1. Cash Flow And Capital Budgeting
Professor Thomson
Fin 3013

2. 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.

3. Financing Costs
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 (can separate the investment decision from the financing decision).
Financing costs are captured in the discounting future cash flows to present i.e. use the correct discount rate to adjust for the systematic risk of the project.

4. Capital Investment Decisions
The with and without principle – Capital project evaluation should be done by assessing the cash flows with and without undertaking the project. I.e. We need to consider the INCREMENTAL cash flows due to the project.
Stand Alone Basis – another way of stating this principle is to consider the project on a stand alone basis (by looking only at the incremental cash flows that result from this project).

5. Other Considerations
Sunk Costs - A sunk cost is a cost that has been expended in the past, and whether you do or do not undertake the project, these costs no longer effect the incremental cost of the project.
Opportunity cost – There is no such thing as a free lunch. If a firm already owns something that can be applied to a new project – it could also be sold on Ebay. The amount you could sell it for on Ebay represents the opportunity cost of using an existing asset on a new project.
Side effects – In considering the incremental costs, one has to consider any side effects. If additional advertising of our new product, also increases sales of our other products, these sides effects must be part of the incremental costs (also cannibalization).

6. Net Working Capital
New or expanded projects often require additional working capital (such as additional inventory) that must be considered as part of the incremental cost of the project.
For project analysis, the simplest case is when additional working capital is required at the beginning of the project that will be brought back to base line levels at the end of the project.

7. Investment Pro Forma
A pro forma is the standard analysis of cash flows that one does to determine if a proposed capital project is a good investment.
A pro forma includes listing the expected cash flows over time, and computing of the investment criteria such as NPV, IRR, PI, and Payback.

8. Investment Pro Forma (simplified)
Source
Time 0 1 2 3
OCF
OCF1
OCF2
OCF3
NWC
-NWC
Investment
-Invest
Salvage (ATCF)
Total ATCF
ATCF0
ATCF1
ATCF2
ATCF3
All numbers are ATCF’s

9. Investment Pro Forma (simplified)
A project that costs 100 and requires 20 of new net working capital will provide incremental operating cash flows of $60 for the next three years. The after tax cash flow from salvaging the equipment will be 15. What are the project’s ATCF? What is the IRR?
Source
Time 0 1 2 3
OCF 60
NWC
-20 20
Investment
-100 15
Total ATCF
-120 95

10. Investment Cash Flows
Cash Flows from Investment Projects are commonly separated into 3 components
1. Operating Cash Flows (OCF)
OCF = EBIT – Taxes + Depreciation
2. Change in Net Working Capital (NWC)
3. Investment Cost
Initial Investment at time period zero
At the end of the project you may recover some of your investment cost if you can sell (salvage) your capital goods.
All of the above are presented on an after tax cash basis (i.e. they are ATCF’s)

11. The Idea of Depreciation
Some people think of depreciation as the wearing out of capital equipment (your car gets old and unreliable)
From an accounting viewpoint, depreciation has a different interpretation
Example: You can by a new TV for $1095 that you think will last you 3 years (1095 days). What is the daily cost of watching TV?

12. Depreciation (continued)
Depreciation assigns the cost of a capital good over the period you receive benefits from it.
Warning: The cash flow occurred when you bought the TV. If we consider the Depreciation Expense as $1 per day for the three years we watch TV, we have a depreciation expense each day, but not a cash flow each day. We had a big negative cash flow the day we bought the TV.

13. Depreciation (continued)
When you pay someone wages to work on a given day, you take a labor expense that day, and you have a cash flow that day.
We pay taxes on our profit, not on our revenues. We deduct our costs from our revenue to determine the profit that we are taxed on.

14. Depreciation (continued)
For capital goods, depreciation is a recognized expense, but the cash flow occurred in the past when the capital good was purchased.
When the good was purchased, no tax deduction for the expense of the good is allowed. Instead, we use depreciation to smear out the capital good cost over time. In other words, we will get our tax deduction in the future in response to a cost (cash flow) incurred today.
Depreciation expense, thus affects future taxes, not current taxes.

15. 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 – the investment cash flow made at time period zero, reduced future taxes when you are allowed to take a deduction for the depreciation expense.

