# professor john zietlow mba 621 cash flow and capital budgeting chapter 8

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Professor John ZietlowMBA 621Cash Flow And Capital BudgetingChapter 8

Chapter 8: Overview8.1Types of Cash Flows Cash flow vs. accounting profit Fixed asset expenditures Working capital expenditures Terminal value Incremental cash flow vs. sunk costs Opportunity costs8.2Cash Flow for Classicaltunes.com8.3Cash Flows, Discounting, and Inflation8.4Special Problems in Capital Budgeting Equipment replacement and equivalent annual cost Excess Capacity8.5Summary

Types of Cash FlowsFirst step in capital budgeting: determine the relevant CFsThe incremental after-tax cash outflow (investment) and resulting cash flows. Cash flows, rather than accounting values, are used. The cash flows of any project having simple cash flows can include three basic components: (1) initial investment, (2) operating CFs, and (3) terminal CF All projects have the first two componentsInitial investment includes all set up costsAlso includes incremental working capital investmentOperating cash flows are after-tax net cash flows using the firms marginal tax rateCF, not earnings, so add depreciation back inThe terminal CF usually related to liquidation of the projectInclude disposal costs and after-tax salvage values, if any

Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profitMost important distinction: non-cash chargesTwo ways to treat non-cash chargesCan compute net income and add depreciation backCan compute after-tax income, then add tax savingsDemonstrate two methods (next slide) by assuming a firm purchases a fixed asset today for $30,000Plans to depreciate over 3 years using straight-line methodUsing machine, firm will produce 10,000 units/yearProduct sells for $3/unit and costs $1/unitFirm pays taxes at a 40% marginal rate

Two Methods Of Handling Depreciation To Compute Cash FlowSimplest and most common technique:Add depreciation back in

An Overview Of DepreciationLargest non-cash charge for most projects: depreciation Firms allowed to charge off portion of assets cost each year For tax purposes, depreciation is regulated by the IR Code, as laid out most recently in the Tax Reform Act of 1986. A firm will often use different depreciation methods for financial reporting and tax purposes, which is quite legal.Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS) In US & UK, different depreciation methods can be used for taxes and financial reporting MACRS standards, which apply to both new and used assets, require a taxpayer to use as an asset's depreciable life the appropriate MACRS recovery period. There are six MACRS recovery periods--3, 5, 7, 10, 15, and 20 years--excluding real estate (not depreciable). The first four property classes defined next slide.

The First Four Depreciation MACRS Classes

Property class

Definition

3-year

Research equipment & certain tools

5-year

Computers, typewriters, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets

7-year

Office furniture, fixtures, most mfg equipment, railroad track, single-purpose agricultural and horticultural structures

10-year

Equipment used in petroleum refining or in the manufacture of tobacco and certain food products

MACRS Recovery PeriodsFor tax purposes, assets in the first four property classes depreciated by the double-declining balance (200%) method Also computed using the half-year convention and switching to straight-line when advantageous.The approximate percentages written off each year for the first four property classes are given in Table 8.1. Rather than using these, the firm can use either straight-line depreciation over the asset's recovery period with the half-year convention or the alternative depreciation system. We use MACRS figures as these generally provide for the fastest writeoff & thus the best CF effects for profitable firmsMACRS requires use of the half-year convention, so assets assumed to be acquired in mid-yearSo only half of first year's deprec is recovered in year 1 Final half-year of depreciation is recovered in the year immediately following the asset's stated recovery period. Deprec %s for an n-year asset thus given for n + 1 years

Depreciation Percentages By Year

Depreciation percentage by recovery year

Recovery year

3-year

5-year

7-year

10-year

1

33%

20%

14%

10%

2

45

32

25

18

3

15

19

18

14

4

7

12

12

12

5

12

9

9

6

5

9

8

7

9

7

8

4

6

9

6

10

6

11

4

Totals

100%

100%

100%

100%

Finding Initial Cost of Fixed Asset PurchaseCap budget decisions usually entail acquiring fixed asset.Initial cost typically measured as net cash outflowIf new asset, net initial cost fairly simple to computeJust purchase price plus installation costsIf new asset purchased to replace existing asset, finding net initial cost much more complicatedMust account for purchase and installation cost of new assetPlus after-tax inflow or outflow from old asset = sale price net of removal costs, plus or minus tax impact of saleTax impact from sale of old asset depends on assets sale price and book valueSale price below book value capital loss (tax benefit)Sale price above book value, but below purchase price firm must pay tax on recaptured depreciationSale price above purchase price firm must pay tax on recaptured depreciation plus capital gain

