Fins5514_w04 - Ck l i c t od n e a d os t 9 2 W i t he a c h o ft h e s e t y p e so fc a s hf o l w s y o us h o uda l s kt h ec l a s s sa t r t

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Unformatted text preview: Ck l i c t od n e a d os t 9 . 2 W i t he a c h o ft h e s e t y p e so fc a s hf o l w, s y o us h o uda l s kt h ec l a s s sa t r t t od ee t r m i n e i ft h e c a s hf o l w sa r e r e l e v a n t. P e rs o n a l e x a m p le s o f su n k c o s ts of te n h e lp t h e st q u e si t o no nt h ep r e vo i u s under si l d e s ot h a t i t h e yc a n A sk u d e n ts s ta n d th e ssu e . th e s tu d e n ts to c o n s id e r a h y p o t h e ti c a l s i tu a ti o n in w h ic h p u rc h a s e d a com put er fo r $ 1 ,5 0 0 w h i le in h ig h s c h o o l. A now a v a i la b l e t hat a l so c o s ts $1, 500. T he re l e v ant fa c t o r wh at b e n e f it s wo u l d be p r o v id e d by th e p ri c e . Th e c o st of th e o r i g in a l c o m p u te r b e t te r com p u te r is i rre l e v ant . a c o ll e g e s tu d e n t b e tt e r com put er is s to the d e c is i o n a re o ju s t if y t he pu r c h a se t O p p o ru t nt i yc o s t s– t h ec l a s sc i e x a m pe l o fa no p p ot ru nt i yc o s ti s i m p o r t a n tt o p on i t o u t t h a t t hs i i sn o t “ f r e e . ”A tt h ev e r yl e a s t w e u s e i t ,w e c o s t o u r s e l v e st h e s e l l i n gp rc i eo ft h e a s s e t . t h eu s eo fl a n do r pa l n t t h a t i sa l r e a d yo w n e d .I ti s c o uds l e l l t h e l a n d ; c o n s e q u e n t l y , i fw e c h o o s et o Cl i ck to add n o t es A g o o de x a m pe l o fa p o st i i v e sd i e e f f e c t i sw h e ny o u wl i l e sa t b l i s ha n e w d is r b t i ui t o n s y se t m wt i ht hs p i r oe j c t t h a t c a n b eu s e df o re xs i i t n go rf uu t r e p r oe j c t s .T h e b e n e ft i p r o v i d e dt ot h o s e p r oe j c t sn e e d st ob e c o n sd i e r e d . T h e m o s t c o m m o nn e g a t i v es i d ee f f e c ti se r o so i no rc a n n i b a l i s m , w h e r et h ei n t r o d u c t i o no fa n e w p r o d u c t wl i lr e d u c e t h e s a l e so fe xs i i t n g , sm i i l a rp r o d u c t s . A g o o dr e a l w o r de l x a m p e is M l c D o n a l d ’ si nr t o d u c t i o no f t h e Ac r h D e l u x e s a n d w i c h .I n se t a d o fg e n e r a t i n ga l l n e w s ae l s , i tp rm i a r i l yr e d u c e ds a l e si nt h e Bg M i a ca n d t h eQ u a r t e r P o u n d e r . A d dt i i o n a l e x a m pe l sa r e p r o vd i e di naL e c t u r e Tpi i nt h e I M . I t i si m p o r t a n t t oc o n sd i e rc h a n g e si nN W C .W e n e e dt or e m e m b e rt h a t o p e r a t i n gc a s hf l o w d e rv i e df r o m t h e i n c o m es a t t e m e n t a s s u m e sa l l s a l e sa r ec a s hs a l e sa n dt h a t t h e C O G Sw a sa cu t a l l yp a i di nc a s hd u rn i gt h a t p e ro i d . B yl o o kn i ga tc h a n g e si nN W C s p e c i fc i a l l y ,w e c a na du j s t f o rt h e df i f e r e n c e i nc a s hf o l w t h a t r e s u l t sf r o m a c c o u n in t gc o n v e ni t o n s . M o s tp r o j e c t s wl i lr e q u i r e a ni n c r e a s ei nN W Ci nt i i a l l ya sw e b u i l di n v e n t o r ya n d r e c e i v a be l s . T h e n ,w er e c o v e rN W Ca t t h ee n do ft h e p r oe j c t . W ed on o ti n c l u d e fn i a n c i n gc o ss t . Su t d e ns o t f t e nh a v e df i fc i ut l y u n d e r sa t n d i n gw h yw h e ni t a p p e a r st h a tw e w i l l o n l yr a i s e c a p i t a li fw e t a k et h ep r oe j c t .I t i s im p o ra t n t t op on i t o u t t h a t b e c a u s eo fe c o n o m i e so fs c a l e ,c o m p a ne i s g e n e r a l l yd on o t fn i a n c ei n dvd i i u a l p r oe j c t s .I n se t a d ,t h e yf n i a n c et h ee ni t r ep ot rf oi l o o fp r oe j c t sa to n e t i m e .T h e oh t e rr e a s o nh a st o d o wt i hm a i na t i n i n ga t a r g e t c a p i t a l sr t u c t u r eo v e rt i m e , b u t n o t n e c e s s a r i l ye a c hy e a r . Fn i al l y , c fo i n u a ni n t c ngc ig n. o s ti si n cu l d e di nt h er e q ur i e d r e t u r n , t h u si n cu l dn i gt h e fn i a n c i n g r e l a t e dc a s h fo l w sw o ud l b ed o u be l T a x e s wl i l t a xb a ss i . c h a n g e a st h ef i r ms ’ t a x a be l i n c o m ec h a n g e s . C o n s e q u e nl t y , w eh a v et oc o n sd i e r c a s hf l o w so na na fe t r 9 .3 9 .3 Lecture Tip: It should be strongly emphasized that a project’s cash flows i mply changes in future firm cash flows and, therefore, in the firm’s future f inancial statements. Examples of such relationships are given in the IM. Operating cash flow – students often have to go back to the income statement t o see that the two definitions of operating cash flow are equivalent when there i s no interest expense. Lecture Tip: Students sometimes become disheartened at what they perceive a s complexities in the various capital budgeting calculations. You may find it useful to remind them that, in reality, setting up timelines and performing c alculations are typically the least burdensome portion of the task. Rather, the difficulties arise principally in two areas: (1) generating good investment projects and (2) developing reliable cash flow estimates for these projects. Lecture Tip: Some students may still question why we are ignoring interest, since it is clearly a cash outflow. It should be strongly emphasized that we do not ignore interest expense (or any other financing expense, for that matter); r ather, we are only evaluating asset related cash flows. It should be stressed t hat interest expense is a financing cost, not an operating cost. More on this i ssue is discussed in the IM. 9. 1 Ck l i c t od n e a d os t 9.4 9 . 3 Le c t u r e T ip : It sh o u l d be s tr o n g l y im p l y changes in fu t u re fi rm c a sh f in a n c i a l s t a te m e n t s . E x a m p le s of e m p h a si z e d t hat a p r o j e c t’ s c a sh f lo w s f lo w s an d, t h e re fo re , in th e fi rm ’ s fu t u r su c h r e la tio n s h i p s a re gi ven in th e IM . e O p e r a tin g to s ee th a t is no i n te r cas h f lo w – s tu d e n ts o f te n have the tw o d e f in i tio n s of o p e r a ti n g e st p: e x p e n se . S tu d e n t s so m e t im es becom e to go c a sh back f lo w to the in c o m e a re e q u iv a l e n t s ta t e m e n t wh en t h e re L e c tu r e Ti d is h e a r te n e d at w hat t hey p e r c e iv e as c o m p l e x it ie s in th e v a ri o u s c a p it a l b u d g e ti n g c a lc u la t io n s . Y ou m ay fi n d it u s e fu l to re m in d th e m th a t , in r e a l it y , s e tt in g up ti m e li n e s and p e r f o r m in g c a lc u l a ti o n s a re ty p i c a ll y th e le a s t b u rd e n s o m e p o r ti o n of th e ta s k . R a t h e r, th e d if f ic u l ti e s a r is e p r in c i p a lly in tw o a re a s : ( 1) g e n e r a ti n g good in v e s tm ent p ro j e c ts and Ti p: (2 ) devel st o p in g re l m ia b l e cas ll h f lo w ti o n e s ti w m at es fo r i t h e se p r o je c t i s. , Cl i ck to add n o t es Cl i ck to add n o t es L e c tu r e Some u d e n ts ay s ti q ues hy we a re g n o r in g n te r e s t si n c e it is c le a r ly a c a sh o u tf lo w . It sh o u l d be s tr o n g l y e m p h a si z e d t hat w e do not i g n o re in t e r e s t expens e ( or any o th e r f in a n c in g e x p e n se , fo r th a t m a tt e r ) ; ra t h e r, we a re only e v a lu a ti n g a sse t r e la t e d c a sh f lo w s. It s h o u ld be s t re s s e d th a t in t e r e s t expens e is s u e is d i sc u sse d in is a f i n a n c in g th e IM . c o st , n ot an o p e r a ti ng c o s t. M o re on t h is 9 .1 9 .4 9 .1 9 .4 Lecture Tip: You might find it useful to clearly delineate the link between the stand-alone principle and the concept of value additivity. By viewing projects a s “mini-firms,” we imply that the firm as a whole constitutes a portfolio of m ini-firms. As a result, the value of the firm equals the combined value of its c omponents. This is the essence of value additivity, and it is assumed to hold generally whether we are discussing the cash flows in a simple time-value problem, the value of a project, or the value of the firm. Note also that an understanding of this concept paves the way for the analysis of mergers and a cquisitions. For a merger to “create value,” the value additivity principle m ust be violated. (Violations take the form of production efficiencies, e conomies of scale, etc.) Perhaps a key value of this approach is that it places t he burden of proof on those proposing the merger, just as the capital budgeting process places the burden of proof on those proposing investment in t he project. Ask the students why net fixed assets is decreasing each year. It is important t hat they understand why this is happening when they go to compute the net c apital spending in the next slide. 9. 2 Ck l i c t od n e a d os t Ck l i c t od n e a d os t 9.5 9 . 1 L e c tu r e Tip: Yo u m ig h t f st a n d - a lo n e p r i n c ip le and as “m in i- f ir m s , ” m i n i- f ir m s. As a c o m p o n e n t s. Th i in d the it u s e fu l concep t to of c le a r ly d e li n e a te v a lu e a d d i ti v ity . the By lin k b et ween th e v ie w in g p r o j e c ts As k th a t th e st u dent s th e y u n d e rs t al sp e n d i ng wh y net and wh y in th e f ix e d a s s e ts is th i s is happ eni s li de. d e c re a s i n g each year . It is im p o r ta n t ng wh en th e y go to c o m p u te the net 9 . 4 w e imply th a t the fi rm as a w h o le c o n s t itu t e s a p o r t f o li o of r e s u lt , th e val u e of th e fi rm equal s th e com bi ned v a lu e of i ts s is th e e sse n c e of val ue a d d iti v it y , and it is a ssu m ed to h o ld ar e d i sc u ssi n g th e c a sh fl o w s in a s im p le t im e - v a lu e a p r o je c t , or th e val u e of th e fi rm . N o te a ls o th a t an concept paves the way fo r th e a n a ly s i s of m e rg e rs and c a p it next g e n e r a l ly wh et h er we p r o b le m, th e val ue o f u n d e r s t a n d in g of th is a c q u is iti o n s . For a m er g e r to “ c re a t e v a lu e , ” th e val ue a d d iti v it y p r in c i p le mus t be v io l a te d . (V io la t io n s t ake th e fo r m of p r o d u c t io n e f f i c ie n c i e s , econom i es of sc a l e , e tc . ) P e rh a p s a key val ue o f th is a p p ro a c h is t hat it p la c e s th e b u rd e n of pr oof on th o s e b u d g e ti n g p r o c e ss p la c e s th e th e pr o j e c t. p ro p o s i b u rd e n ng of th e m e r g e r, ju s t as th e c a p i ta l p ro o f on t h o se p r o p o s in g i n v e s tm ent i n Cl i ck to add n o t es Cl i ck to add n o t es 9 .2 9 .5 9 .2 9 .5 W ith ea ch of the se typ es of cash flo ws, y ou sh ould a sk the cl ass the q uesti on on th e prev ious sl ide so th at the y can s tart to de termi ne if the ca sh flow s a re relev ant. OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780; or OCF = NI + depreciation = 21,780 + 30,000 = 51,780 Personal examples of sunk costs often help students understand the issue. Ask t he students to consider a hypothetical situation in which a college student purchased a computer for $1,500 while in high school. A better computer is now available that also costs $1,500. The relevant factors to the decision are what benefits would be provided by the better computer to justify the purchase price. The cost of the original computer is irrelevant. O ppo rtuni ty cos ts – the cla ssic ex ampl e of an opp ortu nity c ost is th e u se of lan d or plan t that i s a lread y owne d. It is i mpo rtant to p oin t out th at this i s n ot “free .” At th e very le ast we co uld sel l t he lan d; con sequ ent ly, i f w e c hoo se to u se it, we cost ou rselv es the se llin g price o f th e asset . A g ood ex amp le of a posi tive si de effec t i s when y ou wil l e stab lish a new d istrib uti on syst em with t his pro ject th at c an be us ed for exi stin g or futur e p roje cts. T he ben efit pr ovid ed to th ose pro ject s n eeds t o be con side red. T he mos t c omm on neg ativ e side effe ct is eros ion or ca nnib alis m, wh ere the in trod uct ion of a new p rodu ct will re duce th e s ales of ex istin g, s imila r p rodu cts. A g ood re al-wo rld exa mple i s M cDo nald ’s intro duc tion o f t he Arch De luxe s andw ich. Inste ad of gen erati ng all n ew sale s, it pri maril y redu ced sal es in the B ig Mac a nd th e Q uarte r Po und er. A ddi tion al exam ples a re p rovi ded in a L ectu re Tip in th e IM. It i s i mpor tant to c onsi der cha nge s i n NWC. We nee d to reme mber th at ope ratin g cash fl ow deriv ed from t he i nco me state men t a ssum es all sale s a re cash sa les and t hat th e C OGS was ac tual ly pai d in cash d urin g that p eriod . B y loo kin g at chan ges in NW C spec ifica lly, we can ad just fo r t he diffe renc e i n cash flo w that res ults fro m a ccou nti ng con ven tion s. M ost pro ject s wi ll requ ire an in creas e i n NWC in itial ly as we bu ild in vent ory an d re ceiv able s. Th en, we recov er NWC at t he end o f t he pro ject. W e do no t i nclu de fin anci ng cos ts. St uden ts ofte n hav e d ifficu lty u nder stand ing wh y when i t appe ars tha t w e w ill o nly ra ise cap ital if we ta ke the p rojec t. It is im porta nt to po int ou t that b ecau se of econ omi es of scale , co mpan ies g ene rally d o not fin ance i ndiv idu al proj ects. Inste ad, they fi nan ce the en tire po rtfoli o of proj ects at on e time . Th e o the r re ason h as to do wit h main tain ing a ta rget cap ital st ructu re ove r t ime, but no t nece ssaril y each y ear. F inal ly, fi nan cing c ost is inc lud ed in th e re qui red retu rn, t hus inc lud ing th e finan cing -rela ted cas h flows w o uld be d oub le c oun ting . T axe s wi ll cha nge as th e firm’s tax able i ncom e chan ges. Con sequ ent ly, w e h ave to c onsi der cas h flows on a n aftert ax bas is. Note that in the Table in the book, the negative signs have already been c arried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending. Change in NWC = We have a net investment in NWC in year 0 of 20,000; we get the investment back at the end of the project when we sell our inventory, c ollect on our receivables and pay off our payables. Students often forget that we get the investment back at the end. Capital Spending – remember that Net capital spending = change in net fixed a ssets + depreciation. So in year one NCS = (60,000 – 90,000) + 30,000 = 0; The same is true for the other years. Lecture Tip: Capital spending at the time of project i nception (i.e., the “initial outlay”) includes the following items: + purchase price of the new asset - selling price of the asset replaced (if applicable) 9. 3 + costs of site preparation, setup, and startup +/- increase (decrease) in tax liability due to sale of old asset at other than book value = net capital spending 9.6 1 Lecture Tip: It should be strongly emphasized that a project’s cash flows imply changes in future firm cash flows and, therefore, in the firm’s future financial statements. Examples of such relationships are given in the IM. Ck l i c t o a dne d os t 9 . 3 L e c tu r e Ti p: It s h o u ld be st r o n g ly c a sh es of em p has iz e d th a t a p r o je c t ’s c a sh f lo w s O p e r a ti n g to s ee th a t i s no in te r e cas h f lo w – s tu d e n t the tw o d e f in i ti o ns e st p: e x p e n se . S tu d e n t s so m e t im es becom e d is h e a r te n e d at wh at t hey p e r c e iv e s o f te n have of o p e r a ti n g to go c a sh back f lo w to a re th e in c o m e e q u iv a l e n t s ta t e m e n t w h e n t h e re i m p ly changes in f u tu r e f ir m f i n a n c ia l s ta t e m e n ts . E xam p l f lo w s su c h r and, th e r e f o r e , in the f ir m ’ s f u tu r e e la ti o n s h ip s a re g iv e n in the IM . L e c tu r Ti as com p le x it ie s in th e v a ri o u s c a p it a l b u d g e ti n g c a lc u l a t io n s . Y ou m ay fi n d it u s e fu l to re m in d t hem th a t , in r e a l it y , s e tt in g up ti m e l in e s and p e r f o r m in g cal c u l a ti o n s a re ty p i c a ll y th e le as t b u rd e n s o m e p o r ti o n o f th e t a sk . R a t h e r, th e d if f ic u l ti e s a ri s e p r in c i p a ll y in tw o a re a s : (1 ) g e n e r a t in g good in v e s t m e n t p ro j e c ts e and Ti p: (2 ) de vel st o p in g re l m ia b l e c a sh ll f lo w on e s ti w m at es fo r i t h e se p r o je c t i s. t, L e c tu r Some u d e n ts ay s ti q u e s ti hy we a re g n o r in g n te r e s si n c e it is c l e a r ly a not i g n o re in t e r e s t ra t h e r, we ar e o nly t i c a sh o u t f lo w . It sh o u l d be s tr o ngly e m p h a si z e d th a t w e do exp ens e (o r any o th e r f in a n c in g e x p e n se , fo r th a t m a tt e r ) ; e v a lu a t in g a sse t r e la t e d c a sh fl o w s. It s h o u ld be s t re s s e d is a f i n a n c in g th e IM . c o st , no t an o p e r a ti ng c o s t. M or e on t h is h at in t e r e s t exp ens e ssu e is d i sc u sse d in 9 .1 9 .4 Ck l i c t o a dne d os t 9 . 4 L e c tu r e Tip : Yo u might fi n d it u s e fu l s ta n d - a lo n e p r in c i p le and th e concept as “ m i n i- f ir m s,” we imply t hat the f ir m i n i- f i r m s. As a r c o m p o n e n ts . T his g e n e r a ll y wh et h er to c le a r l y d e li n e a te of v a lu e a d d it iv i ty . m as a w h ole c o n s ti th e l in k b e tw een th e By v ie w in g p r o je c t s tu t e s a p o r tf o lio of A sk th at th e st u d e n ts th e y u n d e rs t al s p endi ng w hy net and wh y in t h e f ix e d a s s e ts is d e c re a s i n g each y ear . It is im p o r ta n t th is is h a p p e n in g wh en t hey go to c o m p u te the net s li de. e s u lt , th e v a lu e of the f ir m e q u a ls is the e sse n c e of val ue a d d i ti v it y , we a re d i sc u ssi n g th e c a sh fl o w s th e com bi ned val ue of it s and it is a ssu m ed to h o ld in a s im p le ti m e - v al ue c a p it next p r o b le m , th e v a lu e of a p r o je c t, or th e v a lu e of the f ir m . No t e a ls o t hat an u n d e r s ta n d i n g of th i s concept paves the way fo r the a n a ly s i s of m e r g e rs and a c q u is i ti o n s. For a m e rg e r to “ c re a t e v a l u e ,” th e val u e a d d i ti v ity p r in c ip l e m u st be v io la t e d . ( V i o la t io n s t ake th e fo rm of p r o d u c ti o n e f f i c ie n c i e s, e c o n o m ie s of s c a le , e t c .) P e rh a p s a key v a lu e of t h is appr oach is th at it th e b u rd e n of p ro o f on t h o se p ro p o s i n g th e m e rg e r , ju s t as th e c a p i ta l b u d g e tin g p ro c e s th e p r o j e c t. s p la c e s t he b u rd e n of p ro o f on th o s e p r o p o s in g i nv es p la c e s tm e n t in 9 .2 9 .5 Ck l i c t odn e a dos t Ck l i c t o a dne d os t 9 . 2 W i t he a c ho ft h e s e t y p e so f c a s hf l o w s ,y o us h o u l da s kt h e sa t r t t od e t e r mn i e if t h e c a s hf l o w sa r er e l e v a n. t Pe r so n a l exam p le s of su n k c o st s o ft en c l a s s t h eq u e si t o no nt h e st ud ent s p r e v i o u s si l d e s ot h a t is t h e yc a n A sk O O N CF CF o t e = = E BI T + d e p re c i e c ia ti abl e a tio n = – t axes = 3 3 ,0 0 0 + 3 0 ,0 0 0 – 1 1 ,2 2 0 = 5 1 ,7 8 0 ; 9 . 5 or h e lp u n d e rs t and th e su e . NI + depr t h e on n 2 1 ,7 80 book, + 3 0 ,0 0 0 negat = 5 1 ,7 8 0 si gns have a lr e a d y been U l tim a te l e q u a ti o n y, th e st u d e n ts to c o n s id e r a h y p o th e t ic a l s it u a ti o n in wh i ch a c o l le g e st u d e n t pu r c h a se d a c o m p u te r fo r $ 1 ,5 0 0 w h i le in high s c h o o l. A b e t te r co m p u te r is no w a v a il a b le th at a ls o c o s ts $ 1 ,5 0 0 . T he r e le v a n t f a c to r s to th e d e c i s io n a re wh at b e n e f its w o u ld be p ro v i d e d by the p r ic e . T he c o st of th e o ri g i nal com p u te r b e tt e r com put is ir r e le v a n t . er to j u s ti fy th e p u rc h a s e th a t in T i th e th e iv e c a r r ie d th r o u ghout th e ta b l e so th a t th e col u m ns can ju s t be added. s t u d e n ts se e m to do b e tt e r w i th t h is fo r m at eve n though th e C FF A sa y s to s u b tr a c t th e changes in NW C and n et c a p it a l sp e n d i n g . O p p o r t u n i t yc o s s –t t h ec l a s s ce i x a m peo l fa no p p o ru t n i t yc o s t i st h e u s e o f i m p o ra t n t t op on i t o u t t h a t t hs i i sn o t“ f r e e” . A t t h ev e r yl e a s t w ec o u l ds e l l u s e i t ,w ec o s t o us r ev l e st h es e l l i n gp r i c e o f t h ea s s e t . l a n do rp l a n t t h a t i sa l r e a d yo w n e d . I t i s t h e l a n d ; c o n s e q u e nl t y ,i fw ec h o o s et o A g o o de x a m p l eo f ap o st i i v es d i ee f f e c ti sw h e ny o u wl i le sa t b l i s han e wd s r i t i b u t i o ns y se t m w i t ht h i sp r oe j c tt h a t c a nb eu s e d f o r e x i si t n go rf uu t r ep r o j e c t s . T h eb e n e ft i p r o v i d e dt ot h o s ep r o j e c t sn e e d st ob ec o n sd i e r e d .T h e m o s t c o m m o nn e g a t i v es d i ee f f e c t i se r o so i no rc a n nb i ai l s m ,w h e r et h e i nr t o d u c t i o no f an e w p r o d u c t w i l l r e d u c et h e s a le so fe xs i i t n g , s ml i i a rp r o d u c t s . Ag o o dr e a l w o r l de x a m p l ei sMD c o n ad l ’ si n t r o d u c t i o no ft h eAc r hD e l u x e s a n d wc i h . I n s t e a do fg e n e r ai t n ga l ln e w s a l e s ,i t p r i m a rl i y r e d u c e ds a l e si nt h e Bg M c i a a n dt h eQ u a re t rP o u n d e r . A d dt i i o n a le x a m pe l sa r ep r o vd i e di n aL e cu t r eT pi i n t h eI M . I t i si m p o ra t n t t oc o n sd i e rc h a n g e si nN W C .W e n e e d t or e m e m b e r t h a t o p e r ai t n gc a s hf o l w d e r i v e df r o mt h e i n c o m e sa t t e m e n t a s s u m e sa l l s a l e sa r e c a s hs a l e sa n dt h a tt h eC O G Sw a sa c t u a l l yp a i di nc a s h d u r i n gt h a tp e r i o d . B yl o o kn i ga t c h a n g e si n N W Cs p e c i f i c a l l y ,w ec a na du j s tf o rt h ed i f f e r e n c ei nc a s hf l o wt h a tr e s ut l sf r o m a c c o u ni t n gc o n v e n t i o n s .M o s t p r oe j c t sw i l l r e q ur i ea ni n c r e a s e i nN W C in t i i a l l ya sw e b ul i d i n v e n t oy r a n d r e c ev i a be l s .T h e n , w e r e c o v e rN W Ca t t h e e n do f th ep r o j e c t . W ed on o t i n cu l d e fn i a n cn i gc o ss t . Su t d e n t so f t e nh a v ed i f f i c ut l yu n d e r sa t n dn i gw h yw h e ni t a p p e a r st h a t w ewl i l o ny l r a i s ec a pt i a l i fw et a k e t h e p r oe j c t .I ti si m p o r t a n t t op o i n t o u t t h a t b e c a u s e o fe c o n o m ie so fs c ae l , c o m p a n i e s g e n e r a l l yd on o tf i n a n c e i n d i vd i u a lp r o j e c t s . I n se t a d ,t h e yf i n a n c e t h e e n t i r e p o rf t oi l oo fp r oe j c t sa t o n et i m e . T h e oh t e rr e a s o nh a st od ow i t h m a i na t i nn i gat a r g e tc a pt i a l sr t u c t u r eo v e rt i m e ,b u t n o tn e c e s s a r i l ye a c hy e a r . Fn i a l l y , c fn i oa u n nin. ti c ngc g o s t i si n c l u d e di nt h e r e q u i r e dr e tu n r ,t h u si n c l u dn i gt h ef i n a n c i n g r e l a t e dc a s hf l o w sw o udb l ed o u b l e T a x e s wl i l t a xb a ss i . c h a n g e a s t h ef ir ms ’ t a x a bei l n c o m e c h a n g e s . C o n s e q u e n t l y , w e h a v e t oc o n s i d e r c a s hf o l w s o n a na f t e r 9 .3 C hange in NW C = We have a get the in v e s t m e n t ba ck at th e c o ll e c t on our r e c e iv a b le s and w e get th e i n v e s tm ent back at n et end pay t he in v e s t m e n t in NW C in year of the p r o je c t wh en we se l l o ff ou r p a y a b le s . S tu d e n t s end . c a p it CS = 0 of 20, 000; we our i n v e n to r y , o ft e n f o rg e t t hat C a p it a l S p e n d in g – re m em ber t hat Net a sse t s + d e p r e c i a tio n . So in year on e N T he sa m e i s tr ue f or th e ot her y e a rs . Ti p: C al sp e n d i n g = change in net fi x ed (6 0 ,0 0 0 – 9 0 ,0 0 0 ) + 3 0 ,0 0 0 = 0 ; L e c tu r e a p it al “i s p e n d in g n iti al out at th e i t im e of p r o je c t t he inc e p t io n f o l lo w in g (i . e . , th e it e m s : la y ” ) n c lu d e s + p u rc h a s e p r ic e s e lli n g p r ic e of + c o st s of si te of t th e he n ew a sse t a sse t r e p la c e d io n , se t up, (i f a p p li s ta r t c a b le ) 9 .6 s a le of o ld p re p a ra t and it y up t o + /in c r e a s e ( a sse t at ot her = net c a p ita l d e c re a s e ) i th a n book n ta x li v a lu e a b il du e 1 s p e n d in g L ec tu r e T i p: It s ho u ld be s t ron g ly im p l y ch a ng e s in fu tu re firm ca s h f in an c ia l s ta te m e nt s . E x a m p le s of e m p h as iz ed t h at a p roj e ct ’s c as h fl o w s fl ow s a nd , th e refo re, in th e firm ’s fut u re su c h rel at io n s h ip s a re g iv en in the IM . Click to add notes 9 .1 9 .1 Lecture Tip: You might find it useful to clearly delineate the link between the stand-alone principle and the concept of value additivity. By viewing projects as “mini-firms,” we imply that the firm as a whole constitutes a portfolio of mini-firms. As a result, the value of the firm equals the combined value of its components. This is the essence of value additivity, and it is assumed to hold generally whether we are discussing the cash flows in a simple time-value problem, the value of a project, or the value of the firm. Note also that an understanding of this concept paves the way for the analysis of mergers and acquisitions. For a merger to “create value,” the value additivity principle must be violated. (Violations take the form of production efficiencies, economies of scale, etc.) Perhaps a key value of this approach is that it places L e c t u r e T i p : I t s h o u l d b e s t r o n g l y f i m i n p a n l y c i cl a h a s n t a g t e e s m i n e n f t u s t . u E r e x a f m i rp m lc e ss a o h f e m p h a s i z e d t h a t a p r o j e c t ’ s c a s h f l o w s f s l u wr o c h s e a l nt a d i , o t n h s e h r e i p f o s r a e r , e i n g ih t v e e ni f i r n m t h ’ s e f I u M t u . r e C l i c k t o a d d n o t e s 9 . 1 9 . 1 Click to add notes L ec tu r e T i p: Y ou m ig h t fin d it u s e ful to c le arl y de li n ea te the lin k b e tw e en the s ta n d-a lo n e p rin ci p le a nd th e co n ce p t of v alu e a d di ti v ity . By vi ew in g p roj ec ts as “m in i-fi rm s ,” we i m p ly t h at th e fi rm as a w h o le c o ns t it u te s a p o rtfo li o of m in i -fi rm s . As a re s u lt , th e v al ue of th e firm eq u al s t he c o m b in e d v al ue of i ts c o m p o n en ts . T hi s is t he es s e n ce of v a lu e ad d it iv i ty , an d it is a ssu m e d to hold g en era ll y w h et h er we are d is c u s s in g the ca s h flo w s in a s i m p le t im e -v al u e p ro b le m , th e v a lu e of a p roj ec t, or t he v a lu e of th e fi rm . N ot e al s o t ha t an u nd e rs ta n di ng of th is co n c ep t p av es th e way fo r th e a n al ys i s of m erg e rs a nd a c q ui s it io n s . F or a m e rge r to “c re at e va lu e ,” t he v a lu e ad d it iv i ty p rin c ip le m u st be v i ol at e d. (V io l at io n s t ak e th e fo rm of pro d uc t io n e ffi ci en c ie s , e c o no m i e s of s c al e, e tc .) P e rh ap s a ke y v al ue of th is ap p ro ac h is th a t it p la ce s th e b urd e n of p roo f on t h os e p ro p os in g th e m e rg er, ju s t as t he c a pi ta l b ud g et in g p ro ce s s p l ac es th e b u rde n of p ro of on th o s e pro p o s in g i nv e s tm e n t in th e p roj ec t. 9 .2 9 .2 With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant. Personal examples of sunk costs often help students understand the issue. Ask the students to consider a hypothetical situation in which a college student purchased a computer for $1,500 while in high school. A better computer is now available that also costs $1,500. The relevant factors to the decision are what benefits would be provided by the better computer to justify the purchase price. The cost of the original computer is irrelevant. Opportunity costs – the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not “free.” At the very least we could sell the land; consequently, if we choose to C l i c k t o a d d n o t e s L e c t u r e T i p : Y o u m i g h t f i n d i t u s e f u l t o c l e a r l y d e l i n e a t e t h e l i n k b e t w e e n t h e a s t s a “ n mn di a l i o n fe i r m p r sn i , ” c w i p e l e i m a n p d l y t te h h a c t o t h n c e ei f p r t m o f a v s a a l u w e hd a od l e i t c i o v n is t y t i . t B u t y e s v i a e p wr o i n t g f o po l io r j o e f c t s mn i i f i r m s . A s a r e s u l t , t h e v a l u e o f t h e f i r m e q u a l s t h e c o m b i n e d v a l u e o f i t s c o m p o n e n t s . T h i s i s t h e e s s e n c e o f v a l u e a d d i t i v i t y , a n d i t i s a s s u m e d t o h o l d g e n e r a l l y w h e t h e r w e a r e d i s c u s s i n g t h e c a s h f l o w s i n a s i m p l e t i m e v a l u e p r o b l e m , t h e v a l u e o f a p r o j e c t , o r t h e v a l u e o f t h e f i r m . N o t e a l s o t h a t a n u n d e r s t a n d i n g o f t h i s c o n c e p t p a v e s t h e w a y f o r t h e a n a l y s i s o f m e r g e r s a n d a c q u i s i t i o n s . F o r a m e r g e r t o “ c r e a t e v a l u e , ” t h e v a l u e a d d i t i v i t y p r i n c i p l e m u s t b e v i o l a t e d . ( Vo i l a t i o n s t a k e t h e f o r m o f p r o d u c t i o n e f f i c i e n c i e s , t e h c e o n b o u me r d i e n s o o f f p s c r o a l o, e f o e n t c t . ) h o P sr e e hr p a p o s p o a s k i n e g y t v hl a e u m e e o r f g t e h r i , s j u a s p t p a r s o a t h c e hc ia sp t i al h t a t i t p l a c e s b u d g e t i n g p r o c e s s p l a c e s t h e b u r d e n o f p r o o f o n t h o s e p r o p o s i n g i n v e s t m e n t i n t h e p r o j e c t . 