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Capital Budgeting Cash Flows Inflation

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					         Capital
       Budgeting                 7
       Cash Flows

       Corporate Financial Management 3e
             Emery Finnerty Stowe
10-1
              Chapter Outline

       7.1 An Overview of Estimating
           Cash Flows
       7.2 Calculating Incremental Cash
           Flows
       7.3 An Example of Incremental
           Cash Flow Analysis
       7.4 Inflation


10-2
        7.1 An Overview of Estimating
                 Cash Flows
       • Costs and benefits are measured in
         terms of cash flow—not income.
       • Cash flows are incremental
         (marginal).
         – The cash flows with the project minus
           the cash flows without the project.
       • Cash flows are after tax.
       • Cash flow timing affects the project’s
         value.
       • Financing costs are included in the
         cost of capital.
10-3
             Tax Considerations
       • Taxes and the timing of tax
         payments significantly affect the
         incremental cash flows. The
         relevant tax rate is the firm’s
         marginal tax rate, T.
       • Revenues, represented by R,
         increase tax liability by TR. When
         the revenue and the tax treatment
         occur simultaneously, the after-tax
         cash flow is the revenue minus the
         tax liability:
         after-tax revenue cash flow = R – TR
                                     = (1 – T) R

10-4
              Tax Considerations
       • Less obvious is that expenses, represented
         by E, reduce tax liability.
       • When the revenue and the tax treatment
         occur When the expense and the tax
         treatment occur simultaneously, the
         algebraic signs carry through and the
         after-tax cash flow is minus the expense
         plus the reduced tax liability:

         after-tax expense cash flow   =–E+T E
                                       = – (1 – T) E




10-5
       • In some cases the cash flow and tax
         treatment are separated. This
         complicates the analysis.
       • The most common situation where
         they are separated is when an asset
         is capitalized (depreciated).
       • Let I0 be a net expenditure to be
         capitalized, and Dt be its
         depreciation expense to be claimed
         in year t.
       • The ―separated‖ incremental after-
         tax cash flow for each depreciation
         expense is +T Dt. (This is just like
         the +T E for an expense.)

10-6
             Tax Considerations
       With depreciation, the stream of after-
         tax incremental cash flows for the
         expenditure, I0, are then:
                   t     0      1    2    3
             . . .
                   CF -I0      TD1 TD2 TD3
             . . .
       The sum of the Dts equals I0. So the
         total amount of tax reduction is T(I0 )
         whether you depreciate or expense
         the item.

10-7
       Suppose you pay $1,000 for an asset. If
         capitalized, depreciation would be
         straight-line to zero over 4 years, 250
         per yr. With a tax rate of 40%, that’s
         100 per yr. after-tax.
       Time     0        1   2       3     4
       Depr.    0       250 250     250   250
        ATCF -1,000     100 100     100   100
       If expensed: -600 0 0         0     0
         Which set of cash flows is preferred?




10-8
             Tax Considerations
       • The difference between expensing
         and depreciating—and between
         alternative tax treatments in most
         cases, then, is because of the time
         value of money.
       • If you have a choice, expense rather
         than capitalize—because of the time
         value of money.
       • Unfortunately, you rarely have a
         choice!

10-9
          7.2 Calculating Incremental
                  Cash Flows
        • Net initial investment outlay.
        • Future net operating cash flows.
        • Non-operating cash flows required to
          support the initial investment outlay.
          – E.g., cash flows associated with a major
            overhaul.

        • Net salvage value received upon
          termination of the project.

10-10
         Net Initial Investment Outlay

        • Cash expenditure.

        • Changes in net working capital.
        • Net cash flow from sale of old
          asset (if any).
        • Investment tax credits.



10-11
                Cash Expenditure
        • Let I0 be the net expenditure to be
          capitalized, E0 be the net
          expenditure to be expensed
          immediately, and T be the firm’s
          marginal tax rate.

