Cash Flow

And Capital Budgeting

 Cash Flow Versus Accounting Profit

Capital budgeting is concerned with cash flow,

not accounting profit.

To evaluate a capital investment, we must

know:

Incremental cash outflows of the

investment (marginal cost of investment),
and
Incremental cash inflows of the investment
(marginal benefit of investment).
The timing and magnitude of cash flows
and accounting profits can differ
2 dramatically.
 Cash Flows: Financing Costs and
Taxes
Financing costs should be excluded when
evaluating a projects cash flows.

Both interest expense from debt

financing and dividend payments to
equity investors should be excluded.

Financing costs are captured in the

process of discounting future cash flows.

Only after-tax cash flows are relevant as

only such cash flows can be distributed to
3 investors.
 Cash Flows: Noncash Expenses

Noncash expenses include depreciation,

amortization, and depletion.
Accountants charge depreciation to spread a fixed
assets costs over time to match its benefits.
Capital budgeting analysis focuses on cash inflows
and outflows when they occur.
Non-cash expenses affect cash flow through their
impact on taxes:
Compute after-tax net income and add depreciation back,
or
Ignore depreciation expense but add back its tax savings.

4
 Cash Flows: Noncash Expenses

Assume a firm purchases a fixed asset today

for $30,000.

Plans to depreciate over 3 years using

straight-line method.

Costs $1/unit
Firm will produce
10,000 units/year Sells for
$3/unit

Firm pays taxes at 40% marginal rate.

5
 Cash Flows: Noncash Expenses

Method 1 Method 2
Adding non-cash expenses Find after-tax profits, add back
back to after-tax earnings non-cash deduction tax savings

Sales $30,000 Sales $30,000

Cost of goods (10,000) Cost of goods (10,000)

Gross profits $20,000 Pre-tax income $20,000

Depreciation (10,000) Taxes (40%) (8,000)

Pre-tax income $10,000 Aft-tax income $12,000

Taxes (40%) (4,000) Depreciation $4,000

tax savings
Net income after $6,000
tax Cash Flow $16,000
Cash flow $16,000
= NI + deprec
6
 Depreciation
Many countries allow one depreciation
method for tax purposes and another for
reporting purposes.
Accelerated depreciation methods, such as the
modified accelerated cost recovery system (MACRS),
increase the present value of an investments tax
benefits.
Relative to MACRS, straight-line depreciation results
in higher reported earnings early in an investments
life.
Because depreciation only affects cash flow
through taxes, we consider only the
depreciation method that a firm uses for tax
purposes when determining project cash
flows.
7
 Table 9.1 U.S. Tax Depreciation Allowed
for Various MACRS Asset Classes.

8
 Fixed Asset Expenditures
Initial cash flows:
Cash outflow to acquire/install fixed assets
Cash inflow from selling old equipment
Cash inflow (outflow) if selling old equipment
below (above) tax basis generates tax savings
(liability)
New equipment costs $10
million,
An example.... $0.5 million to install
Old equipment fully
Tax rate =
depreciated, sold for $1
40%
million

Initial investment: Outflow of $10.5 million,

and after-tax inflow of $0.60
million from selling the old
9 equipment
 Working Capital Expenditures
Many capital investments require additions to
working capital.
Net working capital (NWC) = current assets
current liabilities
Increase in NWC is a cash outflow; decrease in
NWC is a cash inflow.

An example
Operate booth from November 1 to January 31
Order $15,000 calendars on credit, delivery by
Nov 1
Must pay suppliers $5,000/month, beginning Dec
1
Expect to sell 30% of inventory (for cash) in Nov;
60% in Dec; 10% in Jan
10 Always want to have $500 cash on hand
 Working Capital for Calendar Sales
Booth
Oct 1 Nov 1 Dec 1 Jan 1 Feb 1

Cash $0 $500 $500 $500 $0

Inventory 0 15,000 10,500 1,500 0

Accts payable 0 15,000 10,000 5,000 0

Net WC 0 500 1,000 (3,000) 0
Monthly in WC NA +500 +500 (4,000) +3,000

Payments and Oct 1 to Nov 1 to Dec 1 to Jan 1 to

Nov 1 Dec 1 Jan 1 Feb 1
inventory
Reduction in $0 $4,500 $9,000 $1,500
inventory [30%] [60%] [10%]
Payments $0 ($5,000) ($5,000) ($5,000)

Net cash flow ($500) ($500) +$4,000 ($3,000)

11
 Terminal Value
When evaluating an investment with indefinite
life-span, the projects terminal value is
calculated:

Forecasts more than

Construct cash-flow 5 to 10 years have
forecasts for 5 to 10 high margin of error;
years use terminal value
instead.
The terminal value is intended to reflect the
value of a project at a given future point in
time.
The terminal value is usually large relative to
12
all the other cash flows of the project.
 Terminal Value

Different ways to calculate terminal values:

Use final year cash flow projections and assume that

all future cash flow grow at a constant rate;
Multiply final cash flow estimate by a market
multiple, or
Use investments book value or liquidation value.
JDS Uniphase cash flow projections for
acquisition of SDL Inc.

