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    • 1. Chapter 10 - Cash Flows and Other Topics in Capital Budgeting  2005, Pearson Prentice Hall
    • 2. 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 return on the investment?
      • The relevant project information follows:
    • 3.
      • The cost of the new machine is $127,000 .
      • Installation will cost $20,000 .
      • $4,000 in net working capital will be needed at the time of installation.
      • The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase.
      • Simplified straight line depreciation is used.
      • Class life is 5 years, and the firm is planning to keep the project for 5 years.
      • Salvage value at the end of year 5 will be $50,000 .
      • 14% cost of capital; 34% marginal tax rate.
    • 4. Capital Budgeting Steps
      • 1) Evaluate Cash Flows
      • Look at all incremental cash flows occurring as a result of the project.
      • Initial outlay
      • Differential Cash Flows over the life of the project (also referred to as annual cash flows).
      • Terminal Cash Flows
    • 5. Capital Budgeting Steps
      • 1) Evaluate Cash Flows
      0 1 2 3 4 5 n 6 . . .
    • 6. Capital Budgeting Steps
      • 1) Evaluate Cash Flows
      Initial outlay 0 1 2 3 4 5 n 6 . . .
    • 7. Capital Budgeting Steps
      • 1) Evaluate Cash Flows
      Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
    • 8. Capital Budgeting Steps
      • 1) Evaluate Cash Flows
      Terminal Cash flow Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
    • 9.
      • 2) Evaluate the Risk of the Project
      • We’ll get to this in the next chapter.
      • For now, we’ll assume that the risk of the project is the same as the risk of the overall firm.
      • If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.
      Capital Budgeting Steps
    • 10.
      • 3) Accept or Reject the Project
      Capital Budgeting Steps
    • 11. 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
    • 12. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “time 0?”
      • (127,000)
      • + ( shipping and installation costs)
      • (Depreciable asset)
      • + (Investment in working capital)
      • + After-tax proceeds from sale of old asset
      • Net Initial Outlay
    • 13. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “time 0?”
      • (127,000)
      • + ( 20,000 )
      • (Depreciable asset)
      • + (Investment in working capital)
      • + After-tax proceeds from sale of old asset
      • Net Initial Outlay
    • 14. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “time 0?”
      • (127,000)
      • + ( 20,000 )
      • (147,000)
      • + (Investment in working capital)
      • + After-tax proceeds from sale of old asset
      • Net Initial Outlay
    • 15. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “time 0?”
      • (127,000)
      • + ( 20,000 )
      • (147,000)
      • + (4,000)
      • + After-tax proceeds from sale of old asset
      • Net Initial Outlay
    • 16. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “time 0?”
      • (127,000)
      • + ( 20,000 )
      • (147,000)
      • + (4,000)
      • + 0
      • Net Initial Outlay
    • 17. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “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
    • 18. Step 1: Evaluate Cash Flows
      • a) Initial Outlay : What is the cash flow at “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
    • 19. Step 1: Evaluate Cash Flows
      • b) Annual Cash Flows : What incremental cash flows occur over the life of the project?
    • 20.
      • 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:
    • 21.
      • 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:
    • 22.
      • 85,000
      • - 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:
    • 23.
      • 85,000
      • (29,750)
      • - Depreciation on project
      • Incremental earnings before taxes
      • - Tax on incremental EBT
      • Incremental earnings after taxes
      • + Depreciation reversal
      • Annual Cash Flow
      For Years 1 - 5:
    • 24.
      • 85,000
      • (29,750)
      • (29,400)
      • Incremental earnings before taxes
      • - Tax on incremental EBT
      • Incremental earnings after taxes
      • + Depreciation reversal
      • Annual Cash Flow
      For Years 1 - 5:
    • 25.
      • 85,000
      • (29,750)
      • (29,400)
      • 25,850
      • - Tax on incremental EBT
      • Incremental earnings after taxes
      • + Depreciation reversal
      • Annual Cash Flow
      For Years 1 - 5:
    • 26.
      • 85,000
      • (29,750)
      • (29,400)
      • 25,850
      • (8,789)
      • Incremental earnings after taxes
      • + Depreciation reversal
      • Annual Cash Flow
      For Years 1 - 5:
    • 27.
      • 85,000
      • (29,750)
      • (29,400)
      • 25,850
      • (8,789)
      • 17,061
      • + Depreciation reversal
      • Annual Cash Flow
      For Years 1 - 5:
    • 28.
      • 85,000
      • (29,750)
      • (29,400)
      • 25,850
      • (8,789)
      • 17,061
      • 29,400
      • Annual Cash Flow
      For Years 1 - 5:
    • 29.
      • 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:
    • 30. Step 1: Evaluate Cash Flows
      • c) Terminal Cash Flow : What is the cash flow at the end of the project’s life?
      • Salvage value
      • +/- Tax effects of capital gain/loss
      • + Recapture of net working capital
      • Terminal Cash Flow
    • 31. Step 1: Evaluate Cash Flows
      • c) Terminal Cash Flow : What is the cash flow at the end of the project’s life?
      • 50,000 Salvage value
      • +/- Tax effects of capital gain/loss
      • + Recapture of net working capital
      • Terminal Cash Flow
    • 32. 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).
    • 33. Step 1: Evaluate Cash Flows
      • c) Terminal Cash Flow : What is the cash flow at the end of the project’s life?
      • 50,000 Salvage value
      • (17,000) Tax on capital gain
      • Recapture of NWC
      • Terminal Cash Flow
    • 34. Step 1: Evaluate Cash Flows
      • c) Terminal Cash Flow : What is the cash flow at the end of the project’s life?
      • 50,000 Salvage value
      • (17,000) Tax on capital gain
      • 4,000 Recapture of NWC
      • Terminal Cash Flow
    • 35. Step 1: Evaluate Cash Flows
      • c) Terminal Cash Flow : What is the cash flow at the end of the project’s life?
      • 50,000 Salvage value
      • (17,000) Tax on capital gain
      • 4,000 Recapture of NWC
      • 37,000 Terminal Cash Flow
    • 36. Project NPV:
      • CF(0) = -151,000.
      • CF(1 - 4) = 46,461.
      • CF(5) = 46,461 + 37,000 = 83,461.
      • Discount rate = 14%.
      • NPV = $27,721.
      • We would accept the project.
    • 37. 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?
    • 38. Capital Rationing
      • You could rank the projects by IRR:
    • 39. Capital Rationing
      • You could rank the projects by IRR:
      1 IRR 5% 10% 15% 20% 25% $
    • 40. Capital Rationing
      • You could rank the projects by IRR:
      1 2 IRR 5% 10% 15% 20% 25% $
    • 41. Capital Rationing
      • You could rank the projects by IRR:
      1 2 3 IRR 5% 10% 15% 20% 25% $
    • 42. Capital Rationing
      • You could rank the projects by IRR:
      1 2 3 4 IRR 5% 10% 15% 20% 25% $
    • 43. Capital Rationing
      • You could rank the projects by IRR:
      1 2 3 4 5 IRR 5% 10% 15% 20% 25% $
    • 44. Capital Rationing
      • You could rank the projects by IRR:
      1 2 3 4 5 $X Our budget is limited so we accept only projects 1, 2, and 3. IRR 5% 10% 15% 20% 25% $
    • 45. Capital Rationing
      • You could rank the projects by IRR:
      1 2 3 $X Our budget is limited so we accept only projects 1, 2, and 3. IRR 5% 10% 15% 20% 25% $
    • 46. Capital Rationing
      • Ranking projects by IRR is not always the best way to deal with a limited capital budget.
      • It’s better to pick the largest NPVs.
      • Let’s try ranking projects by NPV.
    • 47. Problems with Project Ranking
      • 1) Mutually exclusive projects of unequal size (the size disparity problem)
      • The NPV decision may not agree with IRR or PI.
      • Solution: select the project with the largest NPV .
    • 48. Size Disparity Example
      • Project A
      • year cash flow
      • 0 (135,000)
      • 1 60,000
      • 2 60,000
      • 3 60,000
      • required return = 12%
      • IRR = 15.89%
      • NPV = $9,110
      • PI = 1.07
    • 49. Size Disparity Example
      • Project B
      • year 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 A
      • year cash flow
      • 0 (135,000)
      • 1 60,000
      • 2 60,000
      • 3 60,000
      • required return = 12%
      • IRR = 15. 89%
      • NPV = $9,110
      • PI = 1.07
    • 50. Size Disparity Example
      • Project B
      • year 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 A
      • year cash flow
      • 0 (135,000)
      • 1 60,000
      • 2 60,000
      • 3 60,000
      • required return = 12%
      • IRR = 15. 89%
      • NPV = $9,110
      • PI = 1.07
    • 51. Problems with Project Ranking
      • 2) The time disparity problem with mutually exclusive projects.
      • NPV and PI assume cash flows are reinvested at the required rate of return for 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 .
    • 52. Time Disparity Example
      • Project A
      • year cash flow
      • 0 (48,000)
      • 1 1,200
      • 2 2,400
      • 3 39,000
      • 4 42,000
      • required return = 12%
      • IRR = 18.10%
      • NPV = $9,436
      • PI = 1.20
    • 53. Time Disparity Example
      • Project B
      • year cash flow
      • 0 (46,500)
      • 1 36,500
      • 2 24,000
      • 3 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 2,400
      • 3 39,000
      • 4 42,000
      • required return = 12%
      • IRR = 18.10 %
      • NPV = $9,436
      • PI = 1.20
    • 54. Time Disparity Example
      • Project B
      • year cash flow
      • 0 (46,500)
      • 1 36,500
      • 2 24,000
      • 3 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 2,400
      • 3 39,000
      • 4 42,000
      • required return = 12%
      • IRR = 18.10 %
      • NPV = $9,436
      • PI = 1.20
    • 55. 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?
    • 56.
      • The after-tax cash flows are:
      • Year Machine 1 Machine 2
      • 0 (45,000) (45,000)
      • 1 20,000 12,000
      • 2 20,000 12,000
      • 3 20,000 12,000
      • 4 12,000
      • 5 12,000
      • 6 12,000
      • Assume a required return of 14%.
    • 57. Step 1: Calculate NPV
      • NPV 1 = $1,433
      • NPV 2 = $1,664
      • So, does this mean #2 is better?
      • No! The two NPVs can’t be compared!
    • 58. Step 2: Equivalent Annual Annuity (EAA) method
      • If we assume that each project will be replaced an infinite number of times in the future, we can convert each NPV to an annuity .
      • The projects’ EAAs can be compared to determine which is the best project!
      • EAA: Simply annuitize the NPV over the project’s life.
    • 59. 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 .
    • 60.
      • EAA 1 = $617
      • EAA 2 = $428
      • This tells us that:
      • NPV 1 = annuity of $617 per year.
      • NPV 2 = annuity of $428 per year.
      • So, we’ve reduced a problem with different time horizons to a couple of annuities.
      • Decision Rule: Select the highest EAA. We would choose machine #1.
    • 61. Step 3: Convert back to NPV 
    • 62. Step 3: Convert back to NPV
      • Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.
    • 63. Step 3: Convert back to NPV
      • Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.
      • NPV 1 = 617/.14 = $4,407
       
    • 64. Step 3: Convert back to NPV
      • Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.
      • NPV 1 = 617/.14 = $4,407
      • NPV 2 = 428/.14 = $3,057
        
    • 65. Step 3: Convert back to NPV
      • Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return.
      • NPV 1 = 617/.14 = $4,407
      • NPV 2 = 428/.14 = $3,057
      • This doesn’t change the answer, of course; it just converts EAA to an NPV that can be compared.
        
    • 66. Practice Problems: Cash Flows & Other Topics in Capital Budgeting
    • 67.
      • Project Information :
      • Cost of equipment = $400,000 .
      • Shipping & installation will be $20,000 .
      • $25,000 in net working capital required at setup.
      • 3-year project life, 5-year class life.
      • Simplified straight line depreciation.
      • Revenues will increase by $220,000 per year.
      • Defects costs will fall by $10,000 per year.
      • Operating costs will rise by $30,000 per year.
      • Salvage value after year 3 is $200,000 .
      • Cost of capital = 12%, marginal tax rate = 34% .
      Problem 1a
    • 68. Problem 1a
      • Initial Outlay :
      • (400,000) Cost of asset
      • + ( 20,000 ) Shipping & installation
      • (420,000) Depreciable asset
      • + ( 25,000 ) Investment in NWC
      • ($445,000) Net Initial Outlay
    • 69.
      • 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 EAT
      • 84,000 Depreciation reversal
      • 160,560 = Annual Cash Flow
      For Years 1 - 3: Problem 1a
    • 70.
      • Terminal Cash Flow :
      • Salvage value
      • +/- Tax effects of capital gain/loss
      • + Recapture of net working capital
      • Terminal Cash Flow
      Problem 1a
    • 71.
      • Terminal Cash Flow :
      • Salvage value = $200,000 .
      • Book value = depreciable asset - total amount depreciated.
      • Book value = $168,000.
      • Capital gain = SV - BV = $32,000 .
      • Tax payment = 32,000 x .34 = ($10,880) .
      Problem 1a
    • 72.
      • Terminal Cash Flow :
      • 200,000 Salvage value
      • (10,880) Tax on capital gain
      • 25,000 Recapture of NWC
      • 214,120 Terminal Cash Flow
      Problem 1a
    • 73. 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!
    • 74.
      • Project Information :
      • For the same project, suppose we can 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
    • 75.
      • Terminal Cash Flow :
      • Salvage value
      • +/- Tax effects of capital gain/loss
      • + Recapture of net working capital
      • Terminal Cash Flow
      Problem 1b
    • 76.
