Capital Budgeting

Cash Flows
An Overview of Estimating Cash
Flows

Costs and benefits are measured in terms of

cash flow—not income.
Cash flow timing is critical.
Cash flows must be measured on an
incremental after-tax basis.
Financing costs are included in the discount
rate.
Calculating Incremental Cash
Flows
Costs and benefits associated with a capital
budgeting project are measured in terms of cash
flows rather than earnings.
Cash flows must be on an incremental (or
marginal) basis.
 These are the firm’s cash flows with the project minus
the firm’s cash flows without the project.
Cash flows must be measured on an after-tax
basis.
Incremental Cash Flows for a
Project
Net initial investment outlay.
Future net operating cash flows.
Non-operating cash flows required to
support the initial investment outlay.
 Cash flows associated with a major overhaul.
Net salvage value received upon
termination of the project.
Net Initial Investment Outlay

Cash expenditure.
Changes in net working capital.
Net cash flow from sale of old asset (if
any).
Investment tax credits.
Cash Expenditure

Let I0 be the net expenditure to be

capitalized, E0 be the net expenditure to be
expensed immediately, and T be the firm’s
marginal tax rate.
Cash expenditure = – I0 – E0 + E0
= – I0 – (1 – E0
Changes in Net Working Capital

At the start of a project, an investment of net

working capital may be required.
 Operating cash
 Inventory
 Accounts receivable
 Accounts payable
A project could also reduce the net working
capital requirements.
 Asset replacement
Net Cash Flow from Sale of Old
Asset
If an old asset is to be replaced by a new one, the
sale of the old asset generates a cash flow.
If the selling price is greater than the book value
of the old asset, taxes will have to be paid on this
sale.
If the selling price is less than the book value of
the old asset, a tax credit is generated.
Net Cash Flow from Sale of Old
Asset
Let S0 be the selling price of the old asset,
and B0 be its book value.
Net cash flow from sale of old asset =
S0 -  (S0 – B0) = S0  (1 – ) + 
B0
Tax on capital gains (a.k.a.
depreciation recapture). Tax
credit if negative.
 Net Initial Outlay

Let C0 be the net initial outlay. Let Wbe the

change in the net working capital. Let Ic be the
investment tax credit. Then,

C0 = – I0 – W – (1 – TE0 + S0 (1 – T) + T B0 +
Ic
Net Operating Cash Flow

Let R be the change in periodic revenue

and E be the change in periodic expenses
associated with the project. Let D be the
change in the periodic depreciation
expense.
The Cash Flow After Tax (CFAT) is given
by
CFAT = (R – E) (1 – T) + T  D
Net Operating Cash Flow

By rearranging the terms, we can re-write CFAT

as after-tax net income plus depreciation:

CFAT = (R – E – D)(1 – T) + D

Non-Operating Cash Flows

These are treated in the same way as initial

cash expenditure.
The expensed non-operating cash flows are
multiplied by (1 - T) to adjust for taxes.
Capitalized non-operating cash flows create
a cash outflow when they occur and a
depreciation tax shield in subsequent years.
Net Salvage Value

Let S denote the selling price of the asset and

B denote its book value. Let REX denote the
cleanup and removal expenses (to be
expensed) and W be the net working capital
recovered upon termination of the project.
Net salvage value =
S (1 –T) + T B – REX  (1 – T)
+ W
 Incremental Cash Flow Example
• New technology can lower production costs by $1.2M a year
• Current machine was purchased 5 years ago for $3M and is being
depreciated using straight-line depreciation to a zero book value over a
10 year period. It’s current market value is thought to be $1.75M
• There are no investment credits at this time.
• The cost of the new machine is $5.1M plus $400,000 in shipping and
$200,000 installation costs (which can be expensed)
• New process will result in an initial increase in inventories of $40,000
and accounts payables of $25,000.
• The tax rate is 40%.
• The cost of capital is 12%.
• After 10 years the new machine is expected to be sold off for $350,000
• Reclamation costs are expected to be $150,000.
 Perma-Filter Co.

Annual depreciation on old machine is

$ 3,000,000
$ 300,000 
10
Current book value of old machine is
$3,000,000 - 5×($300,000) = $1,500,000 = B0
• Selling price of old machine is
$1,750,000 = S0
Investment tax credit is not available.
 Ic = 0
Perma-Filter Co.

If the replacement is made, the investment in net

working capital is
 Increase in Inventory - Increase in Accounts Payable
 = $40,000 - $25,000 = $15,000 = W
Net expenditure to be capitalized is
I0 = $5,100,000 + $400,000 = $5,500,000
Installation cost to be expensed immediately is
$200,000 ( = E0).
 Perma-Filter Co.
The net initial outlay is $3,985,000.

