_cb and cash flow (fm keown10e chap10

7/22/2019 _CB and Cash Flow (FM Keown10e Chap10

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CHAPTER 12

Cash Flows and Other Topics inCapital Budgeting

2005, Pearson Prentice Hall


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Capital Budgeting:The process of planning

for purchases of long-term assets.

For example: Our firm must decide whether

to purchase a new plastic molding machine

for $127,000. How do we decide?

Will the machine be profitable?

Will our firm earn a high rate of returnon

the investment?

The relevant project information follows:


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The cost of the new machine is $127,000.

Installation will cost $20,000.

$4,000in net working capital will be needed atthe time of installation.

The project will increase revenues by $85,000per

year, but operating costs will increase by 35%ofthe revenue increase.

Simplified straight line depreciation is used.

Class life is 5years, and the firm is planning tokeep the project for 5years.

Salvage value at the end of year 5 will be $50,000.

14%cost of capital; 34%marginal tax rate.


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Capital Budgeting Steps

1) Evaluate Cash Flows

Look at all relevant cash flows

occurring as a result of the project.

Initial outlay

Differential Cash Flowsover the life

of the project (also referred to asannual cash flows).

Terminal Cash Flows


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IDENTIFYING RELEVANT CASH FLOWS

A) PROJECT CASH FLOW vs ACCOUNTINGINCOME

1) COST OF FIXED ASSETS

- Asset purchases represent negative cash flows.- Full cost of the asset includes shipping andinstallation costs, used as the depreciable basis tocalculate depreciation charges.

- The fixed assets are often sold at the end ofprojects life, giving after-tax cash proceeds whichrepresents a +ve cash flow.


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2) NON CASH CHARGES

- Depreciation is subtracted from revenues. Depreciationshelters income from taxation, has an impact on cash flow, but

it is NOT a cash flow, thus MUST be added back to net income

when estimating projects CF.

3) CHANGES IN NET OPERATING WORKING CAPITAL

- When sales expand, accounts receivable increase. Payablesand accruals spontaneously increase, and this reduces the

cash to finance inventories and receivables.

- At end of projects life, inventories will be used but notreplaced, receivables will be collected without replacement,

bringing cash inflows. NOWC will be returned and added

back to the cash flow.


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4) INTEREST EXPENSES

NOT included in project cash flow for 2 reasons. Firstly

because they are already accounted for in the cost of

capital (Required rate of return). 2ndly, project cash flow

is the cash flow available to ALL investors, bondholders

AND shareholders, so interest expenses are NOT

subtracted.


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B) INCREMENTAL CASH FLOWS (NET CASH

FLOW IN AN INVESTMENT PROJECT)

1) Sunk Costs: (EXCLUDE from CF)

A cash outlay that has ALREADY been incurred, cannot be

recovered regardless of whether the project is accepted or

rejected. Examples: Consultant fees, fees for marketingsurveys.

2) Opportunity costs: (INCLUDE in CF)

The return on the best ALTERNATIVE use of an asset, thatwill NOT be earned if funds are invested in a particular

project. Example he use of a land for the project site which

could be sold, or the use of space/floor which could have

been rented out.


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3) Effects on Other Parts of the Firm: (either INCLUDED orEXCLUDED)

Externalities -

Effects of a project on cash flows in other parts of the firm.

Often difficult to quantify.

Cannibalization -

Occurs when the introduction of a new product causes sales

of existing products to decline. (Example: IBM for years

refused to provide full support for its PC division because itdid not want to steal sales from its highly profitable

mainstream business. Huge strategic error, because it

allowed Intel, Microsoft , Compaq and others to become

dominant forces in the computer industry.


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0 1 2 3 4 5 n6 . . .


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0 1 2 3 4 5 n6 . . .

Terminal

Cash flow

Annual Cash Flows

Initial

outlay


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2)Evaluate the Risk of the Project

Well get to this in the next chapter.

For now, well assume that the risk of theprojectis the same as the risk of the

overall firm.

If we do this, we can use the firms cost ofcapitalas the discount rate for capital

investment projects.



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3) Accept or Reject the Project



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Step 1: Evaluate Cash Flows

a) Initial Outlay:What is the cash flow at

time 0?

