Making Capital Investment Decisions

1. Making Capital Investment Decisions Estimating Cash Flows Special cases

2. Overview • We are mainly concerned with how to arrive at correct measure of cash flows in numerator of NPV calculations • What are relevant and irrelevant cash flows? • We will also look at some special cases of Discounted Cash Flow (DCF) methods

3. Special Applications of DCF • Evaluating Cost Cutting Proposals • Evaluating Equipment with Different Lives • We will ignore ‘setting bid price’ example in text

4. Relevant Cash Flows • Only INCREMENTAL after-tax cash flows are relevant: • Incremental cash flows: • Changes in cash flows with and without the project • NOT the same as cash flows before and after the project!!

5. Indentifying cash flows • Look For: • Changes in sales and operating costs • Changes in net working capital • Opportunity costs and capital spending • Effect on tax payments

6. Example • Manufacturing operation that uses land that could be sold for $100,000 • With project:(own and use land) CF = $0 • Without project(sell land) CF = +$100,000 • Incremental CF = -$100,000(due to project)

7. Do Not Include... • Sunk Costs and unavoidable expenses • Depreciation • but include effect of depreciation on taxes • Financing payments • e.g. dividends and interest • financing is captured in denominator ‘r’

8. Examples: Include/Ignore? • Market value of land and existing buildings • Costs of demolishing and clearing land • Cost of new access road put in last year • Lost earnings from other products due to managers’ time spent on the new plant • Part of the cost of leasing the president’s airplane • Future depreciation of the new plant • Initial investment on inventories and raw materials • Payments already made for engineering of the new plant

9. Definitions of Operating CF • OCF = operating cash flow • S = sales • C = operating costs • D = depreciation • EBIT = earnings before interest and taxes = S - C - D • T = corporate tax rate OCF = EBIT + D - Taxes

10. Example: • S = $1,000 C = $600 D = $200 T = 34%EBIT = S - C - D = 1000-600-200 = $200Taxes = EBIT x T = 200 x .34 = $68OCF = EBIT + D - Taxes 200 + 200 - 68 = $332Use alternative approaches to arrive at the same answer

11. Alternative Definitions of OCF • Bottoms-up approachOCF = N.I. (without interest expense) + D • Top-down approachOCF = S - C - Taxes • Tax-shield approachOCF = (S - C) x (1-T) + D x T

12. Notice... • In all the alternatives of computing cash flows, taxes must be taken into account • Payment of taxes is a cash outflow • Savings of taxes is a cash inflow • Cash flows are computed on an after-tax basis

13. Multiply by T or (1-T)? • When you are calculating the amount of tax, you multiply by T • When you are calculating the amount of tax savings due to an expense (such as depreciation expense or any other expense), you multiply by T • When you are calculating the amount of after-tax cash flow, you multiply by (1-T)

14. Example • Before Tax CF: $1000 [= CF] • Tax @ 40%: $400 [= CF x T] • After Tax Income: $600 [= CF x (1-T)]

15. Example • Taking a project increases tax deductible expense by $1,000 • How much savings in taxes does this result? • T = 40% • Answer: 1000 x .40 = $400 • This is the amount by which the taxes are lower

16. Depreciation • Depreciation is a way accountants measure ‘wear and tear’ or ‘using-up’ of assets • It does not reflect actual cash going out • Depreciation is a tax-deductible expense • Tax savings due to depreciation is (D x T) • tax savings is a cash inflow • tax savings is called depreciation tax shield

17. Example: Depr. Tax Shield • The Latte Stand project requires purchasing coffee equipment for $12,000 which will be depreciated on a straight-line basis over 4 years to zero book value. The tax rate is 38%. • What is the annual depreciation? • What are the cash flow consequences of depreciation?

18. Note • Equipment can be sold before it is fully depreciated • The book value (BV) of the machine in any year is the original cost – accumulated depreciation • Example. $1m machine is being depreciated straight line over 10 years to zero book value. What is its BV in year 6?

19. Accelerated Depreciation • IRS allows a quicker schedule of depreciation than straight-line depreciation • This method is called Accelerated Depreciation • Assets are categorized in different ‘classes’ • e.g. “5-year class”

20. Accelerated Depreciation • $500,000 investment is depreciated over 4 years as 3-year MACRS to zero book value • What is the annual depreciation? • What is the annual depreciation tax shield?

21. Salvage Value • The latte equipment will be sold at the end of 4 years for $5,600. • What are the cash flows resulting from salvage at the end of the project?

22. Salvage • Sale of equipment can result in • Taxable gain if BV < MV OR • Taxable loss if BV > MV OR • Neither if BV = MV

24. Net Working Capital • Net working capital (NWC) = S.T. Assets - S.T. Liabilities • Businesses need NWC to conduct business • NWC ties up money (i.e. it is an investment) • What are S.T. Assets and Liabilities of a firm? • Increase in NWC is cash outflow • Decrease in NWC is cash inflow

25. ST Assets Cash Marketable securities Accounts Receivables Inventory ST Liabilities Accounts payable Wages due Taxes due NWC NWC = ST Assets - ST Liabilities

26. Without Project ($s) Acct Rec’v 4,500 Inventories 6,000 Acct Pay’b 3,900 With Project ($s) Acct Rec’v 6,700 Inventories 9,000 Acct Pay’b 3,400 Example: NWC What is the change in NWC? What is the cash inflow / outflow?

27. NWC at Project End • When projects have finite life, the money tied up in NWC becomes available when the project ends • Hence, one typically encounters situations where a drop in NWC occurs at the end of project’s life • This results in a cash inflow

28. Application: Cost Cutting • Buying a new machine press for $350,000 is estimated to result in $145,000 in annual pre-tax savings. MACRS five-year class depreciated to zero book value, and has sale price of $75,000. Also required spare parts of $17,000 and $2,500 in inventory for each succeeding year of the project. T = 34%, r = 15%. Buy new machine?

29. Equivalent Annual Cost (EAC) • Useful: • when alternatives have different economic lives • we will use and replace the equipment indefinitely • Trick: • Calculate NPV of alternatives • Use NPV as PV of annuity to calculate PMT over the ‘n’ years of useful life

30. EAC Example FiltrationPrecipitation • Economic Life 5 years 8 years • Installation Cost $1.1 mill $1.9 mill • Annual Oper. Cost $60,000 $10,000 • Salvage value $0 $0 • Depreciable life 5 years 8 years • Discount rate 12% 12% • T = .34, Straight line depreciation

31. Notice... • The two alternative have different lives • Cannot directly compare them • We usually assume that the machines are replaced indefinitely at end of their lives • Hence we convert NPV to Equivalent Annual Costs (EAC)

32. EAC ex. continued.. Filtr. Precip. • After tax oper. cost -$39,600 -$6,600 • Depr. tax shield $74,800 $80,750 • Oper. Cash flow $35,200 $74,150 • PV of Oper. cash flow $126,888 $368,350 • Investment -$1,100,000 -$1,900,000 • NPV @ 12% -$973,112 -$1,531,650 • EAC