1 cash flows and other topics in capital budgeting chapter 10

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Cash Flows and OtherCash Flows and OtherTopics in Capital BudgetingTopics in Capital Budgeting

Chapter 10Chapter 10

3Cash Flows in GeneralCash Flows in General

Measure cash flows that change if a project is undertakenMeasure cash flows that change if a project is undertakenSunk cost is irrelevantSunk cost is irrelevantOpportunity cost is relevantOpportunity cost is relevantDo not include allocation of Do not include allocation of existingexisting overhead overheadDo subtract lost sales of other productsDo subtract lost sales of other products Include cost savings as a positive cash flow.Include cost savings as a positive cash flow.

Measure Incremental Cash FlowsMeasure Incremental Cash Flows

4Cash Flows in GeneralCash Flows in General

New Project vs. Replacement ProjectNew Project vs. Replacement ProjectNew project – simply addition to companyReplacement – replace and existing old machine or plant.

Financing costs - Interest and Dividend payments. are not considered Financing costs - Interest and Dividend payments. are not considered operating cash flows. Financing cost are used to discount the cash operating cash flows. Financing cost are used to discount the cash flows to find NPV,etc.flows to find NPV,etc.

Only include CASH inflows and outflows.Only include CASH inflows and outflows.

5Estimating Cash FlowsEstimating Cash Flows

Initial OutlayInitial OutlayThree Types of Cash FlowsThree Types of Cash Flows

0 1 2 3

Initial Outlay

6Estimating Cash FlowsEstimating Cash Flows

Initial OutlayInitial OutlayOperating (Differential) Cash FlowsOperating (Differential) Cash Flows

Three Types of Cash FlowsThree Types of Cash Flows

Initial OutlayOperating Cash Flows

0 1 2 3

7Estimating Cash FlowsEstimating Cash Flows

Initial OutlayInitial OutlayOperating (Differential) Cash FlowsOperating (Differential) Cash FlowsTerminal Cash FlowTerminal Cash Flow

Three Types of Cash FlowsThree Types of Cash Flows

Initial OutlayOperating Cash Flows Terminal Cash Flow

0 1 2 3

8Estimating Cash FlowsEstimating Cash Flows

Cost of AssetsCost of Assets Installation and ShippingInstallation and ShippingNon-Expense Outlays (i.e. Working Capital)Non-Expense Outlays (i.e. Working Capital)Expense Outlays after tax (i.e. Training Expenses)Expense Outlays after tax (i.e. Training Expenses)

Initial OutlayInitial Outlay

9Estimating Cash FlowsEstimating Cash Flows

Cost of AssetsCost of Assets Installation and ShippingInstallation and ShippingNon-Expense Outlays (i.e. Working Capital)Non-Expense Outlays (i.e. Working Capital)Expense Outlays after tax (i.e. Training Expenses)Expense Outlays after tax (i.e. Training Expenses)

Initial OutlayInitial Outlay

Sale of Old MachineSale of Old MachineOnly for Replacement ProjectsOnly for Replacement Projects

10Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Sale of Old MachineSale of Old MachineTaxes on MachineTaxes on Machine

Only for Replacement ProjectsOnly for Replacement Projects

Cost of AssetsCost of Assets Installation and ShippingInstallation and ShippingNon-Expense Outlays (i.e. Working Capital)Non-Expense Outlays (i.e. Working Capital)Expense Outlays after tax (i.e. Training Expenses)Expense Outlays after tax (i.e. Training Expenses)

11Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%.

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%.

12Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000

13Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000

14Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000

15Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400 4,000(1-0.40)

16Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

17Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

Salvage Value 10,000

18Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

Salvage Value 10,000–Taxes – 4,000

.4(10,000 – 0)

Tax rate x (Salvage Value-Book Value)

19Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

Salvage Value 10,000–Taxes – 4,000

– 6,000

20Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

Salvage Value 10,000–Taxes – 4,000

– 6,000Initial Outlay +49,400

21Estimating Cash FlowsEstimating Cash FlowsInitial OutlayInitial Outlay

Cost of Machine +48,000Installation & Shipping 2,000Working Capital 3,000Training (after tax) 2,400

+55,400Less: Sale of Old Machine

Salvage Value 10,000–Taxes – 4,000

– 6,000Initial Outlay +49,400

0 1 2 3 4 5

-49,400

22Estimating Cash FlowsEstimating Cash Flows

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Terminal Cash FlowTerminal Cash Flow

Recover Working Capital +3,000

23Estimating Cash FlowsEstimating Cash Flows

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Terminal Cash FlowTerminal Cash Flow

Recover Working Capital +3,000Sell “New” Machine 15,000

24Estimating Cash FlowsEstimating Cash Flows

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Terminal Cash FlowTerminal Cash Flow

Recover Working Capital +3,000Sell “New” Machine 15,000Tax on Sale -6,000

.4(15,000-0)

25Estimating Cash FlowsEstimating Cash Flows

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Example:Example:Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Terminal Cash FlowTerminal Cash Flow

Recover Working Capital +3,000Sell “New” Machine 15,000Tax on Sale -6,000Terminal Cash Flow +12,000

26Capital RationingCapital Rationing In large companies, many projects are evaluated each yearIn large companies, many projects are evaluated each yearManagement often imposes a limit that can be spent on new Management often imposes a limit that can be spent on new

projects adopted during the year–projects adopted during the year–Capital RationingCapital Rationing In order to allocate scarce resources, choose the group of In order to allocate scarce resources, choose the group of

projects whose initial outlays are within the capital spending projects whose initial outlays are within the capital spending limit while at the same time maximizing NPV of the group of limit while at the same time maximizing NPV of the group of projects. projects.

27Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

The following independent projects are subject to a The following independent projects are subject to a $100,000 capital budget.$100,000 capital budget.

All Projects have NPV > 0, PI > 1All Projects have NPV > 0, PI > 1

28Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

2, 3 & 4 40,000 3,000+30,000 +2,500+20,000 +1,000

90,000 6,500

ProjectCombinations IO NPV

29Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

2, 3 & 4 40,000 3,000+30,000 +2,500+20,000 +1,000

90,000 6,500

5 90,000 6,000

ProjectCombinations IO NPV

30Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

2, 3 & 4 40,000 3,000+30,000 +2,500+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,50040,000 3,00090,000 4,500

ProjectCombinations IO NPV

31Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

2, 3 & 4 40,000 3,000+30,000 +2,500+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,50040,000 3,00090,000 4,500

1,3 & 4 50,000 1,50030,000 2,50020,000 1,000

100,000 5,000

ProjectCombinations IO NPV

32Capital RationingCapital Rationing

ExampleExample

Project IO NPV PI1 50,000 1,500 1.032 40,000 3,000 1.0753 30,000 2,500 1.0834 20,000 1,000 1.055 90,000 6,000 1.067

2, 3 & 4 40,000 3,000+30,000 +2,500+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,50040,000 3,00090,000 4,500

1,3 & 4 50,000 1,50030,000 2,50020,000 1,000

100,000 5,000

ProjectCombinations IO NPV

33