Chapter 10

Cash Flows and Other Topics in Capital Budgeting

Chapter Objectives Guidelines to measure cash flows Calculate a project’s benefits and costs—or free cash flows Options or flexibility in capital budgeting Measure measure of risk in capital budgeting decisions Acceptability of a new project using the risk- adjusted discount method of adjusting for risk Simulation for imitating the performance of a project Difficulties of a multinational firm in estimating cash flows

Incremental Cash Flows Only incremental after-tax cash flows matter Must consider incremental expenses

Capital Budgeting Consider: – Incremental Costs/expenses – Opportunity Costs – Incremental overhead costs Ignore: – Sunk Costs – Interest payments and financing cash flows

Sunk Costs Cash flows that have already taken place are called sunk costs Costs that have been sunk into a project and can not be undone

Opportunity Costs Opportunity cost cash flows should reflect net cash flows that would have been received if the project were rejected

Overhead Costs Must include incremental overhead costs or costs that were incurred as a result of the project

Interest Payments and Financing Costs Interest charges associated with raising funds for a project are not a relevant cash outflow. Required rate of return implicitly accounts for the cost of raising funds to finance a new project.

Free Cash Flow Calculations Relevant cash flows 1.Initial cash outlay 2.Differential flows over the project’s life 3.Terminal cash flow

Initial Cash Outlay Immediate cash outflow necessary to purchase the asset and put it in operating order May include: – Purchase cost – Installation – Shipping/Freight – Set-up cost – Non-expense cash outlays—increased working-capital requirements

Differential Flows over a Project’s Life Incremental after-tax cash flows resulting form the project being considered Any increase in interest payments incurred as a result of issuing bonds to finance the project will not be included Adjustments for the incremental change in taxes should be included Changes in net working capital should be included

Terminal Cash Flow Flows associated with the project’s termination May include: – Salvage value of the project plus or minus – Any taxable gains or losses associated with the sale

Measuring the Operating Cash Flows Project’s change in operating cash flows After tax savings or earnings that result from the new project – New sales or cost savings offset by any increased expenses—on an after-tax basis – Include any increases in overhead Change in sales – change in costs – change in taxes

Steps in Calculating Operating Cash Flows 1.Earnings before interest and taxes with and without the project 2.Subtract the change in taxes (ignore interest expense) 3.Add back depreciation

Change in Net Working Capital Additional investment in working capital minus any additional short-term liabilities that were generated

Change in Capital Spending Include any changes in capital spending as a result of the project

Differential Free Cash Flows Changes in earnings before interest and taxes – less – Change in taxes – less – Change in depreciation – less – Change in net working capital – less – Change in Capital Spending

Options in Capital Budgeting Value in flexibility 1.Option to delay a project 2.Option to expand a project 3.Option to abandon a project

Risk in Capital Budgeting Decisions Project Standing alone risk Contribution to firm risk Systematic risk

Project Standing Alone Risk A project’s risk ignoring the fact that much of the risk will be diversified away as the project is combined with other projects and assets

Contribution-to-Firm Risk Amount of risk that the project contributes to the firm as a whole; considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets.

Systematic Risk Risk of the project from the viewpoint of a well-diversified shareholder; This measure takes into account that some of the risk will be diversified away as the project is combined with the firm’s other projects and in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolios.

Risk Theoretically, the only risk of concern to shareholders is systematic risk In reality, the possibility of bankruptcy makes a project’s contribution-to-firm risk a relevant risk measure in addition to systematic risk

Risk and Capital Budgeting Risk-adjusted discount rates – Investors demand higher returns for more risky projects. As the risk of a project increases, the required rate of return is adjusted upward. Present Value of a project is calculated at the higher, risk adjusted rate

Measurement of Risk Estimating risk of a project can be difficult. Historical stock return data relates to an entire firm, rather than a specific project or division. Risk must be estimated. Options to estimate risk include: Accounting Beta Pure Play Method Simulation Scenario Analysis Sensitivity Analysis

Beta Accounting Beta Method – Can be estimated via time-series regression on a division’s return on assets on the market index Pure Play Method – Identifies publicly traded firms engaged solely in the same business as the project, using that firm’s return data to judge the project.

Simulation – Imitating the performance of the project under evaluation Scenario Analysis – Range of possible outcomes under the worst, best, and most likely case Sensitivity analysis – Determines how the distribution of possible net present values are affected by a change in one particular value