1.  The age-adjusted mortality rate for cancer is essentially unchanged over the past half-century, at about 200 deaths per 100,000 people. This is despite President Nixon’s declaration of a “war on cancer” more than thirty years ago, which led to a dramatic increase in funding and public awareness.  Believe it or not, this flat mortality rate actually hides some good news. Over the same period, age-adjusted mortality from cardiovascular disease has plummeted, from nearly 600 people per 100,000 to well beneath 300.* What does this mean?  Many people who in previous generations would have died from heart disease are now living long enough to die from cancer instead.  Indeed, nearly 90 percent of newly diagnosed lung-cancer victims are fifty-five or older; the median age is seventy-one. The flat cancer death rate obscures another hopeful trend. For people twenty and younger, mortality has fallen by more than 50 percent, while people aged twenty to forty have seen a decline of 20 percent. These gains are real and heartening — all the more so because the incidence of cancer among those age groups has been increasing. (The reasons for this increase aren’t yet clear, but among the suspects are diet, behaviors, and environmental factors.)

2. Capital Budgeting and Cash Flow Analysis

3.  This chapter discusses capital budgeting and capital expenditures.  It deals with the financial management of the assets on a firm’s balance sheet.  We will be looking at management of long term assets 3

4.  Capital Budgeting: the process of planning for purchases of assets whose returns are expected to continue beyond a year  Capital Expenditure: a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year 4

5.  Expand an existing product line  Working capital  Refunding  Leasing  Merger and acquisition  Enter a new line of business  Replacement  Advertising campaign  R&D  Education and training 5

6.  Firm’s overall cost of funds  Remember WACC is the overall CoC for a company  The CoC is the investors’ required rate of return  Provides a basis for evaluating capital investment projects  The CoC is the hurtle rate of projects 6

7.  Independent  Put in candy machines and add a new parking lot  Mutually Exclusive  Build a conveyor system or buy team of forklifts  Contingent  Put in a drainage system but only if build a new parking lot 7

8.  The majority of our decisions will come from Mutually Exclusive project decisions  Purchase new machine  Purchase used machine  Rent machine  Repair old machine 8

9.  The best firms always have more projects than they have money  Most companies have a limited amount of dollars available for investment 9

10.  A firm should operate at the point where Marginal cost of an additional unit = marginal revenue  See next slide  Invest in the most profitable projects first  Continue accepting projects as long as the rate of return exceeds the MCC 10

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12.  It is not as easy as accepting projects A,B,C,D, and E  All projects may not be known at one time  So you always need some free cash flow for new projects  Changing markets, technology, and corporate strategies can make current projects obsolete and new ones profitable.  Estimates of CFs have varying degrees of uncertainty but we assume they are the same 12

13.  Step 1  Generating proposals  Step 2  Estimating CFs  Step 3  Evaluating alternatives and selecting projects  Step 4  Reviewing prior decisions 13 Today's lecture will cover

14.  Growth opportunities  Apple’s iPad  Cost reduction opportunities  Ford’s new production line  Required to meet legal requirements  United Steel’s pollution abatement equip  Required to meet health & safety standards  Phillip Morris’s new packaging of cigarettes  Most of these project ideas come from marketing, R&D, or external 14

15.  Once projects have been suggested and classified cash flows must be generated  This is often done in the accounting and finance departments  Estimating cash flows is very difficult and requires a knowledge of both capacity of production and estimation of revenue

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17.  On an incremental basis  How will the entire stream of CF’s for the firm be affected if you don’t adopt the project? Called a what if analysis  On an after-tax basis  Very few projects can be undertaken with before-tax dollars  Include indirect effects  For example when Coke developed Coke Zero. What effect did that have on Diet Coke’s revenues? 17

18.  Exclude sunk costs  If you have already spent it then don’t count it. Example would be survey for land  Opportunity costs of resources  If you are using a warehouse, even if it set vacant, then it must be included in the cost of the project

19.  For help estimating CF’s use the following:  Small Business Association  http://www.sba.gov/  American Cash Flow Institute  http://acfi-online.com/  American Cash Flow Association  http://acfa-cashflow.com/ 19

20. The net investment is the initial cash outlay at T0 Step 1 Cost plus installation and shipping Plus Step 2 Increases in net working capital Minus Step 3 Net proceeds from sale of existing assets Plus or minus Step 4 Taxes associated with the above sale Equals NINV Remember to check out the tax consequences

21.  Suppose the James Corp is considering replacing a dye press in it’s Texas office. The existing dye press was purchased 25 years ago for $600,000. The book value for the dye is $200,000, and James Corp feels they could sell it for $150,000. A new dye press can be purchased for $1,200,000. To deliver the dye and install it will cost an additional $100,000. Assuming the marginal tax rate for James Corp is 40%, calculate the net investment for the dye press.

23.  Harness Technology will spend $800,000 on a piece of equipment that will manufacture fine wire for the electronics industries. The shipping and installation charges will be $240,000 and net working capital will increase $48,000.The equipment will replace an existing machine that has a salvage value of $75,000 and a book value of $125,000. If Shunt has a current marginal tax rate of 34 percent, what is the net investment?

