Making Capital Making Capital Investment DecisionsInvestment Decisions

Estimating Cash FlowsEstimating Cash Flows

Special casesSpecial cases

OverviewOverview We are mainly concerned with how to We are mainly concerned with how to

arrive at correct measure of cash flows in arrive at correct measure of cash flows in numerator of NPV calculationsnumerator of NPV calculations

What are relevant and irrelevant cash What are relevant and irrelevant cash flows?flows?

We will also look at some special cases of We will also look at some special cases of Discounted Cash Flow (DCF) methodsDiscounted Cash Flow (DCF) methods

Special Applications of DCFSpecial Applications of DCF

Evaluating Cost Cutting ProposalsEvaluating Cost Cutting Proposals

Evaluating Equipment with Different LivesEvaluating Equipment with Different Lives

We will ignore ‘setting bid price’ example in We will ignore ‘setting bid price’ example in texttext

Relevant Cash FlowsRelevant Cash Flows

Only INCREMENTAL after-tax cash flows Only INCREMENTAL after-tax cash flows are relevant:are relevant:

Incremental cash flows:Incremental cash flows: Changes in cash flows Changes in cash flows withwith and and withoutwithout the the

projectproject NOTNOT the same as cash flows the same as cash flows beforebefore and and afterafter the the

project!!project!!

Indentifying cash flowsIndentifying cash flows

Look ForLook For::

Changes in sales and operating costsChanges in sales and operating costs Changes in net working capitalChanges in net working capital Opportunity costs and capital spendingOpportunity costs and capital spending Effect on tax paymentsEffect on tax payments

ExampleExample

Manufacturing operation that uses land that Manufacturing operation that uses land that could be sold for $100,000could be sold for $100,000

With projectWith project::(own and use land)(own and use land) CF = $0CF = $0

Without projectWithout project(sell land)(sell land) CF = +$100,000CF = +$100,000

IncrementalIncremental CF CF = -$100,000 = -$100,000(due to project)(due to project)

Do Do NotNot Include... Include... Sunk Costs and unavoidable expensesSunk Costs and unavoidable expenses

DepreciationDepreciation but include effect of depreciation on taxesbut include effect of depreciation on taxes

Financing paymentsFinancing payments e.g. dividends and intereste.g. dividends and interest financing is captured in denominator ‘r’financing is captured in denominator ‘r’

Examples: Include/Ignore?Examples: Include/Ignore? Market value of land and existing buildingsMarket value of land and existing buildings Costs of demolishing and clearing landCosts of demolishing and clearing land Cost of new access road put in last yearCost of new access road put in last year Lost earnings from other products due to Lost earnings from other products due to

managers’ time spent on the new plantmanagers’ time spent on the new plant Part of the cost of leasing the president’s airplanePart of the cost of leasing the president’s airplane Future depreciation of the new plantFuture depreciation of the new plant Initial investment on inventories and raw materialsInitial investment on inventories and raw materials Payments already made for engineering of the new Payments already made for engineering of the new

plantplant

Definitions of Operating CFDefinitions of Operating CF OCF = operating cash flowOCF = operating cash flow S = salesS = sales C = operating costsC = operating costs D = depreciationD = depreciation EBIT = earnings before interest and taxesEBIT = earnings before interest and taxes

= S - C - D= S - C - D T = corporate tax rateT = corporate tax rate

OCF = EBIT + D - Taxes

Example:Example: S = $1,000S = $1,000 C = $600C = $600 D = $200D = $200 T = 34%T = 34%

EBIT = S - C - D = 1000-600-200 = $200EBIT = S - C - D = 1000-600-200 = $200Taxes = EBIT x T = 200 x .34 = $68Taxes = EBIT x T = 200 x .34 = $68

OCF = EBIT + D - TaxesOCF = EBIT + D - Taxes200 + 200 - 68 = $332200 + 200 - 68 = $332

Use alternative approaches to arrive at the same answerUse alternative approaches to arrive at the same answer

Alternative Definitions of OCFAlternative Definitions of OCF Bottoms-up approachBottoms-up approach

OCF = N.I. (without interest expense) + DOCF = N.I. (without interest expense) + D

Top-down approachTop-down approachOCF = S - C - TaxesOCF = S - C - Taxes

Tax-shield approachTax-shield approachOCF = (S - C) x (1-T) + D x TOCF = (S - C) x (1-T) + D x T

Notice...Notice...

In all the alternatives of computing cash In all the alternatives of computing cash flows, taxes must be taken into accountflows, taxes must be taken into account

Payment of taxes is a cash outflowPayment of taxes is a cash outflow Savings of taxes is a cash inflowSavings of taxes is a cash inflow

Cash flows are computed on an Cash flows are computed on an after-taxafter-tax basisbasis

Multiply by T or (1-T)?Multiply by T or (1-T)?

