Foundations of Finance

1
Chapter 10
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Cash Flows and Other Topics in Capital Budgeting
3
NET PRESENT VALUE (NPV)INTERNAL RATE OF RETURN
(IRR)
4
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

5

• The cost of the new machine is 127,000.
• Installation will cost 20,000.
• 4,000 in net working capital will be needed at
  the time of installation.
• The project will increase revenues by 85,000 per
  year, but operating costs will increase by 35 of
  the revenue increase.
• Simplified straight line depreciation is used.
• Class life is 5 years, and the firm is planning
  to keep the project for 5 years.
• Salvage value at 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
2. DETERMINE RISK (DISCOUNT )
3. MAKE ACCEPT/REJECT DECISION

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Capital Budgeting Steps

• 1) Evaluate Cash Flows
• Look at all incremental cash flows occurring as
  a result of the project.
• Initial outlay
• Differential Cash Flows over the life of the
  project (also referred to as annual cash flows).
• Terminal Cash Flows

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Capital Budgeting Steps

• 1) Evaluate Cash Flows

Terminal Cash flow
Initial outlay
Annual Cash Flows
9
Capital Budgeting Steps

• 2) Evaluate the risk of the project.
• Well get to this at the end of this chapter.
• For now, 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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Capital Budgeting Steps

• 3) Accept or Reject the Project.

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 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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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (127,000)
• (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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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (127,000)
• ( 20,000)
• (Depreciable asset)
• (Investment in working capital)
• After-tax proceeds from sale of old asset
• Net Initial Outlay

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (127,000)
• ( 20,000)
• (147,000)
• (Investment in working capital)
• After-tax proceeds from sale of old asset
• Net Initial Outlay

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  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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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  time 0?
• (127,000)
• ( 20,000)
• (147,000)
• ( 4,000)
• 0
• Net Initial Outlay

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Step 1 Evaluate Cash Flows

• a) Initial Outlay What is the cash flow at
  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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Step 1 Evaluate Cash Flows

• b) Annual Cash Flows What incremental cash
  flows occur over the life of the project?

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For Each Year, Calculate

• Incremental revenue
• - Incremental costs
• - Depreciation on project
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• Incremental revenue
• - Incremental costs
• - Depreciation on project
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• - Incremental costs
• - Depreciation on project
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• (29,750)
• - Depreciation on project
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

23
For Years 1 - 5

• 85,000
• (29,750)
• (29,400)
• Incremental earnings before taxes
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• (29,750)
• (29,400)
• 25,850
• - Tax on incremental EBT
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• (29,750)
• (29,400)
• 25,850
• (8,789)
• Incremental earnings after taxes
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• (29,750)
• (29,400)
• 25,850
• (8,789)
• 17,061
• Depreciation reversal
• Annual Cash Flow

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For Years 1 - 5

• 85,000
• (29,750)
• (29,400)
• 25,850
• (8,789)
• 17,061
• 29,400
• Annual Cash Flow

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For Years 1 - 5

• 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

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Step 1 Evaluate Cash Flows

• 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 capital
• Terminal Cash Flow

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Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• 50,000 Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal 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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Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• 50,000 Salvage value
• (17,000) Tax on capital gain
• Recapture of NWC
• Terminal Cash Flow

33
Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• 50,000 Salvage value
• (17,000) Tax on capital gain
• 4,000 Recapture of NWC
• Terminal Cash Flow

34
Step 1 Evaluate Cash Flows

• c) Terminal Cash Flow What is the cash flow at
  the end of the projects life?
• 50,000 Salvage value
• (17,000) Tax on capital gain
• 4,000 Recapture of NWC
• 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
• IRR 21
• We would accept the project.

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Incorporating Risk into Capital Budgeting

• Risk-Adjusted Discount Rate

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How can we adjust this model to take risk into
account?
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How can we adjust this model to take risk into
account?

• Adjust the discount rate (k).

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Risk-Adjusted Discount Rate

• Simply adjust the discount rate (k) to reflect
  higher risk.
• Riskier projects will use higher risk-adjusted
  discount rates.
• Calculate NPV using the new risk-adjusted
  discount rate.

