Finance assignment ASPS
mk59
finslides_3.pptxCash Flows and Capital Budgeting
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Parrino chapter 10
Determine initial cost of project
Estimate project’s future net cash flows by year over its expected life (cash inflows minus cash outflows)
Determine appropriate cost of capital based on riskiness of project
Compute values for project evaluation
NPV
IRR
MIRR
Payback period
Discounted payback period
Profitability index
Make decision based on applicable decision rules
Post-audit and ongoing reviews
Capital Budgeting Process Overview
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Capital
Budgeting
Techniques
(Parrino 9)
Cost of Capital
(Parrino 11)
Capital
Budgeting
Cash Flows
(Parrino 10)
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Explain the difference between independent projects and mutually exclusive projects
List at least four capital budgeting project evaluation methods
Explain which of the four techniques use TVM and/or consider all project cash flows
Determine which is the best method for ranking projects, evaluating mutually exclusive projects, or projects with alternating positive/negative future cash flows
Chapter 9 Review Questions
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Techniques that use TVM and consider all cash flows
NVP -- BEST
IRR
MIRR
Other techniques
Payback period (not TVM, not all cash flows beyond payback)
Discounted payback period (TVM, not all cash flows beyond payback
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Learning Objectives
Explain why incremental after-tax free cash flows are relevant in evaluating a project.
Calculate incremental after-tax free cash flows for a project.
Discuss the five general rules for incremental after-tax free cash flow calculations.
Explain why cash flows stated in nominal dollars should be discounted using a nominal discount rate and cash flows stated in real dollars should be discounted using a real discount rate (i.e., inflation).
Describe how distinguishing between variable and fixed costs can be useful in forecasting operating expenses.
Explain the concept of equivalent annual cost
Use equivalent annual cost to compare projects with unequal lives
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Initial investment
Incremental cash flows
Terminal Value
Include opportunity costs
What are they?
Examples?
Ignore sunk costs
What are they?
Examples?
Relevant Cash Flows for Capital Budgeting
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Only consider incremental cash flows
Difference between cash flows with new project and without
Opportunity costs: Benefits that could have been earned by choosing another project are a cost to the firm
Facility that would be used for new project, but could be productively used for alternative purpose
Sunk costs have already been incurred or committed to and will not be influenced by the project.
Land the firm already owns that could be used for new building, but wouldn’t be sold otherwise
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Cash Flow Components Overview
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Estimating Cash Flows in Practice
Include cash flows only
Do not include allocated costs or overhead unless they occur because of the project.
Include the impact of the project on cash flows of other product lines (cannibalization)
If a project is expected to affect cash flows of another project, include the expected impact on the cash flows of the other project in the analysis.
5 General Rules for Incremental Cash Flow Calculations
(continued)
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Pp. 337-338 of text discuss these 5 rules in detail
Ignore allocated costs
Example: Company allocates $3 million of overhead to 2 manufacturing plants. Considering adding 3rd plant. Should reallocation of overhead among 3 plants be considered in capital budgeting – NO
Cannibalizing
iPhone impact on iPod sales since phone could do everything iPod could do --YES
Chapter 10 has comprehensive example related to Performing Arts Center. I highly recommend that you study it.
On pp. 338-340, text discusses examples situations related to each of these 5 rules.
Estimating Cash Flows in Practice
Include all opportunity costs
Benefits that could have been earned by choosing another project are a cost to the firm.
Ignore sunk costs
Sunk costs have already been incurred or committed to and will not be influenced by the project.
Include only after-tax cash flows
Incremental pre-tax cash flows of a project only matter to the extent that they determine the after-tax free cash flows.
5 General Rules for Incremental Cash Flow Calculations
(continued)
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Opportunity cost – New project will require use of a piece of equipment firm already has. If new project were not accepted, equipment could be sold for $50,000 after-tax proceeds – YES
Sunk costs
$10 million already invested in project that was supposed to product NPV of $20 million Situation changed, no benefits generated to date Can produce $2 million of cash flows if firm invests another $1 million $10 million is sunk cost – IGNORE $1 million investment today vs. $2 million NPV is relevant - YES
Cost of new equipment, buildings, land (including installation)
After-tax salvage value of old equipment (if applicable)
Changes in Net Working Capital (NWC)
NWC = Current Assets – Current Liabilities
Most of these increase
Need more cash to support operations
Increased A/R and Inventory to support increased sales
Increased A/P and Accruals to meet expanded product demand
Increases in NWC are considered a cash outflow
Increases in assets are outflows
Increases in liabilities are inflows
Initial Investment
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Projected after-tax cash flows
Determine revenues and expenses
Find operating income including depreciation expense
Find after-tax operating income
Add back depreciation
Why?
