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 installOld 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 FlowsDepreciationFixed asset expendituresWorking capital expendituresTerminal value Incremental cash flow
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DepreciationLargest noncash item for most
investment projectsAffects the amount of taxes the firm
will payModified 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 ValueTerminal 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 ValueDifferent 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 BillionYear 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$1.125.3$
1.15.2$
1.175.1$
1.11$
1.15.0$
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2.68$05.010.0
41.3$or , 51
PV
grCFPV t
t
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Incremental Cash FlowIncremental cash flows versus sunk
costsCapital 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 CostsCash 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
$6,072 X 071071071
93615 321 ...
,$ XXXDevice A
$5,333Y 071071071071
06518 4321 ....
,$ YYYYDevice 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
000,000,210.1000,125000,000,2000,125 2 NPV
01.1
000,000,210.1
000,000,2 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.