Chap 010
Chap 010
Chap 010
10-1
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
10-2
Chapter Outline
10-3
Capital Budgeting and
Cash Flows
In the previous chapter we
focused on multiple techniques
of capital budgeting to evaluate
projects.
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Project Example - Visual
R = 12%
1 2 3
10-6
Relevant Cash Flows
• The cash flows that should be
included in a capital budgeting
analysis are those that will only
occur (or not occur) if the project is
accepted
• These cash flows are called
incremental cash flows
• The stand-alone principle allows us
to analyze each project in isolation
from the firm simply by focusing
on incremental cash flows
10-7
Relevant Cash Flows
Ex: Company A is considering engaging in a project.
- The project will require a land lot which was bought
by the company 2 years ago at the price of 3 billion
dong.
- The current price of the land lot is 4 billion dong.
- In order to protect the land, the company built a
hurdle around the border of the land lot. The cost of
building the hurdle is 100 mil dong.
- If company A accepts the project, the hurdle will be
removed. The cost of removing the hurdle is 30 mil
dong.
- Things obtained from removing the hurdle can be
liquidated at the price of 15 mil dong.
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What are the relevant cash flows?
Asking the Right Question
You should always ask yourself: “Will this cash
flow occur ONLY IF we accept the project?”
• If the answer is “yes,” it should be included in the
analysis because it is incremental
• If the answer is “no,” it should not be included in the
analysis because it will occur anyway
• If the answer is “part of it,” then we should include
the part that occurs because of the project
10-9
Common Types of Cash Flows
4. Financing costs
10-10
5. Taxes
Common Types of Cash Flows
6. Side effects:
• Positive side effects – benefits to other
projects
• Negative side effects – costs to other
projects
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Chapter Outline
10-12
Pro Forma Statements and
Cash Flow
Definitions:
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation
(when there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF
– net capital spending (NCS)
– changes in NW
10-13
Project Pro Forma Income
Statement
Sales (50,000 units at $200,000
$4.00/unit)
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
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Chapter Outline
10-15
Projected Capital
Requirements
Year
0 1 2 3
10-17
Project Example - Visual
R = 20%
1 2 3
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Evaluate the Project
Enter the cash flows into the
calculator and compute NPV
and IRR:
So….Deal
or No Deal?
10-21
More on NWC
Why do we have to consider changes in NWC
separately?
GAAP requires that sales be recorded on the income
statement when made, not when the cash is received.
GAAP also requires that we record the cost of goods
sold when the corresponding sales are made, whether
we have actually paid our suppliers to date.
Finally, we have to buy inventory to support sales,
although we haven’t collected cash yet.
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Depreciation
The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
IRS for tax purposes
Calculation:
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After-tax Salvage
If the salvage value is different from
the book value of the asset, then there
is a tax effect
Book value = initial cost – accumulated
depreciation
After-tax salvage = salvage –
T*(salvage – book value at time of sale)
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After-tax Salvage
Computation
1. Market Value – Book Value = gain (or loss)
4. After-tax Salvage =
Market Value – taxes paid or
Market Value + tax benefit
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Example: Depreciation and
After-tax Salvage
You purchase equipment for $100,000, and it costs
$10,000 to have it delivered and installed.
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Example: Depreciation and
After-tax Salvage
The company’s marginal tax rate is 40%.
What is the depreciation expense and the
after-tax salvage in year 6 for each of the
following three scenarios (A-C)?
0 1 2 3 4 5 6
$ -110,000 Sell =
$17,000
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Example A: Straight-line
Suppose the appropriate depreciation schedule is
straight-line:
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Example A: Straight-Line
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $17,000
Capital gain/loss = 0
10-35
Replacement Problem
Every problem we
have presented What if we have an
thus far represents old asset to replace
a newly purchased with a new asset?
asset.
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Example: Replacement
Problem
Original Machine New Machine
Initial cost = 100,000 Initial cost = 150,000
Annual depreciation = 9,000 5-year life
Purchased 5 years ago Salvage in 5 years = 0
Book Value = 55,000 Cost savings = 50,000 per
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Replacement Problem
Computing Cash Flows
Remember that we are interested in
incremental cash flows
If we buy the new machine, then we
will sell the old machine
What are the cash flow consequences
of selling the old machine today
instead of in 5 years?