9 . 2 9 . 2 W ith each of th e se typ e s of ca s h fl o w s , y ou sh ou ld s t a rt to d e t er m i n e if the c a sh f lo w s a re re l e v an t . a sk th e c la ss th e qu e stio n on t he p re v i o u s slid e so th a t th e y can P ers o n al e x am p l es of s u nk co s t s o fte n h el p s tu d en t s u n d ers t an d t he i s s u e. A sk th e s tu d e nt s to c on s i de r a h y p ot he t ic al s i tu at io n in w h ic h a co l le g e s tu d en t p urc h as e d a co m p u te r fo r $ 1 ,5 0 0 w h il e in h i gh s ch o ol . A b et te r c o m p ut er is n ow av a ila b le t h at a ls o c o s ts $1 , 50 0 . The re le v an t fac to rs to t he d e ci s io n a re w ha t b en e fit s w o u ld be p rov i de d by th e b e tt er c o m p ut e r to j u s ti fy th e p u rc h as e p ri ce . The co s t of the ori g in al c om pu t er is irre le va n t. O p p o rt u n i t y co s t s – th e c la ssi c e x a m pl e of an o p p o rt u n i t y c o st is im p or ta nt to p oi nt o ut tha t th is is not “f re e . ” At the v e ry l ea s t we use it , we c o st o u rs e l v e s th e se l lin g p ri c e of t he a sse t. th e use of c o u ld se ll la n d or p l an t th a t is a l re a d y o wn e d. It is t he la n d; c o n s e q u en t l y , if we c h oo se to Click to add notes A g oo d e x a m pl e of a po siti ve sid e ef fe c t is wh e n y ou w il l e sta bl ish a n ew d i s t ri b u t i o n sy ste m w i th th is p ro j e c t tha t c an be u se d f or e x istin g or f u t u re p ro j e c t s . The b e ne f it pr ov id e d to th ose p ro j e c t s ne e d s to be co n s i d er e d . Th e m os t c om m o n ne g a tiv e si de e ffe c t is e ro s i o n or c a n nib a lism , w h e re th e i ntr od u c tio n of a n ew p ro d u c t w il l re d u c e the sa le s of e x isti ng , sim ila r p ro d u c t s . A g oo d r e a l -w o rl d e xa m p le is M c D o n a l d ’s i n t ro d u c t i o n of the A r ch D e lu x e s a n d w i ch . In s t e a d of g e n e ra t i n g a ll n ew sa le s, it p ri m a r i l y r e d u c ed sa le s in the Big M ac an d t he Q u a rt e r P ou n de r . A d di tio na l e x a m ple s a re p ro v i d e d in a L ec t u r e T ip in th e IM. It is i m p o rt a n t to co n s i d er c h a ng e s in N W C. We n e ed to r e m e m b er t ha t o pe r a ting c a sh fl o w d e ri v e d f ro m th e inc o m e sta te m e n t a s s u m es a ll sa le s a re c a sh sa le s an d th a t th e C OGS wa s a c tu a lly p a id in c a sh d u ri n g t ha t p er i o d . By l oo k ing at c ha n ge s in NW C s p e c i fi c a l l y , we c an a dj ust f or th e d i ffe re n c e in c a sh f low t h at r es u l t s f ro m a cc o u n t i n g c on ve n tio n s. M o st p r o j ec t s w ill r eq u i re an i n c re a s e in N WC i ni tia lly as we bu ild inv e n tor y an d r e c e i v ab l e s . Th e n, we re c o v e r N WC at t he e nd of the p ro j e c t . We do n ot inc l ud e f i n an c i n g c o sts. St u d e n t s o ft en h av e d i ffi c u l t y u n d e rs t a n d i n g why wh e n it ap p e ar s tha t we w ill on ly ra i s e c a p i t al if we ta ke th e pr oje c t. It is i m p o rt an t to po in t ou t th a t be c a u se of e c o no m ie s of sc a le , c o m pa n ie s g e n e ra l l y do n ot fi n a n c e i nd iv idu a l p ro j e ct s . I n s t ea d , the y fi n a n c e th e e n tir e p o rt fo l i o of pr oje c ts at o ne t i m e. T he oth e r r ea s o n h as to do w ith m a in ta in ing a t a rg et c a p ita l s t r u c t u re ov e r ti m e , b ut not n e c e s s a ri l y each y e ar . Fi n a l l y , fi n a n c i n g co s t is in c lu de d in t he re q u i r e d re t u rn , thu s in c lu din g the fi n a n c i n g -r el a t e d c a sh f low s w o uld be d o ub le c ou n tin g. Ta x e s w ill ta x b a sis. c h a ng e as th e fi r m ’s ta x a ble in c om e c h a ng e s. C on se qu e n tly , we h av e to c on sid e r c a sh fl o w s on an a ft e r- 9 .3 9 .3 Operating cash flow – students often have to go back to the income statement to see that the two definitions of operating cash flow are equivalent when there is no interest expense. Lecture Tip: Students sometimes become disheartened at what they perceive as complexities in the various capital budgeting calculations. You may find it useful to remind them that, in reality, setting up timelines and performing calculations are typically the least burdensome portion of the task. Rather, the difficulties arise principally in two areas: (1) generating good investment projects and (2) developing reliable cash flow estimates for these projects. W ih t e ah c o f t h e s e t y p e s o f c a s h f l o w s ,y o u s hu o l d a s kh t e c l a s s t h e q u e s to i n o nh t e p r ei v o u s s ld i e s oh t a tt h e y c a n s t a r tt o d e t e r m i n e i f t h e c a s h f l o w s a r e r e l ea v n t . P e r s o n a l e x a m p l e s o f s u n k c o s t s o f t e n h e l p s t u d e n t s u n d e r s t a n d t h e i s s u e . A s k t h e s t u d e n t s t o c o n s i d e r a h y p o t h e t i c a l s i t u a t i o n i n w h i c h a c o l l e g e s t u d e n t p u r c h a s e d a c o m p u t e r f o r $ 1 , 5 0 0 w h i l e i n h i g h s c h o o l . A b e t t e r c o m p u t e r i s ww n o h a t a b v e a n i e l a f b i t l s e wa t h o u t l a ds l b o e cr p o s o t v s i d $ e 1 d , 5 b 0 y 0 . t h T e h b e e r t t e e l rv e c a o n m tp f a u c t e tr o ro t s t j o u s tt e h i f ye d tc h e i s p i or u n c a h r a e s e p r i c e . T h e c o s t o f t h e o r i g i n a l c o m p u t e r i s i r r e l e v a n t . O po pr t u n iy t c o s t s –h t e c l a s s i c ea x m p l e o f a n o po pr t u n iy t c o s ti s t h e u s e o f l a n d o r p l a nt t h a ti s a le r a d y o w n e dI . t i s u i mt s e p o i , a tt r t w n e c o o s p t o ore i u not t s ut l v e s h a t h t e t h s i e s li n t i ln sg o“ pf r i c r e e e o . f ” t A h e tt a h s et s e v . e r ye l a s t w e c ol u d s e l lt h e l ad n ;c n o s eu q e n ty i l , f w e c ho o s e t o C l i c k t o a d d n o t e s c Ao a n go b e d u e s x e d a m f o p r l e e x o i f s tn a i ps g ii u o o r tv f e t u s r i d e e p e rf o fe j e c ci t t s .T s w h h e e b n e y n o e u fw i tp ile r l oi v se d t a b dohs ls i t h t a o n e e w p d r o i s j e ti r c tu b s n to i e e n d s s y t o s t e b m ew cihh o n t st i d e i r s e dT p . r o j h e e c tt m ht o a s t s c a o l m e s m o o f n e x n i ei s g tn , a tv i g em s i s iia d e le r f p f e r o c tu d i s c e t s r .A o o s i o go n da r c rni e a lw n br a o ls i lm d, ea xh w me e p r l ei e t h s M i n c tou D r oai dc n l to dn ’ s i n o to f r a d n u e c wro to i p n o d fc u t h tw c e Ah ilr l r euue d D e c l e x t h e s ad n w i c h . I n s t e a d o f g e n e r a tn i g a l ln e w sl a e s ,i t p r i m a r iy l r e d u cd e s a l e s i n t h e B i g M a c ad n t h e Q u a r t e r P o ud n e r . A d ii d to