Capital Budgeting – Further Considerations

For 9.220Chapter 7

Lecture Outline

Introduction The input for evaluating projects –

relevant cash flows Inflation: real vs. nominal analysis Taxes: CCA detailed calculations Summary and conclusions

Introduction Up to this point we have examined the methods or

techniques for capital budgeting: NPV, IRR, PI, Payback, AAR.

All, except AAR, use cash flows for the analysis. AAR is not accepted as a good technique of analysis.

Now we turn to cash-flow analysis. From where do we get the cash flows? We need to determine which cash flows should be included in the analysis and how to include them properly. Here we bring in the concepts of relevant cash flows, inflation, and taxes.

Relevant cash flows

The main principles behind which cash flows to include in capital budgeting analysis are as follows:

1. Only include cash flows that change as a result of the project being analyzed. Include all cash flows that are impacted by the project. This is often called an incremental analysis – looking at how cash flows change between not doing the project vs. doing the project.

Relevant cash flows

2. Use projections of cash flows, not accounting income. Accounting income ≠ cash. Accounting income

cannot be spent, a firm can be losing cash but have positive accounting income, so accounting income is not necessarily representative of cash. Cash is what really generates value; cash can be spent!

Depending on arbitrary accounting policies, income can easily be manipulated, so, by itself, it is not a reliable input for capital budgeting analysis.

Which cash flows are relevant to the project analysis, which are not?

Examples Type of Cash Flow

Is it Relevant to the analysis? Why?

Sunk Costs

Opportunity Costs

Side Effects (or incidental effects)

Interest Expense (or financing charges)

Working Capital Changes Required by the Project – the cash flow effects

Working capital (WC) items do not show up as costs or revenues, however changes to the WC items either require or free-up cash.

Increases in current assets required for the project imply that cash is used so a cash outflow occurs. To increase inventories requires cash. To increase the cash-register float also requires cash. An increase in accounts receivable (AR) means that

the cash you may have recognized, through revenue, hasn’t been received yet. In effect, if your project requires you to increase credit for your customers (an AR increase), then this uses up cash that you would otherwise have.

More on working capital changes Increases in current liabilities, on the other hand, free-

up cash, so a cash inflow occurs. Increasing accounts payable (AP) means that a cost

cash flow you may have recognized elsewhere has not yet been paid, therefore the increase in AP is a cash saving or inflow.

For other payables, the analysis is the same. Salaries payable, utilities payable, etc.

Overall, changes in net working capital (NWC) represent cash flows.

Working Capital Example Without the Project With the Project

(that ends in 2006)WC item

2003 2004 2005 2006

Inven-tory

$10 $10 $10 $10

AR $20 $21 $26 $25

AP $5 $5 $10 $10

NWC $25 $26 $26 $25

WC item

2003 2004 2005 2006

Inven-tory

$12 $12 $14 $10

AR $26 $26 $28 $25

AP $8 $8 $13 $10

NWC $30 $30 $29 $25

NWC Solution No project, change in NWC CF’s are as follows:

With the project, change in NWC CF’s are as follows:

Change in NWC results in the following incremental cash flows that should be included in the project analysis:

2003 2004 2005 2006

Cash flow

2003 2004 2005 2006

Cash flow

2003 2004 2005 2006

ΔCash flow

Salvage Values and Clean-up Costs – Self Study

The change in salvage value or clean-up costs represent cash flows related to a project.

Example: consider a project to build an ice-cream stand on some leased land that is currently used for a parking lot. At the end of the lease, in 5 years, the land must be returned to a natural state.

Salvage/Clean-up Analysis – Self Study Without the Ice-Cream

Stand Project Year 0 cash flow: $0.

Nothing needs to be done, the parking lot can continue for 5 years.

Year 5 cash flows: -$20,000 to clean up the parking lot material. Sell the parking lot gate for scrap for $200.