        • Cash expenditure = – I0 – E0 + T E0
                             = – I0 – (1 – T) E0



10-12
        Changes in Net Working Capital
        • At the start of a project, an
          investment of net working capital
          may be required.
          –   Operating cash
          –   Inventory
          –   Accounts receivable
          –   But, an increase in accounts payable
              offsets some of the net working capital
              needs.
        • A project could also reduce the net
          working capital requirements.
          – Asset replacement

10-13
        Net Cash Flow from Sale of
                Old Asset
        • If an existing asset is being replaced
          by a new one, the sale of the old
          asset may generate a cash flow.
        • If the selling price is greater than
          the net book value of the old asset,
          taxes will have to be paid on this
          sale.
        • If the selling price is less than the
          net book value of the old asset, a
          tax credit is generated.

10-14
        Net Cash Flow from Sale of Old
                    Asset
   • Let S0 be the selling price of the old asset, and
     B0 be its net book value.
   • Taxes on the sale will be T (S0 – B0). So the net
     cash flow from sale of old asset is:


                    S0 - T (S0 – B0)




10-15
               Net Initial Outlay

   • Let C0 be the net initial outlay. Let DW be the
     change in the net working capital. Let Ic be the
     investment tax credit. Then,


   C0 = – I0 – DW – (1 – T) E0 + S0 – T(S0 – B0) + Ic




10-16
          Net Operating Cash Flow
   • Let DR be the change in periodic revenue and
     DE be the change in periodic expenses
     associated with the project. Let DD be the
     change in the periodic depreciation expense.

   • The Net Operating Cash Flow After Tax (CFAT)
     is given by




10-17
          Net Operating Cash Flow

        CFAT = DR - DE - Tax liability
               = DR - DE - T(DR - DE - DD)

        CFAT = (1 - T)(DR - DE) + TDD

    CFAT = after-tax operating income
                     + tax credit on depreciation


10-18
              Net Operating Cash Flow

    • Alternatively, by rearranging the terms, we can
      rewrite CFAT as:

    CFAT = (1 - T)(DR - DE - DD) + DD
          = after-tax net income + depreciation

    Note that there is no interest expense, and this
      ―after-tax net income‖ is not from an accounting
      income statement.

10-19
          Non-Operating Cash Flows
   • These are treated in the same way as the initial
     cash expenditure.
   • The expensed non-operating cash flows are
     multiplied by (1 - T) to adjust for taxes,
     because the cash flow and tax treatment occur
     simultaneously.
   • Capitalized non-operating cash flows create a
     cash outflow when they occur, but only in
     subsequent years does the tax treatment create
     the depreciation tax shields.


10-20
                Net Salvage Value
   • Let S be the selling price of the asset and B its
     book value. Let REX be the cleanup and
     removal expenses (to be expensed) and DW the
     net working capital recovered upon termination
     of the project.

   • Net salvage value =
              = S - T(S - B) - (1 - T)REX + DW



10-21
    10.3 An Example of Incremental Cash
               Flow Analysis
   • See handout on Perma-Filter Co.,
     attached as speaker notes.




10-22
        Perma-Filter: By-Item Cash Flows

    • Net expenditure to be capitalized is
      I0 = 5,100,000 + 400,000 = $5,500,000
           after-tax CF = -$5,500,000
    • Installation cost to be expensed immediately
      is E0 = $200,000, after-tax CF = -$120,000
    • The replacement requires an investment in
      net working capital:
        – Inventory increase - Accounts Payable increase
        – = 40,000 - 25,000 = $15,000
          after-tax CF = -$15,000
10-23
        Perma-Filter: By-Item Cash Flows

    • Annual depreciation on the old machine is
          (3,000,000 - 0)/10 = $300,000/yr
    • Therefore, the current net book value is
      3,000,000 - 5(300,000) = $1,500,000 = B0
    • Selling price of old machine is $1,750,000 = S0
    • Taxes on the difference are $100,000, so the
      after-tax CF for the old machine is $1,650,000
    • There is no investment tax credit, Ic = 0


10-24
         Perma-Filter: By-Item Cash Flows

   • Annual depreciation expense on the new
     machine is
        (5,500,000 - 350,000)/10 = $515,000/yr
        after-tax CF is $206,000/yr, years 1-10
   • In the first five years after the replacement,
     the firm ―loses‖ the depreciation expense on
     the old machine, after that, depreciation on
     the old machine (if kept) would be $0.


