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

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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