10. cash flow in capital budgeting

Chapter 11
Cash Flows and
Other Topics
in Capital
Budgeting

Copyright © 2011 Pearson Prentice Hall.
All rights reserved.

Learning Objectives

1. Identify guidelines by which we measure
cash flows.
2. Explain how a project’s benefits and costs –
that is, its free cash flows –are calculated.
3. Explain the importance of options or flexibility
in capital budgeting.
4. Explain what the appropriate measure of risk
is for capital-budgeting purposes.
© 2011 Pearson Prentice Hall. All rights
reserved. 11-2

Learning Objectives

5. Determine the acceptability of a new project
using the risk-adjusted discount method of
adjusting for risk.
6. Explain the use of simulating for imitating
the performance of a project under
evaluation.
7. Explain why a multinational firm faces a
more difficult time estimating cash flows
along with increased risks.
reserved. 11-3

Slide Contents

 Guidelines for Capital Budgeting
 Free Cash Flow calculations
 Options in Capital Budgeting
 Risk and the Investment Decision
 Measurement of Systematic Risk
 The Multinational Firm

reserved. 11-4

1. Guidelines for
Capital Budgeting

 To evaluate investment proposals, we
must first set guidelines by which we
measure the value of each proposal.
 In effect, we are deciding what is and
what isn’t relevant cash flow.

reserved. 11-5

Guidelines for
Capital Budgeting

1. Use free cash flows, not accounting profits
2. Think Incrementally
3. Beware of cash flows diverted from existing
products
4. Look for incidental or synergistic effects
5. Work in working-capital requirements

reserved. 11-6

Guidelines for
Capital Budgeting

6. Consider incremental expenses
7. Sunk costs are not incremental cash flows
8. Account for opportunity costs
9. Decide if overhead costs are truly
incremental cash flows
10. Ignore interest payments and financing
flows
reserved. 11-7

Use Free Cash Flows

 Free cash flow accurately reflects the
timing of benefits and costs—when
money is received, when it can be
reinvested, and when it must be paid
out.
 Accounting profits do not reflect actual
money in hand.
reserved. 11-8

Incremental Cash Flows

 After-tax free cash flows must be
measured incrementally.
 Determining incremental free cash flow
involves determining the cash flows with
and without the project. Incremental is
the “additional cash flows” (inflows or
outflows) that occur due to the project.
reserved. 11-9

Beware of Diverted
Cash Flows

 Not all incremental free cash flow is relevant.
 Thus new product sales achieved at the cost
of losing sales from existing product line are
not considered a benefit.
 However, if the new product captures sales
from competitors or prevents loss of sales to
new competing products, it would be a
relevant incremental free cash flows.
© 2011 Pearson Prentice Hall. All rights 11-
reserved. 10

Incidental or
Synergistic Effects

 Although some projects may take sales
away from a firm’s current projects, in
other cases new products may add
sales to the existing line. This is called
synergistic effect and is a relevant cash
flow.

reserved. 11

Working Capital Requirement

 New projects require infusion of working
capital (such as inventory to stock the
shelves), which would be an outflow.
 Generally, when the project terminates,
working capital is recovered and there
is an inflow of working capital.

reserved. 12

Sunk Costs

 Sunk costs are cash flows that have already
occurred (such as marketing research) and
cannot be undone. Sunk costs are considered
irrelevant to decision making.
 Managers need to ask two basic questions:
 Will this cash flow occur if the project is accepted?
 Will this cash flow occur if the project is rejected?
 If the answer is “Yes” to #1 and “No” to #2, it
will be an incremental cash flow.
reserved. 13

Opportunity Costs

 Opportunity cost refers to cash flows
that are lost because of accepting the
current project.
 For example, using the building space
for the project will mean loss of potential
rental revenue.

reserved. 14

Overhead Costs

 Must include incremental overhead
costs or costs that were incurred as a
result of the project and relevant to
capital budgeting
 Note, not all overhead costs may be
relevant (example, utilities bill may have
been the same with or without the
project)
reserved. 15

Interest Payments and Financing
Costs

 Interest payments and other financing
cash flows that might result from raising
funds to finance a project are not
relevant cash flows.
 Reason: Required rate of return
implicitly accounts for the cost of raising
funds to finance a new project.
reserved. 16

2. Free Cash Flow Calculations

 Three components of free cash flows:
 The Initial outlay
 The differential flows over the project’s life
 The Terminal cash flow

reserved. 17

2.1 Initial Cash Outlay

 The initial cash outlay is the immediate cash
outflow necessary to purchase the asset and
put it in operating order.
 This includes: (1) Purchase cost, Set-up cost,
Installation, Shipping/Freight (2) increased
working-capital requirements (3) sale of
existing asset and tax implications (if the
project replaces an existing project/asset)

reserved. 18

Sale and Taxes

 If Sale = Book Value ==> No tax effect
 If sale > BV (but less than cost)
==> recaptured depreciation, taxed as
ordinary income
 If sale > BV (greater than cost)
==> anything above cost, taxed as capital
gain, rest taxed as recaptured depreciation
 If sale < BV ==> capital loss
==> tax savings
reserved. 19

2.2 Annual Free Cash Flows

 Annual free cash flows is the incremental
after-tax cash flows resulting form the project
being considered.
 Free Cash flow considers the following:
 Cash flow from operations
 Cash flows from working capital requirements
 Cash flows from capital spending

reserved. 20

Calculating Operating
Cash Flows

 Step 1: Measure the project’s change in
after-tax operating cash flows
 Operating cash flows
= Changes in EBIT
– Changes in taxes
+ Change in depreciation

Note, depreciation is a non-cash expense but
influences the cash flows through impact on
taxes (see next two slides).
reserved. 21

Depreciation and Cash Flow

 Earnings before Tax and Dep. 40,000
 Depreciation 25,000
 Earnings before tax (EBT) 15,000
 If the corporation is taxed at 30%,
taxes = .3*15000 = $4,500
 If the depreciation was $0,
EBT = $40,000 and
taxes = .3*40000 = $12,000
reserved. 22

Depreciation and Cash Flow

 ==> Depreciation is a “non-cash
expense” BUT affects Cash Flow
through its impact on “taxes”;
 Depreciation ==> ↑in Expense
==> ↓ in taxes
=> ↑CF

reserved. 23

Change in Net
Working Capital

 Step 2: Calculate the cash flows from
the change in net working capital

This refers to additional investment in
current assets minus any additional
short-term liabilities that were
generated.

reserved. 24

Steps in Calculating Operating
Cash Flows

 Step 3: Determine the cash flows from
the change in capital spending

This refers to any capital spending
requirements during the life of the
project.

reserved. 25

Putting it all together

 Step 4: Project free cash flows
= change in EBIT
– changes in taxes
+ change in depreciation
– change in net working capital
– change in capital spending

reserved. 26

2.3 Terminal Cash Flow

 Terminal cash flows are flows
associated with the project at
termination.
 It may include:
 Salvage value of the project
 Any taxable gains or losses associated
with the sale of any asset
reserved. 27

Refer to Example 11.2

 Initial outlay = $200,000 + $30,000 = $230,000
 ∆Operating cash flow
= EBIT + Depreciation
= $155,600
(see Tables 11-1, 11-2)
 Terminal free cash flows
= ∆Operating cash flow
+ ∆ net working capital
= $185,600
(See Table 11-3)
reserved. 28

Table 11-1

reserved. 29

Table 11-2

reserved. 30

Table 11-3

reserved. 31

3. Options in
Capital Budgeting

 Options add value to capital budgeting
project by being able to modify the
project based on future developments
(that are currently unknown). Some
common options are:
 Option to delay a project
 Option to expand a project
 Option to abandon a project
reserved. 32

Option to Delay

 Almost every project has a mutually exclusive
alternative—waiting and pursuing at a later
time.
 It is conceivable that a project with a negative
NPV now may have a positive NPV if
undertaken later on. This could be due to
various reasons such as favorable changes in
fashion, technology, economy, or borrowing
costs.

reserved. 33

Option to Expand

 Even if a project is currently
unprofitable, it may be useful to
determine whether the profitability of the
project will change if the company is
able to expand in the future.
 Example: Firms investing in negative
NPV projects to gain access to new
markets
reserved. 34

Option to Abandon

 It may be necessary to abandon the project
before its estimated life due to inaccurate
project analysis models or cash flow forecasts
or due to changes in market conditions.
 When comparing two projects with similar
NPVs, project that is easier to abandon may
be more desirable (example, temporary
versus permanent workers, lease versus buy)

reserved. 35

4. Risk and the
Investment Decision

Two main issues:
 What is risk and how should it be
measured?
 How should risk be incorporated into a
capital budgeting analysis?

reserved. 36

Three Perspectives on Risk

 Project standing alone risk
 Project’s contribution-to-firm risk
 Systematic risk

reserved. 37

Project Standing Alone Risk

 This is a project’s risk ignoring the fact
that much of the risk will be diversified
away as the project is combined with
other projects and assets.
 This is an inappropriate measure of risk
for capital budgeting projects.

reserved. 38

Contribution-to-Firm Risk

 This is the amount of risk that the project
contributes to the firm as a whole;
 This measure considers the fact that some of
the project’s risk will be diversified away as
the project is combined with the firm’s other
projects and assets but ignores the effects of
diversification of the firm’s shareholders.

reserved. 39

Systematic Risk

 Risk of the project from the viewpoint of a
well-diversified shareholder;
 This measure takes into account that some of
the risk will be diversified away as the project
is combined with the firm’s other projects and
in addition, some of the remaining risk will be
diversified away by the shareholders as they
combine this stock with other stocks in their
portfolios.

reserved. 40

Relevant risk

 Theoretically, the only risk of concern to
shareholders is systematic risk.
 Since the project’s contribution-to-firm
risk affects the probability of bankruptcy
for the firm, it is a relevant risk measure.
 Thus we need to consider both the
project’s contribution-to-firm risk and the
project’s systematic risk.
reserved. 41

Incorporating Risk into Capital
Budgeting

 We know that investors demand higher
returns for more risky projects.
 As the risk of a project increases, the required
rate of return is adjusted upward to
compensate for the added risk.
 This risk adjusted discount rate is then
used for discounting free cash flows (in NPV
model) or as the benchmark required rate of
return (in IRR model)
reserved. 42

5. Measurement of Systematic
Risk

 Estimating risk of a project can be difficult
Historical stock return data relates to an
entire firm, rather than a specific project or
division. Risk must be estimated. Options to
estimate risk include:
 Accounting Beta
 Pure Play Method
 Simulation
 Scenario Analysis
 Sensitivity Analysis
reserved. 43

Beta

 Accounting Beta Method
 Can be estimated via time-series
regression on a division’s return on assets
on the market index
 Pure Play Method
 Identifies publicly traded firms engaged
solely in the same business as the project,
using that firm’s return data to judge the
project.
reserved. 44

Simulation

 Involves the process of imitating the
performance of the project under
evaluation (See Figure 11-6)
 Done by randomly selecting observations
from each of the distributions that affect the
outcome of the project and continuing with
this process until a representative record of
the project’s probable outcome is
assembled.
reserved. 45

Scenario Analysis

 Identifies the range of possible
outcomes under the worst, best, and
most likely cases.

reserved. 46

Sensitivity Analysis

 Determining how the distribution of
possible net present values or internal
rate of return for a particular project is
affected by a change in one particular
input variable while holding all other
input variables constant (also known as
what-if analysis).

reserved. 47

6. The Multinational Firm

 Process of measuring the incremental
after-tax cash flows to the company as a
whole gets more difficult when dealing with
competition from abroad.
 Calculating the right base case (i.e. incremental
cash flows if project not taken) is difficult
 International opportunities come with risks such as
currency fluctuations that can distort cash flow
projections.
reserved. 48

Figure 11-1

reserved. 49

Figure 11-2

reserved. 50

Figure 11-3

reserved. 51

Figure 11-4

reserved. 52

Figure 11-5

reserved. 53

Figure 11-6

reserved. 54

Figure 11-6 (cont.)

reserved. 55

Figure 11-7

reserved. 56

Table 11-4

reserved. 57

Table 11-5

reserved. 58

Table 11-5 (cont.)

reserved. 59

Key Terms

 Contribution-to-firm risk
 Incremental after-tax free cash flows
 Initial outlay
 Project standing alone risk
 Pure play method

reserved. 60

Key Terms

 Risk-adjusted discount rate
 Scenario analysis
 Sensitivity analysis
 Simulation
 Systematic risk

reserved. 61

10. cash flow in capital budgeting

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