1. FI 3300 - Corporate Finance Zinat Alam 1 FI3300 Corporation Finance – Chapter 11 Cash Flow & Capital Budgeting

2. FI 3300 - Corporate Finance Zinat Alam 2 Learning Objectives Find project cash flows Describe the difference between independent and mutually exclusive projects. Compare projects with different lives using the equivalent annual series technique.

3. FI 3300 - Corporate Finance Zinat Alam 3 Estimating project cash flows 1 For this chapter, we focus on the NPV, IRR and PI capital budgeting rules. To apply these rules, we need the project’s cash flows and the appropriate discount rate. In this chapter, you will learn how to estimate a project’s cash flows. The discount rate will still be given to you.

4. FI 3300 - Corporate Finance Zinat Alam 4 Estimating project cash flows 2  Guidelines: Add back depreciation to net income. Ignore interest expense. All project cash flows must be incremental. Ignore allocated costs and sunk costs. Include opportunity costs. Net working capital.

5. FI 3300 - Corporate Finance Zinat Alam 5 Add back depreciation Depreciation is a non-cash charge and must be added to net income to estimate cash flow. Cash flow = net income + depreciation expense = (revenue – cost)x(1-t c ) + (t c x depreciation) t c : corporate tax rate Note: Cost = all costs except depreciation

6. FI 3300 - Corporate Finance Zinat Alam 6 Ignore interest expense A project’s value (desirability) is determined by the cash flows that generates, not by how the project is financed. In determining a project’s cash flows, we ignore it’s financing cost, i.e., the interest expense.

7. FI 3300 - Corporate Finance Zinat Alam 7 All project cash flows must be incremental  To evaluate a project, we look at the cash flows which it contributes towards the firm’s existing cash flows. In other words, we look at project’s incremental cash flows. How to determine incremental cash flows? Look at the firm’s cash flows without the project. Look at the firm’s cash flows with the project. The difference is the incremental cash flows.

8. FI 3300 - Corporate Finance Zinat Alam 8 Ignore allocated costs and sunk costs Allocated costs: rent, supervisory salaries, administrative costs, and various overhead expenses. These costs are not incremental. They don’t change even if the project is undertaken. Thus, they should not be considered in estimating the project’s incremental cash flows. Sunk (irrecoverable) costs: costs which cannot be recovered regardless of whether the firm undertakes the project. Examples: R&D expenses, consultant fees.

9. FI 3300 - Corporate Finance Zinat Alam 9 Include opportunity costs Suppose the project requires the use of some asset owned by the firm. If the asset is not used by the project, the firm can sell the asset for $X. This $X is the opportunity cost of the asset. Such a cost should be included in the project’s cost. An asset’s opportunity cost is the money that the firm can receive if the asset is put to the next best use. The ‘next best’ use may be to sell the asset.

10. FI 3300 - Corporate Finance Zinat Alam 10 Net working capital 1 Very often, a project will require an initial increase in net working capital. This increase in net working capital must be added to the project’s costs. Assume that this additional working capital is liquidated (sold for cash) at the end of the project’s life. This liquidation is a cash inflow in the last period.

11. FI 3300 - Corporate Finance Zinat Alam 11 Net working capital 2 The opposite pattern is also possible. In other words, if taking on a project REDUCES the net working capital, then the size of this reduction is subtracted from the project’s initial cost. the last period cash inflow.

12. FI 3300 - Corporate Finance Zinat Alam 12 Capital budgeting example  Problem 11.6 You are given the responsibility of conducting the project selection analysis in your firm. You have to calculate the NPV of a given project. The appropriate cost of capital is 12 percent and the firm is in the 30 percent tax bracket. You are provided the following pieces of information regarding the project:

13. FI 3300 - Corporate Finance Zinat Alam 13 Details The project is going to be built on a piece of land that the firm already owns. The market value of the land is $1 million. If the project is undertaken, prior to construction, an amount of $100,000 would have to be spent to make the land usable for construction purposes. In order to come up with the project concept, the company had hired a marketing research firm for $200,000. The firm has spent another $250,000 on R&D for this project.

14. FI 3300 - Corporate Finance Zinat Alam 14 Details The project will require an initial outlay of $20 million for plant and machinery. The sales from this project will be $15 million per year of which 20 percent will be from lost sales of existing products. The variable costs of manufacturing for this level of sales will be $9 million per year. The company uses straight-line depreciation. The project has an economic life of ten years and will have a salvage value of $3 million at the end.

15. FI 3300 - Corporate Finance Zinat Alam 15 Details Because of the project the company will need additional working capital of $1 million which can be liquidated at the end of ten years. The project will require additional supervisory and managerial manpower that will cost $200,000 per year. The accounting department has allocated $350,000 as allocated overhead cost for supervisory and managerial salaries.

