Cash Flows and Other Topics in Capital Budgeting

1
Cash Flows and Other Topics in Capital Budgeting

• Chapter 10

2
Principles Used in this Chapter

• Principle 3
• Cash Not Profits Is King
• Principle 4
• Incremental Cash Flows Its Only What Changes
  That Counts.

3
Incremental Cash Flows

• Decision makers must consider what new cash flows
  the company as a whole will receive if the
  company takes on a given project.
• Only incremental after-tax cash flows matter.

4
Ten Guidelines for Capital Budgeting

• Use free cash flows, not accounting profits.
• Think incrementally.
• Beware of cash flows diverted from existing
  products.
• Look for incidental or synergistic effects.
• Work in working-capital requirements.
• Consider incremental expenses.
• Sunk costs are not incremental cash flows
• Account for opportunity costs.
• Decide if overhead costs are truly incremental
  cash flows.
• Ignore interest payments and financing flows.

5
Use free cash flows

• Free cash flow accurately reflects the timing of
  benefits and costs when money is received, when
  it can be reinvested, and when it must be paid
  out.
• Accounting profits do not reflect actual money in
  hand.

6
Incremental cash flows

• Further, after-tax free cash flows must be
  measured incrementally.
• Determining incremental free cash flow involves
  determining the cash flows with and without the
  project. Incremental is the additional cash
  flows (inflows or outflows) that occur due to
  the project.

7
Beware of diverted cash flows

• Not all incremental free cash flow is relevant.
• Thus new product sales achieved at the cost of
  losing sales from existing product line are not
  considered a benefit.
• However, if the new product captures sales from
  competitors or prevents loss of sales to new
  competing products, it would be a relevant
  incremental free cash flow.

8
Incidental or Synergistic Effects

• Although some projects may take sales away from a
  firms current projects, in other cases new
  products may add sales to the existing line. This
  is called a synergistic effect and is a relevant
  cash flow.

9
Working capital requirement

• New projects require infusion of working capital
  (such as inventory to stock the shelves), which
  would be an outflow.
• Generally, when the project terminates, working
  capital is recovered and there is an inflow of
  working capital.

10
Sunk Costs

• Sunk costs are cash flows that have already
  occurred (such as marketing research) and cannot
  be undone. Sunk costs are considered irrelevant
  to decision making.
• Managers need to ask two basic questions
• Will this cash flow occur if the project is
  accepted?
• Will this cash flow occur if the project is
  rejected?
• If the answer is Yes to 1 and No to 2, it
  will be an incremental cash flow.

11
Opportunity Costs

• Opportunity cost refers to cash flows that are
  lost because of accepting the current project.
• For example, using the building space for the
  project will mean loss of potential rental
  revenue.

12
Overhead Costs

• Incremental overhead costs or costs that were
  incurred as a result of the project and relevant
  to capital budgeting must be included.
• Note, not all overhead costs may be relevant (for
  example, the utilities bill may have been the
  same with or without the project).

13
Interest Payments and Financing Costs

• Interest payments and other financing cash flows
  that might result from raising funds to finance a
  project are not relevant cash flows.
• Reason Required rate of return implicitly
  accounts for the cost of raising funds to finance
  a new project.

14
Free Cash Flow Calculations

• Three components of free cash flows
• Initial outlay
• Annual free cash flows over the projects life
• Terminal cash flow

15
Initial Cash Outlay

• The immediate cash outflow necessary to purchase
  the asset and put it in operating order.
• May include Purchase cost, Set-up cost,
  Installation, Shipping/Freight, increased
  working-capital requirements, tax implications
  (if the project replaces an existing
  project/asset)

16
Sale and Taxes

• If Sale Book Value
• gt No tax effect
• If sale gtBV (but less than cost)
• gt recaptured depreciation, taxed as ordinary
  income
• If sale gt BV (greater than cost)
• gt anything above cost, taxed as capital gain,
  rest taxed as recaptured depreciation
• If sale lt BV
• gt capital loss gt tax savings

17
Annual Free Cash Flows

• Annual free cash flow is the incremental
  after-tax cash flow resulting from the project
  being considered.
• Free Cash flow considers the following
• Cash flow from operations
• Cash flows from working capital requirements
• Cash flows from capital spending

18
Calculating Operating Cash Flows

• Step 1 Measure the projects change in
  operating cash flows
• Operating cash flows
• Changes in EBIT
• - Changes in taxes
• Change in depreciation
• Note, depreciation is a non-cash expense but
  influences the cash flows through impact on taxes
  (see next two slides).

