1 Cash Flows and Other Topics in Capital Budgeting Chapter 10

2 Learning Objectives Learning Objectives  Discuss what is and what is not an incremental cash flow, and why they alone are relevant in capital-budgeting decisions.  Explain how a project’s benefits and costs–that is, its incremental after-tax cash flows–are calculated.  Explain how the capital-budgeting decision process changes when a limit is placed on the dollar size of the capital budget.

3 Cash Flows in General  Measure cash flows that change if a project is undertaken  Sunk cost is irrelevant  Opportunity cost is relevant  Do not include allocation of existing overhead  Do subtract lost sales of other products  Include cost savings as a positive cash flow. Measure Incremental Cash Flows

4 Cash Flows in General  New Project vs. Replacement Project  New project – simply addition to company  Replacement – replace and existing old machine or plant.  Financing costs - Interest and Dividend payments. are not considered operating cash flows. Financing cost are used to discount the cash flows to find NPV,etc.  Only include CASH inflows and outflows.

5 Estimating Cash Flows  Initial Outlay Three Types of Cash Flows  Initial Outlay

6 Estimating Cash Flows  Initial Outlay  Operating (Differential) Cash Flows Three Types of Cash Flows Initial Outlay Operating Cash Flows 

7 Estimating Cash Flows  Initial Outlay  Operating (Differential) Cash Flows  Terminal Cash Flow Three Types of Cash Flows Initial Outlay Operating Cash Flows Terminal Cash Flow 

8 Estimating Cash Flows  Cost of Assets  Installation and Shipping  Non-Expense Outlays (i.e. Working Capital)  Expense Outlays after tax (i.e. Training Expenses) Initial Outlay

9 Estimating Cash Flows  Cost of Assets  Installation and Shipping  Non-Expense Outlays (i.e. Working Capital)  Expense Outlays after tax (i.e. Training Expenses) Initial Outlay  Sale of Old Machine Only for Replacement Projects

10 Estimating Cash Flows Initial Outlay  Sale of Old Machine  Taxes on Machine Only for Replacement Projects  Cost of Assets  Installation and Shipping  Non-Expense Outlays (i.e. Working Capital)  Expense Outlays after tax (i.e. Training Expenses)

11 Estimating Cash Flows Initial Outlay 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:

12 Estimating Cash Flows Initial Outlay Cost of Machine+48,000

13 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000

14 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000

15 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2,400 4,000(1-0.40)

16 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine

17 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine Salvage Value10,000

18 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine Salvage Value10,000 –Taxes– 4,000.4(10,000 – 0) Tax rate x (Salvage Value-Book Value)

19 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine Salvage Value10,000 –Taxes– 4,000 – 6,000

20 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine Salvage Value10,000 –Taxes– 4,000 – 6,000 Initial Outlay+49,400

21 Estimating Cash Flows Initial Outlay Cost of Machine+48,000 Installation & Shipping2,000 Working Capital3,000 Training (after tax)2, ,400 Less: Sale of Old Machine Salvage Value10,000 –Taxes– 4,000 – 6,000 Initial Outlay+49, ,400

22 Estimating Cash Flows 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: Terminal Cash Flow Recover Working Capital+3,000

23 Estimating Cash Flows 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: Terminal Cash Flow Recover Working Capital+3,000 Sell “New” Machine15,000

24 Estimating Cash Flows 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: Terminal Cash Flow Recover Working Capital+3,000 Sell “New” Machine15,000 Tax on Sale-6,000.4(15,000-0)

25 Estimating Cash Flows 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: Terminal Cash Flow Recover Working Capital+3,000 Sell “New” Machine15,000 Tax on Sale-6,000 Terminal Cash Flow+12,000

26 Capital Rationing  In large companies, many projects are evaluated each year  Management often imposes a limit that can be spent on new projects adopted during the year– Capital Rationing  In order to allocate scarce resources, choose the group of projects whose initial outlays are within the capital spending limit while at the same time maximizing NPV of the group of projects.

27 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, The following independent projects are subject to a $100,000 capital budget. All Projects have NPV > 0, PI > 1

28 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, , 3 & 440,0003, ,000+2, ,000+1,000 90,0006,500 Project CombinationsIONPV

29 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, , 3 & 440,0003, ,000+2, ,000+1,000 90,0006, ,0006,000 Project CombinationsIONPV

30 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, , 3 & 440,0003, ,000+2, ,000+1,000 90,0006, ,0006,000 1 & 250,0001,500 40,0003,000 90,0004,500 Project CombinationsIONPV

31 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, , 3 & 440,0003, ,000+2, ,000+1,000 90,0006, ,0006,000 1 & 250,0001,500 40,0003,000 90,0004,500 1,3 & 450,0001,500 30,0002,500 20,0001, ,0005,000 Project CombinationsIONPV

32 Capital Rationing Example ProjectIONPVPI 150,0001, ,0003, ,0002, ,0001, ,0006, , 3 & 440,0003, ,000+2, ,000+1,000 90,0006, ,0006,000 1 & 250,0001,500 40,0003,000 90,0004,500 1,3 & 450,0001,500 30,0002,500 20,0001, ,0005,000 Project CombinationsIONPV

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