With the Ice-Cream Stand Project Year 0 cash flows:

-$14,000 to partially clean up the parking lot material now. Sell parking lot gate for $1,500.

Year 5 cash flows: -$16,000 to

clean up the remaining parking lot material and remove ice cream stand. Sell ice cream stand for scrap for $1,000.

Do the incremental analysis

Salvage/Clean-up Solution – Self Study

No Project New ProjectChange

(incremental cash flow)

Yr.0

$0 -$14,000+$1,500

Net=-$12,500 -$12,500

Yr. 5

-$20,000+$200

Net=-$19,800

-$16,000+$1,000

Net=-$15,000 +$4,800

Inflation Sometimes a projected cash flow is

given as a nominal amount (the expected actual amount of cash to be received or paid).

Sometimes a projected cash flow is given as a real amount (the current or date 0 purchasing power of the cash flow. Note, the real cash flow is not the PV.

Nominal/Real Cash Flow Examples Fred’s contract with his employer states that he will

be paid $100,000 three years from now. This is a nominal cash flow. Fred expects to actually

be paid $100,000 in three years. Currently, the “basket of goods” used to measure the

consumers’ price index costs $125. Sue expects to receive a cash flow in four years that will allow her to purchase 100 of these baskets. This can be represented by a real cash flow. The real cash flow amount would be $12,500. If there is inflation between now and four years from

now, then the nominal (actual) cash flow Sue expects must be more than $12,500. She will expect a nominal cash flow that will buy the same 100 baskets. In terms of year 0 purchasing power, the real cash flow is $12,500.

Are real cash flows the same as present values?

No! Which would you prefer to receive, $1,250

today (which can buy 10 “baskets of goods”) or a dollar amount in 5 year that will buy 10 “baskets of goods” then? The $1,250 today is preferred even though, in

terms of purchasing power, both payments give the same purchasing power.

Since the $1,250 today is preferred, the two cash flows cannot have the same present value.

How do we discount real cash flows? Consider the basket of goods that costs $125

today. Suppose inflation is expected to be 5% each year for the next 5 years. How much, in real dollars, do we need to be able to

purchase 10 baskets in 5 years? Let this be our real cash flow

How much, in nominal dollars do we need to be able to purchase the same 10 baskets in 5 years? This must be the equivalent nominal

cash flow What is the relation between the real and nominal

cash flow? (be exact – formula?)

Discounting real vs. nominal cash flows (continued)

If the relevant discount rate for the nominal cash flow is 12%, then what is its PV today?

What discount rate applied to the real cash flow would get the same PV today?

What is the relation between the real discount rate and the nominal discount rate? (be exact – formula?)

Conclusions on real and nominal cash flows

It is possible to express any cash flow as either a real amount or a nominal amount.

Since the real and nominal amounts are equivalent, the PV’s must be equivalent, so remember the rule:

Use of real cash flows

If a project’s cash flows are expected to grow with inflation, then it may be more convenient to express the cash flows as real amounts rather than trying to predict inflation and the nominal cash flows.

Taxes: the basics

Unfortunately, in most civilized countries both corporations and individuals must pay tax on income and profits.

Tax is a cash outflow. So we must include taxes in our capital budgeting analysis.

Calculating tax effects from non-financing components of the income statement.

Recall the income statement you learned about in accounting …

Whatever affects the income statement amounts will also affect the taxes paid.

*Assume depreciation here is what is recognized for tax purposes. In Canada, this is called capital cost allowance, CCA.

Revenues $1,000

Cost of goods sold $600

Gross Margin $400

Selling, general, and admin expenses

$150

R&D expense $50

Depreciation Expense* $100

Earnings Before Tax $100

Tax (at 40%) $40

Earnings after Tax (Net Income)

$60

Tax consequences and after tax cash flows (assume a tax rate, Tc, of 40%)

Item Before-tax amount

Before-tax cash flow

After-tax cash flow

Revenue Rev$10

Rev$10

=Rev(1-Tc)

Expense Exp$10

-Exp-$10

=-Exp(1-Tc)

CCA CCA$10

$0 =+CCATc

Yearly cash flows after tax Normally we project yearly cash flows for a

project and convert them into after-tax amounts.

