Berlin, Fußzeile1 Cash Flow and Capital Budgeting (Chapter 9 Textbook)

Berlin, 18th of June, 2007Fußzeile2 Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profit. To evaluate a capital investment, we must know: Incremental cash outflows of the investment (marginal cost of investment), and Incremental cash inflows of the investment (marginal benefit of investment). The timing and magnitude of cash flows and accounting profits can differ dramatically.

What To Discount Points to “Watch Out For”  Only incremental cash flows are relevant  Include all incidental effects  Do not forget working capital requirements  Forget sunk costs  Include opportunity costs  Beware of allocated overhead costs

Berlin, 18th of June, 2007Fußzeile4 Financing Costs Financing costs are captured in the discounting future cash flows to present. Both interest expense from debt financing and dividend payments to equity investors should be excluded. Financing costs should be excluded when evaluating a project’s cash flows.

Berlin, 18th of June, 2007Fußzeile5 Cash Flow and Non-Tax Expenses  Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits.  Capital budgeting analysis focuses on cash inflows and outflows when they occur.  Non-cash expenses affect cash flow through their impact on taxes: Compute after-tax net income and add depreciation back, or Ignore depreciation expense but add back its tax savings.

Berlin, 18th of June, 2007Fußzeile6 Depreciation  Accelerated depreciation methods (such as MACRS = Modi- fied Accelerated Cost Recovery System) increase the present value of an investment’s tax benefits.  Relative to MACRS, straight-line depreciation results in higher reported earnings early in an investment’s life. For capital budgeting analysis, the depreciation method for tax purposes matters most. Many countries allow one depreciation method for tax purposes and another for reporting purposes.

Berlin, 18th of June, 2007Fußzeile7 The Initial Investment  Initial cash flows: Cash outflow to acquire/install fixed assets Cash inflow from selling old equipment Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability) Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment An example.... Tax rate = 40% New equipment costs $10 million, $0.5 million to install Old equipment fully depreciated, sold for $1 million

Berlin, 18th of June, 2007Fußzeile8 Working Capital Expenditures  Many capital investments require additions to working capital. Net working capital (NWC) = current assets – current liabilities. Increase in NWC is a cash outflow; decrease a cash inflow. An example… Operate from November, 1 to January, 31 Order $15,000 calendars on credit, delivery by Nov 1 Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan Always want to have $500 cash on hand

9 Working Capital Expenditures (4,000)+500 NA  /m in WC (3,000)1, Net WC 5,00010,00015,0000Accts payable 01,50010,50015,0000Inventory $0$500 $0Cash Feb 1Jan 1Dec 1Nov 1Oct 1 ($5,000) $0Payments ($500)Net cash flow $1,500 [10%] $9,000 [60%] $4,500 [30%] $0Reduction in inventory Jan 1 to Feb 1 Dec 1 to Jan 1 Nov 1 to Dec 1 Oct 1 to Nov 1 Payments and inventory ($500)+$4,000 ($3,000) ,000

Berlin, 18th of June, 2007Fußzeile10 Terminal Value Terminal value is used when evaluating an investment with indefinite life-span: Construct cash-flow forecasts for 5 to 10 years Forecasts more than 5 to 10 years have high margin of error; use terminal value instead. Terminal value is intended to reflect the value of project at a given future point in time. Large value relative to all the other cash flows of the project.

Berlin, 18th of June, 2007Fußzeile11 Terminal Value Different ways to calculate terminal values: Use final year cash flow projections and assume that all future cash flow grow at a constant rate; Multiply final cash flow estimate by a market multiple, or Use investment’s book value or liquidation value. $3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion Year 5Year 4Year 3Year 2Year 1 JDS Uniphase cash flow projections for acquisition of SDL Inc.

Berlin, 18th of June, 2007Fußzeile12 Terminal Value of SDL Acquisition  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 value Terminal Value = $3.25 x 20 = $65 billion Warning ! : market multiples fluctuate over time

Berlin, 18th of June, 2007Fußzeile13 Incremental Cash Flow Incremental cash flows versus sunk costs: Capital budgeting analysis should include only incremental costs. An example… Norman Paul’s current salary is $60,000 per year and he expects it to increase at 5% each year. Norm pays taxes at flat rate of 35%. Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programs Room and board expenses are not incremental to the decision to go back to school

Berlin, 18th of June, 2007Fußzeile14 Incremental Cash Flow  At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year Expected tuition, fees and textbook expenses for next two years while studying in MBA: $35,000 If 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 = $23,850 After-tax inflow: $23,850 x (1-0.35) = $15,503 Yr 3 cash inflow: MBA has substantial positive NPV value if 30 yr analysis period What about Norm’s opportunity cost?

Berlin, 18th of June, 2007Fußzeile15 Opportunity Costs Cash flows from alternative investment opportunities, forgone when one investment is undertaken. NPV of a project could fall substantially if opportunity costs are recognized! First year: $60,000 ($39,000 after taxes) Second Year: $63,000 ($40,950 after taxes) If Norm did not attend MBA program, he would have earned: