Capital Budgeting – Further Considerations

1. Capital Budgeting – Further Considerations For 9.220, Term 1, 2002/03 02_Lecture10.ppt

2. Lecture Outline • Introduction • The input for evaluating projects – relevant cash flows • Inflation: real vs. nominal analysis • Taxes: the basics – preview this section prior to the next lecture • This section includes assigned readings; make sure you do them prior to class. • Summary and conclusions

3. Introduction • Up to this point we have examined the methods or techniques for capital budgeting: NPV, IRR, PI, Payback, AAR. • All, except AAR, use cash flows for the analysis. AAR is not accepted as a good technique of analysis. • Now we turn to cash-flow analysis. From where do we get the cash flows? We need to determine which cash flows should be included in the analysis and how to include them properly. Here we bring in the concepts of relevant cash flows, inflation, and taxes.

4. Relevant cash flows • The main principles behind which cash flows to include in capital budgeting analysis are as follows: • Only include cash flows that change as a result of the project being analyzed. Include all cash flows that are impacted by the project. This is often called an incremental analysis – looking at how cash flows change between not doing the project vs. doing the project.

5. Relevant cash flows • Use projections of cash flows, not accounting income. • Accounting income ≠ cash. Accounting income cannot be spent, a firm can be losing cash but have positive accounting income, so accounting income is not necessarily representative of cash. Cash is what really generates value; cash can be spent! • Depending on arbitrary accounting policies, income can easily be manipulated, so, by itself, it is not a reliable input for capital budgeting analysis.

6. Which cash flows are relevant to the project analysis, which are not?

7. Working Capital Changes Required by the Project – the cash flow effects • Working capital (WC) items do not show up as costs or revenues, however changes to the WC items either require or free-up cash. • Increases in current assets required for the project imply that cash is used so a cash outflow occurs. • To increase inventories requires cash. • To increase the cash-register float also requires cash. • An increase in accounts receivable (AR) means that the cash you may have recognized, through revenue, hasn’t been received yet. In effect, if your project requires you to increase credit for your customers (an AR increase), then this uses up cash that you would otherwise have.

8. More on working capital changes • Increases in current liabilities, on the other hand, free-up cash, so a cash inflow occurs. • Increasing accounts payable (AP) means that a cost cash flow you may have recognized elsewhere has not yet been paid, therefore the increase in AP is a cash saving or inflow. • For other payables, the analysis is the same. • Salaries payable, utilities payable, etc. • Overall, changes in net working capital (NWC) represent cash flows.

9. Without the Project With the Project (that ends in 2005) Working Capital Example

10. NWC Solution • No project, NWC cash flows are as follows: • With the project, NWC cash flows are as follows: • Change in NWC results in the following incremental cash flows that should be included in the project analysis:

11. Salvage Values and Clean-up Costs – Self Study • The change in salvage value or clean-up costs represent cash flows related to a project. • Example: consider a project to build an ice-cream stand on some leased land that is currently used for a parking lot. At the end of the lease, in 5 years, the land must be returned to a natural state.

12. Without the Ice-Cream Stand Project Year 0 cash flow: $0. Nothing needs to be done, the parking lot can continue for 5 years. Year 5 cash flows: -$20,000 to clean up the parking lot material. Sell the parking lot gate for scrap for $200. With the Ice-Cream Stand Project Year 0 cash flows: -$14,000 to partially clean up the parking lot material now. Sell parking lot gate for $1,500. Year 5 cash flows: -$16,000 to clean up the remaining parking lot material and remove ice cream stand. Sell ice cream stand for scrap for $1,000. Salvage/Clean-up Analysis – Self Study Do the incremental analysis

13. Salvage/Clean-up Solution – Self Study

14. Inflation • Sometimes a projected cash flow is given as a nominal amount (the expected actual amount of cash to be received or paid). • Sometimes a projected cash flow is given as a real amount (the current or date 0 purchasing power of the cash flow. • Note, the real cash flow is not the PV.

