Cash flows and capital budgeting.pptx

7/28/2019 Cash flows and capital budgeting.pptx

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Chapter 10:Cash F lows and

Other Topics inCapital Budgeting

2002, Prentice Hall, Inc.


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Capital Budgeting:the process of planning

for purchases of long-term assets.

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:


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The cost of the new machine is $127,000.

Installation will cost $20,000.

$4,000 in net working capital will be needed atthe time of installation.

The project will increase revenues by $85,000 per

year, but operating costs will increase by 35% ofthe revenue increase.

Simplified straight line depreciation is used.

Class life is 5 years, and the firm is planning tokeep 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.


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Capital Budgeting Steps

1) Evaluate Cash Flows

0 1 2 3 4 5 n6 . . .


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0 1 2 3 4 5 n6 . . .

Initial

outlay


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0 1 2 3 4 5 n6 . . .

Annual Cash Flows

Initial

outlay


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0 1 2 3 4 5 n6 . . .

Terminal

Cash flow

Annual Cash Flows

Initial

outlay


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2) Evaluate the risk of the project.

well 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 firms cost of

capital as the discount rate for capital

investment projects.



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3) Accept or Reject the Project.



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Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow attime 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


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a) Initial Outlay: What is the cash flow attime 0?

(127,000)+ (shipping and installation costs)

(Depreciable asset)


Net Initial Outlay


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a) Initial Outlay: What is the cash flow at

time 0?

(127,000)+ ( 20,000)

(Depreciable asset)


Net Initial Outlay


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time 0?

(127,000)+ ( 20,000)

(147,000)


Net Initial Outlay


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time 0?

(127,000)+ ( 20,000)

(147,000)

+ ( 4,000)+ After-tax proceeds from sale of old asset

Net Initial Outlay


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time 0?

(127,000)+ ( 20,000)

(147,000)

+ ( 4,000)+ 0

Net Initial Outlay


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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


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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


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b) Annual Cash Flows: What

incremental cash flows occur over the

life of the project?


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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 Each Year, Calculate:


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Incremental revenue

- Incremental costs





Annual Cash Flow

For Years 1 - 5:


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85,000

- Incremental costs





Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)





Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)




Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)

25,850- Tax on incremental EBT



Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)

25,850(8,789)



Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)

25,850(8,789)

17,061


Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)

25,850(8,789)

17,061

29,400

Annual Cash Flow

For Years 1 - 5:


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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

For Years 1 - 5:


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Step 1: Evaluate Cash F lows

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capitalTerminal Cash Flow


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50,000 Salvage value


+ Recapture of net working capitalTerminal Cash Flow


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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)


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(17,000) Tax on capital gain

Recapture of NWCTerminal Cash Flow


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4,000 Recapture of NWC

Terminal Cash Flow


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37,000 Terminal Cash Flow


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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.


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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?


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Capital Rationing

You could rank the projects by IRR:


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Capital Rationing

IRR

5%

10%

15%

20%

25%

$

1

You could rank the projects by IRR:


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Capital Rationing

You could rank the projects by IRR:IRR

5%

10%

15%

20%

25%

$

1 2 3


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Capital Rationing


5%

10%

15%

20%

25%

$

1 2 3 4


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Capital Rationing


5%

10%

15%

20%

25%

$

1 2 3 4 5


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Capital Rationing


5%

10%

15%

20%

25%

$

1 2 3 4 5

$X

Our budget is limited

so we accept onlyprojects 1, 2, and 3.


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Capital Rationing


5%

10%

15%

20%

25%

$

1 2 3

$X

Our budget is limited

so we accept onlyprojects 1, 2, and 3.


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Capital Rationing

Ranking projects by IRR is notalways the best way to deal with a

limited capital budget.

Its better to pick the largest NPVs.

Lets try ranking projects by NPV.


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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.


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Size Dispar ity example

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


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Project B

year cash flow

0 (30,000)

1 15,000

2 15,000

3 15,000


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


IRR = 15.89%

NPV = $9,110

PI = 1.07


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Project B

year cash flow

0 (30,000)

1 15,000

2 15,000

3 15,000


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


IRR = 15.89%

NPV = $9,110

PI = 1.07


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Time Dispar ity example

Project Ayear cash flow

0 (48,000)

1 1,200

2 2,400

3 39,000

4 42,000


IRR = 18.10%

NPV = $9,436

PI = 1.20


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Project Byear cash flow

0 (46,500)

1 36,500

2 24,000

3 2,400

4 2,400


IRR = 25.51%

NPV = $8,455

PI = 1.18


0 (48,000)

1 1,200

2 2,400

3 39,000

4 42,000


IRR = 18.10%

NPV = $9,436

PI = 1.20


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Project Byear cash flow

0 (46,500)

1 36,500

2 24,000

3 2,400

4 2,400


IRR = 25.51%

NPV = $8,455

PI = 1.18


0 (48,000)

1 1,200

2 2,400

3 39,000

4 42,000


IRR = 18.10%

NPV = $9,436

PI = 1.20


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Mutually Exclusive I nvestments with

Unequal L ives

Suppose our firm is planning to

expand and we have to select 1 of 2

machines.

They differ in terms of economic life

and capacity.

How do we decide which machine to

select?

Th ft t h fl


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The after-tax cash flows are:

Year Machine 1 Machine 2

0 (45,000) (45,000)

1 20,000 12,000

2 20,000 12,0003 20,000 12,000

4 12,000

5 12,000

6 12,000

Assume a required return of 14%.


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Step 1: Calculate NPV

NPV1= $1,433

NPV2 = $1,664

So, does this mean #2 is better?

No! The two NPVs cant be

compared!

St 2 E i l t A l


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Step 2: Equivalent Annual

Annui ty (EAA) method

If we assume that each project will be

replaced an infinite number of times in the

future, we can convert each NPV to anannuity.

The projects EAAs can be compared to

determine which is the best project!

EAA: Simply annuitize the NPV over the

projects life.


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EAA with your calculator :

Simply spread the NPV over the life

of the project

Machine 1: PV = 1433, N = 3, I = 14,solve: PMT = -617.24.

Machine 2: PV = 1664, N = 6, I = 14,

solve: PMT = -427.91.

EAA $617


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EAA1 = $617

EAA2 = $428

This tells us that:

NPV1 = annuity of$617 per year.

NPV2 = annuity of$428 per year. So, weve reduced a problem with

different time horizons to a couple of

annuities.

Decision Rule: Select the highest

EAA. We would choose machine #1.


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Step 3: Convert back to NPV


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Assuming infinite replacement, theEAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.


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rate of return.

NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057


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rate of return.

NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057

This doesnt change the answer, of

course; it just converts EAA to a NPV

that can be compared.


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Practice Problems:

Cash F lows & Other Topics

in Capital Budgeting

Project I nformation: Problem 1a


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j

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%


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Problem 1a

I ni tial Outlay:

(400,000) Cost of asset

+ ( 20,000) Shipping & installation

(420,000) Depreciable asset

+ ( 25,000) Investment in NWC($445,000) Net Initial Outlay

For Years 1 - 3: Problem 1a


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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 EAT84,000 Depreciation reversal


For Years 1 3: Problem 1a

Problem 1a


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Terminal Cash F low:

Salvage value


+ Recapture of net working capital

Terminal Cash Flow

Problem 1a


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Problem 1a


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200,000 Salvage value(10,880) Tax on capital gain




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Problem 1b


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Project I nformation:

For the same project, suppose wecan only get $100,000 for the old

equipment after year 3, due to

rapidly changing technology.

Calculate the IRR and NPV for theproject.

Is it still acceptable?

Problem 1b


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Salvage value


+ Recapture of net working capital

Terminal Cash Flow

Problem 1b


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amount depreciated.

Book value = $168,000.

Capital loss = SV - BV = ($68,000) Tax refund = 68,000 x .34 = $23,120


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Automation Project: Problem 2


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Cost of equipment = $550,000

Shipping & installation will be $25,000

$15,000 in net working capital required at setup


Simplified straight line depreciation Current operating expenses are $640,000 per yr.

New operating expenses will be $400,000 per yr.

Already paid consultant $25,000 for analysis.

Salvage value after year 8 is $40,000

Cost of capital = 14%, marginal tax rate = 34%

Problem 2


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Problem 2

I ni tial Outlay:

(550,000) Cost of new machine

+ (25,000) Shipping & installation

(575,000) Depreciable asset

+ ( 15,000) NWC investment(590,000) Net Initial Outlay

For Years 1 5:Problem 2


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240,000 Cost decrease

(115,000) Depreciation increase

125,000 EBIT(42,500) Taxes (34%)

82,500 EAT

115,000 Depreciation reversal


For Years 1 - 5:

Problem 2


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240,000 Cost decrease

( 0) Depreciation increase

240,000 EBIT(81,600) Taxes (34%)

158,400 EAT

0 Depreciation reversal


For Years 6 - 8:

Problem 2


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(13,600) Tax on capital gain15,000 Recapture of NWC


Problem 2 Solution:


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NPV and IRR:

CF(0) = -590,000

CF(1 - 5) = 197,500

CF(6 - 7) = 158,400

CF(10) = 158,400 + 41,400 = 199,800

Discount rate = 14% IRR = 28.13% NPV = $293,543

We would accept the project!

Problem 3


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Replacement Project:

Old Asset (5 years old):

Cost of equipment = $1,125,000


Simplified straight line depreciation

Current salvage value is $400,000 Cost of capital = 14%, marginal tax

rate = 35%


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Problem 3: Sell the Old Asset:


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amount depreciated.

Book value = $1,125,000 - $562,500= $562,500.

Capital gain = SV - BV

= 400,000 - 562,500 = ($162,500)

Tax refund = 162,500 x .35 = $56,875

Problem 3I i ti l O tl


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Problem 3 I ni tial Outlay:

(1,750,000) Cost of new machine

+ ( 56,000) Shipping & installation

(1,806,000) Depreciable asset

+ ( 68,000) NWC investment

+ 456,875 After-tax proceeds (soldold machine)

(1,417,125) Net Initial Outlay

Problem 3


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385,000 Increased sales & cost savings

(248,700) Extra depreciation

136,300 EBT

(47,705) Taxes (35%)

88,595 EAT248,700 Depreciation reversal

337,295 = Differential Cash Flow

For Years 1 - 5:


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Cash flows and capital budgeting.pptx

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