n a le x a m p l e s a r e p r o v i d e dn i a L e c t u r e T i pnh i t e I M . I ti s i m p o r t a nt t o c o n s i d e r c h a ne g s i n N W C .W e n e e do t r e m e m b e r t h a t o p e r a tn i g c a s h f l o we d r i v e d f r o m t h e B i n yok c o l m oi e s gm n t aa t e tc ea h na t n g s s e u s m i n e s N a W l Ce c e ls l a s p s e ai cl i r f c a a ly w s, h s a l e ea c s a n n dh a da t j u s t tf t h o e r C tO h e Gw d i S f f e r a ea s n c c e tn u i a la csao l y p h f i l d w i n ta c h a s tr h e dr s u u ls i tg h n f r t o m a t p e r i o d . r a e c c c e onl i u v a tn b i e g s . c T o h n e v nw e , to s n i e n r e .M c oe v o s rp t Nj r Wt o C tt e c a s we h ilr e l n eu d q oe i f r t h a e nn p i r o cc je . r e a t s e i n N W C i n ii ta ly l a s w e b u id l i n v e n t o r y ad n W e d o n o ti n c l u d e f i n a n c i n g c o s t s .S t u d e n t s o f t e n h a v e d if f i cly u t ud n e r s t a ni d n g w h y w h e n i t a pe p a r s t h a tw e w il l g ol e n n y ea r r a ly i le s d c o a p n ia o t tf l i f n a w nt e c e ae i k nt d i v h i e d p u r a o lp j e r c o t .I j et t c i. s sI i m n s pa t o e r t dtt a , n t h e o y pi f o i n n a to n c tt u e th h e a e t n b tr e i c e a u p s o e r t o f o f lo e i c o o n fm o p re o i j et s c o s f sa a c t o l n e ,c m T eo tm i e p . ah n i e e s f o i ta n h e n r c r ia e n g s o c n o s h ti a s s t i ol n c d oe u d w dna ih t i m t h i e n r t a e iu g qnd nr i ie a r tt e a r u g r e n tc , t aiac h p u s t i n l s tu l r u d c i t n ut g r e h oe e v f i r nm t ac i n eg i n , bt unt r e l a on t e dc e c a e s s h sl a f iy r o l w s e a w c o h u y l d e a b r e . Fu l d i ob n a ly l e , c on u tn i g . t T a ae x x b a si s w s lc i . l h ag n e a s t h e f im r ’ s t a x al b e i n c o m e c h a n g e s .C o n s e q u e n ty l , w e h a v e t o c os n i d e r cs a h f l o w s o n a n a f t e r 9 . 3 9 . 3 O pe ra ti ng c a sh flo w – s tu d en t s o fte n h av e to se e th a t th e tw o d e fin i tio n s of o p e rat in g is no in te res t e x pe n s e . to go ba ck to t he i n co m e ca s h fl o w a re eq u iv al e nt s t at em en t when th e re L ec tu r e T i p: S tu d en ts s o m e ti m es b ec om e di s h ea rte n ed at w h at t he y p erc e iv e as co m p l ex it ie s in t he v a ri o us c ap it a l b u d ge ti n g ca lc u la ti o ns . You m ay fin d it u s efu l to re m i nd t h em th a t, in rea li ty , s et ti ng up t im el in es a nd p e rform in g c a lc u la ti o ns are t yp i ca ll y th e l ea s t bu rd e ns o m e p o rti on of th e ta s k . R a th e r, t he d iffic u lt ie s a ris e p rin c ip a lly in two a re a s : (1 ) ge n era ti n g go o d in v e s tm e n t p ro j ec ts an d (2 ) d e ve lo p in g re li ab l e ca s h flo w es t im a t es for th e s e pro je c ts . L ec tu r e T i p: S om e s tu d en ts m ay s ti ll q u es t io n why we a re ig n o rin g in t ere s t, s in c e it is cl e arl y a ca s h o u tflo w . It s h ou l d be s tro n gl y em p ha s i ze d th a t we do n ot i gn o re in te re s t e x p en s e (o r a ny ot he r fi n an ci n g ex p e ns e, fo r th a t m at te r); r at he r, we are o n ly e v al u at in g a s s et re la te d c as h fl o w s . It s h o u ld be s t res s e d t h at i n te res t e xp e n s e is a fin an c in g c os t , no t an o pe ra tin g c o s t. M o re on t h is is s u e is d is c u s s e d in t he IM . Click to add notes 9 .4 9 .4 Ask the students why net fixed assets is decreasing each year. It is important that they understand why this is happening when they go to compute the net capital spending in the next slide. O p e r a t i n g c a s h f l o w – s t u d e n t s o f t e n h a v e t o g o b a c k t o t h e i n c o m e i t s o n s o e e it ta n h e r t e t s h t e e t x w p o e n d s e e f . i n i t i o n s o f o p e r a t i n g c a s h f l o w a r e e q u i v a l e n t s t a t e m e n t w h e n t h e r e L e c t u r e T i p : S t u d e n t s s o m e t i m e s b e c o m e d i s h e a r t e n e d a t w h a t t h e y p e r c e i v e a s c o m p l e x i t i e s i n t h e v a r i o u s c a p i t a l b u d g e t i n g c a l c u l a t i o n s . Y o u m a y f i n d i t c u a s e l c f u u l l a t t o i o r n e s mn a i r e dy t t hi p e m c a l t l h y a t t h , e i n lr e a e s a t l i b t y u , r d s e et t n i s n o g m u e p p t o i m r te i o l n i n o e f st a h n e d t a p s e k r f . o R r mn a t h i e g r , t h e d i f f i c u l t i e s a r i s e p r i n c i p a l l y i n t w o a r e a s : ( 1 ) g e n e r a t i n g g o o d i n v e s t m e n t p r o j e c t s a n d ( 2 ) d e v e l o p i n g r e l i a b l e c a s h f l o w e s t i m a t e s f o r t h e s e p r o j e c t s . C l i c k t o a d d n o t e s s L i e n cer c t u i t e i T s i c: p l e a S r o l y m a ec s a t u s d h e o n u t s t f m l o a w y . s I t t i s lh l q o u u e ls d t b i o e n s w t r o h n y g w l y e e a m r e pg i h a n s o i z r e i n d g t h i n ae t t w r e e sd t ,o n o t i g n o r e i n t e r e s t e x p e n s e ( o r a n y o t h e r f i n a n c i n g e x p e n s e , f o r t h a t m a t t e r ) ; r a t h e r , w e a r e o n l y e v a l u a t i n g a s s e t r e l a t e d c a s h f l o w s . I t s h o u l d b e s t r e s s e d t h a t i n t e r e s t e x p e n s e i s a f i n a n c i n g c o s t , n o t a n o p e r a t i n g c o s t . M o r e o n t h i s i s s u e i s d i s c u s s e d i n t h e I M . 9 . 4 9 . 4 A sk th e s t u de n ts why ne t fix e d as s e ts is d ec rea s i ng ea ch y e ar. It is im p o rta n t t h at t h ey u n d ers t an d why t hi s is h a pp e ni n g w h en t h ey go to c om p u te the ne t c a p it al s p en d in g in t he n ex t s l id e. Click to add notes 9 .5 9 .5 OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780; or OCF = NI + depreciation = 21,780 + 30,000 = 51,780 Note that in the Table in the book, the negative signs have already been carried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending. Change in NWC = We have a net investment in NWC in year 0 of 20,000; we get the investment back at the end of the project when we sell our inventory, A s k t h e s t u d e n t s w h y n e t f i x e d a s s e t s i s d e c r e a s i n g e a c h y e a r . I t i s i m p o r t a n t c t h a a p t it th a l e s y p u e n n d d e i n r s g ti a n nt d h w e h n y e x tt i h s s is li d e h . a p p e n i n g w h e n t h e y g o t o c o m p u t e t h e n e t C l i c k t o a d d n o t e s 9 . 5 9 . 