Fundamentals of Capital Budgeting

Estimating the Projects Cash FlowsWhat are the relevant cash flows for a project?Include any and all changes in the Firms cash flows that are a direct result of undertaking the projectWhat is the incremental ConceptAn incremental cash flow is the change in a firms cash flow attributable to an investment project. Use incremental cash flows.

Estimating the Projects Cash FlowsWhat are some complicationsSunk Cost

Opportunity Cost

Externalities

Estimating the Projects Cash FlowsWhat are some complications - ContinuedInflation

Net Working Capital

Financing costs

Use After-Tax Cash Flows!

Estimating the Projects Cash FlowsIdentify incremental cash flows for all phases of the project: Initial Investment Outlay: The incremental cash flow that will occur only at the start of the project. Initial Operating Cash Flow: The changes in day to day cash flows that result from the project and continue until the project ends.Terminal Cash Flow: The net cash flow that occurs at the end of the project

Cash Flow Versus Accounting Income:An example:

For year 2001: Accounting ProfitsCash FlowsSales $ 1,000 $ 1,000Costs Except Depreciation( 500) ( 500)Depreciation( 300) - Net Operating Income or Cash Flow 200 500Taxes Based on Op. Income (@30%)( 60) ( 60)Net Income or Cash Flow $ 140 $ 440

Net Cash Flow = Net Income Plus Depreciation =

Cash Flow Versus Accounting Income:An example:

For year 2002: Accounting ProfitsCash FlowsSales $ 1,000 $ 1,000Costs Except Depreciation( 500) ( 500)Depreciation( 100) - Net Operating Income or Cash Flow 400 500Taxes Based on Op. Income (@30%)( 120) ( 120)Net Income or Cash Flow $ 280 $ 380

Net Cash Flow = Net Income Plus Depreciation =

Cash Flow Versus Accounting Income (continued):So we have the following equations for calculatingoperating cash flows: Net cash flow=Net income+ Depreciation. Incremental operating CFt = NI t + Depr t = (S t - OC t ) (1 T) + T ( Depr t ).

Checking this for the example on the last page:

Salvage Value, Book Value, and DepreciationStraight-line Depreciation versus Modified Accelerated Cost Recovery System (MACRS) Depreciation (Appendix 7)Straight-line: Depreciate the initial capital spending down to zero. Often used for stockholder reporting purposes.Modified Accelerated Cost Recovery System (MACRS): Depreciate ACCORDING TO THE FASTEST RATE ACCORDED BY LAW for tax purposes.ClassExamples3-yearEquipment for research; some manufacturing tools.5-yearAutos, computers, etc.7-year Most industrial equipment(LongerSee text.)Example: (Use 7-year MACRS) Year MACRS % Depreciation ($) Ending Book Value 114 225 317 413 5 9 6 9 7 9 8 4

Salvage Value, Book Value, and DepreciationSalvage Value versus Book Value: Tax Implication If (Salvage Value) > (Book Value), then taxes are due on (Salvage Value Book Value).Reason:Excess depreciation must be recaptured!

If (Salvage Value) < (Book Value), then taxes savings are credited on (Book Value Salvage Value).Reason:Assets were under-depreciated!

Bottom Line:After-tax Salvage Value = Salvage Value Taxes= SV (SV BV) (T). Example:

Solution to the Greatyear Tires Expansion Project Problem

Solution to the Greatyear Tires Expansion Project Problem (Cont)

Example: You have been asked by the president of your company to evaluate the proposed acquisition of a spectrometer for the firms R&D department. The equipments base price is $140,000, and it would cost another $30,000 to modify it. The spectrometer falls into the MACRS 3-year class, and would be sold after 3 years for $60,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $8,000. The spectrometer would have no effect on revenues, but is expected to save the firm $50,000 per year in before-tax operating costs, mainly labor. The firms marginal tax rate is 40%.

Whats the initial investment outlay associated with this project? (That is, what is the Year 0 net cash flow?)

Example:

What are the incremental operating cash flows in Years 1, 2, and 3?

Example:

What is the terminal cash flow in Year 3?

Example:

If the projects required rate of return is 12%, should the spectrometer be purchased? (Calculate the projects NPV and make a recommendation.)

Project Risk and Estimating the Projects Required Rate of Return

Risk-adjusted discount rate approach: Increase the discount rate for projects that are riskier than the firms average projects, and

Decrease the discount rate for projects that are less risky than the firms average projects.

Project Risk and Estimating the Projects Required Rate of ReturnMany firms use this approach. Chevron Example:Examples Opportunity Cost Rate*

High Risk Projects

Medium Risk Projects

Low Risk Projects

* This is the rate used for The discount rate in NPV Calculations, and The cutoff rate for IRR analysis

Analyzing the project:Break even

Sensitivity Analysis

Scenario Analysis

Replacement analysis Example The Gehr Company is considering the purchase of a new machine tool to replace an obsolete one. The machine being used for the operation has both a tax book value and market value of 0. It is in good working order, however, and will physically last at least another 10 years. The proposed replacement machine will perform the operation more efficiently with estimated after-tax cash flows of $ 9,000 per year in labor savings and depreciation. The new machine will cost $40,000 delivered and installed and is expected to last 10 years. It will have zero salvage value. Should the firm purchase the new machine? (Assume the firms required rate of return is 10%.)