Key Concepts and Skills

1
Key Concepts and Skills

• Understand how to determine the relevant cash
  flows for various types of proposed investments
• Be able to compute depreciation expense for tax
  purposes
• Understand the various methods for computing
  operating cash flow

2
Relevant Cash Flows

• The cash flows that should be included in a
  capital budgeting analysis are those that will
  only occur if the project is accepted
• These cash flows are called incremental cash
  flows
• The stand-alone principle allows us to analyze
  each project in isolation from the firm simply by
  focusing on incremental cash flows

3
Asking the Right Question

• You should always ask yourself Will this cash
  flow occur ONLY if we accept the project?
• If the answer is yes, it should be included in
  the analysis because it is incremental
• If the answer is no, it should not be included
  in the analysis because it will occur anyway
• If the answer is part of it, then we should
  include the part that occurs because of the
  project

4
Incremental cash flow

• Net cash flow attributable to an investment
  project
• A bad division can yield a good project
• On average the division may have had poor
  performance, but if a new project has NPV it is
  a good project
• Sunk costs
• Cash outlay that has already been committed and
  can not be recovered
• Allocated overhead
• A project may not generate any new overhead but
  will be allocated its share of the companys
  overhead

5
Incidental effects

• One part of the business may affect others
• Positive effects
• Operation of regional airline brings in
  additional passengers to the main hub
• Neutral effects
• Open a new branch bank that simply diverts
  customers from the main bank
• Negative effects
• New business cannibalizes existing business
• Not necessarily bad
• IBMPCs vs. Mainframes

6
Change in Net Working Capital

• Increased current assets needed for a new project
  minus the increase in current liabilities
  incurred for a new project
• change indicates that the company will need
  funds in addition to the fixed assets required to
  undertake the project
• (-) changes usually occur at the end of the life
  of the project

7
Opportunity Costs

• The return on the best alternative use of the
  asset or the highest return that will not be
  earned if funds are invested in a particular
  project
• A company has a parcel of land worth 100,000
  that is being considered as a site for a new
  plant. If the company builds the plant, is there
  any opportunity cost for the land?

8
Depreciation

• The depreciation expense used for capital
  budgeting should be the depreciation schedule
  required by the IRS for tax purposes
• Depreciation itself is a non-cash expense,
  consequently, it is only relevant because it
  affects taxes
• Depreciation tax shield DT
• D depreciation expense
• T marginal tax rate

9
Computing Depreciation

• Straight-line depreciation
• D (Initial cost salvage) / number of years
• Very few assets are depreciated straight-line for
  tax purposes
• In our examples we will generally assume
  depreciation to zero salvage value (for ease of
  computation)
• MACRS
• Need to know which asset class is appropriate for
  tax purposes
• Multiply percentage given in table by the initial
  cost
• Depreciate to zero

10
After-tax Salvage

• If the salvage value is different from the book
  value of the asset, then there is a tax effect
• Book value initial cost accumulated
  depreciation
• After-tax salvage salvage T(salvage book
  value)

11
Example Depreciation and After-tax Salvage

• You purchase equipment for 100,000 and it costs
  10,000 to have it delivered and installed. Based
  on past information, you believe that you can
  sell the equipment for 17,000 when you are done
  with it in 6 years. The companys marginal tax
  rate is 40. What is the depreciation expense
  each year and the after-tax salvage in year 6 for
  each of the following situations?

12
Example Straight-line Depreciation

• Suppose the appropriate depreciation schedule is
  straight-line to a zero salvage value
• D (110,000 0) / 6 18,333 every year for 6
  years
• BV in year 6 0
• After-tax salvage 17,000 - .4(17,000 0)
  17,000(1-.4) 10,200

13
Example Three-year MACRS
BV in year 6 110,000 36,663 48,884 16,302
8,151 0
After-tax salvage 17,000 - .4(17,000 0)
10,200
14
Example 7-Year MACRS
BV in year 6 110,000 15,719 26,939 19,239
13,739 9,823 9,823 14,718
After-tax salvage 17,000 - .4(17,000 14,718)
16,087.20
15
Pro Forma Statements and Cash Flow

