Corporate Finance

Lecture 8

Chapter 11 Textbook

(Exclude Section 11.3)

Capital Flows and Capital Budgeting

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2

The Importance of Capital

Budgeting

• The objective is to create value and the ability to generate cash flows

• To be consistent with wealth maximization principle, an evaluation of a project must be based on cash flows

• How can we make good decisions.

➢Use NPV together with other methods, such as Discounted payback and IRR

➢How to estimate NPV – Need to estimate: Cash flows and Discount rate

Calculating Project Cash

Flows • Guideline:

➢Use after-tax cash flows

➢Use Incremental cash flows

➢Use free cash flows

• Thus, use

Incremental After-tax Free Cash Flows

5

➢ Incremental Cash Flows

• Incremental Cash Flows or the cash flows that add to the total cash flows:

➢The incremental cash flows for a project consist of any cash flows or changes in future cash flows

➢Any cash flow that exists regardless of whether or not a project goes ahead is irrelevant

➢Ask yourself, “Will this CF occur ONLY if a project is accepted?”

➢If Yes then CF is incremental

Incremental Cash Flows

Free Cash Flows (FCFs)

• FCF is a measure of the after-tax cash flows from operations

over and above what is necessary to make any required

investments.

• Companies are free to distribute these cash flows to

creditors and shareholders because these are the cash flows

that are left over after a company has made necessary

investments in working capital and long term assets

• The idea that we can evaluate the cash flows from a project

independently of the cash flows for the company is known as

the stand-alone principle.

➢ i.e. treat the project as if it is a stand-alone company that has its own

revenue, expenses, and investment requirements.

Revenue Revenue

- Cash operating expense - Op Ex

Earnings before interest, tax, EBITDA

depreciation and amortisation

- Depreciation and amortisation - D&A

Earnings before interest and tax EBIT

x (1-Company's marginal tax rate) x (1-tc)

Net operating profit after tax NOPAT

+ Depreciation and amortisation + D&A

Cash flow from operations CF Opns

- Capital expenditure - Cap Exp

- Additions to working capital - Add WC

Free cash flow FCF

The change in the company’s cash income resulting from the

project (excluding interest expense)

Adjustments for the impact of depreciation and amortisation and

investments on FCF.

The FCF Calculation

The FCF Calculation: an example pp 394-6

PART A

PART A: Suppose that you work at an outdoor performing arts centre and

are evaluating a project to increase the number of seats by building four

new box seating areas and adding 5000 seats for the general public. Each

box seating area is expected to generate $400,000 in incremental annual

revenue, while each of the new seats for the general public will generate

$2500 in incremental annual revenue .The incremental expenses

associated with the new boxes and seating will amount to 60% of the

revenues. These expenses include hiring additional personnel to handle

concessions, ushering and security. (These cash flows start at the end of

year 1 and continue until the end of year 10). The new construction will cost

$10 million today and will be fully depreciated (to a value of zero dollar) on a

straight-line basis over the 10-year life of the project. The centre will have to

invest $1 million in additional working capital immediately, but the project will

not require any other working capital investments during its life. This working

capital will be recovered in the last year of the project (year 10). The

centre’s tax rate is 30%. What are the incremental cash flows from this

project? What is the NPV? (Cost of capital is 10%)

Summary of project information: • Life of the project (Years) = 10

• Number of new boxes = 4

• Annual incremental revenue per box = $400,000

• Number of new seats = 5,000

• Annual incremental revenue per seat = $2,500

• Incremental expense (% of revenue) = 60%

• Construction cost (Cap exp) = $10,000,000

• Depreciation per year = $1,000,000

– D&A = Cap Exp/Depreciable life of the investment

= $10,000,000/10 = $1,000,000

• Additional working capital in Year 0 (Add WC) = $1,000,000

– No more working capital will be required during the project life.

• Working capital will be recovered in year 10 = ($1,000,000)

• Tax rate = 30%

• Cost of capital = 10%

Class Workshop

• Take out “Lecture 9 Group Activity

Calculation Worksheet” and do the

following questions in groups during the

class

Your lecturer will guide your group through

the activity

Use FCF Calculation

Worksheet

FCF = [(Revenue – Op Exp – D&A) x (1 – t)] + D&A – Cap Exp - Add

WC

CF Opns

Variable costs

Fixed costs

Calculating NPV • From Lecture 7: How can we adjust the NPV

formula if the cash flows after year 0 are an annuity stream?

• For the above FCFs with a discount rate of 10% what is the NPV?