5 OCF OCF = = E B IT NI + + d ep re ci at io n = – t ax e s = 3 3 ,0 0 0 + 3 0 ,0 0 0 – 1 1, 2 2 0 = 5 1, 7 80 ; or de p rec ia ti o n 2 1 ,7 8 0 + 3 0, 0 00 = 5 1, 78 0 be en U lt im a te ly , e qu a ti o n N ot e th a t in t he T ab l e in t he b o o k, t he n e g ati v e s ig n s h a ve a lre a dy c a rrie d th ro u gh o u t th e ta b le so t h at th e c o lu m n s c an ju s t be a d d ed . s tu d en t s s e em to do b e tt er w it h th is fo rm a t e v en t h ou g h t he C FFA s ay s to s u b tra ct the ch an g e s in NWC a nd net ca p it al s p e nd in g . C h a ng e in NWC = We h av e a g et th e i nv e s tm en t b ac k at t he c o ll e ct on o ur rec ei v ab le s an d we g et th e i nv e s tm e n t ba c k at n et in v es tm e n t in NWC in y ea r end of th e p ro je ct when we s el l p ay off ou r p a y ab le s . S t ud e nt s t he end. 0 of 20 ,0 0 0 ; we ou r i n ve n to ry , o ft en fo rg et t ha t Click to add notes C a p it al S p en d in g – re m e m b er th at Net ca p ita l s p en d in g = ch a ng e in ne t fix e d as s e t s + d e p re c ia ti on . So in year o ne NC S = (60 ,0 0 0 – 9 0 ,0 0 0) + 3 0 ,0 00 = 0; The s am e is tru e fo r th e o th e r y ea rs . L e c tu r e T ip : C ap i ta l s pe n d in g at the tim e of p ro j ec t i n ce pt io n (i .e ., th e “ in it ia l ou t la y ”) in cl ud e s t he f o l lo w in g i te m s : + + p u rch a s e s el li n g co s t s of p ric e of of th e n ew as s e t (if a p pl ic a bl e) s ta rtu p due to s a le of ol d 9 .6 a nd pri ce s i te the as s et re pl ac e d s et u p, p re pa rat io n , +/i nc re as e (d ec re as e ) in ta x li a bi li ty a sse t at o th e r th a n b oo k v a lu e = ne t ca p it al s p en d in g 9 .6 You can also use the formulas to compute NPV and IRR; just remember that the IRR computation is trial and error. Click on the excel icon to go to an embedded spreadsheet that illustrates how the pro formulas and cash flows can be set-up. It also computes the NPV and IRR. O C F O C F = = E B I T +d e p r e c i a t i o n – t a x e s = 3 3 , 0 0 0 + 3 0 , 0 0 0 N I +d e p r e c i a t i o n = 2 1 , 7 8 0 + 3 0 , 0 0 0 =5 1 , 7 8 0 – 1 1 , 2 2 0 = 5 1 , 7 8 0 ; o r N o t e t h a t i n t h e T a b l e i n t h e b o o k , t h e n e g a t i v e s i g n s h a v e a l r e a d y b e e n c a r r i e d t h r o u g h o u t t h e t a b l e s o t h a t t h e c o l u m n s c a n j u s t b e a d d e d . Ut l i m a t e l y , s t u d e n t s s e e m t o d o b e t t e r wt i h t h i s f o r m a t e v e n t h o u g h t h e C F F A e q u a t i o n s a y s t o s u b t r a c t t h e c h a n g e s i n N W Ca n d n e t c a p i t a l s p e n d i n g . C h a n g e i n N W C= W e h a v e a n e t i n v e s t m e n t i n N W Ci n y e a r g e t t h e i n v e s t m e n t b a c k a t t h e e n d o f t h e p r o j e c t w h e n w e s e l l c o l l e c t o n o u r r e c e i v a b l e s a n d p a y o f f o u r p a y a b l e s . S t u d e n t s w e g e t t h e i n v e s t m e n t b a c k a t t h e e n d . 0 o f 2 0 , 0 0 0 ; w e o u r i n v e n t o r y , o f t e n f o r g e t t h a t C l i c k t o a d d n o t e s C a p i t a l S p e n d i n g – r e m e m b e r t h a t N e t c a p i t a l s p e n d i n g = c h a n g e i n n e t f i x e d a s s e t s + d e p r e c i a t i o n . S o i n y e a r o n e N C S = ( 6 0 , 0 0 0 – 9 0 , 0 0 0 ) + 3 0 , 0 0 0 =0 ; T h e s a m e i s t r u e f o r t h e o t h e r y e a r s . L e c t u r e T i p : C a p i t a l s p e n d i n g a t t h e t i m e o f p r o j e c t i n c e p t i o n ( i . e . , t h e “ i n i t i a l o u t l a y ” ) i n c l u d e s t h e f o l l o wn i g i t e m s : +p u r c h a s e p r i c e o f t h e n e w a s s e t s e l l i n g p r i c e o f t h e a s s e t r e p l a c e d ( i f a p p l i c a b l e ) +c o s t s o f s i t e p r e p a r a t i o n , s e t u p , a n d s t a r t u p + / i n c r e a s e ( d e c r e a s e ) i n t a x l i a b i l i t y d u e t o s a l e o f a s s e t a t o t h e r t h a n b o o k v a l u e c a p i t a l s p e n d i n g o l d 9 . 6 = n e t 9 . 6 Y ou ca n a ls o u se t he th e IR R c o m p u tat io n fo rm u la s to c om pu t e is t ria l an d e rror. NPV a nd IR R ; ju s t rem e m b e r th a t C l ic k on th e e xc e l i c on to th e p ro fo rm ul as an d c a sh IR R . go to an e m b ed d e d s pre a ds h e et t h at il lu s t rat es h ow flo w s ca n be s et -up . It al s o c om pu t es th e NPV and Click to add notes 9 .7 9 .7 The first two items mean that our operating cash flow does not include the impact of accounts receivable and accounts payable on cash flow. The third item is very much like the purchase of fixed assets. We have to buy the assets (have the cash outflow) before we can generate sales. By looking at changes in NWC, we can incorporate the increased investment in receivables and inventory that are necessary to support additional sales. Because we look at changes in NWC, and not just current assets, we also incorporate the increase in our payable accounts that partially pays for the investment in inventory and receivables. Y o u c a n a l s o u s e t h e f o r m u l a s t o c o m p u t e t h e I R Rc o m p u t a t i o n i s t r i a l a n d e r r o r . N P V a n d I R R ; j u s t r e m e m b e r t h a t C l i c k o n t h e e x c e l i c o n t o g o t o a n e m b e d d e d s p r e a d s h e e t t h a t i l l u s t r a t e s h o w t h e p r o f o r m u l a s a n d c a s h f l o w s c a n b e s e t u p . I t a l s o c o m p u t e s t h e N P Va n d I R R . C l i c k t o a d d n o t e s 9 . 7 9 . 7 The firs t two it em s m e an th at our o p era ti ng c a sh flo w do e s not in cl u de the i m p a ct of a cc o u nt s re ce iv a bl e a nd a c co u nt s pa y ab le on c a sh flo w . The th ird i t em is v ery m uch li k e th e pu rc h as e of fi xe d a s s e ts . We h a ve to b uy th e as s et s ( ha v e th e c as h o u tfl o w ) b efo re we ca n g e ne rat e s a le s . By l o ok i ng at c ha n g es in NW C, we ca n i nc o rpo ra te t he i n cre as ed i nv e s tm e n t in re ce iv a b le s a nd in v en to ry t ha t are n e ce s s a ry to s up p o rt a d d it io na l s al e s . B e ca u s e we lo o k at c h an g e s in NWC , and n ot j us t c u rren t as s et s , we al s o i n co rp o rat e th e in c rea s e in ou r p a ya b le a c co u nt s t h at p art ia ll y p ay s fo r the i n v es t m e nt in in v en t ory an d re ce iv a bl es . The NWC d is cu s s i on is v e ry im po rta n t an d s h o u ld not s tu d en t s . It m ay be h el p ful to ree m p h as i ze t he p o in t of ca s h flo w th ro ug h a c co u nt in g e n trie s , w h ic h is d on e in IM . be o v erl o ok e d by NW C an d o pe ra ti ng a L ec tu r e T ip in t he Click to add notes 9 .8 9 .8 The MACRS percentages are given in Table 10.7. Lecture Tip: Ask the students why a company might prefer accelerated depreciation for tax purposes to the simpler straight-line depreciation. An example is given in the IM. Another example is provided that reexamines the Majestic Mulch case from the text assuming straight-line, illustrating that the NPV is lower under this circumstance. T h e f i r s t t w o i t e m s m e a n t h a t o u r o p e r a t i n g c a s h f l o w d o e s n o t i n c l u d e t h e i t m e m p a c it s v o ea f r y c c m o u u ct n h s l ie r k e ct e i h v e a p b u l e ra c h n a d s e aoo c c f f u i x n e t s d p a as s y a e b t s l . e W oe n ca h a s v h e f t l o o w b u . y T h te h eh t a s is r d e t s ( h a v e t h e c a s h o u t f l o w ) b e f o r e w e c a n g e n e r a t e s a l e s . B y l o o k i n g a t c h a n g e s i n N W C , w e c a n i n c o r p o r a t e t h e i n c r e a s e d i n v e s t m e n t B i n e r c eui a c e s e v a w b e l e l s o o a n k d a t i nh c v en a ng t o e r y s ih t n a N t W a r e C n , e a c n e d s so n a r t y j u t o s t s c u u p r p r o e n r t ta a d s d s e i t t i s ow , n a e l s a a l l s e o. s i n c o r p o r a t e t h e i n c r e a s e i n o u r p a y a b l e a c c o u n t s t h a t p a r t i a l l y p a y s f o r t h e i n v e s t m e n t i n i n v e n t o r y a n d r e c e i v a b l e s . C l i c k t o a d d n o t e s s T t h u e d e N n W t s . Cd I t m i s a c y u s b s e i o h nl e i pv s f u e l r t y o i r m e eo p m r p t a h n a ti sa z n e d t h s e hp o u o l i d n t n o o f t N bW e o Ca v e r l n o d o k o e p d e r b a y t i n g c a s h f l o w t h r o u g h a c c o u n t i n g e n t r i e s , w h i c h i s d o n e i n a L e c t u r e T i p i n t h e I M . 