Basic Corporate Finance 2-208-97 Lecture 6: Making Capital Investment Decision

1. Basic Corporate Finance2-208-97 Lecture 6: Making Capital Investment Decision

2. Outline for Lecture 6 Project Cash Flows Incremental Cash Flows Project Evaluation Examples Joshua Slive 2

3. Introduction So far, we have studied different parts of the capital budgeting decision. Now, we start bringing these pieces together to make an initial assessment about whether or not the project should be undertaken. Project Evaluation: The application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision. Joshua Slive 3

4. Project Cash Flows Relevant cash flows: The incremental cash flows from assets associated with the decision to invest in a project: any and all changes in the firm�s future cash flows that are a direct consequence of taking the project. Stand-alone principle: Evaluation of a project based on the project�s incremental cash flows. Joshua Slive 4

5. Joshua Slive 5 Cash flows not accounting income Examples: We make a big sale today but allow the customer to pay in 24 months. When should we record the revenue? We buy a delivery truck that will last us ten years. When should we record the expense? Cashflow simple to measure, highly variable and hence not a good measure of profitability Income income & expense accrual and matching principles non-cash items (ex.:depreciation expense) ignores time value of money How do we translate from Income to Cash flow? Note how disguising cashflow is much harder than disguising income (ie Worldcom, Enron)Note how disguising cashflow is much harder than disguising income (ie Worldcom, Enron)

6. Cash Flow From Assets (Sometimes called Free Cash Flow) Operating Cash Flow minus Increases in working capital minus Capital Spending Joshua Slive 6

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8. Operating Cash Flow Start with EBIT, add back non-cash items (like depreciation), and subtract tax. OCF = 35,020 + 13,945 � 7,232 = 41,733 Joshua Slive 8

9. Joshua Slive 9 Net Working Capital (NWC) Definition: Current Assets minus Current Liabilities We can approximate NWC as Cash + Inventory + Accounts receivable � Accounts payable Only the change in NWC is included in our cash flows. NWC is an asset, just like a truck. When we buy a truck, we count the cash flow only at the purchase. We don�t continue counting it each year we own the truck. When NWC increases, we have less money available for other investments. So: An increase in NWC leads to a decrease in cash flows to assets. Any NWC used by a project is returned at the end of the project as an increase in cash flows to assets.

10. Simple NWC Example Fair Play Toys Inc has a five year project to produce mechanical butterflies. This project will require an increase in inventory of $240,000. How will NWC contribute to the cash flow from assets for this project? Joshua Slive 10

11. Capital Spending Asset purchases and sales create cash flows at the time they occur. Always focus on markets values and not book (GAAP) values. We only use book values to calculate capital gains/loses: If we sell an asset for more than it�s book value, we must pay tax on the difference. Remember that the capital gains tax rate is 50% of the usual marginal tax rate. Joshua Slive 11

12. Joshua Slive 12 Trucksalot Example The Trucksalot company is planning to expand its current fleet of delivery trucks and has hired you as a financial advisor to estimate the investment project's net present value (NPV). After days of careful analysis you have determined that the initial cost of the project would involve a capital investment of $2,000,000. The expansion would also require an additional investment in inventory of $200,000. This additional inventory would no longer be required once the trucks are taken off the road. The company's opportunity cost of capital is 7�%. The additional trucks would increase Trucksalot annual sales by $2,000,000 for the next 4 years at which time the trucks will be scrapped. Additional annual expenses of $500,000 would also be incurred due to maintenance fees on the trucks. Depreciation expenses for the truck would be $500,000 per year. The company�s tax rate is 40%. What is the NPV of this project?

13. Incremental Cash Flows Remember that we never really calculate the NPV of a company or a project (even though we may refer to it like that) � we calculate the NPV of a decision. To find the incremental cash flows: Think of the cash flows of the company if it decides �yes�. Think of the cash flows of the company if it decides �no�. Any difference in the cash flows between these two possible companies is an incremental cash flow. Joshua Slive 13

14. Incremental Cash Flows We should use only cash flows that change as a result of our decision for the project. Incremental cash flow excludes: Sunk Costs: Expenses that must be paid whether or not the project is accepted, including all past costs, whether associated with the project or not. Financing costs: Only cash flow from assets, not financing costs such as interest expenses are considered. NPV uses the cost of capital (r) to incorporate financing costs into the decision rule. Allocated overhead: Administration costs that exist with or without the project. Joshua Slive 14

15. Incremental Cash Flows Incremental cash flow includes: Opportunity costs: Benefits forgone in order to accept the project. Side effects: Impacts on other projects from accepting this project. Net working capital: Increased cash and short-term asset requirements. Tax: Corporate income tax and adjustments from capital cost allowance. Joshua Slive 15

16. Depreciation Definition: Depreciation for tax purposes, that is, the amount of an asset�s value that you are allowed to deduct from taxable income each year. Asset classes: Intangible assets (straight-line depreciation). Tangible assets (declining balance method or Capital Cost Allowance). Depreciation is not a cash flow and should not be considered as such when calculating NPV. Depreciation is a tax-deductible expense. We must consider the tax savings linked to depreciation as positive cash flow in NPV calculation. Joshua Slive 16

17. Straight Line Depreciation Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, constant yearly increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. Joshua Slive 17

18. Straight Line Depreciation Suppose you bought manufacturing equipment for $100,000 today and you estimate the salvage value would be $20,000. Then, the value of the equipment with respect to straight-line depreciation is as follows Joshua Slive 18

19. Capital Cost Allowance (CCA) Capital Cost Allowance is the depreciation system in Canada. CCA is deducted before taxes and acts as a tax shield. Every capital assets is assigned to a specific asset class by the government. Every asset class is given a depreciation method and rate. Joshua Slive 19

20. CCA calculations The CCA rate gives the percentage of the asset value that can be written off (used as a tax shield) each year. Because CCA is a percentage, the tax-value of the asset never goes to zero; we generate a declining perpetuity of tax shields. CCA rules are complicated: Half-year rule: only half the normal CCA in the first year and this applies to net acquisitions. Closing asset pools can generate a terminal loss or recaptured depreciation (but this rarely happens for continuing companies). Selling or salvaging assets reduces the tax shields in the future. Joshua Slive 20

21. CCA calculations example Suppose you bought manufacturing equipment (CCA rate 30%) for $100,000 today and you estimate the salvage value would be $10,000 at the end of year 5. Then, the undepreciated capital cost (UCC) of the equipment with respect to CCA is * Half-year rule applied ** Salvage value deducted Joshua Slive 21

22. Present Value of CCA Tax Shields PVCCATS is the present value of tax shield provided by capital cost allowances. PVCCATS = The company bought an asset for $C The CCA rate for this class of asset is d The required rate of return on the company is r The marginal tax rate is Tc The company keeps the asset pool open forever S is the salvage or disposal value of the asset in t years. Joshua Slive 22

23. The Tax Shield Approach With CCA, we can�t calculate OCF = EBIT + depreciation � taxes, because CCA will generate a perpetuity of tax shields. Instead, we calculate OCF under the assumption that there is no depreciation. OCF = EBITDA*(1-tax rate) = (Incremental Revenue � Incremental Costs)*(1-tax) Then we separately add in the tax effects of depreciation using PVCCATS. Joshua Slive 23

24. Joshua Slive 24 Trucksalot Example with CCA The Trucksalot company is planning to expand its current fleet of delivery trucks and has hired you as a financial advisor to estimate the investment project's net present value (NPV). After days of careful analysis you have determined that the initial cost of the project would involve a capital investment of $2,000,000. The expansion would also require an additional investment in inventory of $200,000. This additional inventory would no longer be required once the trucks are taken off the road. The company's opportunity cost of capital is 7�%. The additional trucks would increase Trucksalot annual sales by $2,000,000 for the next 4 years at which time the trucks will be scrapped. Additional annual expenses of $500,000 would also be incurred due to maintenance fees on the trucks. The trucks are in a CCA class with a 30% CCA rate. The company�s tax rate is 40%. What is the NPV of this project?

