Chapter 8

Cash Flow and Capital

Budgeting

Professor XXXXX
Course Name / #

2007 Thomson South-Western

 Cash Flow and Capital
Budgeting
The kinds of cash flows that may appear in
almost any type of investment
How to deal properly with the problem of
inflation in capital budgeting problems
Special problems and situations that arise in
the capital budgeting process
The human element in capital budgeting

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 Cash Flow versus Accounting
Profit
Inpreparing financial statements for
external reporting, accountants have a
different purpose in mind than
financial analysts have when they
evaluate the merits of an investment.
Accountants measure the inflows and
outflows of a businesss operations on an
accrual basis rather than on a cash basis.
E.g., depreciation

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 Cash Flow versus Accounting
Profit
For capital budgeting purposes, financial
analysts focus on incremental cash in-
flows and outflows.
This emphasis simply recognizes that no
matter what earnings a firm may show on
an accrual basis, it cannot survive for long
unless it generates cash to pay its bills.
When calculating a projects NPV, analysts
should ignore the costs of raising the money
to finance the project.

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 The Initial Investment
Many capital budgeting problems begin with
an initial outflow to acquire/install fixed assets.
Must also consider:
Cash inflow from selling old equipment
Cash inflow (outflow) if selling old equipment below
(above) tax basis generates tax savings (liability)
New equipment costs $10
million,
An example.... $0.5 million to install

Tax rate = Old equipment has been fully

40% depreciated, sold for $1
million

The initial investment would then be an outflow of $10.5

million, and an after-tax inflow of $0.60 million from selling
5 the old equipment
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 Types of Cash Flows
Depreciation
Fixedasset expenditures
Working capital expenditures
Terminal value
Incremental cash flow

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 Depreciation
Largest noncash item for most
investment projects
Affects the amount of taxes the firm
will pay
Modified accelerated cost recovery
system (MACRS)
definesthe allowable annual
depreciation deductions for various
classes of assets
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 Depreciation
Many countries allow firms to use one depreciation
method for tax purposes and another for reporting
purposes
Accelerated depreciation methods (such as MACRS)
increase the present value of an investments tax
benefits
Relative to MACRS, straight-line depreciation results in
higher reported earnings early in an investments life

Which method would you expect companies to use when

they file their taxes, and which would they use when
preparing public financial statements?

For capital budgeting analysis, it is the

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depreciation method for tax purposes that matters
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 Two Methods Of Handling
Depreciation To Compute Cash
Flow
Adding non-cash expenses Find after-tax profits, add back
Assume a firm
back to after-tax purchasesnon-cash
earnings a fixed
chargeasset today
tax savings

Sales $30,000for $30,000

Sales $30,000

Cost of goods (10,000) Cost of goods (10,000)

Plans
Gross profitsto depreciate
$20,000 over
Pre-tax3 years$20,000
income using
Depreciation straight-lineTaxes
(10,000) method(40%) (8,000)

Pre-tax income $10,000 Aft-tax income $12,000

Costs $1/unit
Firm (40%)
Taxes will produce
(4,000) Depreciation $4,000
10,000 units/year tax savings
Net income $6,000 Sells for
Cash Flow
$3/unit $16,000
Cash flow $16,000
= NI + deprec

9 Firm pays taxes at Simplest

a 40% and most common technique:
marginal
Add depreciation back in rate
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 Tax Depreciation Schedules
by Asset Class

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 Fixed Asset Expenditures
When a firm sells an old piece of
equipment, there will be a tax
consequence of the sale if the selling
price exceeds or falls below the old
equipments book value.
If the firm sells an asset for more than its
book value, the firm must pay taxes on the
difference.
If a firm sells an asset for less than its book
value, then it can treat the difference as a
tax-deductible expense.