When you are calculating the When you are calculating the amount of taxamount of tax, , you multiply by you multiply by TT

When you are calculating the When you are calculating the amount of tax amount of tax savingssavings due to an expense (such as due to an expense (such as depreciation expense or any other expense), depreciation expense or any other expense), you multiply by you multiply by TT

When you are calculating the amount of When you are calculating the amount of after-after-tax cash flowtax cash flow, you multiply by , you multiply by (1-T)(1-T)

ExampleExample

Before Tax CF:Before Tax CF: $1000 [= CF]$1000 [= CF] Tax @ 40%:Tax @ 40%: $400 [= CF x T] $400 [= CF x T] After Tax Income:After Tax Income: $600 [= CF x (1-T)] $600 [= CF x (1-T)]

ExampleExample

Taking a project increases tax deductible Taking a project increases tax deductible expense by $1,000expense by $1,000

How much savings in taxes does this result?How much savings in taxes does this result? T = 40%T = 40%

Answer: 1000 x .40 = $400Answer: 1000 x .40 = $400 This is the amount by which the taxes are lowerThis is the amount by which the taxes are lower

DepreciationDepreciation Depreciation is a way accountants measure Depreciation is a way accountants measure

‘wear and tear’ or ‘using-up’ of assets‘wear and tear’ or ‘using-up’ of assets It does not reflect actual cash going outIt does not reflect actual cash going out

Depreciation is a tax-deductible expenseDepreciation is a tax-deductible expense

Tax savings due to depreciation is (D x T)Tax savings due to depreciation is (D x T) tax savings is a cash tax savings is a cash inflowinflow tax savings is called tax savings is called depreciation tax shielddepreciation tax shield

Example: Depr. Tax ShieldExample: Depr. Tax Shield The Latte Stand project requires purchasing The Latte Stand project requires purchasing

coffee equipment for $12,000 which will be coffee equipment for $12,000 which will be depreciated on a straight-line basis over 4 depreciated on a straight-line basis over 4 years to zero book value. The tax rate is years to zero book value. The tax rate is 38%.38%.

What is the annual depreciation?What is the annual depreciation? What are the cash flow consequences of What are the cash flow consequences of

depreciation?depreciation?

NoteNote

Equipment can be sold before it is fully Equipment can be sold before it is fully depreciateddepreciated

The book value (BV) of the machine in any The book value (BV) of the machine in any year is the original cost – accumulated year is the original cost – accumulated depreciationdepreciation Example. $1m machine is being depreciated Example. $1m machine is being depreciated

straight line over 10 years to zero book value. straight line over 10 years to zero book value. What is its BV in year 6?What is its BV in year 6?

Accelerated DepreciationAccelerated Depreciation IRS allows a quicker schedule of IRS allows a quicker schedule of

depreciation than straight-line depreciationdepreciation than straight-line depreciation

This method is called Accelerated This method is called Accelerated DepreciationDepreciation

Assets are categorized in different ‘classes’Assets are categorized in different ‘classes’ e.g. “5-year class”e.g. “5-year class”

Accelerated DepreciationAccelerated Depreciation

$500,000 investment is depreciated over 4 $500,000 investment is depreciated over 4 years as 3-year MACRS to zero book valueyears as 3-year MACRS to zero book value What is the annual depreciation?What is the annual depreciation? What is the annual depreciation tax shield?What is the annual depreciation tax shield?

Salvage ValueSalvage Value

The latte equipment will be sold at the end The latte equipment will be sold at the end of 4 years for $5,600.of 4 years for $5,600.

What are the cash flows resulting from What are the cash flows resulting from salvage at the end of the project? salvage at the end of the project?

SalvageSalvage

Sale of equipment can result inSale of equipment can result in Taxable gain if BV < MVTaxable gain if BV < MV

OROR Taxable loss if BV > MVTaxable loss if BV > MV

OROR Neither if BV = MVNeither if BV = MV

Gain ExampleGain Example Loss ExampleLoss Example

Book Value of Asset in Book Value of Asset in year of sale (BV)year of sale (BV)

$10,000$10,000 $10,000$10,000

Sale price of asset (MV)Sale price of asset (MV) $15,000$15,000 $5,000$5,000

Gain (+)/Loss (-) on saleGain (+)/Loss (-) on sale +$5000+$5000 -$5,000-$5,000

Cash flow from tax Cash flow from tax paid/saved on gain/loss paid/saved on gain/loss from salefrom sale

-$2,000-$2,000 +$2,000+$2,000

Here, gain on sale Here, gain on sale to taxes being to taxes being

paidpaid on the gain on the gain (cash outflow)(cash outflow)

Here, loss on sale Here, loss on sale leads to taxes leads to taxes

being being savedsaved (cash (cash inflow)inflow)

Net Working CapitalNet Working Capital Net working capital (NWC)Net working capital (NWC)

= S.T. Assets - S.T. Liabilities= S.T. Assets - S.T. Liabilities Businesses Businesses needneed NWC to conduct business NWC to conduct business NWC ties up money (i.e. it is an investment)NWC ties up money (i.e. it is an investment) What are S.T. Assets and Liabilities of a firm?What are S.T. Assets and Liabilities of a firm?