10-38
Replacement Problem
Pro Forma Income Statements
Year 1 2 3 4 5
Cost 50,000 50,000 50,000 50,000 50,000
Savings
Depr.
New 49,995 66,675 22,215 11,115 0
Old 9,000 9,000 9,000 9,000 9,000
Increm. 40,995 57,675 13,215 2,115 (9,000)
EBIT 9,005 (7,675) 36,785 47,885 59,000
Taxes 3,602 (3,070) 14,714 19,154 23,600
NI 5,403 (4,605) 22,071 28,731 35,400
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Replacement Problem
Incremental Net Capital Spending
Year 0
Cost of new machine = 150,000 (outflow)
After-tax salvage on old machine = 65,000
- .4(65,000 – 55,000) = 61,000 (inflow)
Incremental net capital spending = 150,000 – 61,000
= 89,000 (outflow)
Year 5
After-tax salvage on old machine = 10,000
- .4(10,000 – 10,000) = 10,000 (outflow because we
no longer receive this)
10-40
Replacement Problem
Cash Flow From Assets
Year 0 1 2 3 4 5
OCF 46,398 53,070 35,286 30,846 26,400
In 0 0
NWC
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Replacement Problem
Analyzing the Cash Flows
Now that we have the cash flows, we
can compute the NPV and IRR
1. Enter the cash flows
2. Compute the NPV and the IRR
Compute NPV = $54,801.74
Compute IRR = 36.28%
Should the company replace the
equipment?
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Chapter Outline
10-43
Other Methods for
Computing OCF
Bottom-Up Approach
Works only when there is no interest expense
OCF = NI + depreciation
Top-Down Approach
OCF = Sales – Costs – Taxes
Don’t subtract non-cash deductions
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Example: Cost Cutting
1. Your company is considering a new computer system
that will initially cost $1 million.
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Example: Cost Cutting
(continued)
4. The system is expected to have a salvage value of
$50,000 at the end of year 5.
5. There is no impact on net working capital.
6. The marginal tax rate is 40%.
7. The required return is 8%.
10-46
Example: Setting the Bid
Price
Consider the following information:
1. The Army has requested bids for multiple
use digitizing devices (MUDDs)
2. Deliver 4 units each year for the next 3
years
3. Labor and materials estimated to be
$10,000 per unit
4. Production space leased for $12,000 per
year
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Example: Setting the
Bid Price (continued)
5. Requires $50,000 in fixed assets with
expected salvage of $10,000 at the end of
the project (depreciate straight-line)
6. Requires an initial $10,000 increase in
NWC
7. Tax rate = 34%
8. Firm’s required return = 15%
10-50
Ethics Issues
In an L.A. Law episode, an automobile
manufacturer knowingly built cars that had a
significant safety flaw. Rather than redesigning the
cars (at substantial additional cost), the
manufacturer calculated the expected costs of
future lawsuits and determined that it would be
cheaper to sell an unsafe car and defend itself
against lawsuits than to redesign the car. What
issues does the financial analysis overlook?
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Quick Quiz
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Comprehensive Problem
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Terminology
• Incremental cash flows
• Sunk costs
• Opportunity costs
• Stand-alone (or independent) projects
• Net Working Capital (NWC)
• Operating Cash Flow (OCF)
• Cash Flow From Assets (CFFA)
10-54
Terminology
(continued)
• Straight line depreciation
• MACRS depreciation
• Market value vs. book value
• After-tax salvage value
• Bid price
• Equivalent Annual Cost (EAC)
10-55
Formulas
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation (when
there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF –
net capital spending (NCS)
– changes in NW
Bottom-Up Approach
OCF = NI + depreciation
Top-Down Approach
OCF = Sales – Costs – Taxes
Tax Shield Approach
OCF = (Sales – Costs)(1 – T) +
Depreciation*T
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Key Concepts and Skills
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What are the most
important topics of this
chapter?
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Questions?
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