Finance B

December 21, 2023 (Week 5)

Prof. Tatsuo KUROGI
You need both basic & financial
calculators in today’s class !! 2
Foundations of Finance
Tenth Edition, Global Edition

Chapter 11

Cash Flows and Other

Topics in Capital Budgeting

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Learning Objectives
11.1 Identify guidelines by which we measure cash flows.
11.2 Explain how a project’s benefits and costs—that is, its
free cash flows—are calculated.
11.3 Explain the importance of options, or flexibility, in
capital budgeting.
11.4 Understand, measure, and adjust for project risk.

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Guidelines for Capital Budgeting

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Guidelines for Capital Budgeting
• To evaluate investment proposals, we must first set
guidelines by which we measure the value of each
proposal.
• We must know what is and what isn’t relevant cash flow.

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Use Free Cash Flows Rather Than
Accounting Profits
• Free cash flow accurately reflects the timing of benefits
and costs—when money is received, when it can be
reinvested, and when it must be paid out.
• Accounting profits do not reflect actual money in hand.

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Think Incrementally
• After-tax free cash flows must be measured incrementally.
• Determining incremental free cash flow involves
determining the cash flows with and without the project.
Incremental is the “additional cash flows” (inflows or
outflows) that occur due to the project.

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Beware of Cash Flows Diverted
from Existing Products
• Not all incremental free cash flow is relevant.
• Thus new product sales achieved at the cost of losing
sales from existing product line are not considered a
benefit.
• However, if the new product captures sales from
competitors or prevents loss of sales to new competing
products, it would be a relevant incremental free cash flow.

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Look for Incidental or Synergistic
Effects
• Although some projects may take sales away from a firm’s
existing projects (such as introducing a new flavor of ice
cream), in other cases new projects may add sales to the
existing line (such as adding a coffee store to an existing
retail store).
• This is called synergistic effect and is a relevant cash flow.

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Work in Working-Capital
Requirements
• New projects require infusion of working capital (such as
inventory to stock the shelves), which would be an outflow.
• Generally, when the project terminates, working capital is
recovered, and there is an inflow of working capital.

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Consider Incremental Expenses
• Similar to cash inflows, cash outflows must also be
considered on an incremental basis.
• For example, replacing an existing equipment may require
training expense (an incidental expense) for current
employees on the new equipment.

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Sunk Costs Are Not Incremental
Cash Flows
• Sunk costs are cash flows that have already occurred
(such as marketing research) and cannot be undone. Any
cash flows that are not affected by the accept/reject
criterion should not be included in the analysis.
• Managers need to ask two basic questions:
1. Will this cash flow occur if the project is accepted?
2. Will this cash flow occur if the project is rejected?

• If the answer is “Yes” to 1 and “No” to 2, it will be an

incremental cash flow.

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Account for Opportunity Costs
• Opportunity cost refers to cash flows that are lost
because of accepting the current project.
• For example, using the building space for the project will
mean loss of potential rental revenue.

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Decide If Overhead Costs Are Truly
Incremental Cash Flows
• Incremental overhead costs or costs that were incurred as
a result of the project and relevant to capital budgeting
must be included.
• Note, not all overhead costs may be relevant (for example,
utilities bill may have been the same with or without the
project).

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Ignore Interest Payments and
Financing Flows
• Interest payments and other financing cash flows that
might result from raising funds to finance a project are not
relevant cash flows.
• Reason: Required rate of return implicitly accounts for the
cost of raising funds to finance a new project.

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Incremental cash flows refer to

A) the difference between after-tax cash flows and

before-tax accounting profits.
B) the new cash flows that will be generated if a
project is undertaken.
C) the cash flows of a project, minus financing costs.
D) the cash flows that are foregone if a firm does not
undertake a project.

Question 1 17
AFB Systems is considering a new marketing campaign that
will require the addition of a new computer programmer and
new software. The programmer will occupy an office in
AFB's current building and will be paid $8,000 per month.
The software license costs $1,000 per month. The rent for
the building is $4,000 per month. AFB's computer system is
always on, so running the new software will not change the
current monthly electric bill of $900. The incremental
expenses for the new marketing campaign are .