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 Working Capital
Expenditures
Many capital investments require
additions to working capital
Net working capital (NWC) = current assets
minus current liabilities
Increase in NWC is a cash outflow; decrease a
cash inflow
An example
Operate booth from November 1 to January 31
Order $15,000 calendars on credit, delivery by
Nov 1
Must pay suppliers $5,000/month, beginning
Dec 1
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Expect to sell 30% of inventory (for cash) in
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12 Nov; 60% in Dec; 10% in Jan
 Working Capital For Calendar
Sales Booth
Oct 1 Nov 1 Dec 1 Jan 1 Feb 1

Cash $0 $500 $500 $500 $0

Inventory $0 $15,000 $10,500 $1,500 $0

Accts payable $0 $15,000 $10,000 $5,000 $0

Net WC $0 $500 $1,000 ($3,000)
$0
Monthly in WC NA +$500 +$500 ($4,000) +$3,000

Payments and Oct 1 to Nov 1 to Dec 1 to Jan 1 to

inventory Nov 1 Dec 1 Jan 1 Feb 1
Reduction in $0 $4,500 $9,000 $1,500
inventory [30%] [60%] [10%]
Payments $0 ($5,000) ($5,000) ($5,000)

13 Net cash flow ($500) ($500) +$4,000 ($3,000)

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 Terminal Value
Terminal value used when evaluating an
investment with indefinite life-span

Forecasts more than 5 to

Construct cash-flow
10 years have high
forecasts for 5 to 10
margin of error; use
years
terminal value instead

Terminal value is intended to reflect the

value of
a project at a given future point in time
14 Large value relative to all the other cash flows
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 Terminal Value
Different ways to calculate terminal values

Use final year cash flow projections and assume that

all future cash flows grow at a constant rate
Multiply final cash flow estimate by a market multiple
Use investments book value or liquidation value

JDS Uniphase cash flow projections for

acquisition of SDL Inc.
Year 1 Year 2 Year 3 Year 4 Year 5
$0.5 Billion $1.0 Billion $1.75 Billion $2.5 Billion $3.25 Billion
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 Terminal Value of SDL
Acquisition
If we assume that cash flow continues to grow at 5% per
year (g = 5%, r = 10%, cash flow for year 6 is $3.41
billion):CF $3.41
PVt t 1
, or PV5 $68.2
rg 0.10 0.05
Terminal value is $68.2 billion; value of entire project is
$0. 5 $1 $1.75 $2.5 $3.25 $68.2
1
2
3
4
5
5
$48.7
1. 1 1. 1 1. 1 1. 1 1. 1 1. 1

$42.4 billion of total $48.7 billion from terminal value

Using price-to-cash-flow ratio of 20 for companies in the

same industry as SDL to compute terminal value
Terminal Value = $3.25 x 20 = $65 billion
Caveat : market multiples fluctuate over time
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 Incremental Cash Flow
Incremental cash flows versus sunk
costs
Capital budgeting analysis should include only
incremental costs

An example
Norman Pauls current salary is $60,000 per year and
expect increases of 5% each year
Norm pays taxes at flat rate of 35%
Sunk costs: $1,000 for GMAT course and $2,000 for
visiting various programs
Room and board expenses are not incremental to the
17 decision to go back to school
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 Incremental Cash Flow
At end of two years assume that Norm receives a salary
offer of $90,000, which increases at 8% per year
Expected tuition, fees and textbook expenses for next
two years while studying in MBA: $35,000
If Norm worked at his current job for two years, his
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salary would have increased to $66,150: 60, 000 1 .05 2
$66,150
Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
After-tax inflow: $23,850 x (1-0.35) = $15,503
Yr 3 cash inflow: $90,000 1.08 $60,000 1.05 1 0.35 $18,032
3

MBA has substantial positive NPV value if 30 yr

analysis period

What about Norms opportunity cost?

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 Opportunity Cost
Incapital budgeting, the
opportunity costs of one
investment are the cash flows on
the alternative investment that the
firm decides not to make.

