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Cash Flow And Capital Budgeting

Cash Flow And Capital Budgeting. Professor XXXXX Course Name / Number. 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 XXXXX Course Name / Number

  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. • 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.

  4. 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: • Compute after-tax net income and add depreciation back, or • Ignore depreciation expense but add back its tax savings.

  5. 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

  6. 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.

  7. 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)

  8. 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

  9. 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

  10. 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.

  11. 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

  12. 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

  13. 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 Incremental Cash Flow Incremental cash flows versus sunk costs: • Capital budgeting analysis should include only incremental costs.

  14. 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 • 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?

  15. 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!

  16. $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.

  17. 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

  18. 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:

  19. Year One Cash Flow • Purchase of additional $10,000 in fixed assets • 2nd year depreciation expenses for MACRS 5-year asset class is 32%. An additional 20% depreciation deduction for assets purchased this year • 32% x $50,000 + 20% x $10,000= $18,000 • Non cash expense; has to be added back when computing cash flow for the year • Net working capital for year one is: • NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614 • Increase in NWC; cash outflow of $6,614

  20. Year One Cash Flow • Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com. • Tax savings = 40% x $13,043 = $5,217 • Net operating cash inflow = pretax loss + tax savings + depreciation • Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174 Net Cash Flow:

  21. Year Two Cash Flow • Purchase of additional $5,000 in fixed assets • Assets purchased at the onset of the project have allowable depreciation of 19.2% (19.2% x $50,000 = $9,600) • An additional 32% depreciation deduction for assets purchased in year 1 and 20% depreciation of assets purchased this year • Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000= $4,200 = $13,800 • Changes in working capital are result of following transactions: • Increases in current assets: • $500 increase in cash balance • $7,115 increase in accounts receivables • $11,383 increase in inventory • Increase in current liabilities: • $6,696 increase in account payables • Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)

  22. Year Two Cash Flow • Pretax profit in year two is $1,649. • The company must pay taxes of $660 (40% x $1,649-- cash outflow. • Net operating cash inflow = pretax profit + tax + depreciation • Operating cash inflow = $1,649 - $660 + $13,800 = $14,789 Net Cash Flow:

  23. Terminal Value for Jazz CD Investment • If we assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,): • Second approach used by Classicaltunes.com to compute terminal value for the project: use the book value at end of year six: • Plant and Equipment (P&E) at end of year six is $31,328. • The firm liquidates total current assets and pays off current debts: • $85,850 - $29,810 = $56,040 • Terminal value = $31,328 + $56,040 = $87,368.

  24. NPV for Jazz CD Project • 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.

  25. 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;

  26. 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 ensure that managers select the combination of projects with the highest NPV.

  27. 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.

  28. 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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