Maximizing Returns: Project Cash Flows and Investment Decisions

1. Chapter eight Making capital investment decisions

2. Learning objectives LO8.1 Understand how to determine the relevant cash flows for a proposed project. LO8.2 Understand how to determine if a project is acceptable. LO8.3 Understand how to set a bid price for a project. LO8.4 Understand how to evaluate the equivalent annual cost of a project.

3. Chapter organisation • Project cash flows: a first look • Incremental cash flows • Project cash flows • More on project cash flows • Some special cases of discounted cash flow analysis • Summary and conclusions

4. Project cash flows • The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project. • The stand-alone principle is the evaluation of a project based on the project’s incremental cash flows.

5. Types of cash flows • Sunk costs  a cost that has already been incurred and cannot be removed  incremental cash flow. • Opportunity costs  the most valuable alternative that is given up if a particular investment is undertaken = incremental cash flow. • Side effects  erosion  the cash flows of a new project that come at the expense of a firm’s existing projects = incremental cash flow. continued

6. Types of cash flows • Financing costs  the interest rate used to discount the cash flows reflects, in part, the financing costs of the project  incremental cash flow. • An investment of the firm in the project’s net working capital represents an additional cost of undertaking the investment. • Always use after-tax incremental cash flow, since taxes are definitely a cash flow.

7. Investment evaluation Step 1  Calculate the tax effect of the decision. Step 2  Calculate the cash flows relevant to the decision. Step 3  Discount the cash flows to make the decision.

8. Example—Investment evaluation • Purchase price $42 000. • Salvage value $1 000 at end of Year 3. • Net cash flows: Year 1 $31 000 Year 2 $25 000 Year 3 $20 000. • Tax rate is 30%. • Depreciation 20%, reducing balance. • Required rate of return 12%.

9. Solution—Depreciation schedule

10. Solution—Taxable income

11. Year 0 Year 1 Year 2 Year 3 Tax paid (6 780) (5 484) 1 764 Net cash flow 31 000 25 000 20 000 Salvage value 1 000 Outlay (42 000) Cash flow $(42 000) $24 220 $19 516 $22 764 Solution—Cash flows

12. Solution—NPV and decision Decision: NPV > 0, therefore, ACCEPT.

13. Interest • As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return). • Interest costs should not, therefore, be included as an explicit cash flow. • Interest costs are included in the required rate of return (discount rate) used to evaluate the project.

14. Depreciation • The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes. • Depreciation is a non-cash expense; consequently, it is only relevant because it affects taxes. continued

15. Depreciation • There are two methods of depreciation: • prime cost (straight-line method in accounting) • diminishing value (reducing balance method in accounting) • Depreciation tax shield = DT where D = depreciation expense T = marginal tax rate.

16. Disposal of assets • If the salvage value > book value, a gain is made on disposal. This gain is subject to tax (excess depreciation in previous periods). • If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods).

17. Capital gains tax • Capital gains made on the sale of assets such as rental property are subject to taxation. • For taxation purposes, the calculation of a capital gain is complicated and depends upon whether the seller is an individual or an entity, such as a company or trust. • Capital losses are not a tax deduction but can be offset against future capital gains.

18. Inflation • When a project is being evaluated, anticipated inflation would be reflected in the estimates of the future cash flows and the interest rate used as the discount rate in the analysis. • As a result, there will be no distortion to the analysis by not identifying inflation specifically.

19. Incremental form of analysis • The description ‘incremental’ is often replaced by ‘marginal’. • The advantage of using a marginal form of analysis is that there will only be one calculation and not two. • By using a marginal form we are implicitly analysing one option: that is, to do nothing. • The sign of the NPV tells us whether or not it is sensible to change.

20. Example—Incremental cash flows A firm is currently considering replacing a machine purchased two years ago, with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below:

21. Solution—Taxable income

22. Solution—Cash flows

23. Solution—NPV and decision Decision: NPV < 0, therefore, REJECT.

24. A note on cash flows • Cash flows do not always conveniently occur at the end of the period. • Taking revenue at the period end is a conservative approach to evaluation. • If the facts make it necessary to take cash flows as occurring at the beginning of the period, this only requires a minor adjustment to the analysis. • The period examined could be yearly, monthly or even weekly. If so, the discount rate must match the period (e.g. a weekly analysis needs a weekly rate).

25. Setting the bid price • How to set the lowest price that can be profitably charged. • Cash outflows are given. • Determine cash inflows that result in zero NPV at the required rate of return. • From cash inflows, calculate sales revenue and price per unit.

26. Example—Setting the bid price • Consider the following information: • A local distributor has requested bid for 5 trucks each year for the next 4 years. • You can buy a truck for $12 000. • Need to lease a factory space for $30 000 per year. • Labour and material costs are $ 6 000 per year. • Requires $72 000 in fixed assets (initial outlay) with expected salvage of $5 000 at the end of the project (depreciate straight-line). • Tax rate = 30% • Required return = 20% continued

27. Example—Setting the bid price Solution: • Step 1: Find the net initial outlay • Step 2: Find the cash inflows (CFs) over the life of the project that makes NPV zero. continued

28. Example—Setting the bid price • Assuming that the CF is the same for each year and that it occur at the end of each year, we can write: continued

29. Example—Setting the bid price • Step 3: Find the sale price that gives a cash inflow of $27 161 per year. Cash inflow = Profit + Depreciation $27 161 = Profit + ($72 000/4) Profit = $27 161 − $18 000 = $9 161 We know: Profit = (Sales − Costs − Depreciation)(1 − TC) Sales = $9 161/0.70 + $120 000 + $18 000 = $151 087 Sales per truck = $151 087 / 5 = $30 218

30. Setting the option value • A buy option is an arrangement that gives the holder the right to buy an asset at a fixed price sometime in the future. Option value = Asset value × Probability of the value – Present value of the exercise price × Probability the exercise price will be paid

31. Annual equivalent cost (AEC) • When comparing two mutually-exclusive projects with different lives, it is necessary to make comparisons over the same time period. • AEC is the present value of each project’s costs calculated on an annual basis. • NPVs are calculated, and then converted to AECs using the relevant PVIFA (present value interest factor for annuities). • Select the project with the lowest AEC.

32. Example—AEC • Project A costs $3 000, and then $1 000 per annum for the next four years. • Project B costs $6 000, and then $1 200 for the next eight years. • Required rate of return for both projects is 10 per cent. • Which is the better project?

33. Solution—Project A

34. Solution—Project B

35. Solution—Interpretation ‘Project A is better, because it costs $1 946 per year compared to Project B’s $2 325 per year’.

36. Annual equivalent benefit (AEB) • The AEB is used when comparing projects with cash inflows and outflows, but with unequal lives. • The steps required to calculate the AEB are the same as those used for AEC. • Select the project with the highest AEB.

37. Quick quiz • How do we determine if cash flows are relevant to the capital budgeting decision? • What are the different methods for computing operating cash flow, and when are they important? • What is the basic process for finding the bid price? • What is equivalent annual cost, and when should it be used?

38. Summary and conclusions • Discounted cash flow (DCF) analysis is a standard tool in the business world. • The information provided for a specific decision may be complex; however, the analysis reduces to three distinct steps: Step 1  Calculate the taxable income Step 2  Calculate the cash flows relevant to the decision Step 3  Discount the cash flows to make the decision. • Cash flows should be identified in a way that makes economic sense.