15. Nominal/Real Cash Flow Examples • Fred’s contract with his employer states that he will be paid $100,000 three years from now. • Currently, the “basket of goods” used to measure the consumers’ price index costs $125. Sue expects to receive a cash flow in four years that will allow her to purchase 100 of these baskets. • This can be represented by a real cash flow.

16. Are real cash flows the same as present values? • No! • Which would you prefer to receive, $1,250 today (which can buy 10 “baskets of goods”) or a dollar amount in 5 year that will buy 10 “baskets of goods” then? • The $1,250 today is preferred even though, in terms of purchasing power, both payments give the same purchasing power. • Since the $1,250 today is preferred, the two cash flows cannot have the same present value.

17. How do we discount real cash flows? • Consider the basket of goods that costs $125 today. Suppose inflation is expected to be 5% each year for the next 5 years. • How much, in real dollars, do we need to be able to purchase 10 baskets in 5 years? • Let this be our real cash flow • How much, in nominal dollars do we need to be able to purchase the same 10 baskets in 5 years? • This must be the equivalent nominal cash flow • What is the relation between the real and nominal cash flow? (be exact – formula?)

18. Discounting real vs. nominal cash flows (continued) • If the relevant discount rate for the nominal cash flow is 12%, then what is its PV today? • What discount rate applied to the real cash flow would get the same PV today? • What is the relation between the real discount rate and the nominal discount rate? (be exact – formula?)

19. Conclusions on real and nominal cash flows • It is possible to express any cash flow as either a real amount or a nominal amount. • Since the real and nominal amounts are equivalent, the PV’s must be equivalent, so remember the rule:

20. Use of real cash flows • If a project’s cash flows are expected to grow with inflation, then it may be more convenient to express the cash flows as real amounts rather than trying to predict inflation and the nominal cash flows.

21. Taxes: the basics • Unfortunately, in most civilized countries both corporations and individuals must pay tax on income and profits. • Tax is a cash outflow (yes, really). So we must include taxes in our capital budgeting analysis.

22. Calculating tax effects from non-financing components of the income statement. • Recall the income statement you learned about in accounting … • Whatever affects the income statement amounts will also affect the taxes paid. • *Assume depreciation here is what is recognized for tax purposes. In Canada, this is called capital cost allowance, CCA. • **The interest expense is financing related, so interest and its tax effect should be removed from our analysis.

23. Tax consequences and after tax cash flows (assume a tax rate, Tc, of 40%)

24. Yearly cash flows after tax • Normally we project yearly cash flows for a project and convert them into after-tax amounts. • CCA deductions are due to an asset purchase for a project. CCA is calculated as a % of the Undepreciated Capital Cost (UCC). Since a % amount is deducted each year, the UCC will never reach zero so CCA deductions can actually continue even after the project has ended (and thus shelter future income from taxes). All CCA-caused tax savings should be recognized as cash inflows for the project that caused them.

25. CCA Preview – read thoroughly for next class • Read the assigned sections of Chapter 7, then pay particular attention to the following: • See table 7.3 and accompanying text in the chapter for an example of CCA and UCC calculations. See table 7.7 and accompanying text in the chapter for the corresponding CCA tax shields and the PV of the tax savings due to CCA. • Equation 7.6, p. 203, allows us to calculate the sum of the present values of all CCA tax shields and includes an adjustment in case the asset is sold (and reduces future CCA deductions). This equation, although complicated looking, is nothing more than the PV of one declining perpetuity minus the PV of a second declining perpetuity.

26. Summary and Conclusions • All relevant cash flows for a project must be included in the capital budgeting analysis for a project. • Relevant cash flows are those that change as a result of accepting the project. • We exclude things that don’t change. We also exclude interest charges or financing expenses because these are accounted for in the discount rate. • Tax effects must also be included. CCA is a special case to consider because the tax savings may continue beyond the end of the project. • Once we have all after-tax cash flow effects projected, we can conduct our analysis of a project using our preferred methods: NPV, IRR, or PI; Payback may also be used but its oversimplification should be recognized.