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Cash Flow And Capital Budgeting

Cash Flow And Capital Budgeting. Professor Thomson Fin 3013. 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).

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Cash Flow And Capital Budgeting

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  1. Cash Flow And Capital Budgeting Professor Thomson Fin 3013

  2. 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). Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profit. • The timing and magnitude of cash flows and accounting profits can differ dramatically.

  3. Financing costs should be excluded when evaluating a project’s cash flows (can separate the investment decision from the financing decision). • Both interest expense from debt financing and dividend payments to equity investors should be excluded. Financing Costs • Financing costs are captured in the discounting future cash flows to present i.e. use the correct discount rate to adjust for the systematic risk of the project.

  4. Capital Investment Decisions • The with and without principle – Capital project evaluation should be done by assessing the cash flows with and without undertaking the project. I.e. We need to consider the INCREMENTAL cash flows due to the project. • Stand Alone Basis – another way of stating this principle is to consider the project on a stand alone basis (by looking only at the incremental cash flows that result from this project).

  5. Other Considerations • Sunk Costs - A sunk cost is a cost that has been expended in the past, and whether you do or do not undertake the project, these costs no longer effect the incremental cost of the project. • Opportunity cost – There is no such thing as a free lunch. If a firm already owns something that can be applied to a new project – it could also be sold on Ebay. The amount you could sell it for on Ebay represents the opportunity cost of using an existing asset on a new project. • Side effects – In considering the incremental costs, one has to consider any side effects. If additional advertising of our new product, also increases sales of our other products, these sides effects must be part of the incremental costs (also cannibalization).

  6. Net Working Capital • New or expanded projects often require additional working capital (such as additional inventory) that must be considered as part of the incremental cost of the project. • For project analysis, the simplest case is when additional working capital is required at the beginning of the project that will be brought back to base line levels at the end of the project.

  7. Investment Pro Forma • A pro forma is the standard analysis of cash flows that one does to determine if a proposed capital project is a good investment. • A pro forma includes listing the expected cash flows over time, and computing of the investment criteria such as NPV, IRR, PI, and Payback.

  8. Investment Pro Forma (simplified) All numbers are ATCF’s

  9. Investment Pro Forma (simplified) A project that costs 100 and requires 20 of new net working capital will provide incremental operating cash flows of $60 for the next three years. The after tax cash flow from salvaging the equipment will be 15. What are the project’s ATCF? What is the IRR?

  10. Investment Cash Flows Cash Flows from Investment Projects are commonly separated into 3 components 1. Operating Cash Flows (OCF) OCF = EBIT – Taxes + Depreciation 2. Change in Net Working Capital (NWC) 3. Investment Cost Initial Investment at time period zero At the end of the project you may recover some of your investment cost if you can sell (salvage) your capital goods. All of the above are presented on an after tax cash basis (i.e. they are ATCF’s)

  11. The Idea of Depreciation • Some people think of depreciation as the wearing out of capital equipment (your car gets old and unreliable) • From an accounting viewpoint, depreciation has a different interpretation • Example: You can by a new TV for $1095 that you think will last you 3 years (1095 days). What is the daily cost of watching TV?

  12. Depreciation (continued) • Depreciation assigns the cost of a capital good over the period you receive benefits from it. • Warning: The cash flow occurred when you bought the TV. If we consider the Depreciation Expense as $1 per day for the three years we watch TV, we have a depreciation expense each day, but not a cash flow each day. We had a big negative cash flow the day we bought the TV.

  13. Depreciation (continued) • When you pay someone wages to work on a given day, you take a labor expense that day, and you have a cash flow that day. • We pay taxes on our profit, not on our revenues. We deduct our costs from our revenue to determine the profit that we are taxed on.

  14. Depreciation (continued) • For capital goods, depreciation is a recognized expense, but the cash flow occurred in the past when the capital good was purchased. • When the good was purchased, no tax deduction for the expense of the good is allowed. Instead, we use depreciation to smear out the capital good cost over time. In other words, we will get our tax deduction in the future in response to a cost (cash flow) incurred today. • Depreciation expense, thus affects future taxes, not current taxes.

  15. Cash Flow and Non-Tax Expenses • 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 – the investment cash flow made at time period zero, reduced future taxes when you are allowed to take a deduction for the depreciation expense.

  16. Depreciation Many countries allow one depreciation method for tax purposes and another for reporting purposes. • Accelerated depreciation methods (such as 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. For capital budgeting analysis, the depreciation method for tax purposes matters most.