25. Which approach do we use? We now have two approaches to calculating OCF: Year-by-year: OCF = EBIT + depreciation � taxes Tax-shield: OCF = EBITDA*(1 � tax rate) then separately add PVCCATS When using CCA depreciation, we must always use the tax shield approach to account for perpetual tax shields. Don�t mix them up! If you add PVCCATS, then you must not include depreciation in your OCF calculations (either in EBIT or by adding it back)! Joshua Slive 25

26. Cash Flow From Assets:Checklist � Tax Shield Approach Period 0: Initial investment Fixed assets Opportunity costs Investment in NWC Period 1�T: OCF =EBITDA*(1-tax rate) Calculate EBITDA as incremental revenues � incremental costs Period T: Salvage value from resale of assets Taxes on capital gains or losses Recovery of NWC PVCCATS Joshua Slive 26

27. A project valuation example MEL Inc. is a company that produces watches. Its low weekly production of 500 units obliges it to keep an average inventory of $100,000, which is relatively high for the size of the company. A proposed solution is to purchase a new machine with a higher production capacity. By doing so, the inventory could be reduced to a level of $20,000. The new machine would cost $500,000 including installation expense. This machine would have a service life of 7 years and a resale value of $50,000 and it would need be serviced at the end of the 6th year that would cost $20,000 in depreciable expenses. The new machine would create additional $60,000 per year in before tax cash flows for the company compared to the old machine. The old machine was purchased 5 years ago for $200,000. Its current commercial value is approximately $100,000 and its commercial value would be $20,000 in 7 years and it does not need to be serviced in 6 years. Find the NPV of this project if the marginal tax rate for MEL Inc is 40% and the required rate of return for this project is 10%. The CCA rate for this category of machines is 20% and the asset pool will NOT be terminated after 7 years. Joshua Slive 27

28. NPV (financial) Break-Even Analysis If we aren�t sure of all our forecasting data, we may want to calculate what are the minimal values we need to have a valuable project � ie, a project with at least zero NPV. For example: �What is the minimum selling price we must obtain for our product for this project to add value to the company?� This example is what the text calls �finding the bid price� but might also be called �finding the NPV break-even price�. What is the NPV break-even opportunity cost of capital sometimes called? Joshua Slive 28

29. Bid Price Example Sonno Inc. is a Montr�al-based furniture company. Its directors are considering expanding into the Qu�bec City market. They bought land in that area several years ago for $150,000. It is presently worth the same amount. Expansion would require the construction of a new plant for $350,000. The company spent $20,000 on a study of the Qu�bec City market, which showed that the branch plant should be able to sell its output in the new market for 5 years, after which the plant would have to be closed. At the end of 5 years, it is estimated that the land would be worth $100,000 and the plant $160,000. The plant could be depreciated at a rate of 15% for tax purposes. The market study also found that The marginal tax rate would be 30% The new plant could produce 10,000 chairs per year at a unit cost of $15 The expansion would require additional working capital of $5,000 at the outset. Sonno has a discount rate of 14% for such projects. What is the minimum price they need to be able to charge for the chairs for the project to be financially interesting? Joshua Slive 29

30. Equipment With Different Lives Suppose you can choose between two machines. Machine A costs $10K to buy, $1K/yr and lasts 2 years. Machine B costs $12K to buy, $1.1K/yr and lasts 3 years. Your discount rate is 10%. What should you do? PV(A) = -$11.73K PV(B) = -$14.73K You cannot compare PVs of equipment with different lives because of the difference in service periods. What if instead of buying the machines, we found a company that would rent them to us. What would be a fair rental price? Joshua Slive 30

31. Equipment With Different Lives Equivalent Annual Cost (EAC): The level cost per period that has the same PV as buying and operating the equipment (with all its associated CFs). Find the payment on an annuity that has the same PV as the purchase of the equipment. Joshua Slive 31