16. Depreciation
Many countries allow 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.
For capital budgeting analysis, the depreciation method for tax purposes matters most.

17. Depreciation: 1. Straight Line
Example: Purchase a truck for $20,000 that you will use for 5 years and then sell for $4000

18. Depreciation: 2. MACRS
2. MACRS – Modified Accelerated Cost Recovery System
Investments are classified into MACRS classes such as 3 year, 5 year, etc.
When using MACRS, salvage value is not considered (implicitly assumed to be zero).
The annual depreciation percent for each class is stated such as shown below for the 3-year asset class.
Year 1 2 3 4
Allowance
33.33%
44.44
14.82
7.41

19. Example MACRS Depreciation
You purchase a new capital asset that fits into the 3 year MACRS class. The cost of the asset is $1 million and you believe you can sell it for $200,000 after three years of service. What is your depreciation expense in year 3?
Answer: Year 3 Depreciation
= $1,000,000 x = 148,200.
Year 1 2 3 4
Allowance
33.33%
44.44
14.82
7.41

20. Useful Formulas
Project ATCF = OCF – NWC – Investment (Note: These are all ATCF’s)
OCF = EBIT – Taxes + Depreciation
(EBIT = Sales – Operating Costs – Depreciation)
Taxes = t*EBIT, where t = tax rate
Straight Line (Annual) Depreciation = (Investment – Est. Salvage)/Years
ATCF from Salvage = Salvage – tax
(Salvage is the Sale Price of salvaged equipment)
tax = t(Salvage – BookVal) where t= tax rate,
BookVal = Investment – Accumulated Depreciation

21. Ex 9.1 ATCF from Salvage (Straight Line Depreciation)
You purchased a new lawnmower for your Landscape business for $5000 that you expected to use for 3 years, and then sell for $500. After 2 years you saw a great deal on another mower so you decided to replace your mower, and sold your old mower for $ What is your ATCF from selling your old mower (tax rate = 30%)?

22. Example 9.2 Computing OCF
Noble’s Best Doughnuts is considering buying a dough machine for $150,000 that it will depreciate (straight line) over its expected 3 year life. It expects to sell the machine for $30,000 at that time. Doughnut sales are projected to increase $100,000 per year. Operating costs are 30% of sales. Noble pays a 34% tax on its income. What are the incremental OCF’s Noble can expect from this project over the next 3 years?

23. Example 9.3 OCF with MACRS
Same as 9.1, but use MACRS for computing the depreciation, i.e. what are the OCF’s?
Year 1 2 3 4
Allowance
33.33%
44.44
14.82
7.41

24. Example 9.4: NWC simplified
Noble’s Best Doughnuts will need additional supplies of doughnut mix and sprinkles to feed this machine. It estimates it will need to keep an additional $10,000 of baking supplies on hand during the life of the project. What are the ATCF’s associated with the change in NWC to support this project?

25. Example 9.5 Investment CF’s
As noted earlier, Noble’s Best Doughnuts will invest $150,000 on the new doughnut machinery, and expects to sell the used machinery after 3 years for $30,000.
What is the ATCF from Salvage using straight line depreciation?
What is the ATCF from Salvage using MACRS?
What are the ATCF’s from investment?

26. Example 9.6 What will Noble’s pro forma look like for:
Straight Line depreciation
MACRS depreciation
For each case above, what is the IRR of the project?

27. Capital budgeting analysis should include only incremental costs.
Incremental Cash Flow
Capital budgeting analysis should include only incremental costs.
An example…Should Norman Paul pursue an MBA?
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 (IGNORE)
Room and board expenses are not incremental to the decision to go back to school

28. What about Norm’s opportunity cost?
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 for 2 years
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?

29. Opportunity Costs
Cash flows from alternative investment opportunities, forgone when one investment is undertaken.
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:
NPV of a project could fall substantially if opportunity costs are recognized!

30. Can a firm accept all investment projects with positive NPV?
Capital Rationing
Can a firm accept all investment projects with positive NPV?
Reasons why a company would not accept all projects:
Limited availability of skilled personnel to be involved with all the projects;
Financing may not be available for all projects.
Companies are reluctant to issue new shares to finance new projects because of the negative signal this action may convey to the market.