16. FI 3300 - Corporate Finance Zinat Alam 16 Calculate initial cost  Initial cost is the sum of: Market value of land: $1 mil (opportunity cost) Land improvement $100 k Plant & machinery: $20 mil Incremental working capital: $1 mil Initial cost = 1,000,000 + 100,000 + 20,000,000 + 1,000,000 = $22,100,000

17. FI 3300 - Corporate Finance Zinat Alam 17 Calculate the annual incremental cash flow: step 1  Calculate the annual depreciation expense For this project, fixed assets refer to $20mil plant & machinery. Therefore, Depreciation = (20,000,000 – 3,000,000)/10 = $1,700,000  Calculate incremental sales Incremental sales = 0.8 x 15,000,000 = $12,000,000

18. FI 3300 - Corporate Finance Zinat Alam 18 Calculate the annual incremental cash flow: step 2 Draw up the incremental income statement Incremental sales12,000,000 Less Incremental variable cost9,000,000 Less Incremental managerial salaries200,000 Less Incremental depreciation1,700,000 Equals Incremental taxable income1,100,000 Less Incremental tax @30%330,000 Equals Incremental net income770,000 Add back depreciation1,700,000 Incremental cash flow$2,470,000

19. FI 3300 - Corporate Finance Zinat Alam 19 Consider other cash flows  At the end of project’s life (t=10), company Recovers $1 mil additional working capital (item 9) Receives $3 mil salvage value from plant & machinery (item 8) Additional cash flows at end of project = 1,000,000 + 3,000,000 = $4,000,000

20. FI 3300 - Corporate Finance Zinat Alam 20 Let’s bring all the cash flows together 1 CF0 (initial cost) = $22,100,000 Annual incremental after-tax cash flow (Year 1 through Year 10) = $2,470,000 Additional cash flow in Year 10 = $4,000,000  So in year 10, the company receives a total of = 2,470,000 + 4,000,000 = $6,470,000

21. FI 3300 - Corporate Finance Zinat Alam 21 Let’s bring all the cash flows together 2 To compute NPV, enter cash flows in this way: CF0 = -22,100,000 C01 = 2,470,000, F01=9 C02 = 6,470,000, F02=1 Then press NPV, enter I = 12, press CPT and NPV. NPV = -$6,856,056.17 Decision: reject the project.

22. FI 3300 - Corporate Finance Zinat Alam 22 Mutually Exclusive Projects  Projects are mutually exclusive if accepting one implies that the other projects will be foregone.  When projects are mutually exclusive and have equal lives, you have to  rank the projects based on their NPVs  choose the best project, provided the project’s NPV is positive  With mutually exclusive projects, choosing the project with the highest NPV is always correct.

23. FI 3300 - Corporate Finance Zinat Alam 23 Question  Consider the following mutually exclusive projects, for a firm using a discount rate of 10%: ProjectNPVIRRPI A$100,00010.2%1.04 B$111%1.11 C$70,00023%1.32 D$24,00013%1.44 Which project(s) should the firm accept and why?

24. FI 3300 - Corporate Finance Zinat Alam 24 Comparing projects with unequal lives: Equivalent annual series (EAS)  When projects are mutually exclusive but have unequal lives We construct the equivalent annual series (EAS) of each project and We choose the project with the highest EAS  A project’s EAS is the payment on an annuity whose life is the same as that of the project and whose present value, using the discount rate of the project, is equal to the project’s NPV.

25. FI 3300 - Corporate Finance Zinat Alam 25 Calculating EAS  Consider Projects J & K, with the following cash flows. The discount rate is 10%. ProjectC0C1C2C3C4 J-120006000 K-180007000

26. FI 3300 - Corporate Finance Zinat Alam 26 EAS for Project J  To compute Project J’s EAS, do the following: Compute Project J’s NPV Verify that NPV(J) = $2,921.11 Find the payment on the 3-year (life of project J) annuity whose PV is equal to $2,921.11. Enter the following values: N=3, I/Y=10, PV=-2921.11, FV=0, Then CPT, PMT. PMT = 1,174.62, which is Project J’s EAS. So, finding EAS is nothing more than finding the payment of an annuity.

27. FI 3300 - Corporate Finance Zinat Alam 27 EAS for Project K Verify that Project K’s NPV= $4,189.06 Find the payment on the 4-year (life of project K) annuity whose PV is equal to $ 4,189.06. Enter the following values: N=4, I/Y=10, PV=- 4,189.06, FV=0, Then CPT, PMT. PMT = 1,321.53, which is Project K’s EAS. Recall that Project J’s EAS=1174.62 So, choose Project K since it has the higher EAS.

