1 Cash Flow vs. Accounting Income Project Income Statement Revenues -Depreciation (D) - All other costs EBT -Taxes Project NI (PNI) Cash flow = PNI + Noncash expenses = PNI + Depreciation

2 Cash Flow Time Line CF 0 OCF 1 OCF 2 OCF 3 OCF 4 Initial + Cash OutlayTerminal Cash Flow NCF 0 NCF 1 NCF 2 NCF 3 NCF 4 Distinguish among: 1. Initial cash outlay. 2. Operating cash flows. 3. Terminal cash flow.

3 Data on 4 Period Expansion Project n:4 Years Sales Revenues:$60,000,000 per year starting 2007 Variable Costs:70% of sales per year Fixed Costs:$8,000,000 per year Building:$12,000,000 in 2006 Depreciation:MACRS Mrkt Value:$7,500,000 Equipment:$8,000,000 in 2006 Depreciation:MACRS Mrkt Value:$2,000,000 Net Working Capital (NWC):$6,000,000 Tax:40% Cost of Capital (WACC):12%

4 BQC Expansion Project ($000s) Building($12,000) Equipment(8,000) Increase in NWC(6,000) Total Investment($26,000)

5 BQC Expansion Project ($000s)

6 Calculating Net Salvage After Tax 1) Book Value = original value - accumulated depreciation 2) Capital Gain or (Loss) = selling price - book value 3) Net Salvage Value After Tax = selling price - capital gain tax OR = selling price + tax savings from book loss Accumulated depreciation for Building = $1,092,000 Accumulated depreciation for Equipment = $6,640,000

7 1. Buy building : cash flow = ( 12,000 ) 2. Buy machine : cash flow = ( 8,000 ) 3. Annual tax saving from building depreciation 4. Annual tax saving from machine 5. Annual income after tax 6. NWC 7. Salvage in year 2010

8 Accounting Depreciation( Building ) = 1,092 Accounting Depreciation( Equipment ) = 6,640 Book value(Building) = 12, ,092 = 10,908 Book value (Eqipment)=8, ,640 = 1,360

9 BQC Expansion Project Year Depreciation (Building) 1.3% 2.6% 2.6% 2.6% Depreciation (Equipment) 20.0% 32.0% 19.0% 12.0%

10 Time line of consolidated cash flows (000’s) ,0006,7027,1496,73323,116 Payback period: 3.23 Years IRR: 19.3% versus a 12% cost of capital MIRR: 17.2% versus a 12% cost of capital NPV: $5,166

11 Net Salvage Values Total cash flow from salvage value = $8,863,200 + $1,744,000 = $10,607,

12 Data on Replacement Analysis Cost of M 1 (10 years ago):$7,500 Expected Life:15 years Salvage:0 Depreciation Method:Straight line Market value (today):$1,000 Cost of M 2 (today):$12,000 Depreciation Method:MACRS- 3 years Salvage (at year 5):$2,000 Increase in Net Working Capital:$1,000 Increase in Earnings (before tax):$3,000 per (or decrease in costs) year Tax40% WACC 11.5%

13 Replacement Analysis Worksheet 1) Investment Outlay Cost of new equipment($12,000) Net Salvage of old equipment 1,600 (Market value of old equipment 1,000 +Tax savings on sale of old equipment 600) Increase in net working capital (1,000) Total net investment($11,400)

14 Replacement Analysis Depreciation Machine #1:7500 / 15 = 500/year Machine #1 Accumulated Depreciation = 10 years x 500 = ) Book Value = original value - accumulated depreciation 2500 = ) Capital (Loss) = selling price - book value (1500) = ) Net Salvage Value After Tax = selling price + tax savings from book loss 1600 = [ 40%(1500)]

15 Buy Machine #2 Before Taxes After Taxes 1) Earnings ) Tax savings from depreciation MACRS - 3 on 12,000 (new machine) Year% $ Accum depreciation = 12,000

16 Replacement Analysis Worksheet +

17 Replacement Analysis 5) Results Payback period:4.1 years IRR:10.1% versus an 11.5% cost of capital MIRR:10.7% versus an 11.5% cost of capital NPV:-$388.77

18 Capital Budgeting Illustration I. Data on Proposed New Asset MACRS class:3-year Economic life:4 years Price:$200,000 Freight & installation:$40,000 Salvage value:$25,000 Effect on NWC:Increase inventories by $25,000 & increase A/P by $5,000 Revenues:$200,000/year (100,000 units at $2/unit) Costs (excluding depreciation): 60% of sales Tax rate:40% Cost of capital:10%

19 Capital Budgeting Illustration II. Net Investment Outlay (t=0) Price ($200,000) Freight & Installation (40,000) Increase in NWC (20,000) (25, ,000) Net outlay ($260,000)

20 Annual Cash Flows (in ‘000) Year Total revenues$200.0$200.0$200.0$200.0 Operating costs exclude depreciation (60%) Depreciation (next slide) Total costs $199.2 $228.0 $156.0 $136.8 EBT$ 0.8 ($ 28.0) $ 44.0 $ 63.2 Taxes (40%) 0.3 (11.2) Net income$ 0.5 ($ 16.8)$ 26.4$ 37.9 Depreciation Net operating cash flows$ 79.7$ 91.2$ 62.4$ 54.7 Equipment cost ($200) Installation (40) Increase in NWC (20) Salvage value 25 Tax on salvage value (10) Return of NWC 20 Net cash flows ($260.0)$ 79.7$ 91.2$ 62.4$ 89.7 NPV = -$4.0 < $0 Discuss effects of: IRR = 9.3% < k Do not accept project.1. Sunk costs MIRR = 9.6% < k2. Opportunity costs Payback= 3.3 years3. Externalities