(Purchase price of the asset)+ (shipping and installation costs)

(Depreciable asset)

+ (Investment in working capital)+ After-tax proceeds from sale of old asset

Net Initial Outlay


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time 0?

(127,000) Purchase price of asset+ (20,000) Shipping and installation

(147,000) Depreciable asset

+ (4,000) Net working capital+ 0 Proceeds from sale of old asset

($151,000) Net initial outlay


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time 0?

(127,000) Purchase price of asset+ (20,000) Shipping and installation


+ (4,000) Net working capital+ 0 Proceeds from sale of old asset

($151,000) Net initial outlay


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b) Annual Cash Flows:What

incremental cash flows occur over the

life of the project?


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Incremental revenue

- Incremental costs

- Depreciation on project

Incremental earnings before taxes

- Tax on incremental EBT

Incremental earnings after taxes

+ Depreciation reversal

Annual Cash Flow

For Each Year, Calculate:


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Incremental revenue

- Incremental costs

- Depreciation on project

Incremental earnings before taxes- Tax on incremental EBT

Incremental earnings after taxes

+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:


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85,000 Revenue

(29,750) Costs

(29,400) Depreciation

25,850 EBT(8,789) Taxes

17,061 EAT

29,400 Depreciation reversal

46,461 = Annual Cash Flow

For Years 1 - 5:


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c) Terminal Cash Flow:What is the cash

flow at the end of the projects life?

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capitalTerminal Cash Flow


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50,000 Salvage value


+ Recapture of net working capitalTerminal Cash Flow


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Tax Effects of Sale of Asset:

Salvage value = $50,000.

Book value = depreciable asset - total

amount depreciated.

Book value = $147,000 - $147,000

= $0.

Capital gain = SV - BV

= 50,000 - 0 = $50,000.

Tax payment = 50,000 x .34 = ($17,000).


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(17,000) Tax on capital gain

4,000 Recapture of NWC37,000 Terminal Cash Flow


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Project NPV:

CF(0) = -151,000.

CF(1 - 4) = 46,461.

Or CF (1-5) = 45,461

CF(5) = 46,461 + 37,000 = 83,461.

Or CF (5) = 37,000

Discount rate = 14%.

NPV = $27,721.

We would acceptthe project.


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Capital Rationing

Suppose that you have evaluated

five capital investment projects

for your company.

Suppose that the VP of Finance

has given you a limited capital

budget. How do you decide which

projects to select?


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Capital Rationing

You could rank the projects by IRR:


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Capital Rationing


IRR

5%

10%

15%

20%

25%

$

1 2 3 4 5

$X

Our budget is limited

so we accept onlyprojects 1, 2, and 3.


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Capital Rationing


IRR

5%

10%

15%

20%

25%

$

1 2 3

$X

Our budget is limited

so we accept onlyprojects 1, 2, and 3.


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Capital Rationing

Ranking projects by IRR is notalways the best way to deal with a

limited capital budget.

Its better to pick the largest NPVs.

Lets try ranking projects by NPV.


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Problems with Project Ranking

1) Mutually exclusive projects of unequal

size (the size disparityproblem)

The NPV decision may not agree withIRR or PI.

Solution:select the project with the

largest NPV.


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Size Disparity Example

Project Byear cash flow

0 (30,000)

1 15,000

2 15,000

3 15,000

required return = 12%

IRR = 23.38%

NPV = $6,027

PI = 1.20

Project Ayear cash flow

0 (135,000)

1 60,000

2 60,000

3 60,000


IRR = 15.89%

NPV = $9,110

PI = 1.07


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Size Disparity Example

Project Byear cash flow

0 (30,000)

1 15,000

2 15,000

3 15,000


IRR = 23.38%

NPV = $6,027

PI = 1.20

Project Ayear cash flow

0 (135,000)

1 60,000

2 60,000

3 60,000


IRR = 15.89%

NPV = $9,110

PI = 1.07


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Problems with Project Ranking

2) The time disparityproblem with mutuallyexclusive projects.

NPV and PI assume cash flows are

reinvested at the required rate of returnfor

the project.

IRR assumes cash flows are reinvested at

the IRR.

The NPV or PI decision may not agree with

the IRR.

Solution:select the largest NPV.


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Time Disparity Example

Project B

year cash flow

0 (46,500)

1 36,500

2 24,0003 2,400

4 2,400

required return = 12%IRR = 25.51%

NPV = $8,455

PI = 1.18

Project A

year cash flow

0 (48,000)

1 1,200

2 2,4003 39,000

4 42,000


NPV = $9,436

PI = 1.20


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Time Disparity Example

Project B

year cash flow

0 (46,500)

1 36,500

2 24,0003 2,400

4 2,400


NPV = $8,455

PI = 1.18

Project A

year cash flow

0 (48,000)

1 1,200

2 2,4003 39,000

4 42,000


NPV = $9,436

PI = 1.20


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Mutually Exclusive Investments

with Unequal Lives

Suppose our firm is planning to

expand and we have to select one of

two machines.

They differ in terms of economic life

and capacity.

How do we decide which machine to

select?


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The after-tax cash flows are:

Year Machine 1 Machine 2

0 (45,000) (45,000)

1 20,000 12,000

2 20,000 12,0003 20,000 12,000

4 12,000

5 12,000

6 12,000

Assume a required return of 14%.


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Step 1: Calculate NPV

NPV1= $1,433

NPV2= $1,664

So, does this mean #2 is better?

No! The two NPVs cant be

compared!


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Step 2: Equivalent Annual

Annuity (EAA) method

If we assume that each project will be

replaced an infinite number of timesin the

future, we can convert each NPV to anannuity.

The projects EAAs canbe compared to

determine which is the best project!

EAA:Simply annuitize the NPV over the

projects life.


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EAA with your calculator:

Simply spread the NPV over the life

of the project

Machine 1:PV = 1433, N = 3, I = 14,

solve: PMT = -617.24.

Machine 2:PV = 1664, N = 6, I = 14,

solve: PMT = -427.91.


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EAA1= $617

EAA2= $428

This tells us that:

NPV1= annuity of $617per year.

NPV2= annuity of $428per year. So, weve reduced a problem with

different time horizons to a couple of

annuities.

Decision Rule:Select the highest EAA.

We would choose machine #1.


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Step 3: Convert back to NPV

Assuming infinite replacement, theEAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.

NPV 1 = 617/.14 = $4,407

NPV2

= 428/.14 = $3,057


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Step 3: Convert back to NPV

Assuming infinite replacement, theEAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.

NPV 1 = 617/.14 = $4,407

NPV2

= 428/.14 = $3,057

This doesnt change the answer, of

course; it just converts EAA to an NPV

that can be compared.


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Practice Problems:

Cash Flows & Other Topics

in Capital Budgeting

Project I nformation:

Problem 1a


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Cost of equipment = $400,000.

Shipping & installation will be $20,000. $25,000in net working capital required at setup.

3-year project life, 5-year class life.

Simplified straight line depreciation. Revenues will increase by $220,000per year.

Defects costs will fall by $10,000per year.

Operating costs will rise by $30,000per year.

Salvage value after year 3 is $200,000.

Cost of capital = 12%,marginal tax rate = 34%.

Problem 1a


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Problem 1a

I ni tial Outlay:

(400,000) Cost of asset

+ ( 20,000) Shipping & installation


+ ( 25,000) Investment in NWC($445,000) Net Initial Outlay

For Years 1

3:

Problem 1a


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220,000 Increased revenue

10,000 Decreased defects

(30,000) Increased operating costs

(84,000) Increased depreciation

116,000 EBT

(39,440) Taxes (34%)

76,560 EAT84,000 Depreciation reversal


For Years 1 - 3: Problem 1a

Problem 1a


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Terminal Cash F low:

Salvage value


+ Recapture of net working capital

Terminal Cash Flow

Problem 1a

Problem 1a


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amount depreciated.

Book value = $168,000.

Capital gain = SV - BV = $32,000. Tax payment = 32,000 x .34 = ($10,880).

Problem 1a

Problem 1a


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25,000 Recapture of NWC

214,120 Terminal Cash Flow

Problem 1a


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Problem 1a Solution

NPV and IRR:

CF(0) = -445,000

CF(1 ), (2), = 160,560

CF(3 ) = 160,560 + 214,120 = 374,680

Discount rate = 12%

IRR = 22.1%

NPV = $93,044. Accept the project!

