning Objectives 5.Determine the acceptability of a new project using the risk-adjusted discount method of adjusting for risk. 6.Explain the use of simulating for imitating the performance of a project under evaluation. 7.Explain why a multinational firm faces a more difficult time estimating cash flows along with increased risks.

11-3 © 2011 Pearson Prentice Hall. All rights reserved. Slide Contents  Guidelines for Capital Budgeting  Free Cash Flow calculations  Options in Capital Budgeting  Risk and the Investment Decision  Measurement of Systematic Risk  The Multinational Firm

11-4 © 2011 Pearson Prentice Hall. All rights reserved. 1. Guidelines for Capital Budgeting  To evaluate investment proposals, we must first set guidelines by which we measure the value of each proposal.  In effect, we are deciding what is and what isn’t relevant cash flow.

11-5 © 2011 Pearson Prentice Hall. All rights reserved. Guidelines for Capital Budgeting 1.Use free cash flows, not accounting profits 2.Think Incrementally 3.Beware of cash flows diverted from existing products 4.Look for incidental or synergistic effects 5.Work in working-capital requirements

11-6 © 2011 Pearson Prentice Hall. All rights reserved. Guidelines for Capital Budgeting 6.Consider incremental expenses 7.Sunk costs are not incremental cash flows 8.Account for opportunity costs 9.Decide if overhead costs are truly incremental cash flows 10.Ignore interest payments and financing flows

11-7 © 2011 Pearson Prentice Hall. All rights reserved. Use Free Cash Flows  Free cash flow accurately reflects the timing of benefits and costs—when money is received, when it can be reinvested, and when it must be paid out.  Accounting profits do not reflect actual money in hand.

11-8 © 2011 Pearson Prentice Hall. All rights reserved. Incremental Cash Flows  After-tax free cash flows must be measured incrementally.  Determining incremental free cash flow involves determining the cash flows with and without the project. Incremental is the “additional cash flows” (inflows or outflows) that occur due to the project.

11-9 © 2011 Pearson Prentice Hall. All rights reserved. Beware of Diverted Cash Flows  Not all incremental free cash flow is relevant.  Thus new product sales achieved at the cost of losing sales from existing product line are not considered a benefit.  However, if the new product captures sales from competitors or prevents loss of sales to new competing products, it would be a relevant incremental free cash flows.

11-10 © 2011 Pearson Prentice Hall. All rights reserved. Incidental or Synergistic Effects  Although some projects may take sales away from a firm’s current projects, in other cases new products may add sales to the existing line. This is called synergistic effect and is a relevant cash flow.

11-11 © 2011 Pearson Prentice Hall. All rights reserved. Working Capital Requirement  New projects require infusion of working capital (such as inventory to stock the shelves), which would be an outflow.  Generally, when the project terminates, working capital is recovered and there is an inflow of working capital.

11-12 © 2011 Pearson Prentice Hall. All rights reserved. Sunk Costs  Sunk costs are cash flows that have already occurred (such as marketing research) and cannot be undone. Sunk costs are considered irrelevant to decision making.  Managers need to ask two basic questions:  Will this cash flow occur if the project is accepted?  Will this cash flow occur if the project is rejected?  If the answer is “Yes” to #1 and “No” to #2, it will be an incremental cash flow.

11-13 © 2011 Pearson Prentice Hall. All rights reserved. Opportunity Costs  Opportunity cost refers to cash flows that are lost because of accepting the current project.  For example, using the building space for the project will mean loss of potential rental revenue.

11-14 © 2011 Pearson Prentice Hall. All rights reserved. Overhead Costs  Must include incremental overhead costs or costs that were incurred as a result of the project and relevant to capital budgeting  Note, not all overhead costs may be relevant (example, utilities bill may have been the same with or without the project)

11-15 © 2011 Pearson Prentice Hall. All rights reserved. Interest Payments and Financing Costs  Interest payments and other financing cash flows that might result from raising funds to finance a project are not relevant cash flows.  Reason: Required rate of return implicitly accounts for the cost of raising funds to finance a new project.