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 Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one
investment is undertaken

If Norm did not attend MBA, he would have

earned:

First year: $60,000 ($39,000 Second Year: $63,000

after taxes) ($40,950 after taxes)

NPV of a project could fall substantially if opportunity

costs are recognized
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 Cash Inflows, Discounting,
and Inflation
If inflation is in the numerator, be sure that it is
also in the denominator.
If the numerator ignores inflation, so too must the
denominator.
The nominal return reflects the actual dollar
return.
The real return measures the increase in
purchasing power gained by holding a certain
investment.
In general, when the inflation rate is high, so
too will be the nominal rate of return offered by
various investments:
Investors will demand a return that not only keeps
pace with inflation,
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but also offers a positive real return.
 Inflation Rule 1

Nominal cash flows reflect the

same inflation rate that the interest
rate does
Inflation Rule 1 When we
discount cash flows at a nominal
interest rate, embedded in the
22 discount rate is an estimate of
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 Inflation Rule 2

Occasionally an investments cash

flow projections may be stated in
real terms.
Real cash flows only reflect current
prices and do not incorporate upward
adjustments for expected inflation.
Inflation Rule 2 When project
cash flows are stated in real rather
than in nominal terms, the
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appropriate discount rate is the real
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 Equipment Replacement
and Unequal Lives
A firm must purchase an electronic control device
First alternative is a cheaper device, higher
maintenance costs, shorter period of utilization
Second device is more expensive, smaller
maintenance costs, longer life span
Expected cash outflows
Device 0 1 2 3 4
A 12000 1500 1500 1500 -
B 14000 1200 1200 1200 1200

Maintenance costs are constant over time. Use real

discount rate of 7% for NPV
Device NPV
A $15,936
B $18,065

24 Cash outflow device A < cash outflow device B select A?

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 Equivalent Annual Cost

(EAC)
EAC converts lifetime costs to a level annuity; eliminates the
problem of unequal lives
1. Compute NPV for operating devices A and B for their
lifetime
NPV device A = $15,936
NPV device B = $18,065
2. Compute annual expenditure to make NPV of annuity equal
to NPV of operating device

X X X
Device A $15,936 1
2
X $6,072
1.07 1.07 1.07 3

Y Y Y Y
Device B $18,065 1
2
3
Y $5,333
1.07 1.07 1.07 1.07 4
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 Capital Budgeting and
Inflation

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 Special Problems in Capital
Budgeting
Equipment replacement and
equivalent annual cost
Excess capacity

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 Operating and Replacement
Cash Flows for Two Devices

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 Excess Capacity
When firms operate at less than full
capacity, managers encourage alternative
uses of the excess capacity because they
view it as a free asset.
The marginal cost of using excess capacity
is zero in the very short run, but using
excess capacity today may accelerate the
need for more capacity in the future.
When this is so, managers should charge
the cost of accelerating new capacity
development against the current proposal
for using excess capacity.

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 Excess Capacity
Excess capacity not a free asset as
traditionally regarded by managers
Company has excess capacity in a
distribution center warehouse
In two years the firm will invest $2,000,000
to expand the warehouse
The firm could lease the excess space
for $125,000 per year for the next two
years
Expansion plans should begin immediately in
this case to hold inventory for stores that will
come on line in a few months
Incremental cost investing $2,000,000 at
present vs. two years from today
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Incremental cash inflow - $125,000
 Excess Capacity
NPV of leasing excess capacity (assume 10% discount rate)

125,000 2,000,000
NPV 125,000 2,000,000 2
$108,471
1.10 1.1
NPV negative reject to lease excess capacity at $125,000
per year
The firm could compute the value of the lease that would
allow to break even
X 2,000,000
NPV X 2,000,000 2
0
1.10 1 .1
X = $181,818
Leasing the excess capacity for a price above $181,818
would increase shareholders wealth
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 Human Face of Capital
Budgeting
Thebest financial analysts can
provide not only the numbers to
highlight the value of a good
investment, but also can explain
why the investment makes sense,
highlighting the competitive
opportunity that makes one
investments NPV positive and
anothers negative.
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