Year 1 Year 2 Year 3 Year 4 Year 5

$0.5 Billion $1.0 Billion $1.75 Billion $2.5 Billion $3.25 Billion
13
 Terminal Value of SDL Acquisition
Assume that cash flow continues to grow at 5% per
year (g = 5%, r = 10%, cash flow for year 6 is $3.41
billion):
CFt 1 $3.41
PVt , or PV5 $68.2
rg 0.10 0.05

Terminal value is $68.2 billion; value of entire

project is:
$0.5 $1 $1.75 $2.5 $3.25 $68.2
1
2
3
4
5
5
$48.67
1.1 1.1 1.1 1.1 1.1 1.1
$42.4 billion of total $48.7 billion is from terminal
value!
Using price-to-cash-flow ratio of 20 for companies
in the same industry as SDL to compute terminal
value:
Terminal Value = $3.25 x 20 = $65 billion
14 Caveat: market multiples fluctuate over time
 Incremental Cash Flow

Incremental cash flows versus sunk costs:

Capital budgeting analysis should include

only incremental costs.

An example
Norman Pauls current salary is $60,000 per year
and he expects it to increase at 5% each year.
Norm pays taxes at flat rate of 35%.
Sunk costs: $1,000 for GMAT course and $2,000
for visiting various programs
Room and board expenses are not incremental to
the decision to go back to school
15
 Incremental Cash Flow
At end of two years assume that Norm receives a salary
offer of $90,000, which increases at 8% per year
Expected tuition, fees and textbook expenses for each of
the next two years while studying for MBA: $35,000
If Norm had worked at his current job for two years, his
salary would have increased to $60,000 x 1.05 2 = $66,150
Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
After-tax inflow: $23,850 x (1-0.35) = $15,503
Yr 3 cash inflow: ($90,000x1.08 - $60,000x1.05 3)x(1-0.35)
= $18,032
MBA has substantial positive NPV value for 30 yr analysis
period

What about Norms opportunity cost?

16
 Opportunity Costs

Cash flows from alternative investment

opportunities, forgone when one investment
is undertaken.

If Norm did not attend MBA program, he would

have
earned:
First year: $60,000 Second Year: $63,000
($39,000 after taxes) ($40,950 after taxes)

NPV of a project could fall substantially if

opportunity costs are recognized!
17
 Cannibalization

Cannibalization refers to the loss of

sales of an existing product when a
new product is introduced.

Cannibalization is a substitution
effect.

18
 Initial Investment for
Classicaltunes.com
Classicaltunes.com is considering adding jazz
recordings to its offerings.

Firm uses 10% discount rate to calculate NPV and 40% tax
rate.
The average selling price of Classicaltunes CDs is $13.50;
price is expected remain constant indefinitely.
Sales expected to begin when new fiscal year begins.

$50,000 for computer equipment

(MACRS 5-year)
Initial
investment $4,500 for inventory
transactions ($2,500 of which is purchased on credit)
:
$1,000 increase in cash balances
19
20
Projections for Jazz CD Proposal
 Projections for Jazz CD Proposal

Annual Net Cash Flow Estimates for Classicaltunes.com

21
 Year Zero Cash Flow
Invest $3000 in working capital

Initial cash outlay of $50,000 for computer

equipment
Changes in working capital are result of following
transactions:
Purchase of $4,500 in inventory and increase cash balance
by $1000
an inflow of $2,500 from an increase in trade credit
(Account Receivable)

Net Cash Flow:

Increase in gross fixed assets - $50,000

Change in working capital - $3,000
Net cash flow - $53,000

22
 Year One Cash Flow
In year 1, the project earns after-tax income of $561.
No new investment in fixed asset.
Add back the non-cash depreciation charge of $10,000.
Net working capital for year one is:
NWC = Current Assets Current Liabilities
= $2,000 + 5,063 + 7,594 - $4,374 = $10,282
NWC = NWCyear1 NWCyear0 = $10,282 - $3,000 = $7,282
Increase in NWC from year zero: $7,282
net cash flow from working capital: -$7,282
net cash flow: $561 + 10,000 7,282 = $3,279

23
 Year One Cash Flow

Net Cash Flow:

Depreciation $10,000
Invest in working capital (cash -$7,282
outflow)
Net income $561
Net cash flow $3,279
24
 Year Two Cash Flow
In year 2, net income equals $8,580.
To that, add back the $10,000 non-cash depreciation
deduction.
Next, determine the change in working capital: The working
capital balance increased from $10,282 in year 1 to
$20,905 in year 2, so this represents a cash outflow of
10,623.
As in year 1, there are no new investments in fixed assets
to
Net
consider.
Cash Flow:

Depreciation $10,000
Increase in working capital - $10,623
Net income +$8,580
Net cash flow $7,957

25
 Terminal Value for Jazz CD Proposal
If we assume that cash flow continue to grow at 4%
per year at and beyond year 6 (g = 4%, r = 15%,):

CFt 1 1 g CFt 1.04 $34,410 $35,786

CFt 1 $35,786
PVt , or PV6 $325,327
rg 0.15 0.04

Second approach: use the book value at end of year

six:
Plant and Equipment (P&E) at end of year six is $0.
The firm liquidates total current assets (cash 3,500,
accounts receivable 28,125, inventory 42,188) and pays
off current debts (accounts payable 24,300):
Terminal value = $73,813 - $24,300 = $49,513.

