4.+relevant+cash+flow+in+capital+budgeting

8/12/2019 4.+relevant+cash+flow+in+capital+budgeting

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Relevant Cash Flows and Other

Topics in Capital Budgeting

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 10


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Project Cash Flows

When deciding whether or not to make aninvestment, we must first estimate the cash flows thatthe investment will provide

Generally, these cash flows can be categorized asfollows: The initial outlay (IO)

The annual after-tax cash flows (ATCF)

The terminal cash flow (TCF)


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Relevant Cash Flows

Determining the relevant cash flows can sometimesbe difficult, here are some guidelines

Cash flows must be: Incremental (i.e., in addition to what you already have)

After-tax

Ignore those cash flows that are: Sunk costs (monies already spent, and not recoverable)

Additional financing costs (e.g., extra interest expense)


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The Initial Outlay

The initial outlay is the total up-front cost of theinvestment

The initial outlay can consist of many components,among these are: The cost of the investment

Shipping and setup costs

Training costs

Any increase in net working capital

When we are making a replacement decision, we alsoneed to subtract the after-tax salvage value of the oldmachine (or land, building, etc.)


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The Annual After-tax Cash Flows

The annual after-tax cash flows (ATCF) are theincremental after-tax cash flows that the investmentwill provide

Generally, these cash flows fall into four categories: Incremental savings (positive cash flow) or expenses

(negative cash flow)

Incremental income (positive cash flow)

The tax savings due to depreciation Lost cash flows (negative cash flow) from the existing

project. This is an opportunity cost.


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The Terminal Cash Flow

The terminal cash flow consists of those cash flowsthat are unique to the last year of the life of theproject

There may be a number of components of the TCF,but three common categories are: Estimated salvage value

Shut-down costs

Recovery of the increase in net working capital


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Problems in Capital Budgeting

Thus far we have been analyzing relatively simplecapital budgeting problems. The methodolgy thatwe have used is fairly robust, but there are some

difficulties. In particular we will now look atproblems with: Unequal lives

Inflation

Differential risk


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The Unequal Lives Problem

Any time that mutually exclusive projects are beingexamined, it is vital that we make apples to applescomparisons. A perfect example is two projects with

unequal lives.

Suppose, for example, that we are trying to decidebetween projects A and B and that they are mutuallyexclusive. They have the following cash flows, and

the cost of capital is 10%:

0 1 2 3 4 5

3000 3000 3500 4000-10,000

-10,000 6000 6000Project A

Project B


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The Unequal Lives Problem (cont.)

If we calculate the NPVs of both projects, we find: NPVA= $413.22

NPVB = $568.27

From these calculations it appears that project B is thebetter project. However, we are making a potentiallyserious mistake.

Obviously, because we are willing to invest in B we

have a 5-year investment horizon. So, we must ask ifwe accepted project A, what would we do with ourmoney for the remaining 3 years? Only then can avalid comparison be made.


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The Unequal Lives Problem (cont.)

There are two ways to correctly deal with theunequal lives problem: The replacement chain approach

The equivalent annual annuity approach


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The Replacement Chain Approach

The replacement chain approach assumes that aproject will be repeated as many times as necessaryto fit into the investment horizon. In this example,

we need to repeat project A just once so that it has a4-year life (the same a B). After replication, the cashflows for A are:

0 1 2 3 4 5

-10,000 6000 6000Project A

-10,000

6000 6000


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The Rep. Chain Approach (Cont.)

Note that the net cash flow in year 2 is now -$4,000because we must pay for project A a second time.

Now, recalculating the NPV for project A reveals thatthe correct NPV for the entire 4-year horizon isactually $754.73 which exceeds the NPV of project B.

Therefore, when the problem is correctly analyzed,we find that it is actually project A which should be

accepted, not B.


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The EAA Approach

The equivalent annual annuity approach is identicalto the replacement chain approach in its results, but itis much simpler to perform

First, we calculate the NPVs for both projectsassuming that they are NOT replicated. Then, weconvert these NPVs into equivalent annuitypayments that they could provide over the life of the

project.


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The EAA Approach (Cont.)

Using the formula for the present value of anordinary annuity, we simply solve for the annuitypayment:

41322 1 1

11010

2

. ( . ).

PMT

Solving for the payment for project A, we find that itsEAA is $238.09.

Using the same methodology for project B we findthat its EAA is $179.27.

Since the EAA for A is higher than the EAA for B, weshould accept project A.


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Incorporating Risk Estimates

Recall from our discussions in Chapters 1 and 5 thatwe assume that investors are risk averse. This meansthat they will require higher rates of return on higher

risk investments. This means that the WACC is not the appropriate

discount rate for projects that are riskier or less riskythan the average for the firm. Instead, we need to

increase the discount rate for riskier projects anddecrease it for less risky projects. This is known asthe risk-adjusted discount rate (RADR).


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Incorporating Risk Estimates

There are, of course, several other techniques forincorporating risk into our decision making.However, they are beyond the scope of this course.

Just for completeness, here are a few: Certainty equivalents

Scenario analysis

Sensitivity analysis

Monte-Carlo Simulation


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Cash Flow Forecasts

P.V. Viswanath

Valuation of the Firm


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Cash Flows:The Accountants Approach

The objective of the Statement of Cash Flows, prepared by

accountants, is to explain changes in the cash balance

rather than to measure the health or value of the firm


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The Statement of Cash Flows

Cash Flows From Operations

+ Cash Flows From Investing

+ Cash Flows from Financing

Net cash flow from operations,after taxes and interest expenses

Includes divestiture and acquisitionof real assets (capital expenditures)

and disposal and purchase offinancial assets. Also includesacquisitions of other firms.

