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Cash Flow And Capital Budgeting

Cash Flow And Capital Budgeting. Chapter 9. Cash Flow Versus Accounting Profit. Capital budgeting is concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know:. Incremental cash outflows of the investment (marginal cost of investment), and.

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Cash Flow And Capital Budgeting

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  1. Cash FlowAnd Capital Budgeting Chapter 9

  2. Cash Flow Versus Accounting Profit Capital budgeting is concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know: • Incremental cash outflows of the investment (marginal cost of investment), and • Incremental cash inflows of the investment (marginal benefit of investment). • The timing and magnitude of cash flows and accounting profits can differ dramatically.

  3. Cash Flows: Financing Costs and Taxes Financing costs should be excluded when evaluating a project’s cash flows. • Both interest expense from debt financing and dividend payments to equity investors should be excluded. • Financing costs are captured in the process of discounting future cash flows. • Only after-tax cash flows are relevant as only such cash flows can be distributed to investors.

  4. Cash Flows: Noncash Expenses • Noncash expenses include depreciation, amortization, and depletion. • 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, or • Ignore depreciation expense but add back its tax savings.

  5. Costs $1/unit Firm will produce 10,000 units/year Sells for $3/unit Cash Flows: Noncash Expenses Assume a firm purchases a fixed asset today for $30,000. Plans to depreciate over 3 years using straight-line method. Firm pays taxes at 40% marginal rate.

  6. Method 1 Method 2 Adding non-cash expenses back to after-tax earnings Find after-tax profits, add back non-cash deduction tax savings Sales $30,000 Sales $30,000 Cost of goods (10,000) Cost of goods (10,000) Gross profits $20,000 Pre-tax income $20,000 Depreciation (10,000) Taxes (40%) (8,000) Pre-tax income $10,000 Aft-tax income $12,000 Taxes (40%) (4,000) Depreciation tax savings $4,000 Net income after tax $6,000 Cash Flow $16,000 Cash flow = NI + deprec $16,000 Cash Flows: Noncash Expenses

  7. Depreciation Many countries allow one depreciation method for tax purposes and another for reporting purposes. • Accelerated depreciation methods, such as the modified accelerated cost recovery system (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. Because depreciation only affects cash flow through taxes, we consider only the depreciation method that a firm uses for tax purposes when determining project cash flows.

  8. Table 9.1 U.S. Tax Depreciation Allowed for Various MACRS Asset Classes.

  9. New equipment costs $10 million, $0.5 million to install An example.... Tax rate = 40% Old equipment fully depreciated, sold for $1 million Fixed Asset Expenditures • Initial cash flows: • Cash outflow to acquire/install fixed assets • Cash inflow from selling old equipment • Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability) Initial investment: Outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment

  10. Working Capital Expenditures • Many capital investments require additions to working capital. • Net working capital (NWC) = current assets – current liabilities • Increase in NWC is a cash outflow; decrease in NWC is 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

  11. 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 0 Net WC 0 500 1,000 (3,000) Monthly  in WC NA +500 +500 (4,000) 0 +3,000 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

  12. Terminal Value When evaluating an investment with indefinite life-span, the project’s terminal value is calculated: 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. • The terminal value is intended to reflect the value of a project at a given future point in time. • The terminal value is usually large relative to all the other cash flows of the project.

  13. 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 Terminal Value Different ways to calculate terminal values: • Use final year cash flow projections and assume that all future cash flow grow at a constant rate; • Multiply final cash flow estimate by a market multiple, or • Use investment’s book value or liquidation value. JDS Uniphase cash flow projections for acquisition of SDL Inc.

  14. Terminal Value of SDL Acquisition • 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 is 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

  15. Incremental Cash Flow 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 he expects it to increase at 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

  16. 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 each of the next two years while studying for MBA: $35,000 • If Norm had worked at his current job for two years, his salary would have increased to $60,000 x 1.052 = $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: ($90,000x1.08 - $60,000x1.053)x(1-0.35) = $18,032 • MBA has substantial positive NPV value for 30 yr analysis period What about Norm’s opportunity cost?

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

  18. Cannibalization • Cannibalization refers to the loss of sales of an existing product when a new product is introduced. • Cannibalization is a “substitution” effect.