C0 = – I0 – W – (1 – TE0 + S0 (1 – T) + T B0 + Ic
C0 = – $5,500,000 – $ – (1 – .40$200,000 +
$1,750,000×(1 – .40) + .40×$1,500,000 + 0
Perma-Filter Co.

Annual depreciation expense on the new machine

is
$ 5,500,000  $ 350,000
$ 515,000 
10

In the first five years after the replacement, the

firm will “lose” the depreciation expense on the
old machine.
In the last five years, the depreciation on the old
machine (if kept) would be $0.
Perma-Filter Co.

The change in depreciation (D) in years 1

through 5 is
Depreciation on new – depreciation on old
= $515,000 – $300,000 = $215,000
The change in depreciation (D) in years 6
through 10 is simply $515,000.
Since sales do not increase, R = 0.
Since cash expenses decline, E = –$1.2 million.
 Perma-Filter Co.
CFAT1–5 = $806,000
CFAT = (R – E – D)(1 – T) + D

CFAT1–5 = ( – –$1,200,000 – $215,000)(1 – .40) +

$215,000
 Perma-Filter Co.
CFAT6–10 = $926,000
CFAT = (R – E – D)(1 – T) + D

CFAT1–5 = ( – –$1,200,000 – $215,000)(1 – .40) + $215,000

Perma-Filter Co.

After 10 years, the new machine is expected

to be sold off for $350,000 (= S).
The book value of this machine will be
$350,000 (= B).
Removal expenses are $150,000 (= REX).
Net working capital of $15,000 will be
recovered (= W).
Perma-Filter Co.
Net Salvage Value = $275,000

S (1 –T) + TB – REX  (1 – T) + W

$350,000(1 –.40)
+ .4×$350,000 – 150,000  (1
– .40) +$15,000
Perma-Filter Co. - Summary of
Cash Flows

Cash Flow

Initial Investment -$3,985,000

CFAT in years 1 to 5 $806,000

CFAT in years 6 to 10 $926,000

Net Salvage Value $275,000

 Net Present Value

5
806,000 10 926,000 275,000
NPV  $3,985,000   t
 t
 10
t 1 (1  r ) t 6 (1  r ) (1  r )

Accept the project if the NPV is positive, and

reject it if the NPV is negative.
 Perma-Filter Co.

Assume that the replacement project being

considered by Perma-Filter Co. has a cost of
capital of 12%. Should the firm make the
replacement?
5 10
806 ,000 926 ,000 225 ,000
NPV   $ 3,985 ,000  
t 1 (1 .12 ) t
 
t 6 (1 .12 ) t

(1 .12 )10

NPV = $903,076
Adding Value per Share

Since the NPV of the replacement project is

positive, Perma-Filter should make the
replacement.
Assuming Perma-Filter has 500,000 shares
outstanding, making the replacement will
add about $1.81 to each share’s value:
$ 903,076
$ 1 .81 per share
500,000 shares
The Internal Rate of Return (IRR)

The IRR is the discount rate that makes the

NPV equal to zero.
For Perma-Filter’s replacement project,
IRR = 16.95%
Inflation
Inflation effects can be complex because
asset value is a function of both the required
return and the expected future cash flows.
The changes can cancel each other out,
leaving the project’s NPV unchanged.
Inflation

Inflation affects the cash flows from a project.

 Effect on revenues
 Effect on expenses
Inflation also affects the cost of capital.
 The higher the expected inflation, the higher the
return required by investors.
Thus, the effects of inflation must be properly
incorporated in the NPV analysis.
Effect of Inflation on the Cost of
Capital
Notation:
rr = cost of capital in real terms
rn = cost of capital in nominal terms
i= expected annual inflation rate
(1 + rn) = (1 + rr) (1 + i)
rn = rr + i + i×rr
Effect of Inflation on the Cost of
Capital
Inflation affects both revenues and
expenses.
However, depreciation expense is based on
historical cost.
 Depreciation tax credits do not inflate.
Effect of Inflation on the Cost of
Capital
If nominal depreciation tax credits are used, then
we must use:
 Nominal values of revenues and other expenses.
 Nominal cost of capital.
If revenues and other expenses are in real terms,
we must:
 Express depreciation tax credits in real terms.
 Use the real cost of capital.
A consistent treatment of NPV will not alter the
project’s NPV.
Inflation and NPV Analysis

The NPV of the project is unchanged as

long as the cash flows and the cost of
capital are expressed in consistent terms.
 Both in real terms
 Both in nominal terms
If inflation is expected to affect revenues
and expenses differently, these differences
must be incorporated in the analysis.
 Inflation and NPV

Wildcat Washer Works (WWW) is evaluating a new

project which costs $120,000. It has a life of 3 years
and no salvage value. Annual revenues, less
operating expenses (excluding depreciation) are
$55,000 per year in real dollars. WWW will use
straight line depreciation to a zero book value over 3
years. Its marginal tax rate is 40%. The real cost of
capital is 5% and inflation is expected to be 8% per
year.
Compute the NPV of the project in real and in
nominal dollars.
NPV in Real Dollars

Annual after-tax revenues (less expenses), in

real dollars are $55,000(1- 0.40) or $33,000
per year.
Annual depreciation expense (in nominal
dollars) is ($120,000 - $0)/3 or $40,000 per
year.
Annual depreciation tax credit (in nominal
dollars) is $40,000(0.40) or $16,000 per year.
NPV in Real Dollars

In real dollars, the first year’s depreciation tax

credit is worth $16,000/(1.08) or $14,815.
In real dollars, the second year’s depreciation tax
credit is worth $16,000/(1.08)2 or $13,717.
In real dollars, the third year’s depreciation tax
credit is worth $16,000/(1.08)3 or $12,701.
The annual after-tax cash flow is the after tax
revenues (less expenses) plus the depreciation tax
credit.
 NPV in Real Dollars
Year 0 Year 1 Year 2 Year 3

Initial investment ($120,000)

After-tax net rev. $33,000 $33,000 $33,000
Depr. tax credit. $14,815 $13,717 $12,701

Real after-tax
cash flow ($120,000) $47,815 $46,717 $45,701

NPV of real after-tax cash flows at the real cost of capital

(of 5%) is $7,390.03.
NPV in Nominal Dollars

Annual depreciation expense (in nominal

dollars) is ($120,000 - $0)/3 or $40,000 per
year.
Annual depreciation tax credit (in nominal
dollars) is $40,000(0.40) or $16,000 per
year.
NPV in Nominal Dollars
In nominal dollars, revenues net of expenses
in year 1 are $55,000(1.08) or $59,400.
After-tax net revenues = $59,400(1-0.4) or
$35,640.
In nominal dollars, revenues net of expenses
in year 2 are $55,000(1.08)2 or $64,152
After-tax net revenues = $64,152(1-0.4) or
$38,491.
After-tax net revenues in year 3 are $41,570.
NPV in Nominal Dollars

The nominal cost of capital is

rn rr  i  rr i
0.05  0.08  0.08 0.05
13.4%
 NPV in Nominal Dollars
Year 0 Year 1 Year 2 Year 3

Initial investment ($120,000)

After-tax net rev. $35,640 $38,491 $41,570
Depr. tax credit. $16,000 $16,000 $16,000

Nominal after-
tax cash flow ($120,000) $51,640 $54,491 $57,570

NPV of nominal after-tax cash flows at the nominal

cost of capital (of 13.40%) is $7,390.02.
A Little More About Taxes
Because tax laws change often, it is critical
to use the current tax laws to determine
after-tax cash flows for a capital budgeting
decision.
When a choice presents itself, like a choice
in depreciation methods, use the method
that provides the largest present value of tax
credits.
A Note on Tax Considerations

Tax laws are constantly changing:

 Marginal tax rates.
 Provisions for allowable depreciation of
capital assets.
 Investment tax credit.
The marginal tax rate may be higher than
the marginal federal income tax rate due to
state and local taxes.
A Note on Depreciation

The total amount of depreciation tax credits over

the life of the project is independent of the
depreciation method used.
The present value of these tax credits is
dependent on the depreciation method.
 Accelerated versus straight line methods.
A firm should use the depreciation method that
results in the largest present value of depreciation
tax credits.
Evaluating Replacement Cycles

Certain assets need to be replaced after the

original is worn out.
 Example: delivery vehicles
The initial choice may involve alternative
models that essentially do the same job but
differ in their costs and usable life.
The choice can be made in two ways:
 Equivalent Annual Cost method
 Common Horizon method
 Unequal Life Projects
The Mid-Town Transit Co. is considering the purchase of
a special purpose delivery vehicle. Two models are
available:
Model A Model B
Cost $40,000 $60,000
Useful life 5 years 9 years
After-tax annual
operating expenses $12,000 $10,500