11-16 © 2011 Pearson Prentice Hall. All rights reserved. 2. Free Cash Flow Calculations  Three components of free cash flows:  The Initial outlay  The differential flows over the project’s life  The Terminal cash flow

11-17 © 2011 Pearson Prentice Hall. All rights reserved. 2.1 Initial Cash Outlay  The initial cash outlay is the immediate cash outflow necessary to purchase the asset and put it in operating order.  This includes: (1) Purchase cost, Set-up cost, Installation, Shipping/Freight (2) increased working-capital requirements (3) sale of existing asset and tax implications (if the project replaces an existing project/asset)

11-18 © 2011 Pearson Prentice Hall. All rights reserved. Sale and Taxes  If Sale = Book Value ==> No tax effect  If sale > BV (but less than cost) ==> recaptured depreciation, taxed as ordinary income  If sale > BV (greater than cost) ==> anything above cost, taxed as capital gain, rest taxed as recaptured depreciation  If sale capital loss ==> tax savings

11-19 © 2011 Pearson Prentice Hall. All rights reserved. 2.2 Annual Free Cash Flows  Annual free cash flows is the incremental after-tax cash flows resulting form the project being considered.  Free Cash flow considers the following:  Cash flow from operations  Cash flows from working capital requirements  Cash flows from capital spending

11-20 © 2011 Pearson Prentice Hall. All rights reserved. Calculating Operating Cash Flows  Step 1: Measure the project’s change in after-tax operating cash flows  Operating cash flows = Changes in EBIT – Changes in taxes + Change in depreciation Note, depreciation is a non-cash expense but influences the cash flows through impact on taxes (see next two slides).

11-21 © 2011 Pearson Prentice Hall. All rights reserved. Depreciation and Cash Flow  Earnings before Tax and Dep.40,000  Depreciation25,000  Earnings before tax (EBT)15,000  If the corporation is taxed at 30%, taxes =.3*15000 = $4,500  If the depreciation was $0, EBT = $40,000 and taxes =.3*40000 = $12,000

11-22 © 2011 Pearson Prentice Hall. All rights reserved. Depreciation and Cash Flow  ==> Depreciation is a “non-cash expense” BUT affects Cash Flow through its impact on “taxes”;  Depreciation ==>  in Expense ==>  in taxes =>  CF

11-23 © 2011 Pearson Prentice Hall. All rights reserved. Change in Net Working Capital  Step 2: Calculate the cash flows from the change in net working capital This refers to additional investment in current assets minus any additional short-term liabilities that were generated.

11-24 © 2011 Pearson Prentice Hall. All rights reserved. Steps in Calculating Operating Cash Flows  Step 3: Determine the cash flows from the change in capital spending This refers to any capital spending requirements during the life of the project.

11-25 © 2011 Pearson Prentice Hall. All rights reserved. Putting it all together  Step 4: Project free cash flows = change in EBIT – changes in taxes + change in depreciation – change in net working capital – change in capital spending

11-26 © 2011 Pearson Prentice Hall. All rights reserved. 2.3 Terminal Cash Flow  Terminal cash flows are flows associated with the project at termination.  It may include:  Salvage value of the project  Any taxable gains or losses associated with the sale of any asset

11-27 © 2011 Pearson Prentice Hall. All rights reserved. Refer to Example 11.2  Initial outlay = $200,000 + $30,000 = $230,000  ∆Operating cash flow = EBIT + Depreciation = $155,600 (see Tables 11-1, 11-2)  Terminal free cash flows = ∆Operating cash flow + ∆ net working capital = $185,600 (See Table 11-3)

11-31 © 2011 Pearson Prentice Hall. All rights reserved. 3. Options in Capital Budgeting  Options add value to capital budgeting project by being able to modify the project based on future developments (that are currently unknown). Some common options are:  Option to delay a project  Option to expand a project  Option to abandon a project

11-32 © 2011 Pearson Prentice Hall. All rights reserved. Option to Delay  Almost every project has a mutually exclusive alternative—waiting and pursuing at a later time.  It is conceivable that a project with a negative NPV now may have a positive NPV if undertaken later on. This could be due to various reasons such as favorable changes in fashion, technology, economy, or borrowing costs.