Calculating Net Initial Cost Of New Computers For Electrocom MfgElectrocom Mfg wants to replace computers purchased three years ago for $100,000 with newer, faster machinesOld computers have been deprec with 5-year MACRS ruleAccum deprec = $71,200 (71.20%); so book value = $28,800If Electrocom sells its old computers for $10,000, what is net after-tax cash flow from sale? Assume tax rate = 40%Capital loss, sale of old computer = book value - sale price = $28,800 - $10,000 = $18,800 Tax benefit of capital loss (assuming firm has other profits) = capital loss x tax rate = $18,800 x 0.40 = $7,520Net inflow from sale = sale price + tax benefit = $17,520Net initial cost of new computers thus the purchase and installation cost of new computers minus $17,520

Working Capital ExpendituresMany cap investments require additions to working capitalNet working capital (NWC) = curr assets curr liabilitiesIncrease in NWC is a cash outflow; decrease a cash inflowSome curr assets (A/R) can be acquired thru trade credit, but curr liab will go up if credit extended (A/P)Demonstrate impact of WC investment on cash flow with calendar sales booth in mall over Christmas seasonOperate booth from November 1 to January 31 (close Feb1)Order $15,000 calendars on credit, delivery by Nov 1Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan; close up shop Feb 1Always want to have $500 cash on hand; invest cash Nov 1, receive it back Jan 31.

Working Capital For Calendar Sales Booth($500)+$4,000($3,000)$0$0+$3,000

Terminal ValueSome investments have a well-defined life, determined by:Physical life of a piece of equipmentPeriod until a patent expiresPeriod of time covered by a leasing or licensing agreementTerminal value used when evaluating an investment with indefinite life-span1. Construct cash-flow forecasts for 5 to 10 years2. Forecasts more than 5 to 10 years high margin of error; use terminal value insteadTerminal value intended to reflect the value of a project at a given future point in timeLarge value relative to all the other cash flows of the project

Terminal Value of SDL AcquisitionJDS Uniphase projections for acquisition of SDL Inc.

Different ways to calculate terminal values assumptions used to calculate terminal value are very importantUse final year cash flow projections and assume that all future cash flow grow at a constant rateMultiply final cash flow estimate by a market multipleUse investments book value or liquidation valueEstimate recovery of no more than 20 50 percent of original purchase cost (Asplund, 2002)Possibly negative terminal value if high disposal costs

Terminal Value of SDL Acquisition (Continued)If assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):

Terminal value is $68.2 billion; value of entire project is

$42.4 billion of total $48.7 billion from terminal value

Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal valueTerminal Value = $3.25 x 20 = $65 billionCaveat : market multiples fluctuate over time

Incremental Cash FlowIncremental cash flows vs. sunk costsCap budgeting analysis should include only incremental costsFor example, decision to pursue MBA can be based on incremental cash flowsNorman Pauls current salary is $60,000 per year and expect to increase at 5% each yearAssume that Norm pays taxes at flat rate of 35%Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programsRoom and board expenses not incremental to the decision to go back to school (assume the same expenses for room and board in both cases)

Incremental Cash Flow (Continued)At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per yearExpected tuition, fees and textbook expenses for next two years while studying in MBA: $35,000If Norm worked at his current job for two years, his salary would have increased to $66,150:Yr 2 net cash inflow: $90,000 - $66,150 = $23,850After-tax inflow: $23,850 x (1-0.35) = $15,503Yr 3 cash inflow:MBA has substantial positive NPV value if 30 yr analysis periodUnwanted incremental cash outflow cannibalization (sales of new products may come at expense of firms existing products

