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Cash Flow And Capital Budgeting

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					Cash Flow And Capital Budgeting

        Professor Thomson
             Fin 3013
    Cash Flow Versus Accounting Profit

     Capital budgeting concerned with cash flow, not
                    accounting profit.

     To evaluate a capital investment, we must know:


        Incremental cash outflows of the investment
             (marginal cost of investment), and

         Incremental cash inflows of the investment
              (marginal benefit of investment).

        The timing and magnitude of cash flows and
2        accounting profits can differ dramatically.
    Financing Costs
    Financing costs should be excluded when evaluating a
      project’s cash flows (can separate the investment
            decision from the financing decision).



         Both interest expense from debt financing and
        dividend payments to equity investors should be
                           excluded.

        Financing costs are captured in the discounting
        future cash flows to present i.e. use the correct
        discount rate to adjust for the systematic risk of
                           the project.
3
    Capital Investment Decisions
    • The with and without principle – Capital project
      evaluation should be done by assessing the cash
      flows with and without undertaking the project.
      I.e. We need to consider the INCREMENTAL
      cash flows due to the project.
    • Stand Alone Basis – another way of stating this
      principle is to consider the project on a stand
      alone basis (by looking only at the incremental
      cash flows that result from this project).



4
    Other Considerations
    • Sunk Costs - A sunk cost is a cost that has been
      expended in the past, and whether you do or do not
      undertake the project, these costs no longer effect the
      incremental cost of the project.
    • Opportunity cost – There is no such thing as a free
      lunch. If a firm already owns something that can be
      applied to a new project – it could also be sold on
      Ebay. The amount you could sell it for on Ebay
      represents the opportunity cost of using an existing
      asset on a new project.
    • Side effects – In considering the incremental costs, one
      has to consider any side effects. If additional
      advertising of our new product, also increases sales of
      our other products, these sides effects must be part of
      the incremental costs (also cannibalization).
5
    Net Working Capital
    • New or expanded projects often require
      additional working capital (such as additional
      inventory) that must be considered as part of
      the incremental cost of the project.
    • For project analysis, the simplest case is when
      additional working capital is required at the
      beginning of the project that will be brought
      back to base line levels at the end of the project.



6
    Investment Pro Forma
    • A pro forma is the standard analysis of
      cash flows that one does to determine if a
      proposed capital project is a good
      investment.
    • A pro forma includes listing the expected
      cash flows over time, and computing of
      the investment criteria such as NPV, IRR,
      PI, and Payback.

7
    Investment Pro Forma (simplified)

    Source        Time 0      1      2        3

    OCF                    OCF1    OCF2    OCF3

    NWC          -NWC                      NWC

    Investment   -Invest                   Salvage
                                           (ATCF)
    Total ATCF   ATCF0     ATCF1   ATCF2   ATCF3


8                All numbers are ATCF’s
    Investment Pro Forma (simplified)

    A project that costs 100 and requires 20 of new net
    working capital will provide incremental operating
    cash flows of $60 for the next three years. The after
    tax cash flow from salvaging the equipment will be
    15. What are the project’s ATCF? What is the IRR?

    Source          Time 0           1         2            3
    OCF                            60         60            60
    NWC                -20                                  20
    Investment        -100                                  15
    Total ATCF        -120         60         60            95
9
     Investment Cash Flows
      Cash Flows from Investment Projects are
        commonly separated into 3 components
      1. Operating Cash Flows (OCF)
           OCF = EBIT – Taxes + Depreciation
      2. Change in Net Working Capital (NWC)
      3. Investment Cost
            Initial Investment at time period zero
           At the end of the project you may recover some
          of your investment cost if you can sell (salvage)
          your capital goods.
      All of the above are presented on an after tax
         cash basis (i.e. they are ATCF’s)
10
     The Idea of Depreciation
     • Some people think of depreciation as the
       wearing out of capital equipment (your car gets
       old and unreliable)
     • From an accounting viewpoint, depreciation has
       a different interpretation
     • Example: You can by a new TV for $1095 that
       you think will last you 3 years (1095 days).
       What is the daily cost of watching TV?



11
     Depreciation (continued)
     • Depreciation assigns the cost of a capital good
       over the period you receive benefits from it.
     • Warning: The cash flow occurred when you
       bought the TV. If we consider the Depreciation
       Expense as $1 per day for the three years we
       watch TV, we have a depreciation expense each
       day, but not a cash flow each day. We had a
       big negative cash flow the day we bought the
       TV.


12
     Depreciation (continued)
     • When you pay someone wages to work on
       a given day, you take a labor expense that
       day, and you have a cash flow that day.
     • We pay taxes on our profit, not on our
       revenues. We deduct our costs from our
       revenue to determine the profit that we
       are taxed on.


13
     Depreciation (continued)
     • For capital goods, depreciation is a recognized
       expense, but the cash flow occurred in the past
       when the capital good was purchased.
     • When the good was purchased, no tax
       deduction for the expense of the good is
       allowed. Instead, we use depreciation to smear
       out the capital good cost over time. In other
       words, we will get our tax deduction in the
       future in response to a cost (cash flow) incurred
       today.
     • Depreciation expense, thus affects future taxes,
       not current taxes.
14
     Cash Flow and Non-Tax Expenses
     • Accountants charge depreciation to spread a fixed
       asset’s costs over time to match its benefits.

     • Capital budgeting analysis focuses on cash inflows
       and outflows when they occur.

     • Non-cash expenses affect cash flow through their
       impact on taxes – the investment cash flow made
       at time period zero, reduced future taxes when
       you are allowed to take a deduction for the
       depreciation expense.


15
      Depreciation

       Many countries allow one depreciation method for
       tax purposes and another for reporting purposes.

     • Accelerated depreciation methods (such as
       MACRS) increase the present value of an
       investment’s tax benefits.

     • Relative to MACRS, straight-line depreciation
       results in higher reported earnings early in an
       investment’s life.
         For capital budgeting analysis, the depreciation
             method for tax purposes matters most.
16
      Depreciation: 1. Straight Line
      1. Straight Line
                          Investment Cost-Salvage
     Annual Depreciation=
                              Years Of Service
      Example: Purchase a truck for $20,000 that
        you will use for 5 years and then sell for
        $4000
                          20000  4000
     AnnualDepreciation                $3200 / yr
                               5
17
     Depreciation: 2. MACRS
     2. MACRS – Modified Accelerated Cost
       Recovery System
       Investments are classified into MACRS classes such as 3
         year, 5 year, etc.
       When using MACRS, salvage value is not considered
         (implicitly assumed to be zero).
       The annual depreciation percent for each class is stated
         such as shown below for the 3-year asset class.

      Year             1         2         3         4
      Allowance    33.33% 44.44         14.82      7.41
18
     Example MACRS Depreciation
      You purchase a new capital asset that fits into
        the 3 year MACRS class. The cost of the
        asset is $1 million and you believe you can
        sell it for $200,000 after three years of
        service. What is your depreciation expense in
        year 3?

       Year           1     2        3        4
       Allowance   33.33% 44.44    14.82    7.41

      Answer: Year 3 Depreciation
        = $1,000,000 x 0.1482 = 148,200.
19
     Useful Formulas
     Project ATCF = OCF – NWC – Investment
       (Note: These are all ATCF’s)
     OCF = EBIT – Taxes + Depreciation
       (EBIT = Sales – Operating Costs – Depreciation)
       Taxes = t*EBIT, where t = tax rate
     Straight Line (Annual) Depreciation =
       (Investment – Est. Salvage)/Years
     ATCF from Salvage = Salvage – tax
       (Salvage is the Sale Price of salvaged equipment)
       tax = t(Salvage – BookVal) where t= tax rate,
       BookVal = Investment – Accumulated Depreciation

20
     Ex 9.1 ATCF from Salvage
     (Straight Line Depreciation)
       • You purchased a new lawnmower for
         your Landscape business for $5000 that
         you expected to use for 3 years, and
         then sell for $500. After 2 years you
         saw a great deal on another mower so
         you decided to replace your mower,
         and sold your old mower for $1500.
         What is your ATCF from selling your old
         mower (tax rate = 30%)?
21
     Example 9.2 Computing OCF
     • Noble’s Best Doughnuts is considering
       buying a dough machine for $150,000 that
       it will depreciate (straight line) over its
       expected 3 year life. It expects to sell the
       machine for $30,000 at that time.
       Doughnut sales are projected to increase
       $100,000 per year. Operating costs are
       30% of sales. Noble pays a 34% tax on
       its income. What are the incremental
       OCF’s Noble can expect from this project
       over the next 3 years?
22
     Example 9.3 OCF with MACRS
     • Same as 9.1, but use MACRS for computing the
       depreciation, i.e. what are the OCF’s?
      Year           1        2       3        4
      Allowance   33.33%    44.44   14.82    7.41




23
     Example 9.4: NWC simplified
     • Noble’s Best Doughnuts will need
       additional supplies of doughnut mix and
       sprinkles to feed this machine. It
       estimates it will need to keep an additional
       $10,000 of baking supplies on hand during
       the life of the project. What are the
       ATCF’s associated with the change in NWC
       to support this project?

24
     Example 9.5 Investment CF’s
     •  As noted earlier, Noble’s Best Doughnuts
        will invest $150,000 on the new
        doughnut machinery, and expects to sell
        the used machinery after 3 years for
        $30,000.
     1. What is the ATCF from Salvage using
        straight line depreciation?
     2. What is the ATCF from Salvage using
        MACRS?
     3. What are the ATCF’s from investment?
25
     Example 9.6
     •   What will Noble’s pro forma look like for:
         1. Straight Line depreciation
         2. MACRS depreciation
     •   For each case above, what is the IRR of
         the project?




26
     Incremental Cash Flow

        Capital budgeting analysis should include only
                     incremental costs.


     • An example…Should Norman Paul pursue
       an MBA?
       • Norman Paul’s current salary is $60,000 per year and he
         expects it to increase at 5% each year.
       • Norm pays taxes at flat rate of 35%.
       • Sunk costs: $1,000 for GMAT course and $2,000 for
         visiting various programs (IGNORE)
       • Room and board expenses are not incremental to the
         decision to go back to school


27
      Incremental Cash Flow

     • At end of two years assume that Norm receives a salary offer of
       $90,000, which increases at 8% per year
        • Expected tuition, fees and textbook expenses for next two years
           while studying in MBA: $35,000 for 2 years
        • If Norm worked at his current job for two years, his salary would
           have increased to $66,150: $60,000 1.05  $66,150
                                                      2


        • Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
        • After-tax inflow: $23,850 x (1-0.35) = $15,503
        • Yr 3 cash inflow: $90,000 1.08  $60,000 1.053  1  0.35  $18,032
        • MBA has substantial positive NPV value if 30 yr analysis period




                  What about Norm’s opportunity cost?
28
     Opportunity Costs
          Cash flows from alternative investment
       opportunities, forgone when one investment is
                         undertaken.

     If Norm did not attend MBA program, he would have
                           earned:



      First year: $60,000 ($39,000   Second Year: $63,000
               after taxes)          ($40,950 after taxes)



           NPV of a project could fall substantially if
29
              opportunity costs are recognized!
     Capital Rationing
       Can a firm accept all investment projects with
                       positive NPV?

       Reasons why a company would not accept all
                       projects:

        Limited availability of skilled personnel to be
               involved with all the projects;

       Financing may not be available for all projects.

        Companies are reluctant to issue new shares to
     finance new projects because of the negative signal
30          this action may convey to the market.
     Capital Rationing
         Capital rationing: project combination that
       maximizes shareholder wealth subject to funding
                         constraints

         1. Rank the projects using the Profitability Index (PI)
     1. Rank the projects using the Profitability Index (PI)


          2. Select the investment with the highest PI

      3. If funds still available, select the second-highest
          PI, and so on, until the capital is exhausted.

          The steps above helps managers select the
31       combination of projects with the highest NPV.
     Equipment Replacement and
     Unequal Lives
     • A firm must purchase an electronic control device:
        • First alternative is a cheaper device, higher maintenance costs,
          shorter period of utilization
        • Second device is more expensive, smaller maintenance costs,
          longer life span
     • Expected cash outflows:
             Device          0        1      2      3      4
             A           12000     1500   1500   1500      -
             B           14000     1200   1200   1200   1200

         • Maintenance costs are constant over time. Use real discount rate
           of 7% for NPV
             Device         NPV
             A           $15,936
             B           $18,065
       Cash outflow device A < cash outflow device B 
32
                          select A?
     Approach 1: Lowest Common Time
     Frame
                                Year   A       B
     • Each could be            0      12000   14000
       evaluated on a 12        1      1500    1200

       year time table with     2      1500    1200

       the noted CF’s           3      13500   1200
                                4      1500    15200
     • PV of A (@7%             5      1500    1200
       discount rate) is        6      13500   1200
       $48233                   7      1500    1200
                                8      1500    15200
     • PV of B is $42360        9      13500   1200
     • B is cheaper, in a DCF   10     1500    1200
       context, over time       11     1500    1200
                                12     1500    1200
33
     Approach 2: Equivalent Annual
     Cost (EAC)
     • EAC converts lifetime costs to a level annuity; eliminates the
       problem of unequal lives
        • 1. Compute NPV for operating devices A and B for their
          lifetime:
            • NPV device A = $15,936
            • NPV device B = $18,065
        • 2. Compute annual expenditure to make NPV of annuity
          equal to NPV of operating device:

                                  X     X       X
     Device A         $15,936      1
                                         2
                                                           X  $6,072
                                1.07 1.07     1.07 3


                                  Y     Y       Y     Y
     Device B         $18,065      1
                                         2
                                                           Y  $5,333
                                1.07 1.07         3
                                              1.07 1.07 4
34
     Calculator Approach (Device A)
                              Year   CF for A
     •   P/YR = 1
                               0     12000
     •   Enter CF’s
     •   Type 7, press I/YR    1      1500
     •   Press  NPV           2      1500
     •   Press +/-             3      1500
     •   Press PV
     •   Type 3, press N
     •   Press PMT


35
     The Human Face of Capital Budgeting

     • Managers must be aware of optimistic bias in
       these assumptions made by project supporters.

     • Companies should have control measures in place
       to remove bias:
        • Investment analysis should be done by a group
          independent of individual or group proposing
          the project.
        • Project analysts must have a sense of what is
          reasonable when forecasting a project’s profit
          margin and its growth potential.
     • Storytelling: Best analysts not only provide
       numbers to highlight a good investment, but also
36
       can explain why the investment makes sense.
Cash Flow and Capital Budgeting

Certain types of cash flows are common to many
                    investments
Opportunity costs should be included in cash flow
                    projections

  Consider human factors in capital budgeting
38
     Excess Capacity
     • Excess capacity is not a free asset as traditionally
       regarded by managers.
        • Company has excess capacity in a distribution
          center warehouse.
        • In two years, the firm will invest $2,000,000 to
          expand the warehouse.
     • The firm could lease the excess space for
       $125,000 per year for the next two years.
        • Expansion plans should begin immediately in
          this case to hold inventory for stores that will
          come on line in a few months.
        • Incremental cost: investing $2,000,000 at
          present vs. two years from today
        • Incremental cash inflow: $125,000
39
     Excess Capacity
     • NPV of leasing excess capacity (assume 10%
       discount rate):
                                 125,000 2,000,000
     NPV  125,000  2,000,000               2
                                                    $108,471
                                  1.10      1.1
     • NPV negative: reject leasing excess capacity at $125,000 per
       year.
     • The firm could compute the value of the lease that would
       allow break even.
                               X     2,000,000
        NPV  X  2,000,000              2
                                               0
                              1.10      1.1
        • X = $181,818
        • Leasing the excess capacity for a price above $181,818
          would increase shareholders wealth.
40
     Two Methods of Handling
     Depreciation to Compute Cash Flow
      Assume a expenses
     Adding non-cash firm purchases a fixed asset today for
                                    Find after-tax profits, add back
     back to after-tax earnings     non-cash charge tax savings
     Sales            $30,000
                                 $30,000
                                      Sales              $30,000

     Cost of goods    (10,000)          Cost of goods    (10,000)

                                  Pre-tax using
     Plans to depreciate over 3 years income straight-line
      Gross profits $20,000                     $20,000

      Depreciation  (10,000) method (40%)
                                  Taxes         (8,000)

     Pre-tax income   $10,000           Aft-tax income   $12,000
                                   Costs $1/unit
       Firm will
     Taxes (40%)produce
                      (4,000)           Depreciation     $4,000
       10,000 units/year                tax savings
     Net income        $6,000      Sells for $3/unit
                                        Cash Flow        $16,000
     Cash flow        $16,000
     = NI + deprec
                                 a 40% marginal rate
             Firm pays taxes at Simplest and most common technique:
                                Add depreciation back in.
41
     The Initial Investment
     • Initial cash flows:
        • Cash outflow to acquire/install fixed assets
        • Cash inflow from selling old equipment
        • Cash inflow (outflow) if selling old equipment
          below (above) tax basis generates tax
          savings (liability)
                           New equipment costs $10 million,
          An example....        $0.5 million to install

          Tax rate = 40%   Old equipment fully depreciated,
                                  sold for $1 million

         Initial investment: outflow of $10.5 million, and
         after-tax inflow of $0.60 million from selling the
                           old equipment
42
     Working Capital Expenditures
     • Many capital investments require additions to
       working capital.
       • Net working capital (NWC) = current assets –
         current liabilities.
       • Increase in NWC is a cash outflow; decrease a
         cash inflow.

     • An example…
       • Operate booth from November 1 to January 31
       • Order $15,000 calendars on credit, delivery by Nov 1
       • Must pay suppliers $5,000/month, beginning Dec 1
       • Expect to sell 30% of inventory (for cash) in Nov; 60%
         in Dec; 10% in Jan
       • Always want to have $500 cash on hand
43
     Working Capital for Calendar
     Sales Booth
                            Oct 1            Nov 1           Dec 1       Jan 1      Feb 1

     Cash                    $0              $500            $500        $500            $0

     Inventory               0               15,000          10,500      1,500           0

     Accts payable           0               15,000          10,000      5,000           0
     Net WC                  0                500            1,000      (3,000)          0
     Monthly  in WC         NA              +500            +500       (4,000)    +3,000


            Payments and          Oct 1 to       Nov 1 to        Dec 1 to    Jan 1 to
              inventory            Nov 1          Dec 1           Jan 1       Feb 1
            Reduction in             $0             $4,500          $9,000      $1,500
            inventory                               [30%]           [60%]       [10%]
            Payments                 $0          ($5,000)        ($5,000)    ($5,000)

44          Net cash flow           ($500)          ($500)       +$4,000     ($3,000)
     Terminal Value

         Terminal value is used when evaluating an
            investment with indefinite life-span:


                                Forecasts more than 5 to
      Construct cash-flow
                                   10 years have high
      forecasts for 5 to 10
                                   margin of error; use
             years
                                 terminal value instead.

      • Terminal value is intended to reflect the value of
            a project at a given future point in time.
       • Large value relative to all the other cash flows
         of the project.
45
     Terminal Value

         Different ways to calculate terminal values:


           • Use final year cash flow projections and assume that
                 all future cash flow grow at a constant rate;
        • Multiply final cash flow estimate by a market multiple, or
             • Use investment’s book value or liquidation value.


     JDS Uniphase cash flow projections for acquisition of
                          SDL Inc.

         Year 1         Year 2          Year 3         Year 4          Year 5
        $0.5 Billion   $1.0 Billion   $1.75 Billion   $2.5 Billion   $3.25 Billion
46
     Terminal Value of SDL Acquisition
     • Assume that cash flow continues to grow at 5% per
       year (g = 5%, r = 10%, cash flow for year 6 is $3.41
       billion):
                   CFt 1               $3.41
             PVt         , or PV5               $68.2
                   r g              0.10  0.05
     • Terminal value is $68.2 billion; value of entire project is:

       $0.5    $1    $1.75 $2.5 $3.25 $68.2
          1
                2
                        3
                               4
                                      5
                                             5
                                                 $48.67
       1.1    1.1     1.1    1.1    1.1    1.1
        • $42.4 billion of total $48.7 billion from terminal value

     • Using price-to-cash-flow ratio of 20 for companies in the
       same industry as SDL to compute terminal value
        • Terminal Value = $3.25 x 20 = $65 billion
        • Caveat : market multiples fluctuate over time
47
     Initial Investment for Jazz CD
     Project
        Classicaltunes.com is considering adding jazz
                  recordings to its offerings.


        • Firm uses 10% discount rate to calculate NPV and 40%
          tax rate.
        • The average selling price of Classicaltunes CD’s is
          $13.50; price is expected to increase at 2% per year.
        • Sales expected to begin when new fiscal year begins.
                        $50,000 for computer equipment (MACRS 5-
                                          year)
         Initial
      investment           $4,500 for inventory ($2,500 of which
     transactions:                 purchased on credit)


                             $1,000 increase in cash balances
48
     Projections for Jazz CD Proposal
     Abbreviated Project Balance Sheet
      Year                    0      1     2      3      4              5           6
     Year                    0      1     2     3      4            5           6
                         Estimates for 2500
     Annual Cash Flow 1000 $13.77 Classicaltunes.com
     Cash per unit
      Price                                  3000   3200
                        $13.50 2000 $14.05 $14.33 $14.61         3300    3500
                                                                 $14.91 $15.20
     Year
     Accounts
      Units                 0        1       2      3       4         5       6
                            0    4,000 10,000 16,000 26790
                             0 4590 11705 19102        22,000            25,000
                                                                 24,000 31673
                                                                29810
     Receivable
     New Fixed
                       -50000 -10000     -5000 -25000 -40000    -15000 -10000
     Assets
     Inventory           4500 7344 Project Income Statement
                           Abbreviated 18727 30563    42864     47696   50677
     Change in
         Current
      Revenue
     working capital      0
                        5500
                        -3000   55080 32932 52665
                                13934 140454 229221 321482
                                 -6614 -12302 -12771 72855
                                                     -12953     357722
                                                                80806
                                                                 -5109      380080
                                                                            85851
                                                                              -3291
         Assets
      Cost of goods
     Gross P&E            0
                       50000    41861 65000 90000    234682 259349 273657
                                60000 105341 169623 130000 145000 155000
      sold
     Operating cash
     Accumulated         4000    10174  14790 23591 40411    47644  48454
      Gross
     flow profit          0
                       10000    13219                 86800  98374 106422
                                       35114 59597 79952 105160 123672
                                28000 41800 56080
     Depreciation
      SG&A
     Net cash flow    -49000     -6440  -2512 -14180 -12542  27535  35163
     Net P&E              0
                       40000     8262  19664 29799 50048
                                32000 23200 33920     35363 39840
                                                             35772 31328
                                                                    38008
      Expense
     Total assets
      Depreciation     45500
                     10000      45934
                                18000   56132 86585 122903 120646 117179
                                         13800 14280  23872  25208  18512
      Pretax profit   -10000 -13043       1649 15519    27565    37393       49903
     Accounts
                          2500 4320     11016 17978    25214    28057       29810
49   Payable
     Year Zero Cash Flow
     • Initial cash outlay of $50,000 for computer equipment
     • Half-year of MACRS depreciation can be taken in year zero:
        • 20% x $50,000 = $10,000; non cash expense
        • Depreciation expense are deducted from the firm’s classical-
          music CD profits. Savings of $4,000 (40% x $10,000) in taxes
     • Changes in working capital are result of following
       transactions:
        • Purchase of $4,500 in inventory and $1000 cash balance
        • Accounts payable of $2,500 partially finance the $5,500 outlay
        Net Cash Flow:

