Professor Megginson FIN 5043BAD 5283

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Chapter 8
Cash Flow And Capital Budgeting
Professor MegginsonFIN 5043/BAD 5283
Spring 2007
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Cash Flow Versus Accounting Profit
Capital budgeting concerned with cash flow, not
accounting profit
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Cash Flow and Non-Tax Expenses

• Accountants charge depreciation to spread a fixed
  assets costs over time to match its benefits
• Capital budgeting analysis focuses on cash
  inflows and outflows when they occur
• Non-cash expenses affect cash flow through their
  impact on taxes
• Compute after-tax net income and add depreciation
  back
• Ignore depreciation expense but add back its tax
  savings

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Two Methods Of Handling Depreciation To Compute
Cash Flow
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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 investments tax
  benefits
• Relative to MACRS, straight-line depreciation
  results in higher reported earnings early in an
  investments 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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The First Four Depreciation MACRS Classes
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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)

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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
0
0
3,000
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Terminal Value
Terminal 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 Value
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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

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Incremental Cash Flow
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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 3 net cash inflow 90,000 - 66,150 23,850
• After-tax inflow 23,850 x (1-0.35) 15,503
• Yr 4 cash inflow
• MBA has substantial positive NPV value if 30 yr
  analysis period

What about Norms opportunity cost?
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Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken
NPV of a project could fall substantially if
opportunity costs are recognized
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Capital Budgeting Example For NBS Corporation
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Find The Initial Investment For NBS Corporations
New Machine

• NBS Corp must find initial investment required to
  replace an old machine with a new model.
• New machine's purchase price 1,100,000, plus
  50,000 to install will 5-yr MACRS recovery time
• Old machine bought 5 yrs ago for 800,000 was
  being depreciated with 7-year recovery period
• A buyer is willing to pay 200,000 for the
  present machine (including removal costs).
• Firm expects replacement to cause 100,000
  increase in current assets and 70,000 increase
  in current liabilities
• Yielding 30,000 (100,000-70,000) increased NWC
• Ordinary income, capital gains both taxed at 40

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Find Initial Investment For NBS Corporations New
Machine (Cont)

• Book value of current machine found using
  depreciation percentages of 14.3, 24.5, 17.5,
  12.5 and 8.9 percent for years 1, 2, 3, 4, and 5
• yields book value of 178,400 (800,000 - (0.143
  0.245 0.175 0.125 0.089) x 800,000).
• Ordinary gain of 21,600 (200,000 - 178,400) in
  recaptured depreciation also realized on sale.
• Total tax on the gain is 8,640 (21,600) x
  0.40
• These figures yield initial investment of
  988,640
• This is the net cash outflow required at time
  zero
• Initial investment calculation summarized next
  slide

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Calculating NBS Corps Initial Investment
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Finding The Operating Cash Flows

• The benefits expected from a capital expenditure
  are measured as operating cash flows
• These are incremental after-tax cash flows.
• All benefits must be measured on a cash flow
  basis
• Any noncash charges must be added back to net
  profit
• Table 8.A lists NBS Corps expected revenues
  expenses (excl deprec), with old new machines
• Expected useful life of new machine remaining
  usable life of the old machine both five years.
• Depreciable value of new machine the sum of the
  1,100,000 price and 50,000 installation costs
• New machine to be deprec using 5-year period.
• Depreciation (old new) summarized Table 8.B.

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Table 8.A NBS Corps Revenues Expenses For Old
New Machines
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Table 8.B Depreciation Expense For NBS
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Finding Operating Cash Inflows For NBS Corp Old
vs New Machine

• Operating cash inflows (OCFt) in each year found
  using income statement format in Table 8.C.
• Operating cash flow in year t, OCFt , given by
• OCFt (Rt Et Dt) x (1 T) Dt
• Using data from Tables 8.A 8.B into this
  format, and assuming a 40 tax rate, yields Table
  8.D
• Table 8.D summarizes OCFs for each year for both
  the proposed and the present machine.
• The 23,000 yr-6 cash inflow for new machine is
  solely from tax benefit of its year-6
  depreciation deduction.
• Subtracting present machines OCFs from the
  proposed machines operating cash flows yields
  the incremental OCFs each year (column 3, Table
  8.D.)
• These CFs are the amounts by which each year's
  cash flows will increase as a result of the
  replacement.

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Table 8.C Finding Operating Cash Inflows Using
Income Statement Data

• Revenues (Rt)
• - Expenses (excluding depreciation) (Et)____
• Profits before depreciation taxes (PBDTt)
• - Depreciation_________________________
• Net profit before taxes (NPBTt)
• - Taxes (T)____________________________
• Net profits after taxes (NPATt)
• Depreciation (Dt)______________________
• Operating cash flow

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Table 8.D Incremental Operating CFs
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Finding The Terminal Cash Flow

• The terminal cash flow (TCF) is the after-tax
  CF, besides OCFs, in the projects final year
• TCF, which is usually positive, found for
  replacement project using the format in Table
  8.E.
• Proceeds from sale of new and old assets, called
  "salvage value," is amount net of any removal or
  cleanup costs expected at end of the project.
• For replacement projects, proceeds from both the
  new asset and the old asset must be considered.
• For expansion and renewal capital expenditures,
  the proceeds from the old asset would be zero.
• Values of assets often zero at termination of
  project
• Must also account for tax effects of asset
  disposal and changes in net working capital.

