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Chapter 10

Chapter 10. Cash Flows and Other Topics in Capital Budgeting. n t=1. S. ACF t (1 + k). NPV = - IO. t. n t=1. ACF t (1 + IRR). S. IRR: = IO. t. NET PRESENT VALUE (NPV) INTERNAL RATE OF RETURN (IRR).

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Chapter 10

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  1. Chapter 10

  2. Cash Flows and Other Topics in Capital Budgeting

  3. n t=1 S ACFt (1 + k) NPV = - IO t n t=1 ACFt (1 + IRR) S IRR: = IO t NET PRESENT VALUE (NPV)INTERNAL RATE OF RETURN (IRR)

  4. Capital Budgeting: the process of planning for purchases of long-termassets. • example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment? • The relevant project information follows:

  5. The cost of the new machine is $127,000. • Installation will cost $20,000. • $4,000 in net working capital will be needed at the time of installation. • The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. • Simplified straight line depreciation is used. • Class life is 5 years, and the firm is planning to keep the project for 5 years. • Salvage value at year 5 will be $50,000. • 14% cost of capital; 34% marginal tax rate.

  6. CAPITAL BUDGETING STEPS • EVALUATE CASH FLOWS • DETERMINE RISK (DISCOUNT %) • MAKE ACCEPT/REJECT DECISION

  7. Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. • Initial outlay • Differential Cash Flowsover the life of the project (also referred to as annual cash flows). • Terminal Cash Flows

  8. . . . 0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay Annual Cash Flows

  9. Capital Budgeting Steps 2) Evaluate the risk of the project. • We’ll get to this at the end of this chapter. • For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. • If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.

  10. Capital Budgeting Steps 3) Accept or Reject the Project.

  11. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

  12. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

  13. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

  14. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

  15. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset Net Initial Outlay

  16. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + ( 4,000) + 0 Net Initial Outlay

  17. Step 1: Evaluate Cash Flows • a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + ( 20,000) shipping and installation (147,000) depreciable asset + ( 4,000) net working capital + 0 proceeds from sale of old asset ($151,000) net initial outlay

  18. Step 1: Evaluate Cash Flows • b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

  19. For Each Year, Calculate: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  20. For Years 1 - 5: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  21. For Years 1 - 5: 85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  22. For Years 1 - 5: 85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  23. For Years 1 - 5: 85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  24. For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  25. For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

  26. For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow

  27. For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow

  28. For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789)Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow

  29. Step 1: Evaluate Cash Flows • c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

  30. Step 1: Evaluate Cash Flows • c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

  31. Tax Effects of Sale of Asset: • Salvage value = $50,000 • Book value = depreciable asset - total amount depreciated. • Book value = $147,000 - $147,000 = $0. • Capital gain = SV - BV = 50,000 - 0 = $50,000 • Tax payment = 50,000 x .34 = ($17,000)

  32. Step 1: Evaluate Cash Flows • c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow

  33. Step 1: Evaluate Cash Flows • c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000Recapture of NWC Terminal Cash Flow

  34. Step 1: Evaluate Cash Flows • c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow

  35. Project NPV: • CF(0) = -151,000 • CF(1 - 4) = 46,461 • CF(5) = 46,461 + 37,000 = 83,461 • Discount rate = 14% • NPV = $27,721 • IRR = 21% • We would acceptthe project.

  36. Incorporating Risk into Capital Budgeting • Risk-Adjusted Discount Rate

  37. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account?

  38. n t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account? • Adjust the discount rate (k).

  39. Risk-Adjusted Discount Rate • Simply adjust the discount rate (k) to reflect higher risk. • Riskier projects will use higher risk-adjusted discount rates. • Calculate NPV using the new risk-adjusted discount rate.

  40. n t=1 S ACFt (1 + k*) NPV = - IO t Risk-Adjusted Discount Rate

  41. Risk-Adjusted Discount Rates • How do we determine the appropriate risk-adjusted discount rate (k*) to use? • Many firms set up risk classes to categorize different types of projects.

  42. Risk Classes Risk RADR Class (k*) Project Type 1 12% Replace equipment, Expand current business 2 14% Related new products 3 16% Unrelated new products 4 24% Research & Development

  43. Practice Problems:Cash Flows & Other Topics in Capital Budgeting

  44. Problem 1a Project Information: • Cost of equipment = $400,000 • Shipping & installation will be $20,000 • $25,000 in net working capital required at setup • 3-year project life, 5-year class life • Simplified straight line depreciation • Revenues will increase by $220,000 per year • Defects costs will fall by $10,000 per year • Operating costs will rise by $30,000 per year • Salvage value after year 3 is $200,000 • Cost of capital = 12%, marginal tax rate = 34%

  45. Problem 1a • Initial Outlay: (400,000) Cost of asset + ( 20,000) Shipping & installation (420,000) Depreciable asset + ( 25,000) Investment in NWC ($445,000) Net Initial Outlay

  46. Problem 1a For Years 1 - 3: 220,000 Increased revenue 10,000 Decreased defects (30,000) Increased operating costs (84,000) Increased depreciation 116,000 EBT (39,440) Taxes (34%) 76,560 EAT 84,000 Depreciation reversal 160,560 = Annual Cash Flow

  47. Problem 1a • Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

  48. Problem 1a • Terminal Cash Flow: • Salvage value = $200,000 • Book value = depreciable asset - total amount depreciated. • Book value = $168,000. • Capital gain = SV - BV = $32,000 • Tax payment = 32,000 x .34 = ($10,880)

  49. Problem 1a • Terminal Cash Flow: 200,000 Salvage value (10,880) Tax on capital gain 25,000 Recapture of NWC 214,120 Terminal Cash Flow

  50. Problem 1a Solution: • NPV and IRR: • CF(0) = -445,000 • CF(1 ), (2), = 160,560 • CF(3 ) = 160,560 + 214,120 = 374,680 • Discount rate = 12% • IRR = 22.1% • NPV = $93,044. Accept the project!

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