31. Capital Rationing
Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints
1. Rank the projects using the Profitability Index (PI)
1. Rank the projects using the Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds still available, select the second-highest PI, and so on, until the capital is exhausted.
The steps above helps managers select the combination of projects with the highest NPV.

32. 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 -
1500
12000 A
1200
14000 B 4 3 2 1
Device
$15,936 A
$18,065 B
NPV
Device
Cash outflow device A < cash outflow device B  select A?

33. Approach 1: Lowest Common Time Frame
Year A B
12000
14000 1
1500
1200 2 3
13500 4
15200 5 6 7 8 9 10 11 12
Each could be evaluated on a 12 year time table with the noted CF’s
PV of A discount rate) is $48233
PV of B is $42360
B is cheaper, in a DCF context, over time

34. Approach 2: 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 A
Device B

35. Calculator Approach (Device A)
Year
CF for A
12000 1
1500 2 3
P/YR = 1
Enter CF’s
Type 7, press I/YR
Press  NPV
Press +/-
Press PV
Type 3, press N
Press PMT

36. The Human Face of Capital Budgeting
Managers must be aware of optimistic bias in these assumptions made by project supporters.
Companies should have control measures in place to remove bias:
Investment analysis should be done by a group independent of individual or group proposing the project.
Project analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential.
Storytelling: Best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.

37. Cash Flow and Capital Budgeting
Certain types of cash flows are common to many investments
Opportunity costs should be included in cash flow projections
Consider human factors in capital budgeting

39. Excess Capacity
Excess capacity is 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

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

41. Two Methods of Handling Depreciation to Compute Cash Flow
$6,000
Net income
$16,000
Cash flow
= NI + deprec
(4,000)
Taxes (40%)
$10,000
Pre-tax income
(10,000)
Depreciation
$20,000
Gross profits
Cost of goods
$30,000
Sales
Adding non-cash expenses back to after-tax earnings
$4,000
Depreciation tax savings
Cash Flow
$12,000
Aft-tax income
(8,000)
Find after-tax profits, add back non-cash charge tax savings
Simplest and most common technique:
Add depreciation back in.
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

42. 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)
An example....
Tax rate = 40%
New equipment costs $10 million,
$0.5 million to install
Old equipment fully depreciated, sold for $1 million
Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60 million from selling the old equipment

43. 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 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

44. Working Capital for Calendar Sales Booth
(4,000)
+500 NA
Monthly  in WC
(3,000)
1,000
500
Net WC
5,000
10,000
15,000
Accts payable
1,500
10,500
Inventory $0
$500
Cash
Feb 1
Jan 1
Dec 1
Nov 1
Oct 1
+3,000
($5,000) $0
Payments
($500)
Net cash flow
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
Reduction 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
+$4,000
($3,000)

45. Construct cash-flow forecasts for 5 to 10 years
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 a project at a given future point in time.
Large value relative to all the other cash flows of the project.

46. JDS Uniphase cash flow projections for acquisition of SDL Inc.
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 5
Year 4
Year 3
Year 2
Year 1
JDS Uniphase cash flow projections for acquisition of SDL Inc.

47. 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
Caveat : market multiples fluctuate over time

48. Initial Investment for Jazz CD Project
Classicaltunes.com is considering adding jazz recordings to its offerings.
Firm uses 10% discount rate to calculate NPV and 40% tax rate.
The average selling price of Classicaltunes CD’s is $13.50; price is expected to increase at 2% per year.
Sales expected to begin when new fiscal year begins.
Initial investment transactions:
$50,000 for computer equipment (MACRS 5-year)
$4,500 for inventory ($2,500 of which purchased on credit)
$1,000 increase in cash balances

