Chapter 10 - PowerPoint Presentation by mifei

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									Cash Flows and Other Topics
in Capital Budgeting


         Chapter 10
Principles Used in this Chapter

   Principle 3:
       Cash – Not Profits –Is King
   Principle 4:
       Incremental Cash Flows – It’s Only What
        Changes That Counts.



                   Keown, Martin, Petty - Chapter 10   2
Incremental Cash Flows

   Decision makers must consider what new
    cash flows the company as a whole will
    receive if the company takes on a given
    project.
   Only incremental after-tax cash flows matter.




                  Keown, Martin, Petty - Chapter 10   3
 Ten 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.
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.

                         Keown, Martin, Petty - Chapter 10         4
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.




                  Keown, Martin, Petty - Chapter 10   5
Incremental cash flows
   Further, 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.


                  Keown, Martin, Petty - Chapter 10   6
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 flow.

                  Keown, Martin, Petty - Chapter 10   7
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 a synergistic effect and is a
    relevant cash flow.




                   Keown, Martin, Petty - Chapter 10     8
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.




                 Keown, Martin, Petty - Chapter 10   9
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:
    1.   Will this cash flow occur if the project is accepted?
    2.   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.

                         Keown, Martin, Petty - Chapter 10       10
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.




                  Keown, Martin, Petty - Chapter 10   11
Overhead Costs
   Incremental overhead costs or costs that were
    incurred as a result of the project and
    relevant to capital budgeting must be
    included.
   Note, not all overhead costs may be relevant
    (for example, the utilities bill may have been
    the same with or without the project).


                  Keown, Martin, Petty - Chapter 10   12
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.


                  Keown, Martin, Petty - Chapter 10   13
Free Cash Flow Calculations
Three components of free cash flows:

  1.   Initial outlay

  2.   Annual free cash flows over the
           project’s life

  3.   Terminal cash flow
                  Keown, Martin, Petty - Chapter 10   14
Initial Cash Outlay
   The immediate cash outflow necessary to
    purchase the asset and put it in operating
    order.

   May include: Purchase cost, Set-up cost,
    Installation, Shipping/Freight, increased working-
    capital requirements, tax implications (if the project
    replaces an existing project/asset)


                     Keown, Martin, Petty - Chapter 10       15
    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

                           Keown, Martin, Petty - Chapter 10     16
Annual Free Cash Flows

   Annual free cash flow is the incremental after-
    tax cash flow resulting from 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

                     Keown, Martin, Petty - Chapter 10   17
Calculating Operating Cash Flows

Step 1: Measure the project’s change in
 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).
                   Keown, Martin, Petty - Chapter 10      18
Calculating Operating Cash Flows:
Depreciation & 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


                     Keown, Martin, Petty - Chapter 10            19
Calculating Operating Cash Flows:
Depreciation & Cash Flow
   ==> Depreciation is a “non-cash
    expense” BUT affects Cash Flow through
    its impact on “taxes”;

   Depreciation ==> in Expense
                 ==>  in taxes
                 => CF

               Keown, Martin, Petty - Chapter 10   20
Calculating Operating Cash Flows:
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.

                Keown, Martin, Petty - Chapter 10   21
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.


                Keown, Martin, Petty - Chapter 10   22
Calculating Operating Cash Flows:
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


                Keown, Martin, Petty - Chapter 10   23
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.


                 Keown, Martin, Petty - Chapter 10   24
Example: page 305




         Keown, Martin, Petty - Chapter 10   25
Keown, Martin, Petty - Chapter 10   26
Keown, Martin, Petty - Chapter 10   27
 Options in Capital Budgeting
Options add value to capital budgeting projects.
Some common options are:

  1.   Option to delay a project
  2.   Option to expand a project
  3.   Option to abandon a project




                  Keown, Martin, Petty - Chapter 10   28
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.




                    Keown, Martin, Petty - Chapter 10     29
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.




                  Keown, Martin, Petty - Chapter 10   30
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,
    the project that is easier to abandon may be
    more desirable (example, temporary versus
    permanent workers, lease versus buy).



                    Keown, Martin, Petty - Chapter 10     31
Risk and Capital Budgeting
Decisions
Two main issues:
1.   What is risk and how should it be
     measured?
2.   How should risk be incorporated into a
     capital budgeting analysis?




                Keown, Martin, Petty - Chapter 10   32
Three perspectives on risk
   Project standing alone risk

   Contribution-to-firm risk

   Systematic risk



                Keown, Martin, Petty - Chapter 10   33
Project Standing Alone Risk

   A project’s risk, ignoring the possibility
    that much of the risk will be diversified
    away as the project is combined with
    other projects and assets.




                 Keown, Martin, Petty - Chapter 10   34
Contribution-to-Firm Risk
   This is the amount of risk that the project
    contributes to the firm as a whole.

   This measures the project’s risk considering
    the diversification away of risk, but ignores
    the effects of diversification on the firm’s
    shareholders.


                  Keown, Martin, Petty - Chapter 10   35
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.
                   Keown, Martin, Petty - Chapter 10   36
    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.

                   Keown, Martin, Petty - Chapter 10   37
Incorporating Risk into
Capital Budgeting
   We know that investors demand higher
    returns for riskier 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).
                 Keown, Martin, Petty - Chapter 10   38
Measurement of Systematic Risk
   Estimating the 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:
      1.   Accounting Beta
      2.   Pure Play Method
      3.   Simulation
      4.   Scenario Analysis
      5.   Sensitivity Analysis


                     Keown, Martin, Petty - Chapter 10   39
Accounting Beta

   Can be estimated via time-series regression
    on a division’s return on assets on the market
    index




                  Keown, Martin, Petty - Chapter 10   40
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.




                  Keown, Martin, Petty - Chapter 10   41
Simulation
   Involves the process of imitating the
    performance of the project under evaluation
    (See figure 10-6).
       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.


                      Keown, Martin, Petty - Chapter 10     42
Scenario Analysis

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




                  Keown, Martin, Petty - Chapter 10   43
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. (What-if
    analysis.)




                   Keown, Martin, Petty - Chapter 10   44

								
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