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Table 8.E Determining Terminal Cash Flow

• After-tax proceeds from sale of new asset
• Proceeds from sale of new asset
• Tax on sale of new asset
• - After-tax proceeds from sale of old asset
• Proceeds from sale of old asset
• Tax on sale of old asset
• Change in net working capital__________
• Terminal cash flow

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Finding TCF Taxes On Sale Of Assets And
Recapturing Net Working Capital

• As with finding initial investment, taxes must be
  considered on the terminal sale of both the new
  and the old asset for replacement projects
• Only the new asset in other cases.
• Tax calculations apply for TCF whenever an asset
  is sold for a value different from its book
  value.
• If net sale proceeds expected to exceed BV, a tax
  outflow (deduction from sale proceeds) would
  occur.
• If net sale proceeds are below BV, a tax rebate
  shown as cash inflow (addition to sale proceeds)
  would result.
• No taxes due for assets sold at exactly book
  value.
• In finding TCF, also account for the reversion to
  its original status of any net working capital
  investment
• Most often this will show up as a cash inflow

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Calculating TCF For NBS Corporation

• NBS Corp expects to sell the proposed machine to
  net 500,000 at the end of its 5-year usable life
• Old machine can be sold end of year-5 to net
  20,000
• Firm should recover 30,000 NWC at projects end
• Both ordinary income capital gains are taxed at
  40
• Old machine will have BV of zero at end of 5
  years, the new machine will then have BV of
  57,500 (year-6 depreciation).
• Since 500,000 sale price for new machine is
  below its initial installed costs of 1,150,000
  but greater than its BV of 57,500, taxes will be
  due only on recaptured depreciation of 442,500
  (500,000 sale proceeds - 57,500 BV).
• Using 40 tax rate on 442,500 yields 177,000
  tax (0.40 x 442,500) on the sale of the new
  machine.

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Calculating TCF For NBS Corp (Continued)

• NBSs after-tax sale proceeds would thus equal
  323,000 (500,000 proceeds - 177,000 taxes)
• Old machine would net 20,000 at termination
  its BV would be 0, so it would recapture 20,000
  depreciation
• Ordinary taxes of 8,000 (0.40x20,000) would be
  due
• This yields after-tax sale proceeds of 12,000
  (20,000 sale proceeds - 8,000 taxes).
• Putting these values into format in Table 8.E
  results in terminal cash inflow value of
  343,000.
• This represents the after-tax cash flow,
  exclusive of operating cash flows, occurring upon
  termination of the project at the end of year 5.

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Calculating TCF For NBS Corporation
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Deciding Whether To Accept The Project

• Relevant cash flows for NBS Corp's proposed
  replacement expenditure summarized in Table 8.F.
  
• Assume the present and proposed machines equally
  risky, the firm's cost of capital is 8, and a
  maximum payback period of 3 years
• The decisions summarized bottom of Table 8.F
  result.
• Payback period of 4.63 ys exceeds maximum
• Sophisticated NPV, IRR methods also support
  rejection.
• The firm should reject this replacement decision
• Both of the more sophisticated techniques (NPV
  and IRR) indicate that the firm will not enhance
  its owners' wealth if it funds replacement of the
  present machine with the proposed machine

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Table 8.F Relevant Cash Flows Decisions for
NBS Corps Project
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Special Capital Budgeting Topics
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Capital Budgeting and Inflation
Inflation Rule 1 if nominal rate used to
discount cash flow of a project, the embedded
inflation expectation in the nominal rate must be
used to construct the cash flows

• In analysis of Jazz CDs investment, assumption
  that price of a CD increases by 2 per year on
  average
• Revenues expressed in nominal terms
• Discount rate used (10) must reflect current
  market returns to account for inflation rate

Inflation Rule 2 when project cash flows are
stated in real rather than nominal terms, the
appropriate discount rate is the real rate

• Cash flows projections for Classicaltunes.com
  could be expressed in real terms
• Use current price for CDs of 13.50, current-year
  labor costs, current-year prices for fixed assets
  for projections of cash flows

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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

Cash outflow device A lt 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

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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

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The Human Face of Capital Budgeting

• Managers must be aware of optimistic bias in
  these assumptions made by supporters of the
  project
• Companies should have control measures in place
  to remove bias
• Analysis of an investment done by a group
  independent of individual or group proposing the
  project
• Analysts of the project must have a sense of what
  is reasonable when forecasting a projects profit
  margin and its growth potential
• Storytelling
• Best analysts not only provide numbers to
  highlight a good investment, but also can explain
  why the investment makes sense

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Cash Flow and Capital Budgeting
Certain types of cash flows are common to many
investments Opportunity costs should be included
in cash flow projections Discount nominal cash
flows at a nominal rate and real cash flows at a
real rate Consider human factors in capital
budgeting