Net cash flow from the issue andrepurchase of equity, from theissue and repayment of debt and afterdividend payments

= Net Change in Cash Balance

Figure 4.3: Statement of Cash Flows

This is a historical approach. We will modify this to create a

model of cashflows for valuation


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Cash Flows:The Financial Analysts Approach

In financial analysis, we are concerned about Cash flows to Equity: These are the cash flows generatedby assets after all expenses and taxes, after all necessaryreinvestment expenditures, and also after payments dueon the debt. Cash flows to equity, which are after cash

flows to debt but prior to cash flows to equity Cash flow to Firm: This cash flow is before debt

payments but after operating expenses, reinvestmentexpenditures and taxes. This looks at not just the equityinvestor in the asset, but at the total cash flows generatedby the asset for both the equity investor and the lender.

These cash flow measures can be used to valueassets, the firms equity and the entire firm itself.


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Free Cashflows to the Firm Free Cashflows to the firm (FCFF) are defined as cashflows

available for distribution to (all) the stakeholders of the firmwithout impairing the long-run profitability of the firm. Free Cash Flow to Firm = EBIT (1-t) Net Reinvestment where

Net Reinvestment = Incr in Non-cash Working Cap +Cap Exp Depreciation

We do not take into account the tax benefit of interest incomputing FCFF because the tax benefit of interest isaccounted for in the discount rate.


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Free Cashflows to the Firm We can compute historical, i.e. ex-post FCFF by using

information in the Statement of Cashflows: FCFF = Cashflow from Operations + Interest (1-t) Capital

ExpendituresNote that Cashflows from Operations already include changes inworking capital so we do not need to subtract this out again.

However, They also include interest as a negative flow, so we add it back

CFO does not consider changes in cash, so we dont have to make anyadjustment to CFO for changes in cash.

For valuation purposes, we need forecasts of these quantities

and the disaggregated model is more useful. The value of the firm is the discounted present value of

cashflows to the firm + any cash position that the firm mighthave. Cash is considered separately because it is usuallyinterest bearing and its present value is simply its current

value.


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Cashflows to Equity Free Cash Flow to Equity (FCFE) is another cashflow

measure that focuses on cash flows to equityholdersalone.

FCFE = Net Income + Depreciation (Change in noncashWorking Capital) Capital Expenditures Net Debt Paid.

FCFE can also be computed (as an historical quantity)

from the statement of cashflows as FCFE = Cashflow from Operations CapitalExpenditures Net Debt paid (short-term and long-term)

If there are other non-common stock securities, cashflowsassociated with them, such as preferred dividends are

also subtracted. The value of common equity is the discounted present

value of free cashflows to equity plus current cash.


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Basic FCFE model

Free Cashflow to Equity =

Net Income

Plus Depreciation Less Capital Expenditures

Less Change in Non-Cash Working Capital

Plus Net Cash Inflow from Borrowings


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Computation of Historical FCFE

Compute these quantities for the historical timeperiod for which data is available.

Do it for the firm and do it for competitors(competitors or comparable firms might beimportant, if theres not enough data for the firm)


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How to deal with Cash

Assumption: Forecasts derived from theseestimates will generate the value of the firmsequity (other than cash). Hence we need toadd back the value of cash.

A better approach is to figure out the value ofcash required as part of working capital; thisis often computed as 2% of revenues theremainder is excess cash. In this approach,

cash needs would be budgeted as part ofworking capital. Then, only excess cashwould be added back.


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Net Inc or Revenues and Costs?

Each of the components now need to beforecast.

We could forecast Net Income directly;

however, it often makes sense to look at amore comprehensive model for Net Income

Net Income = (Revenues less Costs) lessInterest less Taxes

The drivers for Revenues and Costs could bedifferent, so it would be necessary to modelthese differently.


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CapEx & Depreciation

We see that Capex can be related better to Revenues,rather than to Net Income; hence it might make sense toforecast Revenues and Costs separately.

Depreciation can be related to Capital Expenditures(looking at the model, we see that depreciation is about

half of capital expenditures). If we were simply replenishing capital stock, then wed

have depreciation equal to capital expenditures. Hencethis assumption implies that assets will be growing; thisis appropriate, as long as we have a growing firm.

Once the firm stops growing, this may not beappropriate.

Keep in mind that our analysis is in nominal dollars.


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Change in Non-Cash Working Capital

What are the drivers for non-cash working capital?

What are the components of non-cash workingcapital? Accounts Payable

Accounts Receivable

Cash in hand

Short-term borrowings


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It may make more sense to look at the driversfor the different components separately

on the other hand, an outside analyst may not

have enough information to make theanalysis at this level.

If so, it may be sufficient to analyze changesin non-cash working capital as a function of

change in Net Income or change in Revenues.

Change in Non-Cash Working Capital


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Working Capital or Debt

Should short-term borrowings be considered debt orshould they be included in Working Capital?

If the borrowing has an explicit interest cost, then putit in debt, if not leave it in Working Capital.

If there is an explicit interest cost, it can be factoredinto the cost of capital more easily


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Cashflow from Creditors In order to compute this, we need to look at the

firms capital structure and figure out whether ithas enough debt, right now, or too much debt. Look at the capital structure of other firms in the

industry

How will its capital structure change, goingforward? If its current leverage is too low relative to

target, it would, want to gradually step up debtissuance until it reaches target leverage.

We need to look at issuance costs: it may makesense to wait and then issue a lot of debt at atime to save on the fixed issuance costs.

4.+relevant+cash+flow+in+capital+budgeting

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