28. FI 3300 - Corporate Finance Zinat Alam 28 Another application of EAS  We can use the EAS concept to choose between two machines that do the same job but have different costs and lives.  Consider the following problem.

29. FI 3300 - Corporate Finance Zinat Alam 29 Problem 11.9  Suppose that your firm is trying to decide between two machines, that will do the same job. Machine A costs $90,000, will last for ten years and will require operating costs of $5,000 per year. At the end of ten years it will be scrapped for $10,000. Machine B costs $60,000, will last for seven years and will require operating costs of $6,000 per year. At the end of seven years it will be scrapped for $5,000. Which is a better machine? (discount rate is 10 percent)

30. FI 3300 - Corporate Finance Zinat Alam 30 Step 1: compute the PV of the costs of each machine PV of costs (A) = $90,000 + PV of $5,000 annuity for ten years - PV of the scrap (at t = 10) value of $10,000 = 90000 + 30722.84 – 3855.43 = $116,867.41 PV of costs (B) = $60,000 + PV of $6,000 annuity for seven years - PV of the scrap (at t = 7) value of $5,000 = $60,000 + $29,210.51 - $2,565.79 =$86,644.72

31. FI 3300 - Corporate Finance Zinat Alam 31 Step 2: compute equivalent annual cost (EAC) series of each machine  The equivalent annual cost series is the payment of an annuity that has the same present value as the PV of the machine’s cost. EAC of machine A, EAC(A):  N = 10, I/Y = 10, PV = -116867.41, FV = 0. Then CPT, PMT. This yields EAC(A) = $19,019.63. EAC of machine B, EAC(B):  N = 7, I/Y = 10, PV = -86644.72, FV = 0. Then CPT, PMT. This yields EAC(B) = $17,797.30.  Choose machine B because it has the lower cost.

32. FI 3300 - Corporate Finance Zinat Alam 32 Summary Estimating a project’s after-tax incremental cash flows. Choosing between mutually exclusive projects. Comparing projects with unequal lives using the EAS technique.

33. FI 3300 - Corporate Finance Zinat Alam 33 Another problem (Based on Spring 2001 Final Exam)  ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO has collected the following information about the proposed product.

34. FI 3300 - Corporate Finance Zinat Alam 34 Details 1) The project has an anticipated economic life of 5 years. 2) The company will have to purchase a new machine to produce the screens. The machine has an up front cost (t = 0) of $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (that is, it will be worthless).

35. FI 3300 - Corporate Finance Zinat Alam 35 Details 3) If the company goes ahead with the proposed product, it will have to increase inventory by $280,000 and accounts payable by $80,0000. At t = 5, the net working capital will be recovered after the project is completed. 4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue.

36. FI 3300 - Corporate Finance Zinat Alam 36 Details 5) The company’s interest expense each year will be $350,000. 6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year. 7) The company’s cost of capital is 12%. 8) The company’s tax rate is 30%.

37. FI 3300 - Corporate Finance Zinat Alam 37 Questions What is the initial investment for the project? What is the 3 rd year expected incremental operating cash flow? (i.e., the incremental after tax cash flow) What is the 5 th year incremental non- operating cash flow?

38. FI 3300 - Corporate Finance Zinat Alam 38 Q1: initial investment To answer Q1, you need points 2 & 3. Initial investment = machine cost + change in net working capital = 4,000,000 + (change in current assets – change in current liabilities) = 4,000,000 + (280,000 – 80,000) = $4,200,000

39. FI 3300 - Corporate Finance Zinat Alam 39 Q2: 3 rd incremental operating cash flow To answer Q2, you need points 2,4,6,8. Steps: 1) Incremental sales = 4,500,000 – 500,000 = 4,000,000 2) Annual depreciation = (4,000,000)/5 = 800,000 3) Incremental operating cost for 3 rd year = 0.5 x 4,500,000 = 2,250,000 Next, draw up the incremental income statement

40. FI 3300 - Corporate Finance Zinat Alam 40 Draw up the incremental income statement Incremental sales4,000,000 Less Incremental operating cost2,250,000 Less Incremental depreciation800,000 Equals Incremental taxable income950,000 Less Incremental tax @30%285,000 Equals Incremental net income665,000 Add back depreciation800,000 Incremental cash flow$1,465,000 Q2: 3rd incremental operating cash flow

41. FI 3300 - Corporate Finance Zinat Alam 41 Q3: 5 th year incremental non-operating cash flow Very simple. The only incremental non- operating cash flow is the cash flow from liquidating the increase in net working capital (point 3). 5 th incremental non-operating cash flow = $200,000