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Professor John Zietlow MBA 621

Chapter 8. Cash Flow And Capital Budgeting. Professor John Zietlow MBA 621. Chapter 8: Overview. 8.1 Types of Cash Flows Cash flow vs. accounting profit Fixed asset expenditures Working capital expenditures Terminal value Incremental cash flow vs. sunk costs Opportunity costs

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Professor John Zietlow MBA 621

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  1. Chapter 8 Cash Flow And Capital Budgeting Professor John ZietlowMBA 621

  2. Chapter 8: Overview • 8.1 Types of Cash Flows • Cash flow vs. accounting profit • Fixed asset expenditures • Working capital expenditures • Terminal value • Incremental cash flow vs. sunk costs • Opportunity costs • 8.2 Cash Flow for Classicaltunes.com • 8.3 Cash Flows, Discounting, and Inflation • 8.4 Special Problems in Capital Budgeting • Equipment replacement and equivalent annual cost • Excess Capacity • 8.5 Summary

  3. Types of Cash Flows • First step in capital budgeting: determine the relevant CFs • The incremental after-tax cash outflow (investment) and resulting cash flows. • Cash flows, rather than accounting values, are used. • The cash flows of any project having simple cash flows can include three basic components: • (1) initial investment, (2) operating CFs, and (3) terminal CF • All projects have the first two components • Initial investment includes all set up costs • Also includes incremental working capital investment • Operating cash flows are after-tax net cash flows – using the firm’s marginal tax rate • CF, not earnings, so add depreciation back in • The terminal CF usually related to liquidation of the project • Include disposal costs and after-tax salvage values, if any

  4. Cash Flow Versus Accounting Profit • Capital budgeting concerned with cash flow, not accounting profit • Most important distinction: non-cash charges • Two ways to treat non-cash charges • Can compute net income and add depreciation back • Can compute after-tax income, then add tax savings • Demonstrate two methods (next slide) by assuming a firm purchases a fixed asset today for $30,000 • Plans to depreciate over 3 years using straight-line method • Using machine, firm will produce 10,000 units/year • Product sells for $3/unit and costs $1/unit • Firm pays taxes at a 40% marginal rate

  5. Adding non-cash expenses back to after-tax earnings Find aft-tax profits, add back non-cash charge tax savings Sales $30,000 Sales $30,000 Cost of goods (10,000) Cost of goods (10,000) 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 Taxes (40%) (4,000) Depreciation tax savings $4,000 Net income $6,000 Cash Flow $16,000 Cash flow = NI + deprec $16,000 Two Methods Of Handling Depreciation To Compute Cash Flow Simplest and most common technique: Add depreciation back in

  6. An Overview Of Depreciation • Largest non-cash charge for most projects: depreciation • Firms allowed to charge off portion of asset’s cost each year • For tax purposes, depreciation is regulated by the IR Code, as laid out most recently in the Tax Reform Act of 1986. • A firm will often use different depreciation methods for financial reporting and tax purposes, which is quite legal. • Depreciation for tax purposes is determined by using themodified accelerated cost recovery system (MACRS) • In US & UK, different depreciation methods can be used for taxes and financial reporting • MACRS standards, which apply to both new and used assets, require a taxpayer to use as an asset's depreciable life the appropriate MACRS recovery period. • There are six MACRS recovery periods--3, 5, 7, 10, 15, and 20 years--excluding real estate (not depreciable). • The first four property classes defined next slide.

  7. The First Four Depreciation MACRS Classes

  8. MACRS Recovery Periods • For tax purposes, assets in the first four property classes depreciated by the double-declining balance (200%) method • Also computed using the half-year convention and switching to straight-line when advantageous. • The approximate percentages written off each year for the first four property classes are given in Table 8.1. • Rather than using these, the firm can use either straight-line depreciation over the asset's recovery period with the half-year convention or the alternative depreciation system. • We use MACRS figures as these generally provide for the fastest writeoff & thus the best CF effects for profitable firms • MACRS requires use of the half-year convention, so assets assumed to be acquired in mid-year • So only half of first year's deprec is recovered in year 1 • Final half-year of depreciation is recovered in the year immediately following the asset's stated recovery period. • Deprec %s for an n-year asset thus given for n + 1 years