A) $13,900 per month B) $9,000 per month

C) $13,000 per month D) $8,000 per month.

Question 2 18
A local restaurant owner is considering expanding into another
rural area. The expansion project will be financed through a line
of credit with City Bank. The administrative costs of obtaining
the line of credit are $500, and the interest payments are
expected to be $1,000 per month. The new restaurant will
occupy an existing building that can be rented for $2,500 per
month. The incremental cash flows for the new restaurant
include .
A) $500 administrative costs, $1,000 per month interest
payments, $2,500 per month rent
B) $500 administrative costs, $2,500 per month rent
C) $1,000 per month interest payments, $2,500 per month rent
D) $2,500 per month rent

Question 3 19
Calculating a Project’s Free Cash
Flows

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Free Cash Flow Calculations
• Three components of free cash flows
– Initial outlay
– Annual free cash flows over the project’s life
– Terminal free cash flow

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Initial Cash Outlay (1 of 2)
• The initial cash outlay is the immediate cash outflow
necessary to purchase the asset and put it in operating
order.
• This outlay includes the following:
1. Purchase cost, set-up cost, installation,
shipping/freight, training cost
2. Increased working-capital requirements
3. Sale of existing asset and tax implications (if the
project replaces an existing project/asset)

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Initial Cash Outlay (2 of 2)
Initial cost of sales price taxes recovered or paid from a loss
= − +/−
outlay new asset of theold asset or gain on thesaleof theold asset

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A new machine can be purchased for $1,800,000. It will cost
$35,000 to ship and $15,000 to fine-tune the machine.
The new machine will replace an older version that is fully
depreciated and will be sold for $200,000. The firm's income
tax rate is 35%. What is the initial outlay for capital
budgeting purposes?

A) $1,580,000 B) $1,630,000
C) $1,650,000 D) $1,720,000

Question 4 24
Blackjack Inc. wants to replace a 9 year-old machine with a
new machine that is more efficient. The old machine cost
$70,000 when new and has a current book value of $15,000.
Blackjack can sell the machine to a foreign buyer for
$14,000. Blackjack's tax rate is 35%.
The effect of the sale of the old machine on the initial
outlay for the new machine is .

A) -$14,350 B) -$13,650 C) -$9,100 D) $1,000

Question 5 25
Annual Free Cash Flows
• Annual free cash flows is the incremental after-tax cash
flows resulting form the project being considered.
• Free cash flow considers the following:
– Cash flow from operations
– Cash flows from working capital requirements
– Cash flows from capital spending

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Calculating Operating Cash Flows
(1 of 3)

• Step 1: Measure the project’s change in after-tax

operating cash flows.
• Operating cash flows
= Changes in EBIT − Changes in taxes + Change in
depreciation
• Note, depreciation is a noncash expense but influences
the cash flows through tax effects.
– Higher depreciation expense lowers firm’s profits,
which lowers taxes.

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Calculating Operating Cash Flows
(2 of 3)

• Step 2: Calculate the cash flows from the change in net

working capital.
• This refers to additional investment in current assets
minus any additional short-term liabilities that were
generated.

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Calculating Operating Cash Flows
(3 of 3)

• Step 3: Determine the cash flows from the changes in

capital spending.
• This refers to any capital spending requirements during
the life of the project.

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Putting It All Together
• Step 4: Project free cash flows = change in EBIT −
changes in taxes + change in depreciation − change in net
working capital − changes in capital spending

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If a new project is implemented, it is expected to generate
$800,000 in revenues, $250,000 in cash operating expenses,
and depreciation expense of $150,000 in each year of its 10-
year life.
The corporation's tax rate is 35%. The project will require an
increase in net working capital of $85,000 and a decrease in
net working capital of $75,000 in year ten. What is the free
cash flow from the project in year one?

A) $298,000 B) $375,000 C) $380,000 D) $410,000

Question 6 31
Smith Manufacturing Inc. expects the following results in
year one of a new project:
Revenue $400,000
Cash Expenses 150,000
Depreciation 90,000
EBIT $160,000
Taxes 48,000
Net Income $112,000

The annual change in operating cash flow is equal to .

