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## Chapter 10: Cash Flows and Other Topics in Capital Budgeting

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**Chapter 10: Cash Flows and Other Topics in Capital Budgeting** 2002, 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 the end of 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 in the next 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.**Capital Rationing**• Suppose that you have evaluated 5 capital investment projects for your company. • Suppose that the VP of Finance has given you a limited capital budget. • How do you decide which projects to select?**Capital Rationing**• You could rank the projects by IRR:**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 1**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 2 1**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 2 3 1**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 4 2 3 1**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: 5 4 2 3 1**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: Our budget is limited so we accept only projects 1, 2, and 3. 5 4 2 3 1 $X**IRR**25% 20% 15% 10% 5% $ Capital Rationing • You could rank the projects by IRR: Our budget is limited so we accept only projects 1, 2, and 3. 2 3 1 $X**Capital Rationing**• Ranking projects by IRR is not always the best way to deal with a limited capital budget. • It’s better to pick the largest NPVs. • Let’s try ranking projects by NPV.**Problems with Project Ranking**1) Mutually exclusive projects of unequal size (the size disparity problem) • The NPV decision may not agree with IRR or PI. • Solution: select the project with the largest NPV.**Project A**year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Size Disparity example**Project B**year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20 Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Size Disparity example**Project B**year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20 Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Size Disparity example