9 . 8 9 . 8 The M ACR S p e rc e n tag e s a re g iv en in T ab le 1 0 .7 . L ec tu r e T i p: A sk th e s t ud e n ts w hy a c o m p an y m ig ht p re fer a c ce le rat e d d ep rec ia ti o n for ta x p urp o s e s to th e s i m p le r s t ra i gh t -lin e d ep re ci at io n . An e x a m p le is g iv e n in the IM . A n o th e r ex a m p le is p ro vi d ed t ha t ree x am in es M aj es t ic M u lc h c as e fro m th e te x t a s s u m i ng s tra ig h t-l in e, i ll us t rat in g t h at NPV is l ow e r u n d er th is ci rcu m s t an c e. th e th e Click to add notes 9 .9 9 .9 Note that with MACRS you do not subtract the expected salvage from the initial cost. Also note that the MACRS % is multiplied by the initial cost every year. For some reason, students want to multiply by the book value. T h e M A C R S p e r c e n t a g e s a r e g i v e n i n T a b l e 1 0 . 7 . L e c t u r e T i p : A s k t h e s t u d e n t s w h y a c o m p a n y mg i h t p r e f e r a c c e l e r a t e d d e p r e c i a t i o n f o r t a x p u r p o s e s t o t h e s i m p l e r s t r a i g h t l i n e d e p r e c i a t i o n . A n e x a m p l e i s g i v e n i n t h e I M . A n o t h e r e x a m p l e i s p r o v i d e d t h a t r e e x a mn i e s M a j e s t i c M u l c h c a s e f r o m t h e t e x t a s s u mn i g s t r a i g h t l i n e , i l l u s t r a t i n g t h a t N P V i s l o w e r u n d e r t h i s c i r c u m s t a n c e . t h e t h e C l i c k t o a d d n o t e s 9 . 9 9 . 9 N ot e th a t w it h i n it ia l co s t . M ACR S you do n ot s u b tra ct t he e x pe c te d s al v ag e fro m the A ls o note t h at t he M AC RS so m e rea s o n , s t u de n ts w an t % to is m u lt ip li ed by m u lti p ly by t he the in it ia l co s t book v al ue . e ve ry y ea r. F or Click to add notes 9 .1 0 9.10 The year 5 cash flow is the most difficult for students to grasp. It is important to point out that we are looking for ALL changes in cash flow associated with selling the machine today instead of in 5 years. If we do not sell the machine today, then we will have after-tax salvage of 10,000 in 5 years. Since we do sell the machine today, we LOSE the 10,000 cash flow in 5 years. N o t e t h a t wt i h i n i t i a l c o s t . M A C R S y o u d o n o t s u b t r a c t t h e e x p e c t e d s a l v a g e f r o m t h e y e a r . F o r As l o n o t e t h a t t h e M A C R S s o m e r e a s o n , s t u d e n t s w a n t % i s m u l t i p l i e d b y t h e i n i t i a l c o s t t o m u l t i p l y b y t h e b o o k v a l u e . e v e r y C l i c k t o a d d n o t e s 9 . 1 0 9 . 1 0 The y ea r 5 c as h flo w is the m os t d i fficu l t for s tu d en ts to gra s p . It is im p o rta n t to p o in t o ut t h at we a re l o ok i ng fo r A LL ch a n ge s in c as h fl ow a s s o ci at ed w i th s el li n g th e m a ch in e t od a y in s t ea d of in 5 y ea rs . If we do n ot s e ll the m ac h in e t o d ay , th e n we w il l ha v e aft er-t ax s a l va g e of 10 , 00 0 in 5 y ea rs . S in ce we do s el l th e m a ch i ne t od a y , we LOSE th e 1 0, 00 0 c a sh flo w in 5 y ea rs . Click to add notes 9 .1 1 9.11 The negative signs in the CFFA equation were once again carried through the table. That way outflows are in the table as negative and inflows are positive. T h e y e a r 5 c a s h f l o w i s t h e m o s t d i f f i c u l t f o r s t u d e n t s t o g r a s p . I t i s i m p o r t a n t s te o l p l i o n i g n th t o e u t m t a h c a h t i w n e e t a o r dl e a y o o i n k s i tg n e a d f o o r f A i n L L 5 c y h e a a n rg s . e I s f i w n e c a d s o h n f o lt w a o s e l l s t s h o ei c m a t a e c d h wt i n i e h t o d a y , t h e n w e wl i l h a v e a f t e r t a x s a l v a g e o f 1 0 , 0 0 0 i n 5 y e a r s . S i n c e w e d o s e l l t h e m a c h i n e t o d a y , w e L O S E t h e 1 0 , 0 0 0 c a s h f l o w i n 5 y e a r s . C l i c k t o a d d n o t e s 9 . 1 1 9 . 1 1 The n eg a tiv e s i g ns in the t a bl e . T h at way o ut flo w s CFFA e q u at io n w e re once a re in th e ta bl e as n eg a ti ve ag a in c arri ed t h rou g h th e and in fl ow s are p o s it iv e . Click to add notes 9 .1 2 9.12 Replace the equipment: NPV>0 and IRR>required return. T h e n e g a t i v e s i g n s i n t h e C F F A e q u a t i o n w e r e o n c e t a b l e . T h a t w a y o u t f l o w s a r e i n t h e t a b l e a s n e g a t i v e a g a i n c a r r i e d t h r o u g h t h e a n d i n f l o w s a r e p o s i t i v e . C l i c k t o a d d n o t e s 9 . 1 2 9 . 1 2 R e p la ce t he e q u ip m e nt : NP V>0 an d IR R > re q ui red re tu rn . Click to add notes 9 .1 3 9.13 There are two worksheets. The first allows you to enter the information and work the example during class. The second provides the solutions. You may go directly to this one if you do not wish to show the students how to set up the spreadsheet during class time. The example is an additional one to that provided in the textbook. R e p l a c e t h e e q u i p m e n t : N P V > 0 a n d I R R > r e q u i r e d r e t u r n . C l i c k t o a d d n o t e s 9 . 1 3 9 . 1 3 T h ere a re tw o w ork s h e et s . T he firs t al lo w s yo u to e nt er th e in fo rm a ti on and w ork th e ex a m p le d u rin g c la s s . The s ec o n d pro v id e s t he s o l ut io n s . You m ay go di rec tl y to th is o ne if you do no t w is h to sh o w the s tu d en t s how to s et up th e s p rea d s h ee t du rin g c la s s ti m e. T he e x am p l e is an a d di ti on a l on e to th a t p ro v id e d in th e te xt b oo k . Click to add notes 9 .1 4 9.14 Click on the worksheet to see the solution to the problem. If you wanted to set up a separate spreadsheet using Solver, you certainly could. ; 8 7 5 2 1 0 3 + T B E = F C I . x m b – g v r n q k d u , w l p y s f o c a e h t i A O W L : T r T h e r e a r e t w o w o r k s h e e t s . T h e f i r s t a l l o w s y o u t o e n t e r t h e i n f o r m a t i o n a n d g w o o r d k i r t e h c e t l e y x t a o m t h p i l s e o d n u e r i i n f g y c o l u a s d s o . T n h o e t wc s e i s h o n t d o p s h r o o v w i d t e h s e t s h t e u d s e o n ltt u s i o h o n w s . Y t o o s ut e m u a p y t h e s p r e a d s h e e t d u r i n g c l a s s t i m e . T h e e x a m p l e i s a n a d d i t i o n a l o n e t o t h a t p r o v i d e d i n t h e t e x t b o o k . C l i c k t o a d d n o t e s 9 . 1 4 9 . 1 4 C l ic k on th e w o rk s h ee t to se e th e s o lu t io n to the pro b le m . If up a s ep a rat e s pre a ds h e et u s i ng S o l ve r, yo u c e rtai n ly c o ul d . you w an t ed to se t Click to add notes 9 .1 5 9.15 Annual depreciation expense: Year 1: .1429 x $1million = $142,900 Year 7: .0893 x $1million = $89,300 Year 8: .0446 x $1million = $44,600 Time 0 cash flow = -$1million investment – ($150,000 - $50,000) = $1,100,000 Time 1 and 7 cash flow = ($400,000 - $150,000) x (1 - .4) + (.4 x $89,300) = ...
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This note was uploaded on 04/14/2011 for the course FINS 5514 taught by Professor No during the Three '11 term at University of New South Wales.

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