A) $298,000 B) $202,000
C) $160,000 D) $250,000

Question 7 32
Terminal Cash Flow
• Terminal cash flows are flows associated with the project
at termination.
• It may include the following:
– Salvage value of the project
– Any taxable gains or losses associated with the sale of
any asset

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Waterford Industries is considering the purchase of a new
machine. It will replace an existing but obsolete machine that
will be sold for $50,000. The existing machine is 8 years old,
cost $200,000, had a 10-year useful life, and is being
depreciated to zero using the straight-line method.
Waterford's income tax rate is 35%.
What is the after-tax salvage value of the old machine?

A) $42,000 B) $46,500 C) $50,000 D) $53,500

Question 8 34
When terminating a project for capital budgeting purposes,
the working capital outlay required at the initiation of the
project will .

A) not affect the terminal cash flow.

B) decrease the terminal cash flow because it is a
historical cost.
C) increase the terminal cash flow because it is recaptured.
D) decrease the terminal cash flow because it is an outlay.

Question 9 35
Example (LEE Corporation’s case)
LEE Corporation intends to purchase equipment for $1,500,000.
The equipment has a 5 -year useful life and will be depreciated on
a straight-line basis. Addition of the equipment requires additional
working capital of $20,000. The $20,000 is expected to be
recaptured at the end of the project. LEE's marginal tax rate is 40%.
Use of the equipment is expected to change the company's reported
EBIT by $600,000 in year one, $700,000 in year two, $550,000 in
year three, $200,000 in year four, and $100,000 in year five. Due
to changing market conditions, the equipment did have a salvage
value of $100,000 at the end of year five.

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Example (Initial outlay)
Initial cost of sales price taxes recovered or paid from a loss
= − +/−
outlay new asset of theold asset or gain on thesaleof theold asset

Initial Outlay (Cash flow in year 0)

= $1,500,000 + $20,000 = $1,520,000

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Example: Incremental FCFs
Year 1 Year 2 Year 3 Year 4 Year 5

EBIT $600,000 $700,000 $550,000 $200,000 $100,000

Less: Taxes (40%) 240,000 280,000 220,000 80,000 40,000

Plus: Depreciation 300,000 300,000 300,000 300,000 300,000

Operating Cash Flow $660,000 $720,000 $630,000 $420,000 $360,000

Salvage Value $100,000

Minus: Tax on Gain -40,000

Plus: Recovery of 20,000
Working Capital
Free Cash Flow $660,000 $720,000 $630,000 $420,000 $440,000

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Example (NPV and IRR)
If the required rate of return for this project is 20%,
calculate the project's net present value and internal rate
of return and comment on the acceptability of the project.

NPV = $273,956 and the project is acceptable since

the NPV is positive.
IRR = 28.73% and the project is acceptable since the
IRR exceeds the required rate of return.

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Dave Company, Inc. is considering purchasing a new
grinding machine with a useful life of five years.
The initial outlay for the machine is $165,000.
The expected cash inflows are as follows:
Year After-tax Expected Cash Flow
1 15,000
2 35,000
3 70,000
4 90,000
5 70,000
Given that the firm has a 10% required rate of return, what is
the NPV?

Question 10 40
Options in Capital Budgeting

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Options in Capital Budgeting
• Options add value to capital-budgeting projects by being
able to modify the project based on future developments
(that are currently unknown). Three options are common:
– Option to delay a project
– Option to expand a project
– Option to abandon a project

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The Option to Delay
• Almost every project has a mutually exclusive
alternative—waiting and pursuing at a later time.
• It is conceivable that a project with a negative NPV now
may have a positive NPV if undertaken later on. This
could be due to various reasons, such as favorable
changes in fashion, technology, economy, or borrowing
costs.

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The Option to Expand
• Even if a project is currently unprofitable, it may be useful
to determine whether the profitability of the project will
change if the company is able to expand in the future.
• For example, a firm may choose to invest in a negative
NPV project to gain access to new market.

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The Option to Abandon
• It may be necessary to abandon the project before its
estimated life due to inaccurate project analysis models or
cash flow forecasts or due to changes in market
conditions.
• When comparing two projects with similar NPVs, a project
that is easier to abandon may be more desirable (for
example, hiring temporary versus permanent workers,
leasing versus buying a car). The option to abandon
infuses flexibility, which is desirable.