      • Terminal Cash Flow :
      • Salvage value = $100,000 .
      • Book value = depreciable asset - total amount depreciated.
      • Book value = $168,000.
      • Capital loss = SV - BV = ($68,000) .
      • Tax refund = 68,000 x .34 = $23,120 .
      Problem 1b
    • 77.
      • Terminal Cash Flow :
      • 100,000 Salvage value
      • 23,120 Tax on capital gain
      • 25,000 Recapture of NWC
      • 148,120 Terminal Cash Flow
      Problem 1b
    • 78. Problem 1b Solution
      • NPV and IRR:
      • CF(0) = -445,000.
      • CF(1), (2) = 160,560.
      • CF(3) = 160,560 + 148,120 = 308,680.
      • Discount rate = 12%.
      • IRR = 17.3% .
      • NPV = $46,067. Accept the project!
    • 79.
      • Automation Project :
      • Cost of equipment = $550,000 .
      • Shipping & installation will be $25,000 .
      • $15,000 in net working capital required at setup.
      • 8-year project life, 5-year class life.
      • Simplified straight line depreciation.
      • Current operating expenses are $640,000 per yr.
      • New operating expenses will be $400,000 per yr.
      • Already paid consultant $25,000 for analysis.
      • Salvage value after year 8 is $40,000 .
      • Cost of capital = 14%, marginal tax rate = 34% .
      Problem 2
    • 80. Problem 2
      • Initial Outlay :
      • (550,000) Cost of new machine
      • + ( 25,000 ) Shipping & installation
      • (575,000) Depreciable asset
      • + ( 15,000) NWC investment
      • (590,000) Net Initial Outlay
    • 81.
      • 240,000 Cost decrease
      • ( 115,000 ) Depreciation increase
      • 125,000 EBIT
      • ( 42,500 ) Taxes (34%)
      • 82,500 EAT
      • 115,000 Depreciation reversal
      • 197,500 = Annual Cash Flow
      For Years 1 - 5: Problem 2
    • 82.
      • 240,000 Cost decrease
      • ( 0) Depreciation increase
      • 240,000 EBIT
      • (81,600) Taxes (34%)
      • 158,400 EAT
      • 0 Depreciation reversal
      • 158,400 = Annual Cash Flow
      For Years 6 - 8: Problem 2
    • 83.
      • Terminal Cash Flow :
      • 40,000 Salvage value
      • (13,600) Tax on capital gain
      • 15,000 Recapture of NWC
      • 41,400 Terminal Cash Flow
      Problem 2
    • 84. Problem 2 Solution
      • NPV and IRR:
      • CF(0) = -590,000.
      • CF(1 - 5) = 197,500.
      • CF(6 - 7) = 158,400.
      • CF(10) = 158,400 + 41,400 = 199,800.
      • Discount rate = 14%.
      • IRR = 28.13% NPV = $293,543 .
      • We would accept the project!
    • 85.
      • Replacement Project :
      • Old Asset (5 years old):
      • Cost of equipment = $1,125,000 .
      • 10-year project life, 10-year class life.
      • Simplified straight line depreciation.
      • Current salvage value is $400,000.
      • Cost of capital = 14%, marginal tax rate = 35%.
      Problem 3
    • 86.
      • Replacement Project :
      • 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 $285,000 per year.
      • Operating expenses will fall by $100,000 per year.
      • Already paid $15,000 for training program.
      • Salvage value after year 5 is $500,000.
      • Cost of capital = 14%, marginal tax rate = 34%.
      Problem 3
    • 87. Problem 3: Sell the Old Asset
      • Salvage value = $400,000 .
      • Book value = depreciable asset - total 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 .
    • 88. Problem 3
      • Initial 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 (sold old machine)
      • (1,417,125) Net Initial Outlay
    • 89.
      • 385,000 Increased sales & cost savings
      • (248,700) Extra depreciation
      • 136,300 EBT
      • (47,705) Taxes (35%)
      • 88,595 EAT
      • 248,700 Depreciation reversal
      • 337,295 = Differential Cash Flow
      For Years 1 - 5: Problem 3
    • 90.
      • Terminal Cash Flow :
      • 500,000 Salvage value
      • (175,000) Tax on capital gain
      • 68,000 Recapture of NWC
      • 393,000 Terminal Cash Flow
      Problem 3
    • 91. Problem 3 Solution
      • NPV and IRR:
      • CF(0) = -1,417,125.
      • CF(1 - 4) = 337,295.
      • CF(5) = 337,295 + 393,000 = 730,295.
      • Discount rate = 14%.
      • NPV = (55,052.07) .
      • IRR = 12.55% .
      • We would not accept the project!

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