Opportunity CostsOpportunity cost: cash flows from alternative investment opportunities that are forgone when one investment is undertakenIf Norm did not attend MBA, he would have earned:First year: $60,000 ($39,000 after taxes)Second Year: $63,000 ($40,950 after taxes)Norms opportunity cost: $39,000 + $40,950 = $79,950NPV of a project could fall substantially if opportunity costs are recognizedMBA applications are countercyclical because applicants take into consideration opportunity costsA firm that bought land for an expansion opportunity, for example, should factor into the NPV of firms expansion plans the opportunity cost of selling or leasing the land

Initial Investment for Classicaltunes.com Jazz CD ProjectCompany is considering adding jazz recordings to its offeringsFirm uses 10% discount rate to calculate NPV and 40% tax rateThe average selling price of Classicaltunes CDs is $13.50; price is expected to increase at 2% per yearInitial investment transactions:$50,000 for computer equipment (MACRS 5-year asset class) $4,500 for inventory ($2,500 of which purchased on credit)$1,000 increase in cash balancesSales expected to begin when new fiscal year beginsExpanding sales volume require increases in current assets and additional spending on fixed assetsAny additional financing (besides trade credit) for the project from funds generated by classical-music CD side of the business

Projections for Jazz CD Proposal

Projections for Jazz CD Proposal (Continued)

Annual Cash Flow Estimates

Year Zero Cash FlowInitial cash outlay of $50,000 for computer equipmentEven though sales begin when new fiscal year begins, half-year of MACRS depreciation can be taken in year zero:20% x $50,000 = $10,000; non cash expenseDepreciation expense can be deducted from the firms classical-music CD profits. The company saves $4,000 (40% x $10,000) in taxesChanges in working capital are result of following transactions:Purchase of $4,500 in inventory and $1000 cash balanceAccounts payable of $2,500 partially finance the $5,500 outlayNet Cash Flow: Increase in gross fixed assets - $50,000 Change in working capital - $3,000 Tax savings + $4,000 Net cash flow - $49,000

Year One Cash FlowPurchase of additional $10,000 in fixed assets2nd year depreciation expenses for MACRS 5-year asset class is 32%. An additional 20% depreciation deduction for assets purchased this year32% x $50,000 + 20% x $10,000= $18,000 Non cash expense; has to be added back when computing cash flow for the yearNet working capital for year one is:NWC = Current Assets Current Liabilities = $13,934 - $4,320 = $9,614

Increase in NWC; cash outflow of $6,614

Year One Cash Flow (Continued)Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.comTax savings = 40% x $13,043 = $5,217Net operating cash inflow = pretax loss + tax savings + depreciationOperating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174

Net cash flow: Increase in gross fixed assets - $10,000 Change in working capital - $6,614 Operating cash inflow + $10,174 Net cash flow - $6,440

Year Two Cash FlowPurchase of additional $5,000 in fixed assetsAssets purchased at the onset of the project allowable depreciation of 19.2% (19.2% x $50,000 = $9,600)An additional 32% depreciation deduction for assets purchased in year 1 and 20% depreciation of assets purchased this yearTotal depreciation = $9,600 + 32% x $10,000 + 20% x $5,000= $4,200 = $13,800Changes in working capital are result of following transactions:Increases in current assets:$500 increase in cash balance$7,115 increase in accounts receivables$11,383 increase in inventoryIncrease in current liabilities:$6,696 increase in account payablesChange in NWC = $18,998 - $6,696 = $12,302 (cash outflow)

Year Two Cash Flow (Continued)Pretax profit in year two is $1,649The company must pay taxes of $660 (40% x $1,649); cash outflowNet operating cash inflow = pretax profit + tax + depreciationOperating cash inflow = $1,649 - $660 + $13,800 = $14,789

Net cash flow: Increase in gross fixed assets - $5,000 Change in working capital - $12,302 Operating cash inflow + $14,790 Net cash flow - $2,512

Terminal Value for Jazz CD InvestmentIf assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,)

Second approach used by Classicaltunes.com to compute terminal value for the project use the book value at end of year six:Plant and Equipment (P&E) at end of year six is $31,328The firm liquidates total current assets and pays off current debts$85,850 - $29,810 = $56,040Terminal value = $31,328 + $56,040 = $87,368