Problem 1b


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For the same project, suppose wecan only get $100,000 for the old

equipment after year 3, due to

rapidly changing technology.

Calculate the IRR and NPV for the

project.

Is it still acceptable?

Problem 1b

Problem 1b


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Salvage value


+ Recapture of net working capital

Terminal Cash Flow

Problem 1b

Problem 1b


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amount depreciated.

Book value = $168,000.

Capital loss = SV - BV = ($68,000).

Tax refund = 68,000 x .34 = $23,120.

Problem 1b

Problem 1b


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23,120 Tax on capital gain



Problem 1b


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Problem 1b Solution

NPV and IRR:

CF(0) = -445,000.

CF(1), (2) = 160,560.

CF(3) = 160,560 + 148,120 = 308,680.


IRR = 17.3%.

NPV = $46,067. Accept the project!

Automation Project:

Problem 2


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j

Cost of equipment = $550,000.

Shipping & installation will be $25,000.

$15,000in net working capital required at setup.


Simplified straight line depreciation.

Current operating expenses are $640,000per yr.

New operating expenses will be $400,000per yr.

Already paid consultant $25,000for analysis.



Problem 2


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Problem 2

I ni tial Outlay:

(550,000) Cost of new machine

+ (25,000) Shipping & installation


+ (15,000) NWC investment(590,000) Net Initial Outlay

F Y 1

5 Problem 2


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240,000 Cost decrease

(115,000) Depreciation increase

125,000 EBIT(42,500) Taxes (34%)

82,500 EAT

115,000 Depreciation reversal


For Years 1 - 5: Problem 2

Problem 2


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240,000 Cost decrease

( 0) Depreciation increase

240,000 EBIT(81,600) Taxes (34%)

158,400 EAT

0 Depreciation reversal


For Years 6 - 8:Problem 2

Problem 2


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Problem 2

Problem 2 Solution


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Problem 2 Solution

NPV and IRR:

CF(0) = -590,000.

CF(years 1 - 5) = 197,500.

CF(years 6 - 7) = 158,400 (no

depreciation)

CF(terminal year 8) = 158,400 + 41,400

= 199,800.

Discount rate = 14%.ANSWER

IRR = 28.13% NPV = $293,543.

We would acceptthe project!

Problem 3


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Replacement Project:

Old Asset (5 years old):

Cost of equipment = $1,125,000.


Simplified straight line depreciation.

Current salvage value is $400,000.

Cost of capital = 14%,marginal tax

rate = 35%.

ob e 3

Replacement Project:

Problem 3


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p j

New Asset:

Cost of equipment = $1,750,000.

Shipping & installation will be $56,000.

$68,000 investment in net working capital.

5-year project life, 5-year class life. Simplified straight line depreciation.

Will increase sales by $285,000per year.

Operating expenses will fall by $100,000per year.

Already paid $15,000for training program.



Problem 3: Sell the Old Asset


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Problem 3: Sell the Old Asset



amount depreciated.

Book value = $1,125,000 - $562,500

= $562,500.

Capital gain = SV - BV

= 400,000 - 562,500 = ($162,500).

Tax refund = 162,500 x .35 = $56,875.

Problem 3


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Problem 3I ni tial Outlay:

(1,750,000) Cost of new machine

+ ( 56,000) Shipping & installation

(1,806,000) Depreciable asset

+ ( 68,000) NWC investment

+ 456,875 After-tax proceeds (soldold machine)

(1,417,125) Net Initial Outlay

Problem 3


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385,000 Increased sales & cost savings

(248,700) Extra depreciation

136,300 EBT

(47,705) Taxes (35%)

88,595 EAT248,700 Depreciation reversal

337,295 = Differential Cash Flow

For Years 1 - 5:Problem 3

Problem 3


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Problem 3

P bl 3 S l ti


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Problem 3 Solution

NPV and IRR: CF(0) = -1,417,125.

CF(1 - 4) = 337,295.

CF(5) = 337,295 + 393,000 = 730,295.


NPV = (55,052.07).

IRR = 12.55%.

_cb and cash flow (fm keown10e chap10

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