11-33 © 2011 Pearson Prentice Hall. All rights reserved. Option to Expand  Even if a project is currently unprofitable, it may be useful to determine whether the profitability of the project will change if the company is able to expand in the future.  Example: Firms investing in negative NPV projects to gain access to new markets

11-34 © 2011 Pearson Prentice Hall. All rights reserved. Option to Abandon  It may be necessary to abandon the project before its estimated life due to inaccurate project analysis models or cash flow forecasts or due to changes in market conditions.  When comparing two projects with similar NPVs, project that is easier to abandon may be more desirable (example, temporary versus permanent workers, lease versus buy)

11-35 © 2011 Pearson Prentice Hall. All rights reserved. 4. Risk and the Investment Decision Two main issues:  What is risk and how should it be measured?  How should risk be incorporated into a capital budgeting analysis?

11-37 © 2011 Pearson Prentice Hall. All rights reserved. Project Standing Alone Risk  This is a project’s risk ignoring the fact that much of the risk will be diversified away as the project is combined with other projects and assets.  This is an inappropriate measure of risk for capital budgeting projects.

11-38 © 2011 Pearson Prentice Hall. All rights reserved. Contribution-to-Firm Risk  This is the amount of risk that the project contributes to the firm as a whole;  This measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets but ignores the effects of diversification of the firm’s shareholders.

11-39 © 2011 Pearson Prentice Hall. All rights reserved. Systematic Risk  Risk of the project from the viewpoint of a well-diversified shareholder;  This measure takes into account that some of the risk will be diversified away as the project is combined with the firm’s other projects and in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolios.

11-40 © 2011 Pearson Prentice Hall. All rights reserved. Relevant risk  Theoretically, the only risk of concern to shareholders is systematic risk.  Since the project’s contribution-to-firm risk affects the probability of bankruptcy for the firm, it is a relevant risk measure.  Thus we need to consider both the project’s contribution-to-firm risk and the project’s systematic risk.

11-41 © 2011 Pearson Prentice Hall. All rights reserved. Incorporating Risk into Capital Budgeting  We know that investors demand higher returns for more risky projects.  As the risk of a project increases, the required rate of return is adjusted upward to compensate for the added risk.  This risk adjusted discount rate is then used for discounting free cash flows (in NPV model) or as the benchmark required rate of return (in IRR model)

11-42 © 2011 Pearson Prentice Hall. All rights reserved. 5. Measurement of Systematic Risk  Estimating risk of a project can be difficult Historical stock return data relates to an entire firm, rather than a specific project or division. Risk must be estimated. Options to estimate risk include:  Accounting Beta  Pure Play Method  Simulation  Scenario Analysis  Sensitivity Analysis

11-43 © 2011 Pearson Prentice Hall. All rights reserved. Beta  Accounting Beta Method  Can be estimated via time-series regression on a division’s return on assets on the market index  Pure Play Method  Identifies publicly traded firms engaged solely in the same business as the project, using that firm’s return data to judge the project.

11-44 © 2011 Pearson Prentice Hall. All rights reserved. Simulation  Involves the process of imitating the performance of the project under evaluation (See Figure 11-6)  Done by randomly selecting observations from each of the distributions that affect the outcome of the project and continuing with this process until a representative record of the project’s probable outcome is assembled.

11-46 © 2011 Pearson Prentice Hall. All rights reserved. Sensitivity Analysis  Determining how the distribution of possible net present values or internal rate of return for a particular project is affected by a change in one particular input variable while holding all other input variables constant (also known as what-if analysis).

11-47 © 2011 Pearson Prentice Hall. All rights reserved. 6. The Multinational Firm  Process of measuring the incremental after-tax cash flows to the company as a whole gets more difficult when dealing with competition from abroad.  Calculating the right base case (i.e. incremental cash flows if project not taken) is difficult  International opportunities come with risks such as currency fluctuations that can distort cash flow projections.

Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 11 Cash Flows and Other Topics in Capital Budgeting.

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Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 11 Cash Flows and Other Topics in Capital Budgeting.

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