CCA deductions are due to an asset purchase for a project. CCA is calculated as a % of the Undepreciated Capital Cost (UCC). Since a % amount is deducted each year, the UCC will never reach zero so CCA deductions can actually continue even after the project has ended (and thus shelter future income from taxes). All CCA-caused tax savings should be recognized as cash inflows for the project that caused them.

Detailed CCA Calculations Example: DuoCity Taxi is considering expanding its fleet.

The cost of the new taxis is $1,000,000 now. Taxis fall under CCA Class 16 and are allowed a CCA

rate of 40%. DuoCity’s tax rate is 45% and the relevant opportunity

cost of capital is 15%. The project will generate revenues in excess of

expenditures of $450,000 per year for 5 years. The project will also require an immediate working

capital increase of $50,000, no intermediate changes, and a reversion to normal working capital requirements at the end of 5 years.

Assume the taxis relevant to this project will be sold at the beginning of the 6th year for $100,000.

Analysis using the Tax-Shield Approach: keep CCA tax shield effects separate in the analysis

NPV of above cash flows = PV of CCA tax shields = NPV of the project =

Item Year 0 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5

Asset Purchase/sale

-$1,000,000 $0 $0 $0 $0 +$100,000

Net Revenue less Expense

$0

Working Capital -$50,000 $0 $0 $0 $0

Net -$1,050,000

PV CCA Tax Shields

C = cost of asset d = CCA rate Tc = Corporate tax rate k = Discount rate for CCA tax shields Sn = Salvage value of asset sold in period n with lost CCA deductions

beginning in period n+1 Note: In this course, assume no Capital Gains on disposal of the

asset. Also, assume Asset Pool is not terminated upon disposal of the project’s asset.

ncnc

k1

1

dk

TdS

k12

k1

dk

TdCPV

ShieldsTax CCA

Summary of Capital Budgeting Items and Tax Effects The following formula may help summarize the project’s NPV

calculation. NPV = -initial asset cost1

+ PVSalvage Value or Expected Asset Sale Amount

1

+ PV incremental cash flows caused by the project

2

+ PV incremental working capital cash flows caused by the project

1

– + PVCCA Tax ShieldsFootnotes:1. 1.These items usually have the same before-tax amounts and after-

tax amounts. I.e., there is no tax effect. For asset purchases/sales the tax effect is done through CCA effects.

2. 2.These items usually have the after-tax cash flow equal to the before tax cash flow multiplied by (1-Tc).

Competitive Advantage and Positive NPV Only if there are sources of competitive advantage,

should a positive NPV result. The qualitative analysis of competitive advantage and

the quantitative NPV analysis therefore act to complement each other. Combined, they lead to better decisions.

The stock market recognizes such good decisions by rewarding new projects that utilize or enhance competitive advantages and generate positive NPV’s. Stock prices typically rise on the announcement of a

previously unanticipated project that enhances the corporation’s strategy and generates positive NPV.

Summary and Conclusions A careful NPV (or IRR or PI) analysis will show which projects will add

wealth to the firm. This should be confirmed with an equally careful analysis of the corporate strategy to ensure that the positive NPV result can be shown to be the result of some form of competitive advantage.

All relevant cash flows for a project must be included in the capital budgeting analysis for a project.

Relevant cash flows are those that change as a result of accepting the project.

We exclude things that don’t change. We also exclude interest charges or financing expenses because these are accounted for in the discount rate.

Tax effects must also be included. CCA is a special case to consider because the tax savings may continue beyond the end of the project.

Once we have all after-tax cash flow effects projected, we can conduct our analysis of a project using our preferred methods: NPV, IRR, or PI; Payback may also be used but its oversimplification should be recognized.