**Unformatted text preview: **Chapter 10 Cash Flows and Other Topics in Capital Budgeting NET PRESENT VALUE (NPV) INTERNAL RATE OF RETURN (IRR) NPV = Σ
t=1 n n ACFt ACF (1 + k) t - IO IRR: Σ
t=1 ACFt t (1 + IRR) = IO Capital Budgeting: the process of planning for purchases of long-term assets.
example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. $127,000 How do we decide? How s Will the machine be profitable? Will profitable s Will our firm earn a high rate of return on Will high the investment? the s The relevant project information follows:
s The cost of the new machine is $127,000. The $127,000 s Installation will cost $20,000. Installation $20,000 s $4,000 in net working capital will be needed at the time of installation. at s The project will increase revenues by The $85,000 per year, but operating costs will $85,000 increase by 35% of the revenue increase. 35% s Simplified straight line depreciation is used. s Class life is 5 years, and the firm is planning Class to keep the project for 5 years. s Salvage value at year 5 will be $50,000. Salvage $50,000 s 14% cost of capital; 34% marginal tax rate. 34%
s CAPITAL BUDGETING STEPS
1. EVALUATE CASH FLOWS DETERMINE RISK (DISCOUNT %) MAKE ACCEPT/REJECT DECISION 1. 1. Capital Budgeting Steps
1) Evaluate Cash Flows 1) Evaluate Look at all incremental cash flows Look occurring as a result of the project. occurring s Initial outlay s Differential Cash Flows over the life of the project (also referred to as annual cash flows). annual s Terminal Cash Flows Capital Budgeting Steps
1) Evaluate Cash Flows 1) Evaluate
Initial outlay Terminal Cash flow 0 1 2 3 4 5 6 ... n Annual Cash Flows Capital Budgeting Steps
2) Evaluate the risk of the project. Evaluate s We’ll get to this at the end of this chapter. s For now, we’ll assume that the risk of the For project is the same as the risk of the project overall firm. overall s If we do this, we can use the firm’s cost of If capital as the discount rate for capital capital investment projects. investment Capital Budgeting Steps 3) Accept or Reject the Project. Accept Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow a) Initial at “time 0?” at (Purchase price of the asset) (Purchase + (shipping and installation costs) (Depreciable asset) (Depreciable + (Investment in working capital) + After-tax proceeds from sale of old asset After-tax Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow a) Initial at “time 0?” at (127,000) (127,000) + (shipping and installation costs) (Depreciable asset) (Depreciable + (Investment in working capital) + After-tax proceeds from sale of old asset After-tax Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow at a) Initial “time 0?” “time (127,000) (127,000) + ( 20,000) (Depreciable asset) (Depreciable + (Investment in working capital) + After-tax proceeds from sale of old asset After-tax Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow at a) Initial “time 0?” “time (127,000) (127,000) + ( 20,000) (147,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset After-tax Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow a) Initial at “time 0?” at (127,000) (127,000) + ( 20,000) (147,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset After-tax Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow at a) Initial “time 0?” “time (127,000) (127,000) + ( 20,000) (147,000) (147,000) + ( 4,000) + 0 Net Initial Outlay Net Step 1: Evaluate Cash Flows
s a) Initial Outlay: What is the cash flow at a) Initial “time 0?” “time Purchase price of asset shipping and installation depreciable asset net working capital proceeds from sale of old asset net initial outlay (127,000) (127,000) + ( 20,000) (147,000) (147,000) + ( 4,000) + 0 ($151,000) ($151,000) Step 1: Evaluate Cash Flows
s b) Annual Cash Flows: What b) Annual incremental cash flows occur over the life of the project? life For Each Year, Calculate:
Incremental revenue Incremental - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow For Years 1 - 5:
Incremental revenue Incremental - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow For Years 1 - 5:
85,000 85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes Incremental - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow For Years 1 - 5:
85,000 85,000 (29,750) (29,750) - Depreciation on project Incremental earnings before taxes Incremental - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) (29,400) Incremental earnings before taxes Incremental - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) 25,850 25,850 - Tax on incremental EBT Tax Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) 25,850 25,850 (8,789) (8,789) Incremental earnings after taxes Incremental + Depreciation reversal Depreciation Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) 25,850 25,850 (8,789) (8,789) 17,061 17,061 + Depreciation reversal Depreciation Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) 25,850 25,850 (8,789) (8,789) 17,061 17,061 29,400 29,400 Annual Cash Flow Annual For Years 1 - 5:
85,000 85,000 (29,750) (29,750) (29,400) 25,850 25,850 (8,789) (8,789) 17,061 17,061 29,400 29,400 46,461 = 46,461 Revenue Costs Depreciation EBT Taxes EAT Depreciation reversal Annual Cash Flow Step 1: Evaluate Cash Flows
s c) Terminal Cash Flow: What is the cash c) Terminal flow at the end of the project’s life? flow Salvage value Salvage +/- Tax effects of capital gain/loss + Recapture of net working capital Recapture Terminal Cash Flow Terminal Step 1: Evaluate Cash Flows
s c) Terminal Cash Flow: What is the cash c) Terminal flow at the end of the project’s life? flow 50,000 Salvage value 50,000 +/- Tax effects of capital gain/loss + Recapture of net working capital Recapture Terminal Cash Flow Terminal Tax Effects of Sale of Asset:
Salvage value = $50,000 Salvage $50,000 s Book value = depreciable asset - total Book amount depreciated. amount s Book value = $147,000 - $147,000 = $0. $0. s Capital gain = SV - BV = 50,000 - 0 = $50,000 50,000 s Tax payment = 50,000 x .34 = ($17,000) Tax ($17,000)
s Step 1: Evaluate Cash Flows
s c) Terminal Cash Flow: What is the cash c) Terminal flow at the end of the project’s life? flow 50,000 50,000 (17,000) (17,000) Salvage value Tax on capital gain Recapture of NWC Recapture Terminal Cash Flow Terminal Step 1: Evaluate Cash Flows
s c) Terminal Cash Flow: What is the cash c) Terminal flow at the end of the project’s life? flow 50,000 50,000 (17,000) (17,000) 4,000 4,000 Salvage value Tax on capital gain Recapture of NWC Recapture Terminal Cash Flow Terminal Step 1: Evaluate Cash Flows
s c) Terminal Cash Flow: What is the cash c) Terminal flow at the end of the project’s life? flow 50,000 50,000 (17,000) (17,000) 4,000 4,000 37,000 37,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow Project NPV:
s CF(0) = -151,000 CF(0) -151,000 s CF(1 - 4) = 46,461 CF(1 46,461 s CF(5) = 46,461 + 37,000 = 83,461 CF(5) 83,461 s Discount rate = 14% Discount 14% s NPV = $27,721 NPV $27,721 s IRR = 21% IRR 21% s We would accept the project. We accept the Incorporating Risk into Capital Budgeting
s Risk-Adjusted Discount Rate How can we adjust this model to take risk into account? NPV = NPV Σ n t=1 ACFt ACF t (1 + k) - IO How can we adjust this model to take risk into account? NPV = NPV Σ n t=1 ACFt ACF t (1 + k) - IO s Adjust the discount rate (k). Risk-Adjusted Discount Rate
s Simply adjust the discount rate (k) Simply adjust to reflect higher risk. to s Riskier projects will use higher Riskier higher risk-adjusted discount rates. risk-adjusted s Calculate NPV using the new riskadjusted discount rate. Risk-Adjusted Discount Rate NPV = NPV Σ n t=1 ACFt ACF t - IO (1 + k*) Risk-Adjusted Discount Rates
s How do we determine the How appropriate risk-adjusted discount rate (k*) to use? (k*) s Many firms set up risk classes to Many risk categorize different types of projects. projects. Risk Classes
Risk RADR Risk Class (k*) Class 1 2 3 4 12% 12% 14% 16% 16% 24% 24% Project Type Replace equipment, Expand current business Expand Related new products Unrelated new products Research & Development Practice Problems: Cash Flows & Other Topics in Capital Budgeting Project Information: Project