NPV = −CFo+ CF i 1−

1

1+i n

NPV = _____________________________________ _________________________________________

__________________________________________

Completed FCF Calculation Worksheet

Revenue: Box seating ($400,000 x 4) = $1,600,000

Public seating ($2500 x 5000) = $12,500,000

Total incremental net revenue = $14,100,000

Incremental Op Ex = 0.60x$14,100,000 = $8,460,000

D&A = Cap

Exp/Depreciable life of

the investment

= $10,000,000/10

= $1,000,000

Construction cost (Cap exp) = $10,000,000

Additional working capital in Year 0 (Add WC) = $1,000,000

Working capital will be recovered in year 10 = ($1,000,000)

PART A: Capital Budgeting on

Excel • See “Lecture 9 Example” on the portal and go to the “PART A”

spreadsheet

• Try and complete the worksheet using only formulas referencing

the input variables

• Hints:

• In the table/worksheet write “=“ and then click on the input key

variable you want to put in

• If an input is the same for multiple year click on the input variable

reference and press “F4” and then stretch the formula for all years.

“F4” makes the variable not change as you stretch it over other cells.

• If values are negative reference the key variable with a “-” at the front

• Look at your lecturer’s demonstration.

• Try filling the table in before consulting “Lecture 7 Example-Solutions”

which can be found on the portal

Estimating Cash Flows in Practice

➢Five general rules for incremental

cash flow calculations

• Rule 1: Include cash flows and only cash flows in

your calculations.

• Rule 2: Include the impact of the project on cash

flows from other product lines.

• Rule 3: Include all opportunity costs. By opportunity

costs, we mean the cost of giving up another

opportunity.

• Rule 4: Forget sunk costs.

➢Sunk costs are costs that have already been

incurred but all that matters when you

evaluate a project at a particular point in time

is future investment and what you expect to

receive in return for that investment; this

means that past investments are irrelevant.

• Rule 5: Include only after-tax cash flows in

the cash flow calculations. The incremental

pre-tax earnings of a project only matter to

the extent that they affect the after-tax cash

flows that the company’s investors receive.

If the above special issues are considered, the FCF

values change [see next slide]

E.g. page 399-400 (based on information in the previous question)

The FCF Calculation: an example PART B

1. The chief financial officer requires that each project be assessed 5% of the initial investment to account for costs associated with the accounting, marketing and information technology departments.

2.It is likely that increasing the number of seats will reduce revenues next door at the cinema that your employer also owns. Attendance at the cinema is expected to be lower only when the performing arts centre is staging a big events. The total impact is expected to be a reduction of $500,000 each year, before tax, in the operating profits (EBIT) of the cinema. The depreciation of the cinema’s assts will not be affected.

3. If the project is adopted, the new seating will be built in an area where figures have been placed in the past when the centre has hosted guest lectures by well-known painters or sculptors. The performing arts centre will no longer be able to host such events, and revenue will be reduced by $600,000 each year as a result.

4. The centre already spent $400,000 researching demand for new seating

5. You have just discovered that a new salesperson will be hired if the centre goes ahead with the expansion. This person will be responsible for sales and service of the four new luxury boxes and will be paid $75000 per year, including salary and benefits. The $75000 is not included in the 60% figure for operating expenses that was previously mentioned.

Adjusted FCF Calculations and NPV Info 3: Revenue = $14,100,000 – $600,000 = $13,500,000

D&A = Cap Exp/Depreciable life of the investment = $10,000,000/10 = $1,000,000

Construction cost (Cap exp) = $10,000,000

Additional working capital in Year 0 (Add WC) = $1,000,000

Working capital will be recovered in year 10 = ($1,000,000)

Info 2: The total impact is expected to be a reduction of $500,000 each year

Info 5: If the project goes ahead, a salesperson will be hired & paid $75000 per year.

PART B: Capital Budgeting on

Excel • See “Lecture 9 Example” on the portal and

go to the “PART B” second spreadsheet (see tab on bottom)

• Try and complete the question only by changing the input variables

• Hints: ➢The table / worksheet should have no

numbers, just references to key variables and the additional variables provided in PART B

➢Change the references for relevant parts of the table

➢The NPV will change automatically

Calculating FCFs and NPV

Method 1

There are two methods you can use:

Method 1:

a) Calculate FCFs for years 1-n using spreadsheet or

below formula:

Free Cash Flows (FCF) = [(Revenue – Op Exp – D&A) x (1-t)]

+ D&A – Cap Exp – Add Working Cap

b) Use NPV formula to discount back FCFs to time zero

and subtract initial outlay:

NPV = −CFo+σ 𝑭𝑪𝑭𝒕

(1+𝑖)𝑛

Method 2:

a) Calculate FCFs for years 1-n

• Calculate FCF =[(Revenue – Op Exp) x (1-t)] + D&A *t

• (D&A *t is the tax benefit/saving from depreciation)

b) Discount FCFs and WC and other end of year cash flows

separately

• Discount working capital and capital expenditure separately

Calculating FCFs and NPV

Method 2

NPV = −CFo+ FCF i 1−

1

1+i n +

𝑭𝑪𝑭𝒕

(1+𝑖)𝑛

Blue Mountain Lumber Ltd is considering purchasing a new wood saw that

costs $50,000. The saw will generate revenues of $100,000 per year for five

years. The cost of materials and labour needed to generate these revenues

will total $60,000 per year, and other cash expenses will be $10,000 per

year. The machine will be depreciated on a straight-line basis over five years

to zero. Blue Mountain’s tax rate is 30 percent, and its opportunity cost of

capital is 10 percent. Should the company purchase the saw? Explain why or

why not.

Method 1:

a) [(100,000 – 70,000– 10,000) x (1-0.3)] + 10,000= $24,000

b) NPV:

Method 2:

a) [(100,000 – 70,000) x (1-0.3)] + (10,000*0.3)= $24,000

b) NPV:

Example: Do Individually

Method 1 and 2

NPV = −50,000 + 24,000 0.1

1− 1

1.1 5

NPV = −50,000 + 24,000 0.1

1− 1

1.1 5

Tax and Depreciation ➢ Tax rates and depreciation

• Tax rates

➢ Have implications in capital budgeting decisions

➢ Australian companies have a flat tax rate of 30%

• Depreciation – Produces tax savings (tax shield)

➢ Two main methods (see example on page 405):

• The straight-line depreciation method; or

• Reducing-balance depreciation method

➢Calculating the terminal-year FCFs

• The FCF in the last, or terminal year of a project often includes cash flows that are not typically included in the calculations for other years.

• The salvage value realised from the sale (net of any tax consequences) of the asset - The assets acquired during the life of the project may be sold

➢Tax on salvage value: (Selling price – Book value) * tax rate

• The working capital that has been invested may be recovered.

Example

➢ Arts Centre example – Recall that the initial Cap Exp in the was $10 million and that we used straight- line depreciation. Supposed that the salvage value (selling price) in year 10 of the $10 million investment in the art centre project is expected to be $1 million and the book value of the investment at year 10 is $0.

➢ In this case, the company will pay additional taxes of:

• Tax on sale of an asset = (Selling price – Book value) * tax rate

= ($1,000,000 - $0) x 0.3 = $300,000

➢ Deducting this amount from the $1,000,000 that the company receives from the sale of the assets yields after- tax proceeds of:

• After tax Cap Exp = $1,000000 - $300,000 = $700,000.

Quiz 8 1. The term ___________ refers to the fact that these cash flows reflect the amount

by which the company's total after-tax free cash flows will change if the project is

adopted.

a. periodic

b. ending cash flows

c. incremental

d. none of the above

2. Brown Mack Ltd currently has two large manufacturing divisions that share a single

plant. Brown Mack owns the plant but has calculated that $6 million of overhead

expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a

third manufacturing division, of equal size to the other two divisions, then what

overhead cost should the new division take into account on its capital budgeting cash

flow analysis?

a. $0

b. $2 million

c. $3 million

d. $6 million

Quiz 8 3. Short Answer question: Why do we only want to consider incremental FCFs

when doing NPV analysis for a project?

4. Short-answer question: Why do we deduct depreciation and then add it back

when calculating FCFs?

1. Understand and comment on the role and importance of cash flows in capital

budgeting techniques

2. Differentiate between Accounting Statement of Cash Flows and Capital

Budgeting Cash Flows

3. Calculating the following project Cash Flows

i. Incremental Cash Flows

ii. Free Cash Flows (FCFs)

iii. Incremental After-Tax Free Cash Flows

iv. The FCF Calculation

4. Calculate Cash Flows for NPV analysis with reference to diverse scenarios

and problems and taking into account the following factors:

i. 5 general rules for incremental after-tax free cash flow calculations

ii. Tax rates and depreciation

iii. Calculating Terminal year cash flows

5. Use judgement to calculate FCFs and NPVs using excel

6. Calculate cash flows and NPVs using spreadsheets in excel which are

sensitive to changes in input variables

Learning Outcomes Topic 8