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Capital Budgeting Project Cash Flows and Risk

^. ^. ^. ^. ^. ^. ^. ^. ^. CF 1 (1 + r ) 1. CF 1 (1 + r) 1. CF 1 (1 + r) 1. CF 2 (1 + r ) 2. CF 2 (1 + r) 2. CF 2 (1 + r) 2. CF n (1 + r ) n. CF n (1 + r) n. CF n (1 + r) n. Asset’s Net Value. Asset’s Net Value. Asset’s Net Value. + … +. + … +. + … +.

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Capital Budgeting Project Cash Flows and Risk

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  1. ^ ^ ^ ^ ^ ^ ^ ^ ^ CF1 (1 + r)1 CF1 (1 + r)1 CF1 (1 + r)1 CF2 (1 + r)2 CF2 (1 + r)2 CF2 (1 + r)2 CFn (1 + r)n CFn (1 + r)n CFn (1 + r)n Asset’s Net Value Asset’s Net Value Asset’s Net Value + … + + … + + … + = NPV = CF0 + = NPV = CF0+ = NPV = CF0 + + + + Capital BudgetingProject Cash Flows and Risk • When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future. • When evaluating a capital budgeting project, we must estimate the after-tax cash flows the asset is expected to generate in the future. • Future cash flows generally are uncertain to some degree, so the risk associated with a capital budgeting project should be considered

  2. Capital BudgetingProject Cash Flows and Risk • Cash Flow Estimation • Expansion Project Evaluation • Replacement Analysis • Risk Analysis in Capital Budgeting • Capital Rationing & Multinational Capital Budgeting

  3. Net = + Cash Net income Depreciati on Flow Return of on Return = + capital capital Capital BudgetingRelevant Cash Flows Cash flow versus accounting income

  4. Capital Budgeting—Relevant Cash Flows Incremental cash flows—marginal cash flows (positive and negative) generated by the asset • Sunk cost • Opportunity cost • Externalities • Shipping and installation • Depreciable basis = Purchase price + (Shipping & Installation) • Inflation

  5. Identifying Incremental Cash Flows • Initial investment outlay—includes cash flows that occur only at the beginning of the project’s life. • Incremental operating cash flows—changes in cash flows that are sustained throughout the life of the asset—that is, the cash flow effects are ongoing. • Terminal cash flow—the cash flows that occur only at the end of the life of the asset.

  6. Initial Investment Outlay • Purchase price • Shipping and installation • Cost/Benefit of disposing of old asset • Taxes • Change in net working capital • Net working capital = CA – CL • Other “up-front” inflows/outflows

  7. Incremental Operating Cash Flows • D Cash sales • D Salaries • D Costs of raw materials • D Other cash operating revenues and expenses • D Taxes • Δrevenues or expenses, Δ tax liability • Depreciation—non-cash expense that affects taxes

  8. Terminal Cash Flow • Salvage value of new asset • Taxes • Salvage value of old asset • Taxes • DNet working capital • Other “terminal” inflows/outflows associated with both the new asset and the old asset

  9. Capital Budgeting Project Evaluation • Expansion projects—marginal cash flows include all cash flows associated with adding a new asset to grow the firm. • Replacement analysis—marginal cash flows include changes (+ or -) in the cash flows associated with the new asset that replace the cash flows associated with the old asset that is replaced (maintain existing operations by replacing an old asset).

  10. Expansion Project—Example Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate 34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate 34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate 34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate 34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate 34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate34% • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500) • Increase in gross profit$21,000 • Marginal tax rate34%* • Depreciation methodMACRS Increase production by adding a machine • Purchase price$(47,000) • Installation$(3,000) • Life 3 years • Salvage$5,000 • Increase in net WC$(1,500)* • Increase in gross profit$21,000 • Marginal tax rate34%* • Depreciation methodMACRS

  11. MACRS Depreciation Life Class of Investment Year3-year5-year7-year 133%20%14% 2453225 3151917 471213 5119 669 79 84 100%100%100%