26
 NPV for Jazz CD Proposal
Using assumption that cash flow grow at a steady
rate past year 6:
$3,279 $7,957 $15,785 $24,833
NPV $53,000 1
2
3

1.15 1.15 1.15 1.15 4
$35,211 $34,410 $325,327
6
6
$153,475
1.15 1.15
Using book value assumption for terminal value:
$3,279 $7,957 $15,785 $24,833
NPV $53,000 1
2
3
4

1.15 1.15 1.15 1.15
$35,211 $34,410 $49,513
5
6
$34,233
1.15 1.15
NPV is positive with both methods: investing in Jazz
CD project increases shareholders wealth.
27
 Capital Rationing

Can a firm accept all investment projects with

positive NPV?

Reasons why a company would not accept all

projects:

Limited availability of skilled personnel to be

involved with all the projects;

Financing may not be available for all

projects. Companies are reluctant to issue
new shares to finance new projects because
of the negative signal this action may convey
to the market.
28
 Capital Rationing
Capital rationing: project combination that
maximizes shareholder wealth subject to
funding constraints
1. Rank the projects using Profitability Index
(PI)

2. Select the investment with the highest PI

If funds are still available, select the

3.
second-highest PI, and so on, until the capital
is exhausted.
The steps above ensure that managers select
the combination of projects with the highest
29 NPV.
 Equipment Replacement and Unequal
Lives
A firm must purchase an electronic control device:
First alternative: cheaper device, higher maintenance
costs, shorter period of utilization
Second device: more expensive, smaller maintenance
costs, longer life span
Expected cash outflows:

Using real discount rate of 7%:

Device As cash outflow < Device Bs cash

outflow
30 select A?
 Table 9.4 Capital Rationing and the
Profitability Index (12% required return)

31
 Table 9.5 Operating and Replacement
Cash Flows for Two Devices (all values are
outflows)

32
 Equivalent Annual Cost (EAC)
EAC converts lifetime costs to a level annuity;
eliminates the problem of unequal lives .
1. Compute NPV for operating devices A and B for
their respective lifetimes:
NPV of device A = $15,936
NPV of device B = $18,065
2. Compute annual expenditure (annuity cost) to
make NPV of annuity equal to NPV of operating
device: X X X
Device A $ 15,936 1
2
3
X $6,072
1.07 1.07 1.07

Device B
Y Y Y Y
$18,065 Y $5,333
1.071 1.07 2 1.07 3 1.07 4

Since Device Bs annuity cost is lower, choose

33 Device B.
 Excess Capacity
Excess capacity is not a free asset as traditionally
regarded by managers.
Company has excess capacity in a distribution center
warehouse.
In two years, the firm will invest $2,000,000 to expand the
warehouse.
The firm could lease the excess space for $125,000 per
year (at the beginning of each year) for the next two
years.
Expansion plans should begin immediately in this case to
hold inventory for new stores coming on line in a few
months.
Incremental cost: investing $2,000,000 at present vs. two
years from today
Incremental cash inflow: $125,000 (at the beginning of the
year)
34
 Excess Capacity
NPV of leasing excess capacity (assume 10% discount rate):
125,000 2,000,000
NPV 125,000 2,000,000 2
$108,471
1.10 1 .1
NPV negative: reject leasing excess capacity at
$125,000 per year.

The firm could compute the value of the lease that

would allow break even.
X 2,000,000
NPV X 2,000,000 2
0
1.10 1.1
- X = $181,818 (at the beginning of the year)
- Leasing the excess capacity for a price above $181,818
would increase shareholders wealth.

35
 The Human Face of Capital Budgeting

Managers must be aware of optimistic bias in the

assumptions made by project supporters.
Companies should have control measures in place
to remove bias:
Investment analysis should be done by a group
independent of individual or group proposing the project.
Project analysts must have a sense of what is reasonable
when forecasting a projects profit margin and its growth
potential.
Storytelling: The best analysts not only provide
numbers to highlight a good investment, but also
can explain why the investment makes sense.
36
 Cash Flow and Capital Budgeting

Certain types of cash flows are common to

many investments
Opportunity costs should be included in
cash flow projections
Consider human factors in capital
budgeting

37