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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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