Cash Flow And Capital Budgeting

1. Cash Flow And Capital Budgeting Professor XXXXX Course Name / Number

2. To evaluate a capital investment we must know: • What cash outflows will occur as a result of the investment? • What cash inflows will the investment produce? • The timing and magnitude of cash flows and accounting profits can differ dramatically Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profit

3. 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 • Ignore depreciation expense but add back its tax savings

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

5. Depreciation • Many countries allow firms to use 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 Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements? For capital budgeting analysis, it is the depreciation method for tax purposes that matters

6. New equipment costs $10 million, $0.5 million to install An example.... Tax rate = 40% Old equipment has been fully depreciated, sold for $1 million • The initial investment would then be an outflow of $10.5 million, and an after-tax inflow of $0.60 million from selling the old equipment The Initial Investment • Many capital budgeting problems begin with an initial outflow to acquire/install fixed assets. Must also consider: • Cash inflow from selling old equipment • Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability)

7. Working Capital Expenditures • Many capital investments require additions to working capital • Net working capital (NWC) = current assets minus 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

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

9. Terminal Value Terminal value 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

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

11. Terminal Value of SDL Acquisition • If we 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

12. 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 expect increases of 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 Incremental Cash Flow

13. 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?

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

15. $50,000 for computer equipment (MACRS 5-year) Initial investment transactions: $4,500 for inventory ($2,500 of which purchased on credit) $1,000 increase in cash balances 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

16. Abbreviated Project Balance Sheet Year 0 1 2 3 4 5 6 Annual Cash Flow Estimates for Classicaltunes.com Year 0 1 2 3 4 5 6 Price per unit $13.50 $13.77 $14.05 $14.33 $14.61 $14.91 $15.20 Year 0 1 2 3 4 5 6 Cash 1000 2000 2500 3000 3200 3300 3500 Units 0 4,000 10,000 16,000 22,000 24,000 25,000 New Fixed Assets -50000 -10000 -5000 -25000 -40000 -15000 -10000 Accounts Receivable 0 4590 11705 19102 26790 29810 31673 Abbreviated Project Income Statement Change in working capital -3000 -6614 -12302 -12771 -12953 -5109 -3291 Inventory 4500 7344 18727 30563 42864 47696 50677 Revenue 0 55080 140454 229221 321482 357722 380080 Current Assets 5500 13934 32932 52665 72855 80806 85851 Cost of goods sold 0 41861 105341 169623 234682 259349 273657 Operating cash flow 4000 10174 14790 23591 40411 47644 48454 Gross P&E 50000 60000 65000 90000 130000 145000 155000 Gross profit 0 13219 35114 59597 86800 98374 106422 Accumulated Depreciation 10000 28000 41800 56080 79952 105160 123672 Net cash flow -49000 -6440 -2512 -14180 -12542 27535 35163 SG&A Expense 0 8262 19664 29799 35363 35772 38008 Net P&E 40000 32000 23200 33920 50048 39840 31328 Depreciation 10000 18000 13800 14280 23872 25208 18512 Total assets 45500 45934 56132 86585 122903 120646 117179 Pretax profit -10000 -13043 1649 15519 27565 37393 49903 Accounts Payable 2500 4320 11016 17978 25214 28057 29810 Projections for Jazz CD Proposal

17. 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 $5,500 outlay Net Cash Flow:

18. 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

19. 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:

20. 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)

21. 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:

22. Terminal Value for Jazz CD Investment • If assume that cash flow continues 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

23. NPV for Jazz CD Project • Using assumption that cash flow grows 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

24. Capital Budgeting and Inflation Inflation Rule 1 – if nominal rate used to discount cash flow of a project, the embedded inflation expectation in the nominal rate must be used to construct the cash flows • In analysis of Jazz CD’s investment, assumption that price of a CD increases by 2% per year on average • Revenues expressed in nominal terms • Discount rate used (10%) must reflect current market returns to account for inflation rate Inflation Rule 2 – when project cash flows are stated in real rather than nominal terms, the appropriate discount rate is the real rate • Cash flows projections for Classicaltunes.com could be expressed in real terms • Use current price for CDs of $13.50, current-year labor costs, current-year prices for fixed assets for projections of cash flows

25. Device 0 1 2 3 4 A 12000 1500 1500 1500 - B 14000 1200 1200 1200 1200 Device NPV A $15,936 B $18,065 Equipment Replacement and Unequal Lives • A firm must purchase an electronic control device • First alternative is a cheaper device, higher maintenance costs, shorter period of utilization • Second device is more expensive, smaller maintenance costs, longer life span • Expected cash outflows • Maintenance costs are constant over time. Use real discount rate of 7% for NPV Cash outflow device A < cash outflow device B  select A?

26. Device A Device B Equivalent Annual Cost (EAC) • EAC converts lifetime costs to a level annuity; eliminates the problem of unequal lives • 1. Compute NPV for operating devices A and B for their lifetime • NPV device A = $15,936 • NPV device B = $18,065 • 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device

27. Excess Capacity • Excess capacity – not a free asset as traditionally regarded by managers • Company has excess capacity in a distribution center warehouse • In two years the firm will invest $2,000,000 to expand the warehouse • The firm could lease the excess space for $125,000 per year for the next two years • Expansion plans should begin immediately in this case to hold inventory for stores that will come on line in a few months • Incremental cost – investing $2,000,000 at present vs. two years from today • Incremental cash inflow - $125,000

28. Excess Capacity • NPV of leasing excess capacity (assume 10% discount rate) • NPV negative – reject to lease excess capacity at $125,000 per year • The firm could compute the value of the lease that would allow to break even • X = $181,818 • Leasing the excess capacity for a price above $181,818 would increase shareholders wealth

29. The Human Face of Capital Budgeting • Managers must be aware of optimistic bias in these assumptions made by supporters of the project • Companies should have control measures in place to remove bias • Analysis of an investment done by a group independent of individual or group proposing the project • Analysts of the project 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

30. Cash Flow and Capital Budgeting Certain types of cash flows are common to many investments Opportunity costs should be included in cash flow projections Discount nominal cash flows at a nominal rate and real cash flows at a real rate Consider human factors in capital budgeting