cash flow and capital budgeting
DESCRIPTION
Cash Flow And Capital Budgeting. Professor XXXXX Course Name / Number. 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). - PowerPoint PPT PresentationTRANSCRIPT
Cash Flow And Capital Budgeting
Professor XXXXXCourse Name / Number
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
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.
4
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.
5
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
$16,000Cash 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
6
Depreciation
• 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.
Many countries allow one depreciation method for tax purposes and another for reporting
purposes.
7
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
8
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
9
Working Capital for Calendar Sales Booth
(4,000)+500+500NAMonthly in WC
(3,000)1,0005000Net WC
5,00010,00015,0000Accts payable
01,50010,50015,0000Inventory
$0$500$500$500$0Cash
Feb 1Jan 1Dec 1Nov 1Oct 1
($5,000)($5,000)($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
0
+3,000
10
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.
11
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.
12
Terminal Value of SDL Acquisition
67.48$1.1
2.68$
1.1
25.3$
1.1
5.2$
1.1
75.1$
1.1
1$
1.1
5.0$554321
$68.20.050.10
$3.41PVor ,
grCF
PV 51t
t
• 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
13
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
14
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
150,66$05.1000,60$ 2
032,18$35.0105.1000,60$08.1000,90$ 3
What about Norm’s opportunity cost?
15
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:
16
Initial Investment for Jazz CD ProjectClassicaltunes.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 transaction
s:
$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
17
Projections for Jazz CD Proposal
6543210Year
28057
120646
39840
105160
145000
80806
47696
29810
3300
25214
122903
50048
79952
130000
72855
42864
26790
3200
29810179781101643202500Accounts Payable
11717986585561324593445500Total assets
3132833920232003200040000Net P&E
123672
56080418002800
010000
Accumulated Depreciation
15500090000650006000050000Gross P&E
8585152665329321393
45500
Current Assets
50677305631872773444500Inventory
31673191021170545900Accounts Receivable
35003000250020001000Cash
Abbreviated Project Balance Sheet6543210Year
24,000
$14.91
22,000
$14.61
25,00016,00010,0004,0000Units
$15.20$14.33$14.05$13.77$13.50Price per unit
37393
25208
35772
98374
259349
357722
27565
23872
35363
86800
234682
321482
49903155191649-13043-10000Pretax profit
1851214280138001800010000Depreciation
38008297991966482620SG&A Expense
1064225959735114 13219 0Gross profit
273657
169623
105341
418610Cost of goods sold
380080229221140454550800Revenue
Abbreviated Project Income Statement
Annual Cash Flow Estimates for Classicaltunes.com
-3291-5109-
12953-
12771-
12302-6614-3000
Change in working capital
-10000-15000-
40000-
25000-5000
-10000
-50000
New Fixed Assets
6543210Year
27535
47644
-12542
40411
35163-14180-2512-6440-49000Net cash flow
484542359114790101744000Operating cash flow
18
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
Increase in gross fixed assets - $50,000
Change in working capital - $3,000
Operating cash inflow + $4,000
Net cash flow - $49,000
Net Cash Flow:
19
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 $50,000 + 20% 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
614,6$000,3$614,9$ NWC– NWC NWC 0year 1year
20
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
Increase in gross fixed assets - $10,000
Change in working capital - $6,614
Operating cash inflow + $10,174
Net cash flow - $6,440
Net Cash Flow:
21
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 = $9,600 + 32% x $10,000 + 20% 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)
22
Year Two 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
• 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:
23
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.
325,448$02.010.0
866,35$or ,
866,35$163,35$02.11
61
1
PVgr
CFPV
CFgCF
tt
tt
24
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.
862,213$1.1
325,448$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV
111,10$1.1
368,87$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV
25
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.
26
Capital Rationing
Capital rationing: project combination that maximizes shareholder wealth subject to
funding constraints
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.
1. Rank the projects using the Profitability Index (PI)
The steps above ensure that managers select the combination of projects with the highest
NPV.
27
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.
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