discussion broad

WEEK 13

MAKING CAPITAL INVESTMENT DECISIONS

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

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

COMMON TYPES OF CASH FLOWS

• Sunk costs – costs that have accrued in the past

• Opportunity costs – costs of lost options

• Side effects

▪ Positive side effects – benefits to other projects

▪ Negative side effects – costs to other projects

• Changes in net working capital

• Financing costs

• Taxes

PRO FORMA STATEMENTS AND CASH FLOW

• Capital budgeting relies heavily on pro forma accounting statements, particularly income statements

• Computing cash flows – refresher

▪ 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

NWC

PRO FORMA INCOME STATEMENT

Sales (50,000 units at $4.00/unit) $200,000

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

PROJECTED CAPITAL REQUIREMENTS

Year

0 1 2 3

NWC $20,000 $20,000 $20,000 $20,000

NFA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000

PROJECTED TOTAL CASH FLOWS

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

Change

in NWC

-$20,000 20,000

NCS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

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 cash is received

▪ GAAP also requires that we record cost of goods

sold when the corresponding sales are made,

whether we have actually paid our suppliers yet

▪ Finally, we have to buy inventory to support sales,

although we haven’t collected cash yet

DEPRECIATION

• The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes

• Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes

• Depreciation tax shield = D × T ▪ D = depreciation expense

▪ T = marginal tax rate

COMPUTING DEPRECIATION

• Straight-line depreciation ▪ D = (Initial cost – salvage) / number of years

▪ Very few assets are depreciated straight- line for tax purposes

• MACRS ▪ Need to know which asset class is

appropriate for tax purposes

▪ Multiply percentage given in table by the initial cost

▪ Depreciate to zero

▪ Mid-year convention

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)

EXAMPLE: DEPRECIATION AND AFTER-TAX SALVAGE

• You purchase equipment for $100,000, and it

costs $10,000 to have it delivered and installed.

• Based on past information, you believe that

you can sell the equipment for $17,000 when

you are done with it in 6 years.

• The company’s marginal tax rate is 40%.

• What is the depreciation expense each year

and the after-tax salvage in year 6 for each of

the following situations?

EXAMPLE: STRAIGHT-LINE

• Suppose the appropriate depreciation

schedule is straight-line

▪ D = (110,000 – 17,000) / 6 = 15,500 every year

for 6 years

▪ BV in year 6 = 110,000 – 6(15,500) = 17,000

▪ After-tax salvage =

17,000 - .4(17,000 – 17,000) = 17,000

EXAMPLE: THREE-YEAR MACRS

Year MACRS

percent

D

1 .3333 .3333(110,000)

= 36,663

2 .4445 .4445(110,000)

= 48,895

3 .1481 .1481(110,000)

= 16,291

4 .0741 .0741(110,000)

= 8,151

BV in year 6 =

110,000 – 36,663 –

48,895 – 16,291 –

8,151 = 0

After-tax salvage

= 17,000 -

.4(17,000 – 0) =

$10,200

EXAMPLE: SEVEN-YEAR MACRS

Year MACRS

Percent

D

1 .1429 .1429(110,000) =

15,719

2 .2449 .2449(110,000) =

26,939

3 .1749 .1749(110,000) =

19,239

4 .1249 .1249(110,000) =

13,739

5 .0893 .0893(110,000) = 9,823

6 .0892 .0892(110,000) = 9,812

BV in year 6 =

110,000 – 15,719 –

26,939 – 19,239 –

13,739 – 9,823 –

9,812 = 14,729

After-tax salvage

= 17,000 –

.4(17,000 –

14,729) =

16,091.60

EXAMPLE: REPLACEMENT PROBLEM

• Original Machine

▪ Initial cost = 100,000

▪ Annual depreciation

= 9,000

▪ Purchased 5 years

ago

▪ Book Value = 55,000

▪ Salvage today =

65,000

▪ Salvage in 5 years =

10,000

• New Machine

▪ Initial cost = 150,000

▪ 5-year life

▪ Salvage in 5 years = 0

▪ Cost savings = 50,000 per year

▪ 3-year MACRS depreciation

• Required return = 10%

• Tax rate = 40%

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?

REPLACEMENT PROBLEM – PRO FORMA INCOME STATEMENTS

Year 1 2 3 4 5

Cost

Savings

50,000 50,000 50,000 50,000 50,000

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

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)

REPLACEMENT PROBLEM – CASH FLOW FROM ASSETS

Year 0 1 2 3 4 5

OCF 46,398 53,070 35,286 30,846 26,400

NCS -89,000 -10,000

 In

NWC

0 0

CFFA -89,000 46,398 53,070 35,286 30,846 16,400

REPLACEMENT PROBLEM – ANALYZING THE CASH FLOWS

• Now that we have the cash flows, we can

compute the NPV and IRR

• Enter the cash flows

• Compute NPV = 54,801.74

• Compute IRR = 36.28%

• Should the company replace the equipment?

OTHER METHODS FOR COMPUTING OCF

• Bottom-Up Approach

▪ OCF = NI + depreciation

▪ Works only when there is no interest expense

• Top-Down Approach

▪ OCF = Sales – Costs – Taxes

▪ Don’t subtract non-cash deductions

• Tax Shield Approach

▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T