1. © 2009 Cengage Learning/South-Western Cash Flow And Capital Budgeting Chapter 9

2. 2 Capital budgeting is 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. Cash Flow Versus Accounting Profit

3. 3 Financing costs are captured in the process of discounting future cash flows. 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. Cash Flows: Financing Costs and Taxes Only after-tax cash flows are relevant as only such cash flows can be distributed to investors.

4. 4 Cash Flows: Noncash Expenses Noncash expenses include depreciation, amortization, and depletion. 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.

5. 5 Assume a firm purchases a fixed asset today for $30,000. Plans to depreciate over 3 years using straight-line method. Firm pays taxes at 40% marginal rate. Cash Flows: Noncash Expenses Firm will produce 10,000 units/year Costs $1/unit Sells for $3/unit

6. 6 Cash Flows: Noncash Expenses $6,000 Net income after tax $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 Method 1 $4,000 Depreciation 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 deduction tax savings Method 2

7. 7 Accelerated depreciation methods, such as the modified accelerated cost recovery system (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. Because depreciation only affects cash flow through taxes, we consider only the depreciation method that a firm uses for tax purposes when determining project cash flows. Many countries allow one depreciation method for tax purposes and another for reporting purposes. Depreciation

8. 8 Table 9.1 U.S. Tax Depreciation Allowed for Various MACRS Asset Classes.

9. 9 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 Fixed Asset Expenditures

10. 10 Many capital investments require additions to working capital. Net working capital (NWC) = current assets – current liabilities Increase in NWC is a cash outflow; decrease in NWC is 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 Working Capital Expenditures

11. 11 ($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) (4,000)+500 NA Monthly  in WC (3,000)1,0005000Net WC 5,00010,00015,0000Accts payable 01,50010,50015,0000Inventory $0$500 $0Cash Feb 1Jan 1Dec 1Nov 1Oct 1 0 0 +3,000 Working Capital for Calendar Sales Booth

12. 12 When evaluating an investment with indefinite life- span, the project’s terminal value is calculated: 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. The terminal value is intended to reflect the value of a project at a given future point in time. The terminal value is usually large relative to all the other cash flows of the project. Terminal Value

13. 13 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. Terminal Value

14. 14 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 is 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 Terminal Value of SDL Acquisition

15. 15 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 Incremental Cash Flow

16. 16 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 each of the next two years while studying for MBA: $35,000 If Norm had worked at his current job for two years, his salary would have increased to $60,000 x 1.05 2 = $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: ($90,000x1.08 - $60,000x1.05 3 )x(1-0.35) = $18,032 MBA has substantial positive NPV value for 30 yr analysis period What about Norm’s opportunity cost? Incremental Cash Flow

17. 17 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: Opportunity Costs

18. 18 Cannibalization Cannibalization refers to the loss of sales of an existing product when a new product is introduced. Cannibalization is a “substitution” effect.

19. 19 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 remain constant indefinitely. 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 is purchased on credit) $1,000 increase in cash balances Initial Investment for Classicaltunes.com

20. 20 Projections for Jazz CD Proposal

21. 21 Annual Net Cash Flow Estimates for Classicaltunes.com Projections for Jazz CD Proposal

22. 22 Initial cash outlay of $50,000 for computer equipment Changes in working capital are result of following transactions: Purchase of $4,500 in inventory and increase cash balance by $1000 an inflow of $2,500 from an increase in trade credit (Account Receivable) Increase in gross fixed assets - $50,000 Change in working capital - $3,000 Net cash flow - $53,000 Net Cash Flow: Year Zero Cash Flow Invest $3000 in working capital

23. 23 In year 1, the project earns after-tax income of $561. No new investment in fixed asset. Add back the non-cash depreciation charge of $10,000. Net working capital for year one is: NWC = Current Assets – Current Liabilities = $2,000 + 5,063 + 7,594 - $4,374 = $10,282  NWC = NWC year1 – NWC year0 = $10,282 - $3,000 = $7,282 Increase in NWC from year zero: $7,282 net cash flow from working capital: -$7,282 net cash flow: $561 + 10,000 – 7,282 = $3,279 Year One Cash Flow

24. 24 Depreciation $10,000 Invest in working capital (cash outflow) -$7,282 Net income $561 Net cash flow $3,279 Net Cash Flow: Year One Cash Flow

25. 25 Depreciation$10,000 Increase in working capital- $10,623 Net income+$8,580 Net cash flow$7,957 Net Cash Flow: In year 2, net income equals $8,580. To that, add back the $10,000 non-cash depreciation deduction. Next, determine the change in working capital: The working capital balance increased from $10,282 in year 1 to $20,905 in year 2, so this represents a cash outflow of 10,623. As in year 1, there are no new investments in fixed assets to consider. Year Two Cash Flow

26. 26 If we assume that cash flow continue to grow at 4% per year at and beyond year 6 (g = 4%, r = 15%,): Terminal Value for Jazz CD Proposal Second approach: use the book value at end of year six: Plant and Equipment (P&E) at end of year six is $0. The firm liquidates total current assets (cash 3,500, accounts receivable 28,125, inventory 42,188) and pays off current debts (accounts payable 24,300): Terminal value = $73,813 - $24,300 = $49,513.

27. 27 Using assumption that cash flow grow at a steady rate past year 6: NPV for Jazz CD Proposal Using book value assumption for terminal value: NPV is positive with both methods: investing in Jazz CD project increases shareholders wealth.

28. 28 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. Capital Rationing

29. 29 Capital rationing: project combination that maximizes shareholder wealth subject to funding constraints 1. Rank the projects using Profitability Index (PI) 2. Select the investment with the highest PI 3. If funds are still available, select the second- highest PI, and so on, until the capital is exhausted. The steps above ensure that managers select the combination of projects with the highest NPV. Capital Rationing

30. 30 A firm must purchase an electronic control device: First alternative: cheaper device, higher maintenance costs, shorter period of utilization Second device: more expensive, smaller maintenance costs, longer life span Expected cash outflows: Device A’s cash outflow < Device B’s cash outflow  select A? Equipment Replacement and Unequal Lives Using real discount rate of 7%:

31. 31 Table 9.4 Capital Rationing and the Profitability Index (12% required return)

32. 32 Table 9.5 Operating and Replacement Cash Flows for Two Devices (all values are outflows)

33. 33 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 respective lifetimes: NPV of device A = $15,936 NPV of device B = $18,065 2. Compute annual expenditure (annuity cost) to make NPV of annuity equal to NPV of operating device: Device A Device B Since Device B’s annuity cost is lower, choose Device B. Equivalent Annual Cost (EAC)

34. 34 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 (at the beginning of each year) for the next two years. Expansion plans should begin immediately in this case to hold inventory for new stores coming on line in a few months. Incremental cost: investing $2,000,000 at present vs. two years from today Incremental cash inflow: $125,000 (at the beginning of the year) Excess Capacity

35. 35 NPV of leasing excess capacity (assume 10% discount rate): Excess Capacity -X = $181,818 (at the beginning of the year) -Leasing the excess capacity for a price above $181,818 would increase shareholders wealth. 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.

36. 36 The Human Face of Capital Budgeting Managers must be aware of optimistic bias in the 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: The best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense.

37. 37 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 Cash Flow and Capital Budgeting