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Risk-Adjusted Discount Rate
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Risk-Adjusted Discount Rates

• How do we determine the appropriate risk-adjusted
  discount rate (k) to use?
• Many firms set up risk classes to categorize
  different types of projects.

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Risk Classes

• Risk RADR
• Class (k) Project
  Type
• 1 12 Replace equipment,
• Expand current
  business
• 2 14 Related new products
• 3 16 Unrelated new products
• 4 24 Research Development

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Practice ProblemsCash Flows Other Topics in
Capital Budgeting
44
Problem 1a

• Project Information
• 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

• Initial Outlay
• (400,000) Cost of asset
• ( 20,000) Shipping installation
• (420,000) Depreciable asset
• ( 25,000) Investment in NWC
• (445,000) Net Initial Outlay

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For Years 1 - 3
Problem 1a

• 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 EAT
• 84,000 Depreciation reversal
• 160,560 Annual Cash Flow

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Problem 1a

• Terminal Cash Flow
• Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal Cash Flow

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Problem 1a

• Terminal Cash Flow
• Salvage value 200,000
• Book value depreciable asset - total amount
  depreciated.
• Book value 168,000.
• Capital gain SV - BV 32,000
• Tax payment 32,000 x .34 (10,880)

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Problem 1a

• Terminal Cash Flow
• 200,000 Salvage value
• (10,880) Tax on capital gain
• 25,000 Recapture of NWC
• 214,120 Terminal Cash Flow

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Problem 1a Solution

• NPV and IRR
• CF(0) -445,000
• CF(1 ), (2), 160,560
• CF(3 ) 160,560 214,120 374,680
• Discount rate 12
• IRR 22.1
• NPV 93,044. Accept the project!

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Problem 1b

• Project Information
• For the same project, suppose we can only get
  100,000 for the old equipment after year 3, due
  to rapidly changing technology.
• Calculate the IRR and NPV for the project.
• Is it still acceptable?

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Problem 1b

• Terminal Cash Flow
• Salvage value
• /- Tax effects of capital gain/loss
• Recapture of net working capital
• Terminal Cash Flow

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Problem 1b

• Terminal Cash Flow
• Salvage value 100,000
• Book value depreciable asset - total amount
  depreciated.
• Book value 168,000.
• Capital loss SV - BV (68,000)
• Tax refund 68,000 x .34 23,120

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Problem 1b

• Terminal Cash Flow
• 100,000 Salvage value
• 23,120 Tax on capital gain
• 25,000 Recapture of NWC
• 148,120 Terminal Cash Flow

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Problem 1b Solution

• NPV and IRR
• CF(0) -445,000
• CF(1 ), (2), 160,560
• CF(3 ) 160,560 148,120 308,680
• Discount rate 12
• IRR 17.3
• NPV 46,067. Accept the project!

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Problem 2

• Automation Project
• Cost of equipment 550,000
• Shipping installation will be 25,000
• 15,000 in net working capital required at setup
• 8-year project life, 5-year class life
• 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

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Problem 2

• Initial Outlay
• (550,000) Cost of new machine
• (25,000) Shipping installation
• (575,000) Depreciable asset
• ( 15,000) NWC investment
• (590,000) Net Initial Outlay

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For Years 1 - 5
Problem 2

• 240,000 Cost decrease
• (115,000) Depreciation increase
• 125,000 EBIT
• (42,500) Taxes (34)
• 82,500 EAT
• 115,000 Depreciation reversal
• 197,500 Annual Cash Flow

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For Years 6 - 8
Problem 2

• 240,000 Cost decrease
• ( 0) Depreciation increase
• 240,000 EBIT
• (81,600) Taxes (34)
• 158,400 EAT
• 0 Depreciation reversal
• 158,400 Annual Cash Flow

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Problem 2

• Terminal Cash Flow
• 40,000 Salvage value
• (13,600) Tax on capital gain
• 15,000 Recapture of NWC
• 41,400 Terminal Cash Flow

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Problem 2 Solution

• 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!