10-25
        Perma-Filter: By-Item Cash Flows

   • Recall that annual depreciation on the old
     machine is $300,000/yr. Therefore, there will be
         lost after-tax CF = -$120,000/yr, years 1-5
   • Sales do not increase, and DR = 0.
   • Cash expenses decline, so DE = -$1,200,000/yr,
     giving after-tax CF savings = $720,000/yr, years
     1-10.


10-26
        Perma-Filter: By-Item Cash Flows

   • The new machine is expected to be sold for
               S = $300,000
   • But will have a net book value at that time
     of        B = $350,000
   • The difference creates a tax credit, so the
     after-tax CF = $320,000
   • Removal expenses will be REX = -$150,000,
     and after-tax CF = -$90,000
   • Net working capital (recovered) will be an
         after-tax CF = $15,000
10-27
                  Net Present Value


        See handout on NPV calculation, attached as
        speaker notes.




10-28
             Adding Value per Share

    • The replacement project will create value because the NPV is
      positive. How much value would the project add to each share?

    • With 500,000 shares outstanding, making the replacement will
      add about $1.79 to each share’s value:

           893,417 / 500,000 = $1.79 per share

    • NOTE: It is very important to understand that this does not
      mean the stock price will increase by this amount when the
      project is undertaken. Stock prices are based on expectations.
      The stock price could increase by less because the project was
      partially anticipated. It could also not change because the
      project was fully anticipated, or even fall because the project
      produces less value than had been expected.


10-29
        The Internal Rate of Return (IRR)

   • The IRR is the discount rate that makes
     the NPV equal to zero.
   • For Perma-Filter’s replacement project,
                   IRR = 16.95%




10-30
                    NPV Profile - Perma-Filter Co.
                    $6,000


                    $5,000
NPV ($ thousands)




                    $4,000


                    $3,000


                    $2,000


                    $1,000


                       $-
                               0%   5%       10%         15%   20%   25%

                    $(1,000)

                                         Discount Rate
                    $(2,000)
            New Project Side Effects

    • Innovation can result in the erosion of one or
      more existing products.
        – Sales reduction
        – Decline in market value of existing facilities.
    • Innovation can also lead to enhancement of
      existing and future products and services.
        – Expanding one product line can stimulate sales of
          another. (service contracts).
    • Both erosion and enhancement must be
      incorporated into a capital budgeting analysis.
10-32
                      10.4 Inflation
   • Inflation affects the project’s expected cash
     flows.
        – Effect on revenues
        – Effect on expenses
   • Inflation also affects the cost of capital.
        – The higher the expected inflation, the higher the
          return required by investors.
   • So the effects of inflation must be properly
     incorporated in the NPV analysis.


10-33
        Effect of Inflation on the Cost of
                      Capital
   • Notation:
     rr = cost of capital in real terms
     rn = cost of capital in nominal terms
     i = expected annual inflation rate
              (1 + rn) = (1 + rr) (1 + i)

                   rn = rr + i + irr

10-34
        Effect of Inflation on the Cost of
                      Capital
   • Inflation increases the nominal amounts
     of both revenues and expenses, even
     though their real values may stay the
     same.
   • However, depreciation expense is fixed.
     It is based on historical cost.
        – Therefore, inflation decreases the real value
          of depreciation tax credits.


10-35
        Effect of Inflation on the Cost of
                      Capital
   • If expected future cash flows are given in
     nominal terms, then we must use the
     nominal cost of capital to calculate their
     present value.
   • If expected future cash flows are given in
     real terms, we must use the real cost of
     capital to calculate their present value.



