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Fm10e ch10 Fm10e ch10 Presentation Transcript

  • Chapter 10 - Cash Flows and Other Topics in Capital Budgeting  2005, Pearson Prentice Hall
  • 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:
    • 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.
  • 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
  • Capital Budgeting Steps
    • 1) Evaluate Cash Flows
    0 1 2 3 4 5 n 6 . . .
  • Capital Budgeting Steps
    • 1) Evaluate Cash Flows
    Initial outlay 0 1 2 3 4 5 n 6 . . .
  • Capital Budgeting Steps
    • 1) Evaluate Cash Flows
    Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
  • Capital Budgeting Steps
    • 1) Evaluate Cash Flows
    Terminal Cash flow Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
    • 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
    • 3) Accept or Reject the Project
    Capital Budgeting Steps
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • Step 1: Evaluate Cash Flows
    • b) Annual Cash Flows : What incremental cash flows occur over the life of the project?
    • 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:
    • 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:
    • 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:
    • 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:
    • 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:
    • 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:
    • 85,000
    • (29,750)
    • (29,400)
    • 25,850
    • (8,789)
    • Incremental earnings after taxes
    • + Depreciation reversal
    • Annual Cash Flow
    For Years 1 - 5:
    • 85,000
    • (29,750)
    • (29,400)
    • 25,850
    • (8,789)
    • 17,061
    • + Depreciation reversal
    • Annual Cash Flow
    For Years 1 - 5:
    • 85,000
    • (29,750)
    • (29,400)
    • 25,850
    • (8,789)
    • 17,061
    • 29,400
    • Annual Cash Flow
    For Years 1 - 5:
    • 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:
  • 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
  • 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
  • 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).
  • 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
  • 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
  • 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
  • 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.
  • 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?
  • Capital Rationing
    • You could rank the projects by IRR:
  • Capital Rationing
    • You could rank the projects by IRR:
    1 IRR 5% 10% 15% 20% 25% $
  • Capital Rationing
    • You could rank the projects by IRR:
    1 2 IRR 5% 10% 15% 20% 25% $
  • Capital Rationing
    • You could rank the projects by IRR:
    1 2 3 IRR 5% 10% 15% 20% 25% $
  • Capital Rationing
    • You could rank the projects by IRR:
    1 2 3 4 IRR 5% 10% 15% 20% 25% $
  • Capital Rationing
    • You could rank the projects by IRR:
    1 2 3 4 5 IRR 5% 10% 15% 20% 25% $
  • 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% $
  • 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% $
  • 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.
  • 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 .
  • 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
  • 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
  • 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
  • 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 .
  • 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
  • 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
  • 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
  • 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?
    • 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%.
  • 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!
  • 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.
  • 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 .
    • 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.
  • Step 3: Convert back to NPV 
  • 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.
  • 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
     
  • 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
      
  • 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.
      
  • Practice Problems: Cash Flows & Other Topics in Capital Budgeting
    • 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
  • 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
    • 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
    • Terminal Cash Flow :
    • Salvage value
    • +/- Tax effects of capital gain/loss
    • + Recapture of net working capital
    • Terminal Cash Flow
    Problem 1a
    • 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
    • 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
  • 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!
    • 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
    • Terminal Cash Flow :
    • Salvage value
    • +/- Tax effects of capital gain/loss
    • + Recapture of net working capital
    • Terminal Cash Flow
    Problem 1b
    • 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
    • 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
  • 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!
    • 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
  • 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
    • 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
    • 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
    • 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
  • 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!
    • 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
    • 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
  • 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 .
  • 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
    • 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
    • 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
  • 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!