NPV for Jazz CD ProjectUsing assumption that cash flow grow at a steady rate past year 6

Using book value assumption for terminal value

NPV is positive with both methods investing in Jazz CD project increases shareholders wealth

Nominal and Real ReturnNominal return vs. real returnNominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment

Common in capital budgeting is the use of market rates of return at the time of the analysisMarket interest rates have embedded an assumption about inflationIn this case, use nominal cash flows to reflect the same inflation rate as that embedded in discount rate

Inflation RulesInflation Rule 1 if nominal rate used to discount cash flow of a project, the embedded inflation expectation in the nominal rate must be used to construct the cash flowsIn analysis of Jazz CDs investment, assumption that price of a CD increases by 2% per year on averageRevenues expressed in nominal termsDiscount rate used (10%) must reflect current market returns to account for inflation rateInflation Rule 2 when project cash flows are stated in real rather than nominal terms, the appropriate discount rate is the real rateCash flows projections for Classicaltunes.com could be expressed in real termsUse current price for CDs of $13.50, current-year labor costs, current-year prices for fixed assets for projections of cash flows

Real-Term Cash Flows for Jazz CD InvestmentTo obtain cash flow in real terms discount nominal cash flow at inflation rateFirst year cash flow of -$6,440 restated in real terms

NPV of Jazz CD ProjectReal rate for Classicaltunes.com

NPV of the project discount real-term cash flow at real rate

Discounting real cash flows at real interest rate yields the same NPVas discounting nominal cash flows at nominal rate

Capital Budgeting and InflationIf discount nominal cash flows at real discount rate:Nominal Discount RateReal Discount RateNominal Cash FlowsReal Cash FlowsIf discount real cash flows at nominal discount rate:

Equipment ReplacementA firm must purchase an electronic control deviceFirst alternative cheaper device, higher maintenance costs, shorter period of utilizationSecond device more expensive, smaller maintenance costs, longer life spanExpected cash outflows

Maintenance costs constant over time use real discount rate of 7% for NPV

Cash outflow device A < cash outflow device B select A

Equipment Replacement (Continued)Previous approach ignores the fact that device A will be replaced in year 4 Different approach use cash flows for 12 years select B

Equivalent Annual Cost (EAC)EAC method approximates NPV for operating device with NPV of annuity1. Compute NPV for operating devices A and B for their lifetimeNPV device A = $15,936NPV device B = $18,0652. Compute annual expenditure to make NPV of annuity equal to NPV of operating deviceDevice A

Device B

Equivalent Annual Cost (Continued)The firm chooses device B replacing device B every four years is equivalent to a perpetuity of $5,333The firm assumes that will keep using device B for a long period of timeAssume the firm will use in three years new, less expensive technology that makes current technology obsoleteIn this case, choose the device that has the smallest cash outflow for three years choose A (assume salvage value zero)

Excess CapacityExcess capacity not a free asset as traditionally regarded by managersCompany has excess capacity in a distribution center warehouseIn two years the firm will invest $2,000,000 to expand the warehouse as new stores are built in the regionThe firm could lease the excess space for $125,000 per year for the next two yearsExpansion plans should begin immediately in this case to hold inventory for stores that will come on line in a few monthsIncremental cost investing $2,000,000 at present vs. two years from todayIncremental cash inflow - $125,000

Excess Capacity (Continued)NPV of leasing excess capacity (assume 10% discount rate)

NPV negative reject to lease excess capacity at $125,000 per yearThe firm could compute the value of the lease that would allow to break even

X = $181,818Leasing the excess capacity for a price above $181,818 would increase shareholders wealth

The Human Face of Capital BudgetingNPV of a project is based on a number of assumptionsManagers must be aware of optimistic bias in these assumptions made by supporters of the projectCompanies should have control measures in place to remove biasAnalysis of an investment done by a group independent of individual or group proposing the projectAnalysts of the project must have a sense of what is reasonable when forecasting a projects profit margin and its growth potentialAnother side of determining which projects receive funding storytellingBest analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense