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Lecture 16 Capital Budgeting

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Lecture 16 Capital Budgeting Powered By Docstoc
					16-0                               3/28/02

       Capital Budgeting and                    Lecture
                                                      16
       Project Cash Flow                      Sixth Edition




           Principles of Corporate Finance
             BFIN 351 Sierra Nevada College
                      Lake Tahoe

        Delivered by Mark R. Davidson, MBA
16-1
       Lecture Outline

       • Balance Sheet Model of the Firm – where we are in the course
       • What is Capital Budgeting?
          – A process for making project investment decisions (go / no-go)
             independent of their financing (how you pay for it)
       • Why is it Important?
          – If you do this right it makes you look REALLY smart (and you make
             better decisions)
       • How do we estimate Cash Flows?
          – By looking at all the components of the initial cost and all the
             components of the projected future cash from the project
       • A simple example
       • The Baldwin Company: A more complicated example
       • Summary and Conclusions
16-2
       The Balance-Sheet Model of the Firm
                     The Capital Budgeting Decision

                                                       Current
                                                      Liabilities
          Current Assets
                                                      Long-Term
                                                        Debt


          Fixed Assets        What long-
                              term
           1 Tangible         investments         Shareholders’
           2 Intangible       should the             Equity
                              firm engage
                              in?
16-3
       The Balance-Sheet Model of the Firm
               The Capital Structure (Financing) Decision

                                                      Current
                                                     Liabilities
          Current Assets
                                                     Long-Term
                           What sources                Debt
                           should the firm
                           use to raise
          Fixed Assets     money for
           1 Tangible      investments?
                                                    Shareholders’
           2 Intangible                                Equity
16-4   Capital Budgeting Considers Project Type, Project
       Classification, and Decision Process

       Project Type
          independent project
          mutually exclusive
       Project Classification
          growth
          cost reduction
          legal requirements
       Decision Process
          What do we want to do?                           (generating a proposal)
          How much will it cost / what are the benefits?   (estimating cash flows)
          Which project should we pick?                    (evaluating alternative projects)
          How did we do?                                   (performance evaluation)
16-5   Capital Budgeting is Important Because People
       Aren’t Very Good at it.
       • 67% of fortune 500 firms surveyed generate cash flow
         estimates for capital purchase decisions
       • That means that 1/3 of Fortune 500 firms do not generate
         cash flow estimates for capital purchase decisions!
       • Of the companies who use any cash flow estimates in capital
         budgeting, nearly HALF of their projects do not use this
         rigorous process
       • Who estimates cash flows and conducts this analysis?
          – Typically YOU if you want your project approved
          – (some companies have dedicated analysts but not many –
             not enough!)
16-6   You need accurate numbers to make good Capital
       Budgeting decisions using NPV
          Calculating NPV for a project requires:

          •    Cash Flow Estimates
          •    Discount Rate (cost of capital)

          Note: We will make sure you understand cost of capital and we will get into how to
               calculate it. This is a very important concept… but we’ll go through that in a
               different lecture
16-7
       How do we Estimate Cash Flows?

       • Cash Flow Estimating seems Complicated, but its methodical and VERY
         Important

       • Cash flows matter—not accounting earnings.
          – Much of the work in evaluating a project lies in taking accounting
            numbers and generating cash flows
          – Consider depreciation expense (You never write a check made out to
            “depreciation”)

       • Cash Flows must be considered:
          – in discrete periods (incremental cash flows)
          – after taxes
          – independent of sunk costs
          – inclusive of opportunity costs (alternative uses for resources) and
            indirect costs (but be careful of bogus overhead charges)
          – Inflation matters.
16-8
       Incremental Cash Flows

       • Sunk costs are not relevant
          – Just because “we have come this far” does not mean that
            we should continue to throw good money after bad.
       • Opportunity costs do matter. Just because a project has a
         positive NPV that does not mean that it should also have
         automatic acceptance. Specifically if another project with a
         higher NPV would have to be passed up we should not
         proceed.
       • Indirect costs matter.
          – Erosion and cannibalism are both bad things. If our new
            product causes existing customers to demand less of
            current products, we need to recognize that. We also need
            to be sure the project is not saddled with inappropriate
            overhead charges
16-9
       Estimating Cash Flows

       • Cash Flows from Operations
          – Recall from accounting that:
          Operating Cash Flow = EBIT – Taxes + Depreciation
       • Net Capital Spending
          – Don’t forget salvage value (after tax, of course).
       • Changes in Net Working Capital
          – Recall that when the project winds down, we enjoy a
            return of net working capital.
16-10   Initial Cash Out Flow is called your Net
        Investment
        CF0 (Net Investment) for the purchase of a new snow grooming machine is:

        Cost of the grooming machine:                             $100
        Plus cost of shipping and assembly (no installation):      $10
            Installed Cost:                                       $110
        Plus increase in initial working capital:                   $0
        Minus Proceeds from sale of old grooming machine:          $10
            Net Investment Before Tax Impact                      $100
        Plus Tax on gain from sale of old grooming machine
                                                     ($10x40%):     $4
            CF0 (Net Investment for new machine):                 $104
16-11   We Consider the Incremental Contribution of
        Cash Flows for Our Project

        Net Cash Flows =
           (+) D Operating Earnings After Taxes
           (+) D Depreciation
           (+/-) D Net Working Capital

        Note: Depreciation and NWC are accounting impacts for the project
            – When depreciation increases, after tax earnings increase because
               depreciation lowers pre-tax earnings and therefore lowers taxes
            – When a project involves changing the timing of receipts or payments there is
               a change in Net Working Capital – theoretically this is all reconciled by the
               end of the project
16-12   Salvage Value for a Project May Have
        Significant Tax Consequences
        • Salvage Value is typically considered a Cash Flow in the
          Final Period
        • sale @ book value means the project assets are fully
          depreciated so there is no tax consequence
        • Sale < book value implies an operating loss that will
          decrease taxes
        • Sale > book value implies operating income that will
          increase taxes
        • Sale > original cost implies operating income AND a capital
          gain which will also increase taxes
16-13   Projects Result in Change. Positive Cash Flow
        Change Results in Increased Earnings


                Impact of New Grooming Machine   Year 1 (CF1)   Year 2 (CF2)   Year 3 (CF3)   Year 4 (CF4)
                            Purchase

          (+)             D Revenue                  $80            $90           $100           $100

          (-)          D Operating Cost              $10            $11            $12            $13

          (-)           D Depreciation               $25            $25            $25            $25

          (=)             DOEBT                      $45            $54            $63            $62

          (-)              D Taxes                   $18           $21.6          $25.2          $25.2

          (=)             D O EAT                    $27           $32.4          $37.8          $36.8

          (+)           D Depreciation               $25            $25            $25            $25

          (+)              D NWC                     $0             $0             $0             $0

          (+)          After Tax Salvage              -              -              -             $0

                    Net Cash Flows (CF1-4)           $52           $57.4          $62.8          $61.8
16-14   The Future is Uncertain.
        AND Cash Flow Estimates Are Uncertain
        Accuracy is important:
           confirm revenue assumptions with marketing
           confirm cost assumptions with operations
           confirm financial assumptions with accounting


        We account for uncertainty in a variety of ways:
           adjusting the discount rate (cost of capital) for uncertainty (risk)
           conducting sensitivity and scenario analysis
16-15
        The Baldwin Company: An Example
         Costs of test marketing (already spent): $250,000.
         Current market value of proposed factory site (which we
         own): $150,000.
         Cost of bowling ball machine: $100,000 (depreciated
         according to ACRS 5-year life).
         Increase in net working capital: $10,000.
         Production (in units) by year during 5-year life of the
         machine: 5,000, 8,000, 12,000, 10,000, 6,000.
         Price during first year is $20; price increases 2% per year
         thereafter.
         Production costs during first year are $10 per unit and
         increase 10% per year thereafter.
         Annual inflation rate: 5%
         Working Capital: initially $10,000 changes with sales.
16-16   The Worksheet for Cash Flows of the Baldwin
        Company
                              ($ thousands) (All cash flows occur at the end of the year.)
                                                   Year 0          Year 1         Year 2         Year 3          Year 4 Year 5
        Investments:
        (1) Bowling ball machine                   –100.00                                                                   21.76*
        (2) Accumulated                                            20.00          52.00          71.20           82.72        94.24
            depreciation
        (3) Adjusted basis of                      80.00           48.00          28.80          17.28           5.76
            machine after
            depreciation (end of year)
        (4) Opportunity cost                       –150.00                                                                   150.00
            (warehouse)
        (5) Net working capital                        10.00        10.00         16.32          24.97           21.22               0
            (end of year)
        (6) Change in net                            –10.00                       –6.32           –8.65          3.75         21.22
            working capital
        (7) Total cash flow of                     –260.00                         –6.32          –8.65          3.75        192.98
            investment
            [(1) + (4) + (6)]
           * We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between
           ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less
           depreciation. The capital gain is $24,240 (= $30,000 – $5,760). We will assume the incremental corporate tax for Baldwin on
           this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 [0.34 
           ($30,000 – $5,760)]. The after-tax salvage value is $30,000 – [0.34  ($30,000 – $5,760)] = 21,760.
16-17   The Worksheet for Cash Flows of the Baldwin
        Company
                             ($ thousands) (All cash flows occur at the end of the year.)

                                         Year 0      Year 1     Year 2     Year 3      Year 4   Year 5
        Investments:
        (1) Bowling ball machine         –100.00                                                21.76*
        (2) Accumulated                              20.00      52.00      71.20       82.72     94.24
            depreciation
        (3) Adjusted basis of            80.00       48.00      28.80      17.28       5.76
            machine after
            depreciation (end of year)
        (4) Opportunity cost             –150.00                                                150.00
            (warehouse)
        (5) Net working capital             10.00    10.00      16.32      24.97       21.22            0
            (end of year)
        (6) Change in net                 –10.00                –6.32       –8.65      3.75      21.22
            working capital
        (7) Total cash flow of           –260.00                 –6.32      –8.65      3.75     192.98
            investment
            [(1) + (4) + (6)]


           At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
16-18   The Worksheet for Cash Flows of the Baldwin
        Company (continued)
                         ($ thousands) (All cash flows occur at the end of the year.)


                                          Year 0      Year 1     Year 2     Year 3      Year 4   Year 5
          Income:
           (8) Sales Revenues                         100.00     163.00     249.72      212.20 129.90




          Recall that production (in units) by year during 5-year life of the machine is
          given by:
          (5,000, 8,000, 12,000, 10,000, 6,000).
          Price during first year is $20 and increases 2% per year thereafter.
          Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.
16-19   The Worksheet for Cash Flows of the Baldwin
        Company (continued)
                         ($ thousands) (All cash flows occur at the end of the year.)


                                          Year 0      Year 1     Year 2     Year 3      Year 4   Year 5
          Income:
           (8) Sales Revenues                         100.00     163.00      249.72  212.20 129.90
           (9) Operating costs             50.00       88.00     145.20     133.10 87.84




        Again, production (in units) by year during 5-year life of the machine is given
        by:
        (5,000, 8,000, 12,000, 10,000, 6,000).
        Production costs during first year (per unit) are $10 and (increase 10% per
        year thereafter).
        Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
16-20   The Worksheet for Cash Flows of the Baldwin
        Company (continued)
                         ($ thousands) (All cash flows occur at the end of the year.)


                                          Year 0      Year 1     Year 2     Year 3      Year 4   Year 5
          Income:
           (8) Sales Revenues                         100.00     163.00      249.72  212.20 129.90
           (9) Operating costs             50.00       88.00     145.20     133.10 87.84
          (10) Depreciation                20.00       32.00      19.20       11.52 11.52



         Depreciation is calculated using the Accelerated            Year        ACRS %
         Cost Recovery System (shown at right)                           1       20.00%
                                                                         2       32.00%
         Our cost basis is $100,000
                                                                         3       19.20%
         Depreciation charge in year 4                                   4       11.52%
         = $100,000×(.1152) = $11,520.                                   5       11.52%
                                                                         6       5.76%
                                                                         Total   100.00%
16-21   The Worksheet for Cash Flows of the Baldwin
        Company (continued)
                         ($ thousands) (All cash flows occur at the end of the year.)


                                        Year 0     Year 1     Year 2      Year 3        Year 4   Year 5
        Income:
         (8) Sales Revenues                        100.00     163.00      249.72         212.20 129.90
         (9) Operating costs                        50.00      88.00      145.20        133.10 87.84
        (10) Depreciation                           20.00      32.00       19.20          11.52 11.52
        (11) Income before taxes                    30.00      43.20       85.32          67.58 30.54
             [(8) – (9) - (10)]
        (12) Tax at 34 percent                      10.20       14.69      29.01         22.98   10.38
        (13) Net Income                             19.80       28.51      56.31         44.60   20.16
16-22   Incremental After Tax Cash Flows
        of the Baldwin Company
                           Year 0   Year 1    Year 2    Year 3    Year 4    Year 5

         (1) Sales                  $100.00   $163.00   $249.72   $212.20   $129.90
         Revenues
         (2) Operating               -50.00    -88.00   -145.20    133.10    -87.84
         costs
         (3) Taxes                   -10.20    -14.69    -29.01    -22.98    -10.38

         (4) OCF                      39.80     60.51     75.51     56.12     31.68
         (1) – (2) - (3)
         (5) Total CF      –260.                –6.32     –8.65      3.75    192.98
         of Investment
         (6) IATCF         –260.      39.80     54.19     66.86     59.87    224.66
         [(4) + (5)]


                        $39.80 $54.19 $66.86 $59.87 $224.66
          NPV  -$260 +        +      2
                                        +    3
                                               +     4
                                                       +
                         (1.10) (1.10) (1.10) (1.10)     (1.10)5
          NPV  $51,588.05
16-23
        Summary and Conclusions

        • Capital budgeting is used in making good large-scale
          business decisions
        • We typically employ the NPV decision rule using accurate
          cash flow estimates and discount rates
        • Cash flows must be estimated
           – on an incremental basis.
           – Sunk costs are ignored
           – Opportunity costs and indirect costs matter

        • Homework Assignment:
           – Chapter 7 problems: 7.1, 7.2, 7.3, 7.7

				
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