# Capital Budgeting II. Professor: Burcu Esmer

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1 Capital Budgeting II Professor: Burcu Esmer 1

2 Cash Flows Last chapter introduced valuation techniques based on discounted cash flows. This chapter develops criteria for properly identifying and calculating cash flows. 2

3 Capital Budgeting Remember: Estimate project cash flows (CFs) Estimate a discount rate, if needed Discount the cash flows Select the projects with positive NPV Question: How do we forecast the cash flows? 3

4 Cash Flow vs. Accounting Income Discount actual cash flows (not accounting profits! ) Using accounting income, rather than cash flow, could lead to erroneous decisions. Example A project costs \$2,000 and is expected to last 2 years, producing cash income of \$1,500 and \$500 respectively. The cost of the project can be depreciated at \$1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income. 4

5 Cash Flow vs. Accounting Income Today Year 1 Year 2 Cash Inflow \$1,500 \$ 500 Project Cost - 2,000 Free Cash Flow - 2,000 +1, , Cash NPV= 2,000 \$ (1.10) (1.10) 5

6 Cash Flow vs. Accounting Income Cash Inflow Depreciati on Accounting Income Year 1 \$1,500 -\$1, Year 2 \$ 500 -\$1, Apparent NPV = (1.10) \$41.32 Recognize investment expenditures when they occur! 6

7 Incremental Cash Flows Discount incremental cash flows Include All Indirect Effects Forget Sunk Costs Include Opportunity Costs Recognize the Investment in Working Capital Beware of Allocated Overhead Costs Remember Shutdown Cash Flows Incremental Cash Flow cash flow with project = - cash flow without project 7

8 Include all Indirect Effects Indirect Effect Rule: You must include all indirect effects in your analysis. 8

9 Indirect Effect As CFO of Hidden Valley you are considering building a new salad dressing factory. The new bottled salad dressing will have sales of \$1.25 million, but some of those sales (equivalent to \$10,000 in FCFF) will come from consumers who switch from buying Hidden Valley's existing dry packet salad dressing. Does this affect our decision to produce bottled dressing? -10,000-10,000-10,000-10,000-10, This type of externality is known as : Product cannibalization 9

10 Sunk Costs Sunk Cost A cost that cannot be recovered Sunk Cost Rule: Always ignore sunk costs. 10

11 Sunk Costs Hidden Valley plans to use a building that it owns for its new factory. The building was built at a cost of \$250,000 which we did not include in the initial cost of the project. Should we include it? NO! Whether we accept or reject the project this cost is sunk. I.e. the cost of the building has been incurred and does not depend on whether we accept or reject the project. It is not an incremental cash flow! 11

12 Opportunity Costs Opportunity Cost Benefit or cash flow foregone as a result of an action. Opportunity Cost Rule: Be sure to recognize the opportunity cost (that which is foregone). 12

13 Opportunity Costs Hidden Valley plans to use a building it owns for its new factory. It could rent the building instead for \$15,000 per year (FCFF equivalent). Does this affect our project decision? Yes! If the project is taken then we lose the opportunity to rent the building. So, -15,000-15,000-15,000-15,000-15,

14 Investments in Working Capital Working Capital Rule: Investments in working capital, just like investments in plant and equipment, result in cash outflows. Common ways working capital is overlooked: 1. Forgetting about working capital entirely. 2. Forgetting that working capital may change during the life of the project. 3. Forgetting that working capital is recovered at the end of the project. 14

15 Additional Considerations 1) Remember Terminal Cash Flows 2) Beware of Allocated Overhead Costs 3) Separation of Investment & Financing Decisions 15

16 Separation of Investment & Financing Decisions When valuing a project, ignore how the project is financed. Following the logic from incremental analysis ask yourself the following question: Is the project existence dependent on the financing? If no, you must separate financing and investment decisions. 16

17 Incremental Cash Flows IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? If yes, do not include it in your analysis. If no, include it. 17

18 Question A firm is considering an investment in a new manufacturing plant. The site already is owned by the company, but existing buildings would need to be demolished. Which of the following should be treated as incremental cash flows? a. The market value of the site. b. The market value of the existing buildings. c. Demolition costs and site clearance. d. The cost of a new access road put in last year. e. Lost cash flows on other projects due to executive time spent on the new facility. f. Future depreciation of the new plant. 18

19 Inflation INFLATION RULE Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures 19

20 Inflation Example You own a lease that will cost you \$8,000 this year increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% (nominal) what is the present value cost of the lease? 1 real interest rate = 1+nominal interest rate 1+inflation rate 20

21 Inflation Example - nominal figures Year Cash Flow x x x = 8,240 = 8,487 = 8,742 8, ,491 7,014 6,568 \$29,073 21

22 Inflation Example - real figures Year Cash Flow 0 8,000 8, ,000 8,000 8,000 8, , , ,491 7,014 6,568 = \$ 29,073 22

23 Calculating Cash Flows Think of cash flows as coming from three elements Total cash flow = + cash flows from capital investments + cash flows from changes in working capital + operating cash flows 23