49. Projections for Jazz CD Proposal6 5 4 3 2 1
Year
28057
120646
39840
105160
145000
80806
47696
29810
3300
25214
122903
50048
79952
130000
72855
42864
26790
3200
17978
11016
4320
2500
Accounts Payable
117179
86585
56132
45934
45500
Total assets
31328
33920
23200
32000
40000
Net P&E
123672
56080
41800
28000
10000
Accumulated Depreciation
155000
90000
65000
60000
50000
Gross P&E
85851
52665
32932
13934
5500
Current Assets
50677
30563
18727
7344
4500
Inventory
31673
19102
11705
4590
Accounts Receivable
3500
3000
2000
1000
Cash
Abbreviated Project Balance Sheet
Annual Cash Flow Estimates for Classicaltunes.com
-3291
-5109
-12953
-12771
-12302
-6614
-3000
Change in working capital
-10000
-15000
-40000
-25000
-5000
-50000
New Fixed Assets 6 5 4 3 2 1
Year
27535
47644
-12542
40411
35163
-14180
-2512
-6440
-49000
Net cash flow
48454
23591
14790
10174
4000
Operating cash flow 6 5 4 3 2 1
Year
24,000
$14.91
22,000
$14.61
25,000
16,000
10,000
4,000
Units
$15.20
$14.33
$14.05
$13.77
$13.50
Price per unit
37393
25208
35772
98374
259349
357722
27565
23872
35363
86800
234682
321482
49903
15519
1649
-13043
-10000
Pretax profit
18512
14280
13800
18000
10000
Depreciation
38008
29799
19664
8262
SG&A Expense
106422
59597
35114
13219
Gross profit
273657
169623
105341
41861
Cost of goods sold
380080
229221
140454
55080
Revenue
Abbreviated Project Income Statement

50. Year Zero Cash Flow
Initial cash outlay of $50,000 for computer equipment
Half-year of MACRS depreciation can be taken in year zero:
20% x $50,000 = $10,000; non cash expense
Depreciation expense are deducted from the firm’s classical-music CD profits. Savings of $4,000 (40% x $10,000) in taxes
Changes in working capital are result of following transactions:
Purchase of $4,500 in inventory and $1000 cash balance
Accounts payable of $2,500 partially finance the $5,500 outlay
Net Cash Flow:
Increase in gross fixed assets
- $50,000
Change in working capital
- $3,000
Operating cash inflow
+ $4,000
Net cash flow
- $49,000

51. Year One Cash Flow Purchase of additional $10,000 in fixed assets
2nd year depreciation expenses for MACRS 5-year asset class is 32%. An additional 20% depreciation deduction for assets purchased this year
32% x $50, % x $10,000= $18,000
Non cash expense; has to be added back when computing cash flow for the year
Net working capital for year one is:
NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614
Increase in NWC; cash outflow of $6,614

52. Year One Cash Flow
Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com.
Tax savings = 40% x $13,043 = $5,217
Net operating cash inflow = pretax loss + tax savings + depreciation
Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174
Net Cash Flow:
Increase in gross fixed assets
- $10,000
Change in working capital
- $6,614
Operating cash inflow
+ $10,174
Net cash flow
- $6,440

53. Year Two Cash Flow Purchase of additional $5,000 in fixed assets
Assets purchased at the onset of the project have allowable depreciation of 19.2% (19.2% x $50,000 = $9,600)
An additional 32% depreciation deduction for assets purchased in year 1 and 20% depreciation of assets purchased this year
Total depreciation = $9, % x $10, % x $5,000= $4,200 = $13,800
Changes in working capital are result of following transactions:
Increases in current assets:
$500 increase in cash balance
$7,115 increase in accounts receivables
$11,383 increase in inventory
Increase in current liabilities:
$6,696 increase in account payables
Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)

54. Year Two Cash Flow Pretax profit in year two is $1,649.
The company must pay taxes of $660 (40% x $1,649-- cash outflow.
Net operating cash inflow = pretax profit + tax + depreciation
Operating cash inflow = $1,649 - $660 + $13,800 = $14,789
Net Cash Flow:
Increase in gross fixed assets
- $5,000
Change in working capital
- $12,302
Operating cash inflow
+$14,790
Net cash flow
- $2,512

55. Terminal Value for Jazz CD Investment
If we assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,):
Second approach used by Classicaltunes.com to compute terminal value for the project: use the book value at end of year six:
Plant and Equipment (P&E) at end of year six is $31,328.
The firm liquidates total current assets and pays off current debts:
$85,850 - $29,810 = $56,040
Terminal value = $31,328 + $56,040 = $87,368.

56. NPV for Jazz CD Project
Using assumption that cash flow grow at a steady rate past year 6:
Using book value assumption for terminal value:
NPV is positive with both methods: investing in Jazz CD project increases shareholders wealth.