  12. Expansion ProjectInitial Investment Outlay Purchase Price$(47,000) Installation( 3,000) Δ Net WC( 1,500) Purchase Price$(47,000) Installation( 3,000) Δ Net WC( 1,500) Initial invest outlay$(51,500) Depreciable basis= $47,000 + $3,000 = $50,000

  13. Expansion ProjectIncremental Operating CF Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) Depreciation1 = $50,000(0.33) = $16,500 Depreciation1 = $50,000(0.33) = $16,500 Depreciation2 = $50,000(0.45) = $22,500 Depreciation1 = $50,000(0.33) = $16,500 Depreciation2 = $50,000(0.45) = $22,500 Depreciation3 = $50,000(0.15) = $ 7,500

  14. Expansion ProjectIncremental Operating CF Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) D net income Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) D net income2,970 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510 D net income2,970 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510 D net income2,970( 990) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990) Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,500 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,500 D operating CF19,470 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,50022,500 D operating CF19,470 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,50022,500 D operating CF19,47021,510 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,50022,5007,500 D operating CF19,47021,510 Year 1 Year 2 Year 3 D gross profit$21,000$21,000$21,000 Depreciation(16,500)(22,500)( 7,500) D taxable income4,500( 1,500)13,500 D taxes (34%) (1,530) 510( 4,590) D net income2,970( 990)8,910 Depreciation16,50022,500 7,500 D operating CF19,47021,51016,410

  15. Expansion ProjectTerminal Cash Flow Salvage of asset$5,000 Taxes on sale(510) Δ net working capital1,500 Salvage of asset$5,000 Taxes on sale(510) Δ net working capital1,500 Terminal cash flow 5,990 Salvage of asset$5,000 Taxes on sale(510) % of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500 Gain on sale = Sale price – Book value % of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500 Gain on sale = $5,000– Book value % of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500 Gain on sale = $5,000–$3,500=$1,500 Tax on gain = 0.34 x $1,500 = $510 % of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500 Gain on sale = $5,000–$3,500 % of asset depreciated = 33% + 45% + 15% = 93% Book Value = (0.07)$50,000 = $3,500 Gain on sale = $5,000–$3,500=$1,500

  16. 0 1 2 3 Expansion ProjectCash Flow Time Line 12% (51,500.00) 19,470 21,510 16,410 5,990 17,383.93 22,400 17,147.64 15,943.88 IRR = 10.9% (1,024.55)

  17. Replacement Decision—Example Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate 40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate 40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate 40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate 40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40% 40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40%40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40%40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40%40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40%40% Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000* Marginal tax rate40%40%* Old machineNew Machine Purchase price$(34,000)$(40,000) Original life 6 years 4 years Remaining life 4 years 4 years Current salvage value$16,000-- Book value in four years$4,000$0 Salvage in four years$1,000$2,000 Depreciation$5,000MACRS: 3-yr Operating expense savings--$8,000 Δ Net WC--$1,000 Marginal tax rate40% 40%*

  18. Replacement DecisionInitial Investment Outlay Purchase price of new machine$(40,000) Salvage value of old machine$16,000 Tax on sale of old machine$3,200 Purchase price of new machine$(40,000) Salvage value of old machine$16,000 Tax on sale of old machine$3,200 D working capital$1,000 Purchase price of new machine$(40,000) Salvage value of old machine$16,000 Tax on sale of old machine$3,200 D working capital $1,000 Initial investment outlay$(19,800) Σ depreciation of old machine = $5,000 x 2 = $10,000 Book value of old machine = $34,000 – $10,000 = $24,000 Loss on sale of old machine = $16,000 – $24,000 = $(8,000) Tax on sale = $(8,000) x 0.40 = $(3,200)

  19. Replacement DecisionIncremental Operating CF Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,0001,000(2,200) D Operating CF8,08010,0005,2003,920 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%)80 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000)2,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000)2,200 D taxable income(200) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000)2,200 D taxable income(200)(5,000) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000)2,200 D taxable income(200)(5,000)7,000 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,0001,000(2,200) D Operating CF8,08010,0005,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%)802,000(2,800) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%)802,000 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,0001,000 D Operating CF8,08010,0005,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,0001,000 D Operating CF8,08010,000 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,000 D Operating CF8,08010,000 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%)802,000(2,800)(4,080) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,200 D Operating CF8,080 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,20013,000 D Operating CF8,080 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000) Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D depreciation(8,200)(13,000)(1,000) 2,200 D taxable income(200)(5,000)7,00010,200 D taxes (40%) 802,000(2,800)(4,080) D net income(120)(3,000)4,2006,120 Depreciation8,200 Year 1 Year 2 Year 3 Year 4 Savings$8,000$8,000$8,000$8,000 D Depreciation1= $40,000(0.33) – $5,000 = $8,200 D Depreciation2= $40,000(0.45) – $5,000 = $13,000 D Depreciation1= $40,000(0.33) – $5,000 = $8,200 D Depreciation2= $40,000(0.45) – $5,000 = $13,000 D Depreciation3= $40,000(0.15) – $5,000 = $1,000 D Depreciation4= $40,000(0.07) – $5,000 = $(2,200) D Depreciation1= $40,000(0.33) – $5,000 = $8,200 D Depreciation2= $40,000(0.45) – $5,000 = $13,000 D Depreciation3= $40,000(0.15) – $5,000 = $1,000 D Depreciation1= New depreciation – Old depreciation = $40,000(0.33) – $5,000 = $8,200

  20. Replacement DecisionTerminal Cash Flow Salvage value of new machine$2,000 Tax on sale of new machine(800) D working capital(1,000) Salvage value of new machine$2,000 Tax on sale of new machine(800) D working capital(1,000) Loss of salvage value of old machine(1,000) Salvage value of new machine$2,000 Tax on sale of new machine(800) D working capital(1,000) Loss of salvage value of old machine(1,000) Loss of tax effect on sale of old machine(1,200) Salvage value of new machine$2,000 Tax on sale of new machine(800) D working capital(1,000) Loss of salvage value of old machine(1,000) Loss of tax effect on sale of old machine(1,200) Terminal cash flow(2,000) Salvage value of new machine$2,000 Tax on sale of new machine(800) Book value of new machine = $0 Gain on sale = $2,000 – $0 = $2,000 Tax on sale = $2,000(0.40) = $800 Book value of old machine in four years = $4,000 Gain on potential sale = $1,000 – $4,000 = $(3,000) Tax on potential sale = $(3,000) x 0.40 = $(1,200)

  21. 0 1 2 3 4 Replacement DecisionCash Flow Time Line 12% (19,800.00) 8,080 10,000 5,200 3,920 (2,000) 7,214.29 1,920 7,971.94 3,701.26 1,220.19 IRR = 12.9% 307.68

  22. Incorporating Risk In Capital Budgeting Analysis • Project risk should be evaluated to determine if the appropriate required rate of return is used to compute the project’s NPV (or to compare to its IRR). • If a firm is considering a project that is much riskier than the existing assets, then it makes sense that the firm should expect to earn a higher return on the project than on its existing assets (and vice versa).

  23. Capital Budgeting Project Risk Types of risk associated with projects: • Stand-alone risk—risk of the asset when it is held in isolation—that is, when it stands alone • Corporate, or within-firm, risk—measured by the impact an asset is expected to have on the operations of the firm—that is, how an asset will affect the firm’s total risk if it is purchased and added to existing assets • Beta, or market, risk—the portion of an asset’s risk that cannot be eliminated through diversification—that is, how an asset will affect the firm’s market risk, or beta, if it is purchased and added to existing assets.

  24. Stand-Alone Risk of a Project • Sensitivity analysis—determine by how much the final result of a computation, such as NPV, changes when the values (inputs) needed for the computation are changed. Example—replacement decision illustration: Operating Expense Required Rate Deviation from Savings per Year of Return (k) Base Case (%) NPV % D NPV % D -10$(421.29)(237%)$519.2769% 0307.680307.680 101,036.6423799.85(68) Operating Expense Required Rate Deviation from Savings per Year of Return (k) Base Case (%) NPV % D NPV % D -10$(421.29)(237%)$519.2769% 0 307.68 0 307.68 0 101,036.6423799.85(68) Operating Expense Required Rate Deviation from Savings per Year of Return (k) Base Case (%) NPV % D NPV % D -10$(421.29) (237%)$519.2769% 0307.680307.680 101,036.64 237 99.85(68) Operating Expense Required Rate Deviation from Savings per Year of Return (k) Base Case (%) NPV % D NPV % D -10$(421.29)(237%)$519.2769% 0307.680307.680 101,036.6423799.85(68)

