Chapter 8Cash Flow and Capital

Budgeting

Professor XXXXXCourse Name / #

© 2007 Thomson South-Western

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Cash Flow and Capital Budgeting

The kinds of cash flows that may appear in almost any type of investment

How to deal properly with the problem of inflation in capital budgeting problems

Special problems and situations that arise in the capital budgeting process

The human element in capital budgeting

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Cash Flow versus Accounting Profit

In preparing financial statements for external reporting, accountants have a different purpose in mind than financial analysts have when they evaluate the merits of an investment.Accountants measure the inflows and

outflows of a business’s operations on an accrual basis rather than on a cash basis.E.g., depreciation

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Cash Flow versus Accounting Profit

For capital budgeting purposes, financial analysts focus on incremental cash in-flows and outflows.

This emphasis simply recognizes that no matter what earnings a firm may show on an accrual basis, it cannot survive for long unless it generates cash to pay its bills. When calculating a project’s NPV, analysts

should ignore the costs of raising the money to finance the project.

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The Initial Investment

Many capital budgeting problems begin with an initial outflow to acquire/install fixed assets. Must also consider: 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 has been fully depreciated, sold for $1

million

The initial investment would then be an outflow of $10.5 million, and an after-tax inflow of $0.60 million from selling

the old equipment

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Types of Cash Flows

DepreciationFixed asset expendituresWorking capital expendituresTerminal value Incremental cash flow

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Depreciation

Largest noncash item for most investment projects

Affects the amount of taxes the firm will pay

Modified accelerated cost recovery system (MACRS)defines the allowable annual

depreciation deductions for various classes of assets

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Depreciation

Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes

Accelerated depreciation methods (such as 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

Which method would you expect companies to use when they file their taxes, and which would they use when

preparing public financial statements?

For capital budgeting analysis, it is the depreciation method for tax purposes that matters

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Assume a firm purchases a fixed asset today for $30,000

Plans to depreciate over 3 years using straight-line method

Firm will produce 10,000 units/year

Costs $1/unit

Sells for $3/unit

Firm pays taxes at a 40% marginal rate

$6,000Net income

$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

$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 charge tax savings

Simplest and most common technique:Add depreciation back in

Two Methods Of Handling Depreciation To Compute Cash Flow

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Tax Depreciation Schedules by Asset Class

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Fixed Asset Expenditures

When a firm sells an old piece of equipment, there will be a tax consequence of the sale if the selling price exceeds or falls below the old equipment’s book value. If the firm sells an asset for more than its

book value, the firm must pay taxes on the difference.

If a firm sells an asset for less than its book value, then it can treat the difference as a tax-deductible expense.

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Working Capital Expenditures

Many capital investments require additions to working capital Net working capital (NWC) = current assets

minus current liabilities Increase in NWC is a cash outflow; decrease 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

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Working Capital For Calendar Sales Booth

($4,000)+$500+$500NAMonthly in WC

($3,000)$1,000$500$0Net WC

$5,000$10,000$15,000$0Accts payable

$0$1,500$10,500$15,000$0Inventory

$0$500$500$500$0Cash

Feb 1Jan 1Dec 1Nov 1Oct 1

($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)

$0

$0

+$3,000

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Terminal Value

Terminal value used when evaluating an investment with indefinite life-span

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

• Terminal value is 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

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Terminal Value

Different ways to calculate terminal values

– Use final year cash flow projections and assume that all future cash flows grow at a constant rate

– Multiply final cash flow estimate by a market multiple

– 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.

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Terminal Value of SDL Acquisition

If we 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

7.48$1.1

2.68$

1.1

25.3$

1.1

5.2$

1.1

75.1$

1.1

1$

1.1

5.0$554321

2.68$05.010.0

41.3$or , 5

1

PVgr

CFPV t

t

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Incremental Cash Flow

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

expect increases of 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

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Incremental Cash Flow

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

150,66$05.1000,60$ 2

032,18$35.0105.1000,60$08.1000,90$ 3

What about Norm’s opportunity cost?

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Opportunity Cost

In capital budgeting, the opportunity costs of one investment are the cash flows on the alternative investment that the firm decides not to make.

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Opportunity Costs

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, he would haveearned:

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Cash Inflows, Discounting, and Inflation

If inflation is in the numerator, be sure that it is also in the denominator. If the numerator ignores inflation, so too must the

denominator. The nominal return reflects the actual dollar

return. The real return measures the increase in

purchasing power gained by holding a certain investment.

In general, when the inflation rate is high, so too will be the nominal rate of return offered by various investments: Investors will demand a return that not only keeps

pace with inflation, but also offers a positive real return.

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Inflation Rule 1

Nominal cash flows reflect the same inflation rate that the interest rate does

Inflation Rule 1 — When we discount cash flows at a nominal interest rate, embedded in the discount rate is an estimate of expected inflation.

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Inflation Rule 2

Occasionally an investment’s cash flow projections may be stated in real terms.

Real cash flows only reflect current prices and do not incorporate upward adjustments for expected inflation.

Inflation Rule 2 — When project cash flows are stated in real rather than in nominal terms, the appropriate discount rate is the real rate.

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Equipment Replacement and Unequal Lives A firm must purchase an electronic control device

First alternative is a cheaper device, higher maintenance costs, shorter period of utilization

Second device is more expensive, smaller maintenance costs, longer life span

Expected cash outflows

Maintenance costs are constant over time. Use real discount rate of 7% for NPV

-15001500150012000A120012001200120014000B

43210Device

$15,936A$18,065B

NPVDevice

Cash outflow device A < cash outflow device B select A?

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Equivalent Annual Cost (EAC)

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

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

$6,072 X 071071071

93615321

...

,$XXX

Device A

$5,333Y 071071071071

065184321

....

,$YYYY

Device B

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Capital Budgeting and Inflation

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Special Problems in Capital Budgeting

Equipment replacement and equivalent annual cost

Excess capacity

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Operating and Replacement Cash Flows for Two Devices

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Excess Capacity

When firms operate at less than full capacity, managers encourage alternative uses of the excess capacity because they view it as a free asset.

The marginal cost of using excess capacity is zero in the very short run, but using excess capacity today may accelerate the need for more capacity in the future.

When this is so, managers should charge the cost of accelerating new capacity development against the current proposal for using excess capacity.

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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 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

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Excess Capacity 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

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

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Human Face of Capital Budgeting

The best financial analysts can provide not only the numbers to highlight the value of a good investment, but also can explain why the investment makes sense, highlighting the competitive opportunity that makes one investment’s NPV positive and another’s negative.