If the cost of capital is 15%, which one should it

choose?
Unequal Life Projects

First, compute the total present value of the costs

(TC) over the life of the project.
Next, determine the annual cash flow that, if it
occurred every year, would have a present value
= TC. This annual cash flow is called the
Equivalent Annual Cost (EAC).
Now choose the project that has the lowest EAC.
If both projects have the same EAC, choose the
one with the shorter life.
Computing the EAC

 r (1  r ) 
n
EAC TC  n 
 (1  r )  1 
 EAC for Mid-Town Transit Co.’s
Projects
Model A Model B
Cost $40,000 $60,000
Useful life 5 years 9 years
After-tax annual
operating expenses $12,000 $10,500

Total Present Value ($80,226) ($110,102)

Equivalent Annual
Cost ($23,933) ($23,074)
 Optimal Replacement Frequency

Fisher Plastics uses an extruding machine in

its manufacturing process. The machine costs
$50,000, and annual after-tax operating
expenses are $12,000 per year. If used for 4
years, it can be sold off for an after-tax
salvage value of $5,000. If used for 6 years,
the after-tax salvage value would be only
$3,000. If the cost of capital is 15%, should
Fisher use this machine for 4 or 6 years?
Optimal Replacement Frequency

By replacing the machine every 4 years, the firm

incurs the cost of the new machine sooner.
However, it receives the benefit of a higher
salvage value.
By replacing the machine every 6 years, the firm
incurs the cost of the new machine later.
However, it receives a lower salvage value.
The optimal replacement frequency takes into
account these opposing effects.
 Optimal Replacement Frequency

Replacement Frequency: 4 Years 6 years

Cost $50,000 $50,000
Annual Operating Expenses $12,000 $12,000
Salvage Value (after tax) $5,000 $3,000

Total Present Value ($81,401) ($94,117)

Equivalent Annual Cost ($28,512) ($24,869)
Equivalent Annual Annuity

The EAC annualizes the cost of the project

over its life.
This concept can be applied to annualize
any amount:
 A project’s NPV
 A project’s total revenues
The general term is called the Equivalent
Annual Annuity (EAA).
Equivalent Annual Annuity

The EAA can be used to choose between

two or more mutually exclusive projects
with unequal lives.
Choose the project with the highest EAA.
If two projects have the same EAA, choose
the project with the shorter life.
 Equivalent Annual Annuity

Fisher Plastics is considering a new 6-year

project which has an NPV of $2,650 at a cost
of capital of 15%. What is the project’s
Equivalent Annual Annuity (EAA)?

EAA = $700.
(Solve for PMT on your calculator.)
 Break-Even Analysis
Hancock Cabinets, Inc. is considering a new
project which costs $1.0 million, has a life of 6
years with no salvage value. The unit selling
price is $18, unit variable costs are $8, and
annual fixed costs are $500,000. The cost of
capital is 12% and Hancock’s marginal tax rate
is 40%.
 What is the accounting break-even level of
sales?
 What is the financial break-even level of
sales?
Accounting Break-Even

Contribution Margin = c
= Selling Price - Variable Cost
= $18 - $8 = $10 per unit.
Break-Even Sales = Fixed Costs / c
= $500,000 / $10 = 50,000 units.
At a sales level of 50,000 units, the firm
will make zero profits.
Financial Break-Even Analysis

First find the cash flows necessary to make

the NPV equal to zero.
Annual depreciation = $1.0million / 6 or
$166,667.
Annual depreciation tax credit =
$166,667(0.40) = $66,667.
Present value of these tax credits (at 12%)
is $274,095.
Financial Break-Even Analysis
NPV = 0 = initial investment + PV tax
shield of depreciation + PV after-tax cash
flow on final sale of asset + cash flow
before tax times 1 minus tax rate times
present value annuity factor
NPV = 0 = -$1,000,000 + 274,095 +
(cQ - F) (1-T) PVIFA6 years, 12%
n
PVIFAn,r = (1  r )  1
n
r (1  r )
Financial Break-Even Analysis
NPV = 0 = -$1,000,000 + 274,095 +
(cQ - F) (1-T) PVIFA6 years, 12%
$725,905 = ($10Q - $500,000)(.6)(4.1114)
$725,905/(.6)(4.1114) +$500,000 = $10Q
$794,265 = $10Q
Q = 79,427 units
Break-Even Analysis

Note that the accounting break-even level

of sales (50,000 units) is less than the
financial break-even quantity (79,427).
If Hancock sells 50,000 units per year for 6
years, its accounting income will be zero in
each year. However, the project will have a
negative NPV.
Capital Budgeting in Practice

Most firms used more than one method for capital

budgeting project evaluation.
The NPV profile is the most useful item.
 It provides the most complete view of the project.
A process for appropriating capital after the
projects have been selected must be created by the
firm.
Review of project performance must be done
periodically.
END OF PRESENTATION