25.  The NINV for a multiple-period investment is the PV of the series of outlays discounted at the firm’s cost of capital. Below example CoC = 10% 25

26.  Not only are we concerned with the cost of a project we also need to know how it will effect the firms after tax net cash flows  To do this we need to calculate the change in revenues, costs, and depreciation  See formula next slide

28.  Wabash is replacing an old, fully depreciated stamping line with a more efficient machine. With the increased production, Wabash expects revenues to increase by $155,000, operating expenses to increase by $22,000, and depreciation to increase by $21,878. Compute the net cash flow if net working capital is expected to increase by $30,000  NCF = ($155,000 - $22,000 - $ 21,878)(1 - 0.40) + ($21,878) - ($30,000) = $58,551.2

29.  WalMart is considering expanding their current production facility. This year WalMart had an operating income (EBIT) of $760,000, interest expenses of $120,000, depreciation expenses of $45,000, and capital expenditures of $160,000. Next year, after the expansion is completed, operating income is expected to be $880,000, interest expenses will remain at $120,000, but depreciation will increase to $61,000. To support the expansion, cash is to expected to increase by $5,000, accounts receivable by $12,000, inventories by $8,000, and accounts payable by $7,000. What is the change in WalMart's net operating cash flows attributable to this project, if the tax rate is 40%?

30.  NCF = ($880,000 - $760,000)(1 - 0.40) + ($61,000 - $45,000) - ($5,000 + $12,000 + $8,000 - $7,000) = $70,000  Remember that NWC is equal to  Current assets – current liabilities

32.  After a project is completed we oftentimes can sell the capital asset  This must be considered when calculating the NPV of a project  There are specific tax consequences to this sale  Open to page 331; next slide

33. Case 1Sale = book valueNo tax consequences Case 2Sale < book valueTax savings = marginal tax rate x amount of loss Case 3Sale > book valueTax liability = Gain x marginal tax rate Case 4Sale > costTax liability = (Gain + capital gain) x marginal tax rate 33

34.  The management of Harness Equipment Company is planning to purchase a new milling machine that will cost $160,000 installed. The new machine will be depreciated on a straight line basis over it's 10 year economic life to an estimated salvage value of $10,000. What is the depreciation per year on a straight line basis?  = ($160,000 - $10,000)/10 = $15,000

35.  The total amount of accumulated net working capital (current assets – current liabilities) is usually recovered at the end of the life of the project.  The resulting decrease in net working capital represents an increase in net cash flow!  There are generally no tax considerations associated with the recovery of net working capital. 35

36. NINVNCF + NWC at end

37.  Remember that depreciation is the systematic allocation of the cost of an asset over a period of years  Two primary methods straight line and MACRS  For financial reporting to management, we can use straight-line or various accelerated depreciation methods.  For tax purposes, use the Modified Accelerated Cost Recovery System (MACRS). 37

40.  Lets read example at bottom of page 333  Our two steps will be to calculate both  NINV  NCF

41.  A project that requires a firm to invest funds in additional assets in order to increase sales (or reduce costs)  Calculate the annual net cash flows associated with the project.

42.  Calculating Annual Net Cash Flows  NCF 1 = ($50,000 - $25,000 - $11,000) x (1 -.40) + $11,000 - $5,000 = $14,400  NCF 2 = ($60,000 - $26,500 - $11,000) x (1 -.40) + $11,000 - $5,000 = $19,500  NCF 5 = ($45,000 - $31,562 - $11,000) x (1 -.40) + $11,000 - $22,000 = $34,463 See next slide for complete breakdown

43. *The -22,000 includes the NWC from the NetInv

45.  Our previous example looked at expanding a project. Now we are going to look at replacing an existing project  To do this we must:  Calculate the Net Investment  Calculate Annual Net Cash Flows  Lets read the case at the top of page 336

47.  Calculating Annual Net Cash Flows  NCF 1 = [($85,000 - $70,000) - ($20,000 - $40,000) - ($20,000 - $0)] x (1 -.40) + ($20,000 - $0) - $0 = $29,000

48.  Calculating Annual Net Cash Flows  NCF 10 = [($103,000 - $70,000) - ($29,000 $40,000) - ($20,000 - $0)] x (1 -.40) + ($20,000 - $0) - $0 + $25,000 salvage value - (0.4 x $25,000) tax on salvage value = $49,400

51.  We will learn this in the next lesson, but suppose that the WACC of Briggs & Stratton is equal to 11.25%. What would be the NPV?

52.  Most firms depend on subjective estimates from their managers, sensitivity analysis, computer simulations, and expert opinion when forecasting cash flows.  To become more accurate at this process firms MUST compare actual and projected cash flows 52

53.  A survey of Fortune 500 firms found:  The majority of the firms responding to the survey had annual capital budgets of more than $100 million.  Nearly 67% of the firms prepared formal cash flow estimates for over 60 % of their annual capital outlays.  56% percent indicated that they used single-dollar estimates, 8% used a range of estimates, and 36% used both single-dollar estimates and a range of estimates.