• Capital budgeting relies heavily on pro forma
  accounting statements, particularly income
  statements
• Computing cash flows refresher
• Operating Cash Flow (OCF) EBIT depreciation
  taxes
• OCF Net income depreciation when there is no
  interest expense
• Cash Flow From Assets (CFFA) OCF net capital
  spending (NCS) changes in NWC

16
Other Methods for Computing OCF

• Income Statement Approach
• Works only when there is no interest expense
• OCF NI depreciation
• Tax Shield Approach
• OCF (Sales Costs)(1 T) DepreciationT

17
What To Discount
Points to Watch Out For

• Do not confuse average with incremental payoff.
• Include all incidental effects.
• Do not forget working capital requirements.
• Forget sunk costs.
• Include opportunity costs.
• Beware of allocated overhead costs.

18
Proposed Project

• Cost 200,000 10,000 shipping 30,000
  installation.
• Depreciable cost 240,000.
• Inventories will rise by 25,000 and payables
  will rise by 5,000.
• Economic life 4 years.
• Salvage value 25,000.
• MACRS 3-year class.

19

• Incremental gross sales 250,000.
• Incremental cash operating costs 125,000.
• Tax rate 40.
• Overall cost of capital 10.

20
Set up without numbers a time line for the
project CFs.
0
1
2
3
4
Initial Outlay
OCF1
OCF2
OCF3
OCF4
Terminal CF
NCF0
NCF1
NCF2
NCF3
NCF4
21
Incremental Cash Flow

• Corporate cash flow
• with project
• minus
• Corporate cash flow
• without project

22
Should CFs include interest expense? Dividends?

• NO. The costs of capital are already incorporated
  in the analysis since we use them in discounting.
  
• If we included them as cash flows, we would be
  double counting capital costs.

23
Suppose 100,000 had been spent last year to
improve the production line site. Should this
cost be included in the analysis?

• NO. This is a sunk cost. Focus on incremental
  investment and operating cash flows.

24
Suppose the plant space could be leased out for
25,000 a year. Would this affect the analysis?

• Yes. Accepting the project means we will not
  receive the 25,000. This is an opportunity cost
  and it should be charged to the project.
• A.T. opportunity cost 25,000 (1 - T) 15,000
  annual cost.

25
If the new product line would decrease sales of
the firms other products by 50,000 per year,
would this affect the analysis?

• Yes. The effects on the other projects CFs are
  externalities.
• Net CF loss per year on other lines would be a
  cost to this project.
• Externalities will be positive if new projects
  are complements to existing assets, negative if
  substitutes.

26
Net Investment Outlay at t 0 (000s)
?NWC 25,000 - 5,000 20,000.
27
Depreciation Basics
Basis Cost Shipping
Installation 240,000
28
Annual Depreciation Expense (000s)
29
Year 1 Operating Cash Flows (000s)
30
Year 4 Operating Cash Flows (000s)
31
Net Terminal Cash Flow at t 4 (000s)
32
What if you terminate a project before the asset
is fully depreciated?
Cash flow from sale Sale proceeds - taxes
paid. Taxes are based on difference between
sales price and tax basis, where Basis
Original basis - Accum. deprec.
33
Example If Sold After 3 Years (000s)

• Original basis 240.
• After 3 years 17 remaining.
• Sales price 25.
• Tax on sale 0.4(25-17) 3.2.
• Cash flow 25-3.221.7.

34
Project Net CFs on a Time Line
0
1
2
3
4
(260)
107
118
89
117
Enter CFs in CFLO register and I 10. NPV
81,573. IRR 23.8.
In thousands.
35
Example Cost Cutting

• Your company is considering new computer system
  that will initially cost 1 million. It will save
  300,000 a year in inventory and receivables
  management costs. The system is expected to last
  for five years and will be depreciated using
  3-year MACRS. The system is expected to have a
  salvage value of 50,000 at the end of year 5.
  There is no impact on net working capital. The
  marginal tax rate is 40. The required return is
  8.