19
Calculating Operating Cash Flows Depreciation
Cash Flow

• Earnings before Tax and Dep. 40,000
• Depreciation 25,000
• Earnings before tax (EBT) 15,000
• If the corporation is taxed at 30,
• taxes .315000 4,500
• If the depreciation was 0,
• EBT 40,000 and taxes .340000 12,000

20
Calculating Operating Cash Flows Depreciation
Cash Flow

• gt Depreciation is a non-cash expense BUT
  affects Cash Flow through its impact on taxes
• Depreciation gt ?in Expense
• gt ? in taxes
• gt ?CF

21
Calculating Operating Cash Flows Change in Net
Working Capital

• Step 2 Calculate the cash flows from the change
  in net working capital
• This refers to additional investment in current
  assets minus any additional short-term
  liabilities that were generated.

22
Calculating Operating Cash Flows

• Step 3 Determine the cash flows from the change
  in capital spending
• This refers to any capital spending requirements
  during the life of the project.

23
Calculating Operating Cash Flows Putting it all
together

• Step 4 Project free cash flows
• change in EBIT
• - changes in taxes
• change in depreciation
• - change in net working capital
• - change in capital spending

24
Terminal Cash Flow

• Terminal cash flows are flows associated with the
  project at termination.
• It may include
• Salvage value of the project.
• Any taxable gains or losses associated with the
  sale of any asset.

25
Example page 305
26
(No Transcript)
27
(No Transcript)
28
Options in Capital Budgeting

• Options add value to capital budgeting projects.
• Some common options are
• Option to delay a project
• Option to expand a project
• Option to abandon a project

29
Option to Delay

• Almost every project has a mutually exclusive
  alternative waiting and pursuing at a later
  time.
• It is conceivable that a project with a negative
  NPV now may have a positive NPV if undertaken
  later on. This could be due to various reasons
  such as favorable changes in fashion, technology,
  economy, or borrowing costs.

30
Option to Expand

• Even if a project is currently unprofitable, it
  may be useful to determine whether the
  profitability of the project will change if the
  company is able to expand in the future.
• Example Firms investing in negative NPV
  projects to gain access to new markets.

31
Option to Abandon

• It may be necessary to abandon the project before
  its estimated life due to inaccurate project
  analysis models or cash flow forecasts or due to
  changes in market conditions.
• When comparing two projects with similar NPVs,
  the project that is easier to abandon may be more
  desirable (example, temporary versus permanent
  workers, lease versus buy).

32
Risk and Capital Budgeting Decisions

• Two main issues
• What is risk and how should it be measured?
• How should risk be incorporated into a capital
  budgeting analysis?

33
Three perspectives on risk

• Project standing alone risk
• Contribution-to-firm risk
• Systematic risk

34
Project Standing Alone Risk

• A projects risk, ignoring the possibility that
  much of the risk will be diversified away as the
  project is combined with other projects and
  assets.

35
Contribution-to-Firm Risk

• This is the amount of risk that the project
  contributes to the firm as a whole.
• This measures the projects risk considering the
  diversification away of risk, but ignores the
  effects of diversification on the firms
  shareholders.

36
Systematic Risk

• Risk of the project from the viewpoint of a
  well-diversified shareholder.
• This measure takes into account that some of the
  risk will be diversified away as the project is
  combined with the firms other projects and in
  addition, some of the remaining risk will be
  diversified away by the shareholders as they
  combine this stock with other stocks in their
  portfolios.

37
Relevant risk

• Theoretically, the only risk of concern to
  shareholders is systematic risk.
• Since the projects contribution-to-firm risk
  affects the probability of bankruptcy for the
  firm, it is a relevant risk measure.
• Thus we need to consider both the projects
  contribution-to-firm risk and the projects
  systematic risk.

38
Incorporating Risk into Capital Budgeting

• We know that investors demand higher returns for
  riskier projects.
• As the risk of a project increases, the required
  rate of return is adjusted upward to compensate
  for the added risk.
• This risk adjusted discount rate is then used for
  discounting free cash flows (in NPV model) or as
  the benchmark required rate of return (in IRR
  model).

39
Measurement of Systematic Risk

• Estimating the risk of a project can be
  difficult. Historical stock return data relates
  to an entire firm, rather than a specific project
  or division. Risk must be estimated. Options to
  estimate risk include
• Accounting Beta
• Pure Play Method
• Simulation
• Scenario Analysis
• Sensitivity Analysis

40
Accounting Beta

• Can be estimated via time-series regression on a
  divisions return on assets on the market index

41
Pure Play Method

• Identifies publicly traded firms engaged solely
  in the same business as the project, using that
  firms return data to judge the project.

42
Simulation

• Involves the process of imitating the performance
  of the project under evaluation (See figure
  10-6).
• Done by randomly selecting observations from each
  of the distributions that affect the outcome of
  the project and continuing with this process
  until a representative record of the projects
  probable outcome is assembled.

43
Scenario Analysis

• Identifies the range of possible outcomes under
  the worst, best, and most likely cases.

44
Sensitivity Analysis

• Determining how the distribution of possible net
  present values or internal rate of return for a
  particular project is affected by a change in one
  particular input variable. (What-if analysis.)