24 Calculating Cash Flows 1) Cash Flow from Capital Investments Almost every project requires some sort of initial investment. This is often capitalized from an accounting perspective. In finance, the investment represents a negative cash flow. 2) Cash Flow from Working Capital (WC) Remember: NWC= CA-CL e.g. Slick makes an initial investment of \$10 m in inventories of plastic and steel for its blade plant. In year 1, it accumulates an additional \$20m of raw materials. In year 5, it decides to reduce its inventory from \$20 m to \$15 m. Show the cash flows from changes in working capital. 24

25 Cash Flow from Working Capital (cont) Slick makes an initial investment of \$10 m in inventories of plastic and steel for its blade plant. In year 1, it accumulates an additional \$20 m of raw materials. In year 5, it decides to reduce its inventory from \$20 m to \$15 m. Show the cash flows from changes in working capital. Year Total WC Change in WC CF from change in WC Summary: An increase in WC is an investment a negative cash flow An decrease in WC a positive cash flow 25

26 Calculating Cash Flows (cont.) 3) Operating Cash Flow Operating cash flow = + Revenue - Costs - Taxes Methods of Handling Depreciation Method l: Dollars in Minus Dollars Out (use income statement entries) OCF= revenues cash expenses - taxes Method 2: Adjusted Accounting Profits OCF= after-tax profit + depreciation Method 3: Add Back Depreciation Tax Shield OCF= (revenues cash expenses ) x (1- tax rate) + (tax rate x depreciation) 26 Net profit Depreciation tax shield

27 e.g. Methods of Handling Depreciation A project generates revenues of \$1000, cash expenses of \$600 and depreciation charges of \$200 in a year. The firm s tax bracket is 35%. What is Net Income? Calculate the OCF using all three aproaches. Revenues Cash expense Depreciation 200 Profit before tax Tax at 35% 70 Net profit 130 Method 1: OCF = revenues cash expenses tax = = 330 Method 2: OCF = after-tax profit + depreciation = = 330 Method 3 : OCF = = (revenues cash expenses ) x (1- tax rate) + (tax rate x depreciation) = ( ) x (0.65) x (0.35 x 200) =

28 Recall, Operating Cash Flows Need measure of the actual cash flow created by the project available to pay the debt, preferred, and common stock their required rates of return. Note: Many different books use different acronyms but the process for estimating free cash flow is the same Firm Approach: FCFF Revenues - Costs - Dep EBIT - Tax EBIT(1-t) + DEP OPCF - CapExp - DWC FCFF Free Cash Flow to Firm DO FCFF in 3-Steps: a - operating cash flow b - additional cap. exp. c - change in noncash working capital 28

29 FCFF FCFF (Re v Cost Dep)( 1 t) Dep CapExp DWC (Re v Cost)( 1 t) ( 1 t) Dep Dep CapExp DWC (Re v Cost)( 1 t) ( t) Dep CapExp DWC After tax cash flow Depreciation tax shield Note: from previous slide OPCF=After tax cash flow + Dep. tax shield 29

30 Example Blooper Industries (BI) BI is analyzing a proposal for mining and seeling a small deposit of high-grade magnoosium ore. A consulting study which cost \$800 million has been completed to assess the costs and benefits of the project. The data have been simplified in the following terms: The global unified tax rate is 35%. The inflation rate is 5%. The global unified after-tax cost of capital is 12% for projects with this level of risk. The project life is 5 years. The project would require the purchase of a \$10 million mining equipment. This equipment would be depreciated (straight-line) over 5 years to a zero salvage value. However, experts argue that the equipment could be sold for as much as \$2 million after 5 years. Annual maintenance expenses will be \$10 million in year 1. The working capital requirements will be \$1.5 million starting immediately), then \$ m, \$ m, \$4.493 m, \$4.717 m, \$3.039 m. The consultants estimate that BI will be able to sell 750,000 pounds of magnoosium a year at a price of \$20 a pound in year 1. (For all practical purposes, you can assume that the venture has sufficient profits to immediately take advantage of potential tax shields) 30

31 Blooper Industries Cash Flow From Operations (,000s) in year 1 Revenues - Expenses Depreciation = Profit before 35 % = Net profit + Depreciation = CF from operations 15, , 000 2, 000 3, 000 1, 050 1, 950 2, 000 3, 950 or \$3,950,000 31

32 Blooper Industries Year Cap Invest 10, 000 WC 1,500 4,075 4,279 4,493 4,717 3,039 0 Change in WC 1,500 2, ,679 3,039 Revenues 15,000 15,750 16,538 17,364 18,233 Expenses 10,000 10,500 11,025 11,576 12,155 Depreciati on 2,000 2,000 2,000 2,000 2,000 Pretax Profit 3,000 3,250 3,513 3,788 4,078.Tax (35%) 1,050 1,137 1,230 1,326 1,427 Profit 1,950 2,113 2,283 2,462 2,650 (,000s) 32

33 Blooper Industries Net Cash Flow (entire project) (,000s) Cap Invest Salvage value Change in WC CF from Op Net Cash Flow Year 0-10,000-1,500-11, ,575 3,950 1, ,113 3, ,283 4, ,462 4, ,679 4,651 6, ,300 3,039 4,339 12% = \$4,222,350 33

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