        Increase in gross fixed assets                 - $50,000
        Change in working capital                       - $3,000
        Operating cash inflow                          + $4,000
        Net cash flow                                  - $49,000
50
     Year One Cash Flow
     • Purchase of additional $10,000 in fixed assets
     • 2nd year depreciation expenses for MACRS 5-year asset
       class is 32%. An additional 20% depreciation deduction for
       assets purchased this year
        • 32% x $50,000 + 20% x $10,000= $18,000
        • Non cash expense; has to be added back when computing cash
          flow for the year
     • Net working capital for year one is:
        • NWC = Current Assets – Current Liabilities = $13,934 - $4,320 =
          $9,614

     NWC  NWCyear1 – NWCyear0  $9,614  $3,000  $6,614
        • Increase in NWC; cash outflow of $6,614


51
     Year One Cash Flow

     • Pretax loss of $13,043 in year 1 of Jazz CD project generates
       tax savings for other operations of Classicaltunes.com.
        • Tax savings = 40% x $13,043 = $5,217
     • Net operating cash inflow = pretax loss + tax savings +
       depreciation
        • Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174

        Net Cash Flow:

        Increase in gross fixed assets              - $10,000
        Change in working capital                     - $6,614
        Operating cash inflow                       + $10,174
        Net cash flow                                 - $6,440

52
     Year Two Cash Flow
     • Purchase of additional $5,000 in fixed assets
        • Assets purchased at the onset of the project have allowable
          depreciation of 19.2% (19.2% x $50,000 = $9,600)
        • An additional 32% depreciation deduction for assets purchased in
          year 1 and 20% depreciation of assets purchased this year
        • Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000=
          $4,200 = $13,800
     • Changes in working capital are result of following
       transactions:
        • Increases in current assets:
            • $500 increase in cash balance
            • $7,115 increase in accounts receivables
            • $11,383 increase in inventory
        • Increase in current liabilities:
            • $6,696 increase in account payables
53
        • Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)
     Year Two Cash Flow

     • Pretax profit in year two is $1,649.
        • The company must pay taxes of $660 (40% x $1,649-- cash
          outflow.
     • Net operating cash inflow = pretax profit + tax + depreciation
        • Operating cash inflow = $1,649 - $660 + $13,800 = $14,789

         Net Cash Flow:

        Increase in gross fixed assets   - $5,000
        Change in working capital        - $12,302
        Operating cash inflow            +$14,790
        Net cash flow                    - $2,512

54
     Terminal Value for Jazz CD
     Investment
      • If we assume that cash flow continue to grow at 2% per
        year (g = 2%, r = 10%,):
     CFt 1  1 g   CFt  1.02  $35,163  $35,866
           CFt 1             $35,866
     PVt         , or PV6               $448,325
           rg               0.10  0.02
      • Second approach used by Classicaltunes.com to compute
        terminal value for the project: use the book value at end of year
        six:
         • Plant and Equipment (P&E) at end of year six is $31,328.
         • The firm liquidates total current assets and pays off current
             debts:
              • $85,850 - $29,810 = $56,040
         • Terminal value = $31,328 + $56,040 = $87,368.
55
     NPV for Jazz CD Project
     • Using assumption that cash flow grow at a steady rate
       past year 6:
                        $6,440 $2,513 $14,180 $12,562
       NPV  $49,000      1
                                      2
                                                3
                                                       4
                                                          
                         1.1        1.1       1.1    1.1
         $27,535 $35,163 $448,325
             5
                     6
                                 6
                                        $213,862
           1.1    1.1         1.1
     • Using book value assumption for terminal value:
                        $6,440 $2,513 $14,180 $12,562
       NPV  $49,000      1
                                     2
                                              3
                                                     4
                                                        
                         1.1       1.1      1.1    1.1
         $27,535 $35,163 $87,368
             5
                     6
                                6
                                     $10,111
           1.1     1.1        1.1
     • NPV is positive with both methods: investing in Jazz CD
       project increases shareholders wealth.
56

				
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