s Problem 1a Cost of equipment = $400,000 Cost $400,000 s Shipping & installation will be $20,000 Shipping $20,000 s $25,000 in net working capital required at setup s 3-year project life, 5-year class life s Simplified straight line depreciation s Revenues will increase by $220,000 per year Revenues $220,000 s Defects costs will fall by $10,000 per year Defects $10,000 s Operating costs will rise by $30,000 per year Operating $30,000 s Salvage value after year 3 is $200,000 Salvage $200,000 s Cost of capital = 12%, marginal tax rate = 34% Cost 12%, 34% Problem 1a
s Initial Outlay: (400,000) (400,000) + ( 20,000) (420,000) (420,000) + ( 25,000) ($445,000) ($445,000) Cost of asset Shipping & installation Depreciable asset Investment in NWC Net Initial Outlay For Years 1 - 3:
220,000 220,000 10,000 10,000 (30,000) (30,000) (84,000) 116,000 116,000 (39,440) (39,440) 76,560 76,560 84,000 84,000 160,560 = Problem 1a Increased revenue Decreased defects Increased operating costs Increased depreciation EBT Taxes (34%) EAT Depreciation reversal Annual Cash Flow Problem 1a
s Terminal Cash Flow: Salvage value Salvage +/- Tax effects of capital gain/loss + Recapture of net working capital Recapture Terminal Cash Flow Terminal s Terminal Cash Flow: s Salvage value = $200,000 Salvage $200,000 s Book value = Book Problem 1a depreciable asset - total amount depreciated. amount s Book value = $168,000. s Capital gain = SV - BV = $32,000 s Tax payment = 32,000 x .34 = ($10,880) Tax ($10,880) Problem 1a
s Terminal Cash Flow: 200,000 200,000 (10,880) (10,880) 25,000 214,120 214,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow Problem 1a Solution:
s NPV and IRR: s CF(0) = -445,000 s CF(1 ), (2), = 160,560 s CF(3 ) = 160,560 + 214,120 = 374,680 s Discount rate = 12% s IRR = 22.1% s NPV = $93,044. Accept the project! Problem 1b
Project Information: Project s For the same project, suppose we For can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. rapidly
s Calculate the IRR and NPV for the Calculate project. project. s Is it still acceptable? Problem 1b
s Terminal Cash Flow: Salvage value Salvage +/- Tax effects of capital gain/loss + Recapture of net working capital Recapture Terminal Cash Flow Terminal s Terminal Cash Flow: s Salvage value = $100,000 Salvage $100,000 s Book value = Book Problem 1b depreciable asset - total amount depreciated. amount s Book value = $168,000. s Capital loss = SV - BV = ($68,000) s Tax refund = 68,000 x .34 = $23,120 Tax $23,120 Problem 1b
s Terminal Cash Flow: 100,000 100,000 23,120 23,120 25,000 148,120 148,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow Problem 1b Solution
s NPV and IRR: NPV s CF(0) = -445,000 s CF(1 ), (2), = 160,560 s CF(3 ) = 160,560 + 148,120 = 308,680 s Discount rate = 12% s IRR = 17.3% s NPV = $46,067. Accept the project! Automation Project: Automation Problem 2 s Cost of equipment = $550,000 Cost $550,000 s Shipping & installation will be $25,000 Shipping $25,000 s $15,000 in net working capital required at setup s 8-year project life, 5-year class life s Simplified straight line depreciation s Current operating expenses are $640,000 per yr. Current $640,000 s New operating expenses will be $400,000 per yr. New $400,000 s Already paid consultant $25,000 for analysis. Already $25,000 s Salvage value after year 8 is $40,000 Salvage $40,000 s Cost of capital = 14%, marginal tax rate = 34% Cost 14%, 34% Problem 2
s Initial Outlay: + + (550,000) (550,000) (25,000) (575,000) (575,000) ( 15,000) (590,000) (590,000) Cost of new machine Shipping & installation Depreciable asset NWC investment Net Initial Outlay For Years 1 - 5: Problem 2 Problem 240,000 Cost decrease Cost (115,000) Depreciation increase Depreciation 125,000 EBIT 125,000 (42,500) Taxes (34%) (42,500) 82,500 EAT 82,500 115,000 Depreciation reversal 115,000 197,500 = Annual Cash Flow Problem 2 Problem For Years 6 - 8:
240,000 Cost decrease Cost ( 0) Depreciation increase Depreciation 240,000 EBIT 240,000 (81,600) Taxes (34%) (81,600) 158,400 EAT 158,400 0 Depreciation reversal 158,400 = Annual Cash Flow Problem 2 Problem
s Terminal Cash Flow: 40,000 40,000 (13,600) (13,600) 15,000 41,400 41,400 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow Problem 2 Solution:
s NPV and IRR: s CF(0) = -590,000 s CF(1 - 5) = 197,500 s CF(6 - 7) = 158,400 s CF(10) = 158,400 + 41,400 = 199,800 s Discount rate = 14% s IRR = 28.13% NPV = $293,543 s We would accept the project! We accept ...

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