Capital Budgeting Further Considerations

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Capital Budgeting Further Considerations

• For 9.220
• Chapter 7

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Lecture Outline

• Introduction
• The input for evaluating projects relevant cash
  flows
• Inflation real vs. nominal analysis
• Taxes CCA detailed calculations
• Summary and conclusions

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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.

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Relevant cash flows

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

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Relevant cash flows

• 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.

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

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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.

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Working Capital Example

• Without the Project

• With the Project (that ends in 2006)

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NWC Solution

• No project, change in NWC CFs are as follows
• With the project, change in NWC CFs are as
  follows
• Change in NWC results in the following
  incremental cash flows that should be included in
  the project analysis

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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.

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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
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Salvage/Clean-up Solution Self Study
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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.

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Nominal/Real Cash Flow Examples

• Freds 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.

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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.

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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?)

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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?)

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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 PVs must be equivalent, so
  remember the rule

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Use of real cash flows

• If a projects 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.

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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.

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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.

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

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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.
• DuoCitys 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.

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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

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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 n1
• Note In this course, assume no Capital Gains on
  disposal of the asset. Also, assume Asset Pool
  is not terminated upon disposal of the projects
  asset.

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Summary of Capital Budgeting Items and Tax Effects

• The following formula may help summarize the
  projects NPV calculation.
• NPV -initial asset cost1
• PVSalvage Value or Expected Asset Sale
  Amount1
• PV incremental cash flows caused by the
  project2
• PV incremental working capital cash flows
  caused by the project1
• PVCCA Tax Shields
• Footnotes
• 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.These items usually have the after-tax cash
  flow equal to the before tax cash flow multiplied
  by (1-Tc).

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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
  NPVs.
• Stock prices typically rise on the announcement
  of a previously unanticipated project that
  enhances the corporations strategy and generates
  positive NPV.

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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 dont 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.