  17. Depreciation: 1. Straight Line 1. Straight Line Example: Purchase a truck for $20,000 that you will use for 5 years and then sell for $4000

  18. Depreciation: 2. MACRS 2. MACRS – Modified Accelerated Cost Recovery System Investments are classified into MACRS classes such as 3 year, 5 year, etc. When using MACRS, salvage value is not considered (implicitly assumed to be zero). The annual depreciation percent for each class is stated such as shown below for the 3-year asset class.

  19. Example MACRS Depreciation You purchase a new capital asset that fits into the 3 year MACRS class. The cost of the asset is $1 million and you believe you can sell it for $200,000 after three years of service. What is your depreciation expense in year 3? Answer: Year 3 Depreciation = $1,000,000 x 0.1482 = 148,200.

  20. Useful Formulas Project ATCF = OCF – NWC – Investment (Note: These are all ATCF’s) OCF = EBIT – Taxes + Depreciation (EBIT = Sales – Operating Costs – Depreciation) Taxes = t*EBIT, where t = tax rate Straight Line (Annual) Depreciation = (Investment – Est. Salvage)/Years ATCF from Salvage = Salvage – tax (Salvage is the Sale Price of salvaged equipment) tax = t(Salvage – BookVal) where t= tax rate, BookVal = Investment – Accumulated Depreciation

  21. Ex 9.1 ATCF from Salvage(Straight Line Depreciation) • You purchased a new lawnmower for your Landscape business for $5000 that you expected to use for 3 years, and then sell for $500. After 2 years you saw a great deal on another mower so you decided to replace your mower, and sold your old mower for $1500. What is your ATCF from selling your old mower (tax rate = 30%)?

  22. Example 9.2 Computing OCF • Noble’s Best Doughnuts is considering buying a dough machine for $150,000 that it will depreciate (straight line) over its expected 3 year life. It expects to sell the machine for $30,000 at that time. Doughnut sales are projected to increase $100,000 per year. Operating costs are 30% of sales. Noble pays a 34% tax on its income. What are the incremental OCF’s Noble can expect from this project over the next 3 years?

  23. Example 9.3 OCF with MACRS • Same as 9.1, but use MACRS for computing the depreciation, i.e. what are the OCF’s?

  24. Example 9.4: NWC simplified • Noble’s Best Doughnuts will need additional supplies of doughnut mix and sprinkles to feed this machine. It estimates it will need to keep an additional $10,000 of baking supplies on hand during the life of the project. What are the ATCF’s associated with the change in NWC to support this project?

  25. Example 9.5 Investment CF’s • As noted earlier, Noble’s Best Doughnuts will invest $150,000 on the new doughnut machinery, and expects to sell the used machinery after 3 years for $30,000. • What is the ATCF from Salvage using straight line depreciation? • What is the ATCF from Salvage using MACRS? • What are the ATCF’s from investment?

  26. Example 9.6 • What will Noble’s pro forma look like for: • Straight Line depreciation • MACRS depreciation • For each case above, what is the IRR of the project?

  27. An example…Should Norman Paul pursue an MBA? • 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 (IGNORE) • Room and board expenses are not incremental to the decision to go back to school Incremental Cash Flow • Capital budgeting analysis should include only incremental costs.

  28. 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 next two years while studying in MBA: $35,000 for 2 years • If Norm worked at his current job for two years, his salary would have increased to $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: • MBA has substantial positive NPV value if 30 yr analysis period What about Norm’s opportunity cost?

  29. 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) Opportunity Costs Cash flows from alternative investment opportunities, forgone when one investment is undertaken. NPV of a project could fall substantially if opportunity costs are recognized!

  30. 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. 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;

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

  32. Device 0 1 2 3 4 A 12000 1500 1500 1500 - B 14000 1200 1200 1200 1200 Device NPV A $15,936 B $18,065 Equipment Replacement and Unequal Lives • A firm must purchase an electronic control device: • First alternative is a cheaper device, higher maintenance costs, shorter period of utilization • Second device is more expensive, smaller maintenance costs, longer life span • Expected cash outflows: • Maintenance costs are constant over time. Use real discount rate of 7% for NPV Cash outflow device A < cash outflow device B  select A?