IncreaseIncrease in NWC is cash in NWC is cash outflowoutflow DecreaseDecrease in NWC is cash in NWC is cash inflowinflow

NWCNWC

ST AssetsST Assets CashCash Marketable securitiesMarketable securities Accounts ReceivablesAccounts Receivables InventoryInventory

ST LiabilitiesST Liabilities Accounts payableAccounts payable Wages dueWages due Taxes dueTaxes due

NWC = ST Assets - ST Liabilities

Example: NWCExample: NWC

Without Project ($s)Without Project ($s)

Acct Rec’vAcct Rec’v 4,5004,500 InventoriesInventories 6,0006,000 Acct Pay’bAcct Pay’b 3,9003,900

With Project ($s)With Project ($s)

Acct Rec’vAcct Rec’v 6,7006,700 InventoriesInventories 9,0009,000 Acct Pay’bAcct Pay’b 3,4003,400

What is the change in NWC?What is the cash inflow / outflow?

NWC at Project EndNWC at Project End When projects have finite life, the money When projects have finite life, the money

tied up in NWC becomes available when tied up in NWC becomes available when the project endsthe project ends

Hence, one typically encounters situations Hence, one typically encounters situations where a drop in NWC occurs at the end of where a drop in NWC occurs at the end of project’s lifeproject’s life This results in a cash inflowThis results in a cash inflow

Application: Cost CuttingApplication: Cost Cutting

Buying a new machine press for $350,000 Buying a new machine press for $350,000 is estimated to result in $145,000 in annual is estimated to result in $145,000 in annual pre-tax savings. MACRS five-year class pre-tax savings. MACRS five-year class depreciated to zero book value, and has sale depreciated to zero book value, and has sale price of $75,000. Also required spare parts price of $75,000. Also required spare parts of $17,000 and $2,500 in inventory for each of $17,000 and $2,500 in inventory for each succeeding year of the project. T = 34%, r succeeding year of the project. T = 34%, r = 15%. Buy new machine?= 15%. Buy new machine?

Equivalent Annual Cost (EAC)Equivalent Annual Cost (EAC) UsefulUseful: :

when alternatives have different economic liveswhen alternatives have different economic lives we will use and replace the equipment we will use and replace the equipment

indefinitelyindefinitely

TrickTrick:: Calculate NPV of alternativesCalculate NPV of alternatives Use NPV as PV of annuity to calculate PMT Use NPV as PV of annuity to calculate PMT

over the ‘n’ years of useful lifeover the ‘n’ years of useful life

EAC ExampleEAC ExampleFiltrationFiltration

PrecipitationPrecipitation Economic LifeEconomic Life 5 years5 years 8 years8 years Installation CostInstallation Cost $1.1 mill$1.1 mill $1.9 mill$1.9 mill Annual Oper. CostAnnual Oper. Cost $60,000 $60,000 $10,000 $10,000 Salvage valueSalvage value $0 $0 $0 $0 Depreciable lifeDepreciable life 5 years5 years 8 years8 years Discount rateDiscount rate 12%12% 12%12% T = .34, Straight line depreciationT = .34, Straight line depreciation

Notice...Notice... The two alternative have different livesThe two alternative have different lives

Cannot directly compare themCannot directly compare them

We usually assume that the machines are We usually assume that the machines are replaced indefinitely at end of their livesreplaced indefinitely at end of their lives

Hence we convert NPV to Equivalent Hence we convert NPV to Equivalent Annual Costs (EAC)Annual Costs (EAC)

EAC ex. continued..EAC ex. continued..

FiltrFiltr.. PrecipPrecip.. After tax oper. costAfter tax oper. cost -$39,600-$39,600 -$6,600 -$6,600 Depr. tax shieldDepr. tax shield $74,800 $74,800 $80,750 $80,750 Oper. Cash flowOper. Cash flow $35,200 $35,200 $74,150 $74,150 PV of Oper. cash flowPV of Oper. cash flow $126,888 $126,888 $368,350 $368,350 Investment Investment -$1,100,000-$1,100,000 -$1,900,000 -$1,900,000 NPV @ 12%NPV @ 12% -$973,112-$973,112 -$1,531,650 -$1,531,650 EAC EAC