  19. $50,000 for computer equipment (MACRS 5-year) Initial investment transactions: $4,500 for inventory ($2,500 of which is purchased on credit) $1,000 increase in cash balances Initial Investment for Classicaltunes.com 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 remain constant indefinitely. • Sales expected to begin when new fiscal year begins.

  20. Projections for Jazz CD Proposal

  21. Projections for Jazz CD Proposal Annual Net Cash Flow Estimates for Classicaltunes.com

  22. Year Zero Cash FlowInvest $3000 in working capital • Initial cash outlay of $50,000 for computer equipment • Changes in working capital are result of following transactions: • Purchase of $4,500 in inventory and increase cash balance by $1000 • an inflow of $2,500 from an increase in trade credit (Account Receivable) Net Cash Flow:

  23. Year One Cash Flow • In year 1, the project earns after-tax income of $561. • No new investment in fixed asset. • Add back the non-cash depreciation charge of $10,000. • Net working capital for year one is: • NWC = Current Assets – Current Liabilities = $2,000 + 5,063 + 7,594 - $4,374 = $10,282 • NWC = NWCyear1 – NWCyear0 = $10,282 - $3,000 = $7,282 • Increase in NWC from year zero: $7,282 net cash flow from working capital: -$7,282 net cash flow: $561 + 10,000 – 7,282 = $3,279

  24. Year One Cash Flow Net Cash Flow:

  25. Year Two Cash Flow • In year 2, net income equals $8,580. • To that, add back the $10,000 non-cash depreciation deduction. • Next, determine the change in working capital: The working capital balance increased from $10,282 in year 1 to $20,905 in year 2, so this represents a cash outflow of 10,623. • As in year 1, there are no new investments in fixed assets to consider. Net Cash Flow:

  26. Terminal Value for Jazz CD Proposal • If we assume that cash flow continue to grow at 4% per year at and beyond year 6 (g = 4%, r = 15%,): • Second approach: use the book value at end of year six: • Plant and Equipment (P&E) at end of year six is $0. • The firm liquidates total current assets (cash 3,500, accounts receivable 28,125, inventory 42,188) and pays off current debts (accounts payable 24,300): • Terminal value = $73,813 - $24,300 = $49,513.

  27. NPV for Jazz CD Proposal • Using assumption that cash flow grow 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.

  28. Capital Rationing Can a firm accept all investment projects with positive NPV? Reasons why a company would not accept all projects: Limited availability of skilled personnel to be involved with all the projects; Financing may not be available for all projects. Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market.

  29. Capital Rationing Capital rationing:project combination that maximizes shareholder wealth subject to funding constraints 1. Rank the projects using Profitability Index (PI) 2.Select the investment with the highest PI 3.If funds are still available, select the second-highest PI, and so on, until the capital is exhausted. The steps above ensure that managers select the combination of projects with the highest NPV.

  30. Equipment Replacement and Unequal Lives • A firm must purchase an electronic control device: • First alternative: cheaper device, higher maintenance costs, shorter period of utilization • Second device: more expensive, smaller maintenance costs, longer life span • Expected cash outflows: • Using real discount rate of 7%: Device A’s cash outflow < Device B’s cash outflow  select A?

  31. Table 9.4 Capital Rationing and the Profitability Index (12% required return)

  32. Table 9.5 Operating and Replacement Cash Flows for Two Devices (all values are outflows)

  33. 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 respective lifetimes: • NPV of device A = $15,936 • NPV of device B = $18,065 2. Compute annual expenditure (annuity cost) to make NPV of annuity equal to NPV of operating device: • Since Device B’s annuity cost is lower, choose Device B.

  34. Excess Capacity • Excess capacity is 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 (at the beginning of each year) for the next two years. • Expansion plans should begin immediately in this case to hold inventory for new stores coming on line in a few months. • Incremental cost: investing $2,000,000 at present vs. two years from today • Incremental cash inflow: $125,000 (at the beginning of the year)

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

  36. The Human Face of Capital Budgeting • Managers must be aware of optimistic bias in the assumptions made by project supporters. • Companies should have control measures in place to remove bias: • Investment analysis should be done by a group independent of individual or group proposing the project. • Project analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential. • Storytelling: The best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.

  37. Cash Flow and Capital Budgeting • Certain types of cash flows are common to many investments • Opportunity costs should be included in cash flow projections • Consider human factors in capital budgeting

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