  25. Stand-Alone Risk of a Project • Scenario analysis—compute outcomes using various circumstances, or scenarios. Scenario Savings NPVProbability Best case$10,000$3,9530.2 Most likely case8,0003080.7 Worst case6,000(3,337)0.1 Scenario Savings NPVProbabilityNPV x Pr Best case$10,000$3,9530.2$790.60 Most likely case8,0003080.7215.60 Worst case6,000(3,337)0.1(333.70) (333.70) Expected NPV = 672.50 (333.70) Expected NPV = 672.50 sNPV = 1,962.89 (333.70) Expected NPV = 672.50 sNPV = 1,962.89 CVNPV =2.92

  26. Stand-Alone Risk of a Project • Monte Carlo simulation—try to simulate the real world by identifying all the possible outcomes for all the situations, or variables, that are associated with a capital budgeting project.

  27. Corporate (Within-Firm) Risk • Determine how a capital budgeting project is related to the existing assets of the firm. • If the firm wants to diversify its risk, it will try to invest in projects that are negatively related (or have little relationship) to the existing assets. • If a firm can reduce its overall risk, then it generally becomes more stable and its required rate of return decreases.

  28. Beta (Market) Risk • Theoretically any asset has a beta,, or some way to measure its systematic risk • If we can determine the beta of an asset, then we can use the capital asset pricing model, CAPM, to compute its required rate of return as follows: rproj = rRF + (rM - rRF)proj • Measuring beta risk for a project—it is difficult to determine the beta for a project. • pure play method

  29. Beta (Market) Risk—Example • Capital Budgeting Project Characteristics: • Cost= $100,000 • bproject= 1.5 • rRF= 3.0% • rM= 9.0% • rproject= 3.0% + (9.0% - 3.0%)1.5 = 12.0% • Firm’s Characteristics Before Purchasing the Project: • Total assets = $400,000 • bfirm= 1.0 • Firm’s Beta Coefficient After Purchasing the Project: • Total assets = $400,000 + $100,000 = $500,000

  30. Capital Budgeting—Risk Analysis • The firm generally uses its average required rate of return to evaluate projects with average risk. • The average required rate of return is adjusted to evaluate projects with above-average or below-average risks. Project Required Risk Category Rate of Return Above-average16% Average12 Below-average10 • If risk is not considered, high-risk projects might be accepted when they should be rejected and low-risk projects might be rejected when they should be accepted.

  31. Capital Rationing • If the amount of funds that is invested in capital budgeting projects is constrained, then capital rationing exists. • The firm should invest in the combination of projects that provides the highest combined NPV—that is, that increases the firm’s value by the greatest total amount.

  32. Multinational Capital Budgeting • For the most part, the capital budgeting projects of multinational firms should be evaluated the same as for domestic firms. • Repatriation of cash (earnings) might be restricted • Projects associated with foreign operations generally are considered riskier than domestic projects because: • Movements in exchange rates—that is, exchange rate risk—affect the translation of foreign currency into domestic currency • Risk that foreign governments will takeover or severely restrict operations of foreign subsidiaries—that is, political risk exists

  33. Project Cash Flows and RiskThe Answers • What are the relevant cash flows associated with a capital budgeting project? • Initial investment outlay • Incremental operating cash flows • Terminal cash flow • What is depreciation and how does it affect a project’s relevant cash flows? • The means by which a long-term asset is expensed over time.

  34. Project Cash Flows and RiskThe Answers • How is risk incorporated in capital budgeting analysis? • Projects that are riskier than average are evaluated with higher required rates of return • How do capital budgeting analyses/decisions differ for multinational firms? • Because risk is greater the required rate of return used to evaluate a foreign investment is higher than the required rate of return for similar domestic investments

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