Chapter 7 Cash Flow of Capital Budgeting

Will the machine be profitable? Capital Budgeting: The process of planning for purchases of long-term assets. For example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows:

The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate.

Capital Budgeting Steps 1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. Initial outlay Differential Cash Flows over the life of the project (also referred to as annual cash flows). Terminal Cash Flows

Capital Budgeting Steps 1) Evaluate Cash Flows Terminal Cash flow Initial outlay 1 2 3 4 5 n 6 . . . Annual Cash Flows

Capital Budgeting Steps 2) Evaluate the Risk of the Project We’ll get to this in the next chapter. For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.

Capital Budgeting Steps 3) Accept or Reject the Project

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (20,000) (147,000) + (4,000) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) + (20,000) (147,000) + (4,000) + 0 Net Initial Outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay

Step 1: Evaluate Cash Flows a) Initial Outlay: What is the cash flow at “time 0?” (127,000) Purchase price of asset + (20,000) Shipping and installation (147,000) Depreciable asset + (4,000) Net working capital + 0 Proceeds from sale of old asset ($151,000) Net initial outlay

Step 1: Evaluate Cash Flows b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

For Each Year, Calculate: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow

For Years 1 - 5: 85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow

For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789) Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Tax Effects of Sale of Asset: Salvage value = $50,000. Book value = depreciable asset - total amount depreciated. Book value = $147,000 - $147,000 = $0. Capital gain = SV - BV = 50,000 - 0 = $50,000. Tax payment = 50,000 x .34 = ($17,000).

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows c) Terminal Cash Flow: What is the cash flow at the end of the project’s life? 50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow

Project NPV: CF(0) = -151,000. CF(1 - 4) = 46,461. Discount rate = 14%. NPV = $27,721. We would accept the project.

Capital Rationing Suppose that you have evaluated five capital investment projects for your company. Suppose that the VP of Finance has given you a limited capital budget. How do you decide which projects to select?

Capital Rationing You could rank the projects by IRR:

Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ Our budget is limited so we accept only projects 1, 2, and 3. 1 2 3 4 5 $X

Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15% 20% 25% $ Our budget is limited so we accept only projects 1, 2, and 3. 1 2 3 $X

Capital Rationing Ranking projects by IRR is not always the best way to deal with a limited capital budget. It’s better to pick the largest NPVs. Let’s try ranking projects by NPV.

Problems with Project Ranking 1) Mutually exclusive projects of unequal size (the size disparity problem) The NPV decision may not agree with IRR or PI. Solution: select the project with the largest NPV.

Size Disparity Example Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000 required return = 12% IRR = 15.89% NPV = $9,110 PI = 1.07 Project B year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000 required return = 12% IRR = 23.38% NPV = $6,027 PI = 1.20

Problems with Project Ranking 2) The time disparity problem with mutually exclusive projects. NPV and PI assume cash flows are reinvested at the required rate of return for the project. IRR assumes cash flows are reinvested at the IRR. The NPV or PI decision may not agree with the IRR. Solution: select the largest NPV.

Time Disparity Example Project A year cash flow 0 (48,000) 1 1,200 2 2,400 3 39,000 4 42,000 required return = 12% IRR = 18.10% NPV = $9,436 PI = 1.20 Project B year cash flow 0 (46,500) 1 36,500 2 24,000 3 2,400 4 2,400 required return = 12% IRR = 25.51% NPV = $8,455 PI = 1.18

Mutually Exclusive Investments with Unequal Lives Suppose our firm is planning to expand and we have to select one of two machines. They differ in terms of economic life and capacity. How do we decide which machine to select?

The after-tax cash flows are: Year Machine 1 Machine 2 0 (45,000) (45,000) 1 20,000 12,000 2 20,000 12,000 3 20,000 12,000 4 12,000 5 12,000 6 12,000 Assume a required return of 14%.

Step 1: Calculate NPV NPV1 = $1,433 NPV2 = $1,664 So, does this mean #2 is better? No! The two NPVs can’t be compared!