  9. Depreciation Percentages By Year

  10. Finding Initial Cost of Fixed Asset Purchase • Cap budget decisions usually entail acquiring fixed asset. • Initial cost typically measured as net cash outflow • If new asset, net initial cost fairly simple to compute • Just purchase price plus installation costs • If new asset purchased to replace existing asset, finding net initial cost much more complicated • Must account for purchase and installation cost of new asset • Plus after-tax inflow or outflow from old asset = sale price net of removal costs, plus or minus tax impact of sale • Tax impact from sale of old asset depends on asset’s sale price and book value • Sale price below book value  capital loss (tax benefit) • Sale price above book value, but below purchase price  firm must pay tax on recaptured depreciation • Sale price above purchase price  firm must pay tax on recaptured depreciation plus capital gain

  11. Calculating Net Initial Cost Of New Computers For Electrocom Mfg • Electrocom Mfg wants to replace computers purchased three years ago for $100,000 with newer, faster machines • Old computers have been deprec with 5-year MACRS rule • Accum deprec = $71,200 (71.20%); so book value = $28,800 • If Electrocom sells its old computers for $10,000, what is net after-tax cash flow from sale? Assume tax rate = 40% • Capital loss, sale of old computer = book value - sale price = $28,800 - $10,000 = $18,800 • Tax benefit of capital loss (assuming firm has other profits) = capital loss x tax rate = $18,800 x 0.40 = $7,520 • Net inflow from sale = sale price + tax benefit = $17,520 • Net initial cost of new computers thus the purchase and installation cost of new computers minus $17,520

  12. Working Capital Expenditures • Many cap investments require additions to working capital • Net working capital (NWC) = curr assets – curr liabilities • Increase in NWC is a cash outflow; decrease a cash inflow • Some curr assets (A/R) can be acquired thru trade credit, but curr liab will go up if credit extended (A/P) • Demonstrate impact of WC investment on cash flow with calendar sales booth in mall over Christmas season • Operate booth from November 1 to January 31 (close Feb1) • 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; close up shop Feb 1 • Always want to have $500 cash on hand; invest cash Nov 1, receive it back Jan 31.

  13. 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 sales receipts Oct 1 to Oct 31 Nov 1 to Nov 30 Dec 1 to Dec 31 Jan 1 to Jan 31 Sales revenue [all cash] $0 $4,500 [30%] $9,000 [60%] $1,500 [10%] Payments $0 ($5,000) ($5,000) ($5,000) Net cash flow ($500) Working Capital For Calendar Sales Booth $0 $0 +$3,000 ($500) +$4,000 ($3,000)

  14. Terminal Value • Some investments have a well-defined life, determined by: • Physical life of a piece of equipment • Period until a patent expires • Period of time covered by a leasing or licensing agreement • Terminal value used when evaluating an investment with indefinite life-span • 1. Construct cash-flow forecasts for 5 to 10 years • 2. Forecasts more than 5 to 10 years – high margin of error; use terminal value instead • Terminal value – 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

  15. 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 Terminal Value of SDL Acquisition • JDS Uniphase projections for acquisition of SDL Inc. • Different ways to calculate terminal values – assumptions used to calculate terminal value are very important • 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 • Use investment’s book value or liquidation value • Estimate recovery of no more than 20 – 50 percent of original purchase cost (Asplund, 2002) • Possibly negative terminal value if high disposal costs

  16. Terminal Value of SDL Acquisition (Continued) • If 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

  17. Incremental Cash Flow • Incremental cash flows vs. sunk costs • Cap budgeting analysis should include only incremental costs • For example, decision to pursue MBA can be based on incremental cash flows • Norman Paul’s current salary is $60,000 per year and expect to increase at 5% each year • Assume that 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 – not incremental to the decision to go back to school (assume the same expenses for room and board in both cases)

  18. Incremental Cash Flow (Continued) • 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 • Unwanted incremental cash outflow – cannibalization (sales of new products may come at expense of firm’s existing products

  19. Opportunity Costs • Opportunity cost: cash flows from alternative investment opportunities that are forgone when one investment is undertaken • If Norm did not attend MBA, he would have earned: • First year: $60,000 ($39,000 after taxes) • Second Year: $63,000 ($40,950 after taxes) • Norm’s opportunity cost: $39,000 + $40,950 = $79,950 • NPV of a project could fall substantially if opportunity costs are recognized • MBA applications are countercyclical because applicants take into consideration opportunity costs • A firm that bought land for an expansion opportunity, for example, should factor into the NPV of firm’s expansion plans the opportunity cost of selling or leasing the land

  20. Initial Investment for Classicaltunes.com Jazz CD Project • Company 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 • Initial investment transactions: • $50,000 for computer equipment (MACRS 5-year asset class) • $4,500 for inventory ($2,500 of which purchased on credit) • $1,000 increase in cash balances • Sales expected to begin when new fiscal year begins • Expanding sales volume require increases in current assets and additional spending on fixed assets • Any additional financing (besides trade credit) for the project from funds generated by classical-music CD side of the business

  21. 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 Units 0 4,000 10,000 16,000 22,000 24,000 25,000 Abbreviated Project Income Statement Revenue 0 55080 140454 229221 321482 357722 380080 Cost of goods sold 0 41861 105341 169623 234682 259349 273657 Gross profit 0 13219 35114 59597 86800 98374 106422 SG&A Expense 0 8262 19664 29799 35363 35772 38008 Depreciation 10000 18000 13800 14280 23872 25208 18512 Pretax profit -10000 -13043 1649 15519 27565 37393 49903 Projections for Jazz CD Proposal

  22. Abbreviated Project Balance Sheet Year 0 1 2 3 4 5 6 Cash 1000 2000 2500 3000 3200 3300 3500 Accounts Receivable 0 4590 11705 19102 26790 29810 31673 Inventory 4500 7344 18727 30563 42864 47696 50677 Current Assets 5500 13934 32932 52665 72855 80806 85851 Gross P&E 50000 60000 65000 90000 130000 145000 155000 Accumulated Depreciation 10000 28000 41800 56080 79952 105160 123672 Net P&E 40000 32000 23200 33920 50048 39840 31328 Total assets 45500 45934 56132 86585 122903 120646 117179 Accounts Payable 2500 4320 11016 17978 25214 28057 29810 Projections for Jazz CD Proposal (Continued)

  23. Annual Cash Flow Estimates for Classicaltunes.com Year 0 1 2 3 4 5 6 New Fixed Assets -50000 -10000 -5000 -25000 -40000 -15000 -10000 Change in working capital -3000 -6614 -12302 -12771 -12953 -5109 -3291 Operating cash flow 4000 10174 14790 23591 40411 47644 48454 Net cash flow -49000 -6440 -2512 -14180 -12542 27535 35163 Annual Cash Flow Estimates

  24. Year Zero Cash Flow • Initial cash outlay of $50,000 for computer equipment • Even though sales begin when new fiscal year begins, half-year of MACRS depreciation can be taken in year zero: • 20% x $50,000 = $10,000; non cash expense • Depreciation expense can be deducted from the firm’s classical-music CD profits. The company saves $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: Increase in gross fixed assets - $50,000 Change in working capital - $3,000 Tax savings + $4,000 Net cash flow - $49,000

  25. 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

  26. Year One Cash Flow (Continued) • 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: Increase in gross fixed assets - $10,000 Change in working capital - $6,614 Operating cash inflow + $10,174 Net cash flow - $6,440

  27. Year Two Cash Flow • Purchase of additional $5,000 in fixed assets • Assets purchased at the onset of the project – 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)

  28. Year Two Cash Flow (Continued) • 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: Increase in gross fixed assets - $5,000 Change in working capital - $12,302 Operating cash inflow + $14,790 Net cash flow - $2,512

  29. Terminal Value for Jazz CD Investment • If 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

  30. 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

  31. Nominal and Real Return • Nominal return vs. real return • Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment • Common in capital budgeting is the use of market rates of return at the time of the analysis • Market interest rates have embedded an assumption about inflation • In this case, use nominal cash flows to reflect the same inflation rate as that embedded in discount rate

  32. Inflation Rules • Inflation Rule 1 – if nominal rate used to discount cash flow of a project, the embedded inflation expectation in the nominal rate must be used to construct the cash flows • In analysis of Jazz CD’s investment, assumption that price of a CD increases by 2% per year on average • Revenues expressed in nominal terms • Discount rate used (10%) must reflect current market returns to account for inflation rate • Inflation Rule 2 – when project cash flows are stated in real rather than nominal terms, the appropriate discount rate is the real rate • Cash flows projections for Classicaltunes.com could be expressed in real terms • Use current price for CDs of $13.50, current-year labor costs, current-year prices for fixed assets for projections of cash flows

  33. Real-Term Cash Flow Estimates for Classicaltunes.com Year 0 1 2 3 4 5 6 Nominal cash flow -49000 -6440 -2512 -14180 -12542 27535 35163 Discount factor 1 Real-term cash flow -49000 -6314 -2415 -13362 -11587 24939 31224 Real-Term Cash Flows for Jazz CD Investment • To obtain cash flow in real terms – discount nominal cash flow at inflation rate • First year cash flow of -$6,440 restated in real terms

  34. NPV of Jazz CD Project • Real rate for Classicaltunes.com • NPV of the project – discount real-term cash flow at real rate Discounting real cash flows at real interest rate yields the same NPV as discounting nominal cash flows at nominal rate

  35. NPV Understated NPV Overstated Capital Budgeting and Inflation Nominal Cash Flows Real Cash Flows Nominal Discount Rate • If discount nominal cash flows at real discount rate: Real Discount Rate • If discount real cash flows at nominal discount rate:

  36. Device 0 1 2 3 4 A 12000 1500 1500 1500 - B 14000 1200 1200 1200 1200 Device NPV A $15,936 B $18,065 Equipment Replacement • 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 • Maintenance costs – constant over time – use real discount rate of 7% for NPV • Cash outflow device A < cash outflow device B  select A

  37. Year A B 0 12,000 14,000 1 1,500 1,200 2 1,500 1,200 3 13,500 1,200 4 1,500 15,200 5 1,500 1,200 6 13,500 1,200 7 1,500 1,200 8 1,500 15,200 9 13,500 1,200 10 1,500 1,200 11 1,500 1,200 12 1,500 1,200 NPV(7%) $48,233 $42,360 Equipment Replacement (Continued) • Previous approach ignores the fact that device A will be replaced in year 4 • Different approach – use cash flows for 12 years  select B

  38. Equivalent Annual Cost (EAC) • EAC method approximates NPV for operating device with NPV of annuity • 1. Compute NPV for operating devices A and B for their lifetime • NPV device A = $15,936 • NPV device B = $18,065 • 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device • Device A • Device B

  39. Equivalent Annual Cost (Continued) • The firm chooses device B – replacing device B every four years is equivalent to a perpetuity of $5,333 • The firm assumes that will keep using device B for a long period of time • Assume the firm will use in three years new, less expensive technology that makes current technology obsolete • In this case, choose the device that has the smallest cash outflow for three years – choose A (assume salvage value zero)

  40. Excess Capacity • Excess capacity – 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 as new stores are built in the region • The firm could lease the excess space for $125,000 per year for the next two years • Expansion plans should begin immediately in this case to hold inventory for stores that will come on line in a few months • Incremental cost – investing $2,000,000 at present vs. two years from today • Incremental cash inflow - $125,000

  41. Excess Capacity (Continued) • NPV of leasing excess capacity (assume 10% discount rate) • NPV negative – reject to lease excess capacity at $125,000 per year • The firm could compute the value of the lease that would allow to break even • X = $181,818 • Leasing the excess capacity for a price above $181,818 would increase shareholders wealth

  42. The Human Face of Capital Budgeting • NPV of a project is based on a number of assumptions • Managers must be aware of optimistic bias in these assumptions made by supporters of the project • Companies should have control measures in place to remove bias • Analysis of an investment done by a group independent of individual or group proposing the project • Analysts of the project must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential • Another side of determining which projects receive funding – storytelling • Best analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense

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