10-36
               Inflation and NPV

   Wildcat Washer Works (WWW) is evaluating a
   new project that costs $120,000. It has a life of
   3 years and no salvage value. Annual revenues,
   less operating expenses (excluding depreciation)
   are $65,000 per year in real dollars. WWW will
   use straight line depreciation to a zero book
   value over 3 years. Its marginal tax rate is 40%.
   The real cost of capital is 10% and inflation is
   expected to be 8% per year.
   Compute the NPV of the project in real and in
   nominal dollars.
10-37
             NPV in Real Dollars
   • Annual after-tax revenues (less expenses),
     in real dollars are 65,000(1- 0.40) =
     $39,000 per year.
   • Annual depreciation expense (in nominal
     dollars) is (120,000 - 0)/3 = $40,000 per
     year.
   • Annual depreciation tax credit (in
     nominal dollars) is 40,000(0.40) = $16,000
     per year.
10-38
               NPV in Real Dollars

    • In real dollars, the first year’s depreciation tax
      credit is worth 16,000/(1.08) = $14,815.
    • In real dollars, the second year’s depreciation
      tax credit is worth 16,000/(1.08)2 = $13,717.
    • In real dollars, the third year’s depreciation
      tax credit is worth 16,000/(1.08)3 = $12,701.
    • The annual after-tax cash flow is the after tax
      revenues (less expenses) plus the depreciation
      tax credit.
10-39
                NPV in Real Dollars

   Time Item            BTCF    ATCF       PV@10%

   0     Initial inv.   -120    -120       -120
   1-3   Net rev.       65/yr   39/yr      96.987
   1     Depr.          0       14.815     13.468
   2     Depr.          0       13.717     11.336
   3     Depr.          0       12.701      9.543
                                    NPV=   11.334




10-40
          NPV in Nominal Dollars
   • Annual depreciation expense (in nominal
     dollars) is (120,000 - 0)/3 = $40,000 per
     year.
   • Annual depreciation tax credit (in
     nominal dollars) is 40,000(0.40) = $16,000
     per year.




10-41
           NPV in Nominal Dollars

    • In nominal dollars, revenues net of expenses in
      year 1 are 65,000(1.08) = $70,200.
    • After-tax net revenues = 70,200(1-0.4) =
      $42,120.
    • In nominal dollars, revenues net of expenses in
      year 2 are 65,000(1.08)2 = $75,816
    • After-tax net revenues = 75,816(1-0.4) =
      $45,490.
    • After-tax net revenues in year 3 are $49,129.
10-42
          NPV in Nominal Dollars
   • The nominal cost of capital is:
           rn = rr + i + (i)rr
            = 0.10 + 0.08 + (0.08)(0.10)
            = 0.188
           rn = 18.80%




10-43
               NPV in Nominal Dollars

    Time Item                   BTCF     ATCF        PV@18.8%

    0         Initial inv.      -120     -120        -120
    1-3       Depr.             0/yr     16/yr       34.347
    1         Net rev.          70.200   42.120      35.454
    2         Net rev.          75.816   45.490      32.232
    3         Net rev.          81.881   49.129      29.301
                                             NPV=    11.334


        NOTE:           34.347 = 13.468 + 11.336 + 9.543
        And             35.454 + 32.232 + 29.301 = 96.987
10-44
                                NPV

   Time Item            BTCF ATCF         PV

   0     Initial inv.   -120     -120     -120
   1-3   Net rev.       65/yr    39/yr    96.987 @ 10%
   1-3   Depr.          0        16/yr    34.347 @ 18.8%

                                     NPV= 11.334




10-45
         Inflation and NPV Analysis
   • The NPV of the project is unchanged as
     long as the cash flows and the cost of
     capital are expressed in consistent terms.

   • If inflation is expected to affect revenues
     and expenses differently, these
     differences must be incorporated in the
     analysis.

10-46
                  Summary

   • This chapter describes the critical
     problem of estimating a capital budgeting
     project’s incremental cash flows.
   • We want to leave you with one final
     observation:
   The accuracy of the estimates used in
     capital budgeting is critically
     important.

10-47

				
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