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A major corporation is considering a capital budgeting
project that involves the development of a new technology.
The controller estimates the net present value to be
negative, yet argues that the company should invest in the
project. Which of the following statements is MOST
correct?
A) The controller should be fired for making such a poor
decision.
B) The controller may be considering the option to expand
or modify the project in the future.
C) The profitability index may be greater than one, giving
an accept decision.
D) Capital rationing may exist for the current year.

Question 11 46
Risk and the Investment Decision

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Figure 11.3 A Free Cash Flow
Diagram Based on Possible
Outcomes

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Risk and the Investment Decision
• Two main issues
– What is risk in capital-budgeting decisions, and how
should it be measured?
– How should risk be incorporated into a capital-
budgeting analysis?

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Three Perspectives on Risk
• Project-standing-alone risk
• Contribution-to-firm risk
• Systematic risk

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Project-Standing-Alone-Risk
• This is a project’s risk ignoring the fact that much of the
risk will be diversified away as the project is combined
with other projects and assets.
• This is an inappropriate measure of risk for capital-
budgeting projects.

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Contribution-to-Firm Risk
• This is the amount of risk that the project contributes to
the firm as a whole.
• This measure considers the fact that some of the project’s
risk will be diversified away as the project is combined
with the firm’s other projects and assets but ignores the
effects of the diversification of the firm’s shareholders.

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Systematic Risk
• This is the risk of the project from the viewpoint of a well-
diversified shareholder.
• This measure takes into account that some of the risk will
be diversified away as the project is combined with the
firm’s other projects, and in addition, some of the
remaining risk will be diversified away by the shareholders
as they combine this stock with other stocks in their
portfolios.

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Figure 11.4 Looking at Three
Measures of a Project’s Risk

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Relevant Risk
• Theoretically, the only risk of concern to shareholders is
systematic risk.
• Because the project’s contribution-to-firm risk affects the
probability of bankruptcy for the firm, it is a relevant risk
measure.
• Thus we need to consider both the project’s contribution-
to-firm risk and the project’s systematic risk.

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Incorporating Risk into Capital
Budgeting
• We know that investors demand higher returns for more
risky projects.
• As the risk of a project increases, the required rate of
return is adjusted upward to compensate for the added
risk.
• This risk-adjusted discount rate is then used for
discounting free cash flows (in NPV model) or as the
benchmark required rate of return (in IRR model).

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Figure 11.5 The Risk–Return
Relationship

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Which of the following statements about project standing
alone risk is true?

A) It ignores the fact that much of the risk of a project will

be diversified away as the project is combined with the
firm's other projects.
B) It ignores the cash flows that are associated with a
project that occur beyond the payback period.
C) It takes into consideration the effects of diversification
of the firm's shareholders.
D) It provides the best measure of project risk for a large,
widely-held company.

Question 12 58
KLE Holdings is considering a capital budgeting project with
a life of 7 years that requires an initial outlay of $277,400.
The probability distribution for annual incremental cash flows
is as follows: Probability Incremental Free Cash Flow
4% -$15,000
16% 18,000
55% 65,000
25% 99,000
a. The risk-adjusted required rate of return for this project is
12%. Calculate the risk-adjusted net present value of the
project and the project's IRR.
b. Should the project be accepted?

Question 13 59
✓ Quiz Problems: Posted on MUSCAT
✓ Coverage: Chapters 9, 10, and 11

✓ Deadline: 11:30 pm, December 27 (Wed)

✓ Submission: To MUSCAT

✓ Format: Word or PDF file

✓ Rules: Late submission is subject to a penalty.

No discussions with others.

Take-home Quiz 2 60
✓ Report problems: Will be posted on MUSCAT soon
✓ Deadline: 1:00 pm, January 18 (Thu)

✓ Submission: To MUSCAT

✓ Format: Word or PDF file

✓ Rules: Do not forget your name and student ID number

on your written report.
Late submission is subject to a penalty.
No discussions with others.

Written Report
 Chapter 12
“Determining the Financing
Mix ”
(pp. 428-467)
*You’ll need a basic calculator

Next class (Jan. 11)