  33. Approach 1: Lowest Common Time Frame • Each could be evaluated on a 12 year time table with the noted CF’s • PV of A (@7% discount rate) is $48233 • PV of B is $42360 • B is cheaper, in a DCF context, over time

  34. Device A Device B Approach 2: 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 lifetime: • NPV device A = $15,936 • NPV device B = $18,065 • 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device:

  35. Calculator Approach (Device A) • P/YR = 1 • Enter CF’s • Type 7, press I/YR • Press  NPV • Press +/- • Press PV • Type 3, press N • Press PMT

  36. The Human Face of Capital Budgeting • Managers must be aware of optimistic bias in these 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: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

  38. 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 for the next two years. • Expansion plans should begin immediately in this case to hold inventory for stores that will come on line in a few months. • Incremental cost: investing $2,000,000 at present vs. two years from today • Incremental cash inflow: $125,000

  39. 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 • Leasing the excess capacity for a price above $181,818 would increase shareholders wealth.

  40. Adding non-cash expenses back to after-tax earnings Find after-tax profits, add back non-cash charge tax savings Assume a firm purchases a fixed asset today for $30,000 Sales $30,000 Sales $30,000 Cost of goods (10,000) Cost of goods (10,000) Plans to depreciate over 3 years using straight-line method 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 Costs $1/unit Firm will produce 10,000 units/year Taxes (40%) (4,000) Depreciation tax savings $4,000 Sells for $3/unit Net income $6,000 Cash Flow $16,000 Cash flow = NI + deprec $16,000 Firm pays taxes at a 40% marginal rate Simplest and most common technique: Add depreciation back in. Two Methods of Handling Depreciation to Compute Cash Flow

  41. New equipment costs $10 million, $0.5 million to install An example.... Tax rate = 40% Old equipment fully depreciated, sold for $1 million • Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment The Initial Investment • 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)

  42. 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 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

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

  44. Terminal Value Terminal value is used when evaluating an investment with indefinite life-span: 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. • Terminal value is intended to reflect the value of a project at a given future point in time. • Large value relative to all the other cash flows of the project.

  45. Different ways to calculate terminal values: 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 • 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. Terminal Value

  46. 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 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

  47. $50,000 for computer equipment (MACRS 5-year) Initial investment transactions: $4,500 for inventory ($2,500 of which purchased on credit) $1,000 increase in cash balances Initial Investment for Jazz CD Project 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 to increase at 2% per year. • Sales expected to begin when new fiscal year begins.

  48. Abbreviated Project Balance Sheet Year 0 1 2 3 4 5 6 Annual Cash Flow Estimates for Classicaltunes.com Year 0 1 2 3 4 5 6 Price per unit $13.50 $13.77 $14.05 $14.33 $14.61 $14.91 $15.20 Year 0 1 2 3 4 5 6 Cash 1000 2000 2500 3000 3200 3300 3500 Units 0 4,000 10,000 16,000 22,000 24,000 25,000 New Fixed Assets -50000 -10000 -5000 -25000 -40000 -15000 -10000 Accounts Receivable 0 4590 11705 19102 26790 29810 31673 Abbreviated Project Income Statement Change in working capital -3000 -6614 -12302 -12771 -12953 -5109 -3291 Inventory 4500 7344 18727 30563 42864 47696 50677 Revenue 0 55080 140454 229221 321482 357722 380080 Current Assets 5500 13934 32932 52665 72855 80806 85851 Cost of goods sold 0 41861 105341 169623 234682 259349 273657 Operating cash flow 4000 10174 14790 23591 40411 47644 48454 Gross P&E 50000 60000 65000 90000 130000 145000 155000 Gross profit 0 13219 35114 59597 86800 98374 106422 Accumulated Depreciation 10000 28000 41800 56080 79952 105160 123672 Net cash flow -49000 -6440 -2512 -14180 -12542 27535 35163 SG&A Expense 0 8262 19664 29799 35363 35772 38008 Net P&E 40000 32000 23200 33920 50048 39840 31328 Depreciation 10000 18000 13800 14280 23872 25208 18512 Total assets 45500 45934 56132 86585 122903 120646 117179 Pretax profit -10000 -13043 1649 15519 27565 37393 49903 Accounts Payable 2500 4320 11016 17978 25214 28057 29810 Projections for Jazz CD Proposal

  49. Year Zero Cash Flow • Initial cash outlay of $50,000 for computer equipment • Half-year of MACRS depreciation can be taken in year zero: • 20% x $50,000 = $10,000; non cash expense • Depreciation expense are deducted from the firm’s classical-music CD profits. Savings of $4,000 (40% x $10,000) in taxes • Changes in working capital are result of following transactions: • Purchase of $4,500 in inventory and $1000 cash balance • Accounts payable of $2,500 partially finance the $5,500 outlay Net Cash Flow:

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