Chapter 8 Cash Flow and Capital Budgeting Professor XXXXX Course Name / # © 2007 Thomson South-Western

2 2 2 Cash Flow and Capital Budgeting  The kinds of cash flows that may appear in almost any type of investment  How to deal properly with the problem of inflation in capital budgeting problems  Special problems and situations that arise in the capital budgeting process  The human element in capital budgeting

3 3 3 Cash Flow versus Accounting Profit  In preparing financial statements for external reporting, accountants have a different purpose in mind than financial analysts have when they evaluate the merits of an investment.  Accountants measure the inflows and outflows of a business’s operations on an accrual basis rather than on a cash basis.  E.g., depreciation

4 4 4 Cash Flow versus Accounting Profit  For capital budgeting purposes, financial analysts focus on incremental cash in-flows and outflows.  This emphasis simply recognizes that no matter what earnings a firm may show on an accrual basis, it cannot survive for long unless it generates cash to pay its bills.  When calculating a project’s NPV, analysts should ignore the costs of raising the money to finance the project.

5 5 5 The Initial Investment  Many capital budgeting problems begin with an initial outflow to acquire/install fixed assets. Must also consider:  Cash inflow from selling old equipment  Cash inflow (outflow) if selling old equipment below (above) tax basis generates tax savings (liability) An example.... Tax rate = 40% New equipment costs $10 million, $0.5 million to install Old equipment has been fully depreciated, sold for $1 million The initial investment would then be an outflow of $10.5 million, and an after-tax inflow of $0.60 million from selling the old equipment

6 6 6 Types of Cash Flows  Depreciation  Fixed asset expenditures  Working capital expenditures  Terminal value  Incremental cash flow

7 7 7 Depreciation  Largest noncash item for most investment projects  Affects the amount of taxes the firm will pay  Modified accelerated cost recovery system (MACRS)  defines the allowable annual depreciation deductions for various classes of assets

8 8 8 Depreciation  Many countries allow firms to use one depreciation method for tax purposes and another for reporting purposes  Accelerated depreciation methods (such as MACRS) 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 Which method would you expect companies to use when they file their taxes, and which would they use when preparing public financial statements? For capital budgeting analysis, it is the depreciation method for tax purposes that matters

9 9 9 Assume a firm purchases a fixed asset today for $30,000 Plans to depreciate over 3 years using straight-line method Firm will produce 10,000 units/year Costs $1/unit Sells for $3/unit Firm pays taxes at a 40% marginal rate $6,000Net income $16,000 Cash flow = NI + deprec (4,000)Taxes (40%) $10,000Pre-tax income (10,000)Depreciation $20,000Gross profits (10,000)Cost of goods $30,000Sales Adding non-cash expenses back to after-tax earnings $4,000Depreciation tax savings $16,000Cash Flow $12,000Aft-tax income (8,000)Taxes (40%) $20,000Pre-tax income (10,000)Cost of goods $30,000Sales Find after-tax profits, add back non-cash charge tax savings Simplest and most common technique: Add depreciation back in Two Methods Of Handling Depreciation To Compute Cash Flow

10 Tax Depreciation Schedules by Asset Class

11 Fixed Asset Expenditures  When a firm sells an old piece of equipment, there will be a tax consequence of the sale if the selling price exceeds or falls below the old equipment’s book value.  If the firm sells an asset for more than its book value, the firm must pay taxes on the difference.  If a firm sells an asset for less than its book value, then it can treat the difference as a tax-deductible expense.

12 Working Capital Expenditures  Many capital investments require additions to working capital  Net working capital (NWC) = current assets minus current liabilities  Increase in NWC is a cash outflow; decrease a cash inflow An example… –Operate booth 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

13 Working Capital For Calendar Sales Booth ($4,000)+$500 NA Monthly  in WC ($3,000)$1,000$500$0Net WC $5,000$10,000$15,000$0Accts payable $0$1,500$10,500$15,000$0Inventory $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) $0 +$3,000

14 Terminal Value Terminal value 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 a project at a given future point in time – Large value relative to all the other cash flows of the project

15 Terminal Value Different ways to calculate terminal values – Use final year cash flow projections and assume that all future cash flows grow at a constant rate – Multiply final cash flow estimate by a market multiple – 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.

16 Terminal Value of SDL Acquisition  If we 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  Caveat : market multiples fluctuate over time

17 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 expect increases of 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

18 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?

19 Opportunity Cost  In capital budgeting, the opportunity costs of one investment are the cash flows on the alternative investment that the firm decides not to make.

20 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, he would have earned:

21 Cash Inflows, Discounting, and Inflation  If inflation is in the numerator, be sure that it is also in the denominator.  If the numerator ignores inflation, so too must the denominator.  The nominal return reflects the actual dollar return.  The real return measures the increase in purchasing power gained by holding a certain investment.  In general, when the inflation rate is high, so too will be the nominal rate of return offered by various investments:  Investors will demand a return that not only keeps pace with inflation,  but also offers a positive real return.

22 Inflation Rule 1  Nominal cash flows reflect the same inflation rate that the interest rate does  Inflation Rule 1 — When we discount cash flows at a nominal interest rate, embedded in the discount rate is an estimate of expected inflation.

23 Inflation Rule 2  Occasionally an investment’s cash flow projections may be stated in real terms.  Real cash flows only reflect current prices and do not incorporate upward adjustments for expected inflation.  Inflation Rule 2 — When project cash flows are stated in real rather than in nominal terms, the appropriate discount rate is the real rate.

24 Equipment Replacement and Unequal Lives  A firm must purchase an electronic control device  First alternative is a cheaper device, higher maintenance costs, shorter period of utilization  Second device is more expensive, smaller maintenance costs, longer life span  Expected cash outflows  Maintenance costs are constant over time. Use real discount rate of 7% for NPV A B Device $15,936 A $18,065 B NPV Device Cash outflow device A < cash outflow device B  select A?

25 Equivalent Annual Cost (EAC)  EAC converts lifetime costs to a level annuity; eliminates the problem of unequal lives  1. Compute NPV for operating devices A and B for their lifetime  NPV device A = $15,936  NPV device B = $18,065  2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device Device ADevice B

26 Capital Budgeting and Inflation

27 Special Problems in Capital Budgeting  Equipment replacement and equivalent annual cost  Excess capacity

28 Operating and Replacement Cash Flows for Two Devices

29 Excess Capacity  When firms operate at less than full capacity, managers encourage alternative uses of the excess capacity because they view it as a free asset.  The marginal cost of using excess capacity is zero in the very short run, but using excess capacity today may accelerate the need for more capacity in the future.  When this is so, managers should charge the cost of accelerating new capacity development against the current proposal for using excess capacity.

30 Excess Capacity  Excess capacity – not a free asset as traditionally regarded by managers  Company has excess capacity in a distribution center warehouse  In two years the firm will invest $2,000,000 to expand the warehouse  The firm could lease the excess space for $125,000 per year for the next two years  Expansion plans should begin immediately in this case to hold inventory for stores that will come on line in a few months  Incremental cost – investing $2,000,000 at present vs. two years from today  Incremental cash inflow - $125,000

31 Excess Capacity  NPV of leasing excess capacity (assume 10% discount rate)  NPV negative – reject to lease excess capacity at $125,000 per year  The firm could compute the value of the lease that would allow to break even  X = $181,818  Leasing the excess capacity for a price above $181,818 would increase shareholders wealth

32 Human Face of Capital Budgeting  The best financial analysts can provide not only the numbers to highlight the value of a good investment, but also can explain why the investment makes sense, highlighting the competitive opportunity that makes one investment’s NPV positive and another’s negative.