© 2009 Cengage Learning/South-Western Cash Flow And Capital Budgeting Chapter 9.
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Transcript of © 2009 Cengage Learning/South-Western Cash Flow And Capital Budgeting Chapter 9.
© 2009 Cengage Learning/South-Western
Cash FlowAnd Capital Budgeting
Chapter 9
2
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),
andIncremental cash inflows of the investment
(marginal benefit of investment).
The timing and magnitude of cash flows and accounting profits can differ
dramatically.
Cash Flow Versus Accounting Profit
3
Financing costs are captured in the process of discounting future cash flows.
Both interest expense from debt financing and dividend payments to equity investors should be excluded.
Financing costs should be excluded when evaluating a project’s cash flows.
Cash Flows: Financing Costs and Taxes
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
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.
Cash Flows: Noncash Expenses
Firm will produce 10,000 units/year
Costs $1/unit
Sells for $3/unit
6
Cash Flows: Noncash Expenses
$6,000Net income after tax
$16,000Cash flow = NI + deprec
(4,000)Taxes (40%)
$10,000Pre-tax income
(10,000)Depreciation
$20,000Gross profits
(10,000)Cost of goods
$30,000Sales
Adding non-cash expenses back to after-tax earnings
Method 1
$4,000Depreciation tax savings
$16,000Cash Flow
$12,000Aft-tax income
(8,000)Taxes (40%)
$20,000Pre-tax income
(10,000)Cost of goods
$30,000Sales
Find after-tax profits, add back non-cash deduction tax savings
Method 2
7
• 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.
Many countries allow one depreciation method for tax purposes and another for
reporting purposes.
Depreciation
8
Table 9.1 U.S. Tax Depreciation Allowed for Various MACRS Asset Classes.
9
• 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)
An example....
Tax rate = 40%
New equipment costs $10 million,
$0.5 million to install
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
Fixed Asset Expenditures
10
• 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
Working Capital Expenditures
11
($5,000)($5,000)($5,000)$0Payments
($500)Net cash flow
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
$0Reduction in inventory
Jan 1 to Feb 1
Dec 1 to Jan 1
Nov 1 to Dec 1
Oct 1 to Nov 1
Payments and
inventory
($500) +$4,000 ($3,000)
(4,000)+500+500NAMonthly in WC
(3,000)1,0005000Net WC
5,00010,00015,0000Accts payable
01,50010,50015,0000Inventory
$0$500$500$500$0Cash
Feb 1Jan 1Dec 1Nov 1Oct 1
0
0
+3,000
Working Capital for Calendar Sales Booth
12
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.
Terminal Value
13
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.
$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion
Year 5Year 4Year 3Year 2Year 1
JDS Uniphase cash flow projections for acquisition of SDL Inc.
Terminal Value
14
$68.20.050.10
$3.41PVor ,
grCF
PV 51t
t
• Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):
67.48$1.1
2.68$
1.1
25.3$
1.1
5.2$
1.1
75.1$
1.1
1$
1.1
5.0$554321
• 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
Terminal Value of SDL Acquisition
15
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
Incremental Cash Flow
16
• 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?
Incremental Cash Flow
17
Cash flows from alternative investment opportunities, forgone when one investment
is undertaken.
NPV of a project could fall substantially if opportunity costs are recognized!
First year: $60,000 ($39,000 after taxes)
Second Year: $63,000 ($40,950 after taxes)
If Norm did not attend MBA program, he would have
earned:
Opportunity Costs
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
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.
Initial investment transactions
:
$50,000 for computer equipment(MACRS 5-year)
$4,500 for inventory ($2,500 of which is purchased on credit)
$1,000 increase in cash balances
Initial Investment for Classicaltunes.com
20
Pro
ject
ions
for
Jazz
CD
Pro
posa
l
21
Annual Net Cash Flow Estimates for Classicaltunes.com
Projections for Jazz CD Proposal
22
• 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)
Increase in gross fixed assets - $50,000
Change in working capital - $3,000
Net cash flow - $53,000
Net Cash Flow:
Year Zero Cash FlowInvest $3000 in working capital
23
• 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
Year One Cash Flow
24
Depreciation $10,000
Invest in working capital (cash outflow)
-$7,282
Net income $561
Net cash flow $3,279
Net Cash Flow:
Year One Cash Flow
25
Depreciation $10,000
Increase in working capital - $10,623
Net income +$8,580
Net cash flow $7,957
Net 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.
Year Two Cash Flow
26
• If we assume that cash flow continue to grow at 4% per year at and beyond year 6 (g = 4%, r = 15%,):
327,325$04.015.0
786,35$or ,
786,35$410,34$04.11
61
1
PVgr
CFPV
CFgCF
tt
tt
Terminal Value for Jazz CD Proposal
• 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
• Using assumption that cash flow grow at a steady rate past year 6:
475,153$15.1
327,325$410,34$
15.1
211,35$
15.1
833,24$
15.1
785,15$
15.1
957,7$
15.1
279,3$000,53$
66
4321
NPV
233,34$15.1
513,49$410,34$
15.1
211,35$
15.1
833,24$
15.1
785,15$
15.1
957,7$
15.1
279,3$000,53$
65
4321
NPV
NPV for Jazz CD Proposal
• Using book value assumption for terminal value:
• NPV is positive with both methods: investing in Jazz CD project increases shareholders wealth.
28
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.
Capital Rationing
29
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.
Capital Rationing
30
• 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:
Device A’s cash outflow < Device B’s cash outflow
select A?
Equipment Replacement and Unequal Lives
• Using real discount rate of 7%:
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
• 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:
$6,072 X 07.107.107.1
936,15$321
XXX
Device A
$5,333Y 07.107.107.107.1
065,18$4321
YYYYDevice B
• Since Device B’s annuity cost is lower, choose Device B.
Equivalent Annual Cost (EAC)
34
• 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)
Excess Capacity
35
• NPV of leasing excess capacity (assume 10% discount rate):
471,108$1.1
000,000,2
10.1
000,125000,000,2000,125
2NPV
01.1
000,000,2
10.1000,000,2
2
XXNPV
Excess Capacity
- X = $181,818 (at the beginning of the year) - Leasing the excess capacity for a price above $181,818
would increase shareholders wealth.
• 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.
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
• 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
Cash Flow and Capital Budgeting