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Chapter 11: Cash Flows & Other Topics in Capital Budgeting

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## Chapter 11: Cash Flows & Other Topics in Capital Budgeting

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**Chapter 11: Cash Flows & Other Topics in Capital Budgeting** 2000, Prentice Hall, Inc.**Capital Budgeting: the process of planning for purchases of**long-termassets. • example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment? • The relevant project information follows:**The cost of the new machine is $127,000.**• Installation will cost $20,000. • $4,000 in net working capital will be needed at the time of installation. • The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. • Simplified straight line depreciation is used. • Class life is 5 years, and the firm is planning to keep the project for 5 years. • Salvage value at year 5 will be $50,000. • 14% cost of capital; 34% marginal tax rate.**Capital Budgeting Steps**1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. • Initial outlay • Differential Cash Flowsover the life of the project (also referred to as annual cash flows). • Terminal Cash Flows**. . .**0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows**. . .**0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Initial outlay**. . .**0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Initial outlay Annual Cash Flows**. . .**0 1 2 3 4 5 6 n Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay Annual Cash Flows**Capital Budgeting Steps**2) Evaluate the risk of the project. • We’ll get to this at the end of this chapter. • For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. • If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.**Capital Budgeting Steps**3) Accept or Reject the Project.**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + ( 4,000) + 0 Net Initial Outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + ( 20,000) shipping and installation (147,000) depreciable asset + ( 4,000) net working capital + 0 proceeds from sale of old asset ($151,000) net initial outlay**Step 1: Evaluate Cash Flows**• a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + ( 20,000) shipping and installation (147,000) depreciable asset + ( 4,000) net working capital + 0 proceeds from sale of old asset ($151,000) net initial outlay**Step 1: Evaluate Cash Flows**• b) Annual Cash Flows: What incremental cash flows occur over the life of the project?**For Each Year, Calculate:**Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow**For Years 1 - 5:**85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow**For Years 1 - 5:**85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789)Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow**Step 1: Evaluate Cash Flows**• c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow**Step 1: Evaluate Cash Flows**• c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow**Tax Effects of Sale of Asset:**• Salvage value = $50,000 • Book value = depreciable asset - total amount depreciated. • Book value = $147,000 - $147,000 = $0. • Capital gain = SV - BV = 50,000 - 0 = $50,000 • Tax payment = 50,000 x .34 = ($17,000)**Step 1: Evaluate Cash Flows**• c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow**Step 1: Evaluate Cash Flows**• c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000Recapture of NWC Terminal Cash Flow**Step 1: Evaluate Cash Flows**• c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow**Project NPV:**• CF(0) = -151,000 • CF(1 - 4) = 46,461 • CF(5) = 46,461 + 37,000 = 83,461 • Discount rate = 14% • NPV = $27,721 • We would acceptthe project.**Incorporating Risk into Capital Budgeting**• Risk-Adjusted Discount Rate**n**t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account?**n**t=1 S ACFt (1 + k) NPV = - IO t How can we adjust this model to take risk into account? • Adjust the discount rate (k).**Risk-Adjusted Discount Rate**• Simply adjust the discount rate (k) to reflect higher risk. • Riskier projects will use higher risk-adjusted discount rates. • Calculate NPV using the new risk-adjusted discount rate.**n**t=1 S ACFt (1 + k*) NPV = - IO t Risk-Adjusted Discount Rate**Risk-Adjusted Discount Rates**• How do we determine the appropriate risk-adjusted discount rate (k*) to use? • Many firms set up risk classes to categorize different types of projects.**Risk Classes**Risk RADR Class (k*) Project Type 1 12% Replace equipment, Expand current business 2 14% Related new products 3 16% Unrelated new products 4 24% Research & Development**Summary: Risk and Capital Budgeting**You can adjust your capital budgeting methods for projects having different levels of risk by: • Adjusting the discount rate used (risk-adjusted discount rate method), • Measuring the project’s systematic risk, • Computer simulation methods, • Scenario analysis, • Sensitivity analysis.**Practice Problems:Cash Flows & Other Topics in Capital**Budgeting**Problem 1a**Project Information: • Cost of equipment = $400,000 • Shipping & installation will be $20,000 • $25,000 in net working capital required at setup • 3-year project life, 5-year class life • Simplified straight line depreciation • Revenues will increase by $220,000 per year • Defects costs will fall by $10,000 per year • Operating costs will rise by $30,000 per year • Salvage value after year 3 is $200,000 • Cost of capital = 12%, marginal tax rate = 34%**Problem 1a**• Initial Outlay: (400,000) Cost of asset + ( 20,000) Shipping & installation (420,000) Depreciable asset + ( 25,000) Investment in NWC ($445,000) Net Initial Outlay**Problem 1a**For Years 1 - 3: 220,000 Increased revenue 10,000 Decreased defects (30,000) Increased operating costs (84,000) Increased depreciation 116,000 EBT (39,440) Taxes (34%) 76,560 EAT 84,000 Depreciation reversal 160,560 = Annual Cash Flow**Problem 1a**• Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow**Problem 1a**• Terminal Cash Flow: • Salvage value = $200,000 • Book value = depreciable asset - total amount depreciated. • Book value = $168,000. • Capital gain = SV - BV = $32,000 • Tax payment = 32,000 x .34 = ($10,880)