After-Tax Cash Flows from Operations
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MACRS Depreciation Schedules
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After-tax proceeds from the sale of the new asset
Change in Net Working Capital
Typically recover NWC at the end of a project
Draw down or sell off inventories
Collect A/R
Pay off A/P and accruals
Ultimately ends in a decrease in NWC
Considered an inflow
Add to proceeds of new asset
Terminal Cash Flows
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Risk is the uncertainly of projected cash flows
Greater variability in cash flows = greater risk
Scenario analysis
Consider probability of different cash flows from project
Evaluate their NPV and their range of NPV’s (i.e., expected values)
Simulation
Use statistical modeling to develop a probability of NPV’s for the project
Can view a continuum of risk-return tradeoffs instead of a single-project estimate
Measuring Stand-Alone Risk in Capital Budgeting Projects
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Estimating Project Cash Flows
Need to predict cash flows with relative accuracy
Calculate expected cash flows based on possible cash flows and their probabilities
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Sample calculation on next slide.
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Estimating Project Cash Flows
Expected Cash Flows Calculation Example
$70 x 0.25 = $17.50
$50 x 0.50 = $25.00
$25 x 0.25 = $6.25
$48.75
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Projects with Different Lives
An efficient method of choosing between mutually exclusive projects with different lives is to compute their EAC’s
EACi = kNPVi (1 + k)t (10.5) (1 + k)t - 1
Where:
k = opportunity cost of capital
NPVi = normal NPV of project i
t = lifespan of project
Equivalent Annual Cost (EAC)
Decision Rule: Choose the project with the “best” EAC.
If all projects have positive EAC’s, select the project with the highest EAC.
If all projects have negative EAC’s, select the project with the least negative EAC.
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Projects with Different Lives
Find the EAC for each of two projects. The cost of capital is 10%.
Mower A: Costs $250. Expected to last two years
Mower B: Costs $360. Expected to last three years
EACi = kNPVi (1 + k)t (10.5) (1 + k)t - 1
Equivalent Annual Cost (EAC) Calculation Examples
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Projects with Different Lives
Find the EAC for each of two projects. The cost of capital is 10%.
Mower A: Cost $250. Expected to last two years.
Mower B: Cost $360. Expected to last three years.
EACi = kNPVi (1 + k)t (10.5) (1 + k)t - 1
Equivalent Annual Cost (EAC) Calculation Examples
EACA = (0.10)(-$250) (1 + 0.10)2 = negative $144.05 (1 + 0.10)2 – 1
EACB = (0.10)(-$360) (1 + 0.10)3 = negative $144.76 (1 + 0.10)3 – 1
Decision: Choose Mower A because it has the least negative EAC.
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Relevant cash flows
Only those cash flows that can be repatriated (returned) to the parent company
Additional risk
Exchange rate risk – consider forward rates
Political risk
Need to be compensated for added risks
Considerations for Multinational Budgeting
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Capital Budgeting Tips
Solutions for New Machine Project problem worked in class will be available on BbLearn
Remember to calculate all the components of incremental after-tax cash flows by year for a project
Initial investment and other capital expenditures
Cash flow from operations
Additional working capital – initial and over time
Terminal value
Make sure you can prepare a timeline for project cash flows by year
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New machine can be purchased for a cost of $140,000
Requires $10,000 to install
3-year MACRS recovery period
3-year project useful life
Can be sold for $35,000 (before taxes) at the end of three years
NWC will increase
A/R will increase by $10,000
Inventory will increase by $25,000
A/P will increase by $15,000
Pre-tax cash flows for 3 years (not including depreciation)
New machine EBITDA: $120,000, 1st year; $130,000, 2nd and 3rd years
Firm has a 40% tax rate
WACC = 10.2%
Capital Budgeting Cash Flows
New Machine Example
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Homework & Assignments
Mon., Nov. 24, no later than 12 noon:
Parrino Homework -- Chapter 10, Cash Flows and Capital Budgeting
Online through WileyPLUS via BbLearn
Fri., Dec. 5, no later than 12 noon:
Parrino Homework – Chapter 11, Cost of Capital
Online through WileyPLUS via BbLearn
Fri., Dec. 5, no later than 2:00 pm:
Pre-Exam “In-Class” Assignment #3
Via Support Services with label and date-time stamp
Coming Weeks
Wed., Nov. 26: Evening before Thanksgiving – NO CLASS --Enjoy and be safe!
Wed., Dec. 3: Cost of Capital (Parrino chapter 11)
Thurs., Dec. 4: Supplemental Session (optional), 5:30-8:00 pm, Room 226
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Coming Events
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Appendix
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The Free Cash Flow Calculation
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Estimating Cash Flows in Practice
Progressive, marginal tax system used in U.S.
Proportion of income paid as taxes (i.e., tax rate) increases as amount of taxable income increases
Especially important tax difference from capital budgeting perspective is that depreciation methods allowed by GAAP do not include some allowed by IRS
Straight-line depreciation method allowed by GAAP is often used for financial reporting.
IRS allows accelerated depreciation under the Modified Accelerated Cost Recovery System (MACRS) adopted in 1986 for business tax purposes.
Allows firm to allocate more depreciation expense to early years of project, realize larger tax savings sooner, and increase present value of tax shield
Taxes and Depreciation
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