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Unformatted text preview: 1 0 ower Point Presentation designed by Dr. Sylvia C. Hudgins for Finance 323 at ODU Relevant Cash Flows 2 The cash flows that should be included in a
The
capital budgeting analysis are those that
will only occur if the project is accepted
will
These cash flows are called incremental
These
cash flows
cash
The standalone principle allows us to
The standalone
analyze each project in isolation from the
firm simply by focusing on incremental
cash flows
cash Asking the Right Question 3 You should always ask yourself “Will this
You
cash flow occur ONLY if we accept the
project?”
project?”
If the answer is “yes”, it should be
included in the analysis because it is
incremental
If the answer is “no”, it should not be
included in the analysis because it will
occur anyway
If the answer is “part of it”, then we
should include the part that occurs
because of the project Common Types of Cash Flows 4 Sunk costs – costs that have accrued in the
Sunk
past (Do not include)
past
Opportunity costs – costs of lost options
Opportunity
(Include)
(Include)
Side effects(include)
Positive side effects – benefits to other
projects (Synergy)
Negative side effects – costs to other
projects (erosion)
Changes in net working capital (include)
Taxes (include)
Inflation (included) Pro Forma Statements and Cash Flow 5 Capital budgeting relies heavily on pro
Capital
forma accounting statements, particularly
income statements
income
Computing cash flows – refresher
Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
OCF = Net income + depreciation when
there is no interest expense 6 Estimating Cash Flows
Three Types of Cash Flows Initial Outlay Operating (Differential) Cash Flows 0 Initial Outlay 1 2 Operating Cash Flows 3 Ν Terminal Cash Flow Estimating Cash Flows 7 Initial Outlay (Capital Spending) Cost of Assets Installation and Shipping NonExpense Outlays (i.e. Working Capital) Expense Outlays after tax (i.e. Training Expenses)
Replacement of an old project
Replacement
Salvage value
Taxes Estimating Cash Flows 8 Initial Outlay
Example:
Example: Gasperini Corp. is considering replacing their old production
Gasperini Corp. is considering replacing their old production
machine with a new one. The cost of the new machine is
machine with a new one. The cost of the new machine is
$48,000; installation and delivery cost $2,000. Working Capital
$48,000; installation and delivery cost $2,000. Working Capital
rrequirementson the new machine are $3,000 immediately,
equirements on the new machine are $3,000 immediately,
and training costs amount to $4,000. The old machine can be
and training costs amount to $4,000. The old machine can be
sold for $10,000; its book value is zero. Gasperini has a
sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%.
marginal tax rate of 40%. 9 Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax) +48,000
2,000
3,000
2,400 4,000(10.40) +55,400
Less: Sale of Old Machine Salvage Value
–Taxes 10,000
– 4,000
– 6,000
+49,400 Initial Outlay Tax rate x (Salvage ValueBook Value)
.4(10,000 – 0)
0 49,400 1 2 3 4 5 Estimating Cash Flows
Operating (Differential) Cash Flows
OCFt = (Rt  Ct)(1 T) + DtT
Where:
Rt = Increased revenues (sales) in year t
Ct = Increased costs in year t (if costs decrease
then will have a negative Ct)
T = Marginal Tax Rate
Dt = Increased Depreciation 10 Depreciation 11 The depreciation expense used for capital
The
budgeting should be the depreciation schedule
required by the IRS for tax purposes
required
Depreciation itself is a noncash expense,
Depreciation
consequently, it is only relevant because it
affects taxes
affects
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate OCFt = (Rt  Ct)(1 T) + DtT Depreciation 12 Straightline depreciation
D = (Initial cost ) / number of years
Very few assets are depreciated straightline for
tax purposes: but we use it in class for
simplification MACRS
Need to know which asset class is appropriate for
tax purposes
Multiply percentage given in table by the initial
cost
Depreciate to zero
Midyear convention Estimating Cash Flows 13 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by
increase revenues by $5,000/yr and decrease costs by
$8,000/ yr. They expect to use the machine for 5 years, and
$8,000/ yr. They expect to use the machine for 5 years, and
expect to sell it for $15,000 in 5 years. Assume Gasperini uses
expect to sell it for $15,000 in 5 years. Assume Gasperini uses
tthemodified accelerated cost recovery system (MACRS) for
he modified accelerated cost recovery system (MACRS) for
depreciation.
depreciation. Depreciation (MACRS) 14 Modified ACRS Property Classes (Table 10.6)
Class Examples 3year Equipment used in research 5year Autos, computers 7year Most industrial equipment 15 MACRS Depreciation Allowances (Table 10.7)
Year Property Class
Property
3Year
5Year
7Year 1
2 33.33%
44.44 20.00%
32.00 14.29%
24.49 3
4 14.82
7.41 19.20
11.52 17.49
12.49
12.49 11.52
5.76 8.93
8.93 5
6
7
8 8.93
4.45 Gasperini’s Depreciation over 5 years:
Year MACRS %
Year Depreciation 1 14.29% $7,145 2 24.49% 12,245 3 17.49% 8,745 4 12.49% 6,245 5 8.93% 4,465
38,845 16 Estimating Cash Flows 17 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. OCFt = (Rt  Ct)(1 T) + DtT
OCF1 = (5,000  (8,000))(1 .4) + 7,145(.4)
= (13,000)(.6) + 2,858
= 10,658/yr Estimating Cash Flows 18 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. OCFt = (Rt  Ct)(1 T) + DtT
OCF2 = (5,000  (8,000))(1 .4) + 12,245(.4)
= (13,000)(.6) + 4,898
= 12,698/yr Estimating Cash Flows 19 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. OCFt = (Rt  Ct)(1 T) + DtT
OCF3 = (5,000  (8,000))(1 .4) + 8,745(.4)
= (13,000)(.6) + 3,498
= 11,298/yr Estimating Cash Flows 20 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. OCFt = (Rt  Ct)(1 T) + DtT
OCF4 = (5,000  (8,000))(1 .4) + 6,245(.4)
= (13,000)(.6) + 2,498
= 10,298/yr Estimating Cash Flows 21 Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. OCFt = (Rt  Ct)(1 T) + DtT
OCF5 = (5,000  (8,000))(1 .4) + 4,465(.4)
= (13,000)(.6) + 1,786
= 9,586/yr 22 Estimating Cash Flows
Operating (Differential) Cash Flows
Example (continued):
Example (continued):
Example The new machine Gasperini Corp is considering buying will
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
They expect to use the machine for 5 years, and expect to sell it
ffor$15,000 in 5 years. Assume Gasperini uses the modified
or $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.
accelerated cost recovery system (MACRS) for depreciation. 0 49,400 1 +10,658 2 3 4 +12,698 +11,298 +10,298 5 +9,586 Estimating Cash Flows 23 Operating Cash Flows
BottomUp Approach
Works only when there is no interest expense
OCF = NI + depreciation
TopDown Approach
OCF = Sales – Costs – Taxes
Don’t subtract noncash deductions
Tax Shield Approach
OCF = (Sales – Costs)(1 – T) +
Depreciation*T Estimating Cash Flows 24 Terminal Cash Flow Cash Flow from ending a project Occurs in the last year of a project Calculation
Recover Working Capital
Sell Machine
Pay Taxes
If the salvage value is different from the book
If
value of the asset, then there is a tax effect
value
Book value = initial cost – accumulated
Book
depreciation
depreciation
Aftertax salvage = salvage – T(salvage – book
Aftertax
value)
value) Estimating Cash Flows 25 Terminal Cash Flow
Example:
Example: Gasperini Corp. is considering replacing their old production machine with
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease ccosts by $8,000/
buying will increase revenues by $5,000/yr and decrease osts by $8,000/
yyr.They expect to use the machine for 5 years, and expect to sell ititfor
r. They expect to use the machine for 5 years, and expect to sell for
$15,000 in 5 years. Assume Gasperini uses MACRS
$15,000 in 5 years. Assume Gasperini uses MACRS Recover Working Capital +3,000
Sell “New” Machine
15,000
Tax on Sale
1,538
Terminal Cash Flow
+16,462 .4(15,00011,155) 26 Compute Project’s NPV
Cash Flows from Project
0 49,400 1 +10,658 2 3 4 +12,698 +11,298 5 +10,298 +9,586
+16,462 Initial Outlay
Operating Cash Flows Terminal Cash Flow The required rate of the above project is 11%, Compute its NPV
NPV(11%) = 10658 + 12,698 2 11,298 3 10,298 4+ 9,586 5+ 16,462 5 – 49,400
+
+
(1+.11) (1+.11) (1+ .11) (1+ .11) (1+ .11) (1+ .11) = 50,410.62 – 49,400 = $1,010.62 NPV > 0, therefore accept project 27 Compute Project’s NPV
Cash Flows from Project
0 49,400 1 +10,658 2 3 4 +12,698 +11,298 5 +10,298 +9,586
+16,462 Initial Outlay
Terminal Cash Flow Operating Cash Flows The required rate of the above
project is 11%, Compute its NPV NPV = 1,010.62 Compute NPV P/YR N I/YR PV PMT FV
Nj CFj IRR/YR NPV 28 Compute Project’s NPV
Cash Flows from Project
0 49,400 1 +10,658 2 3 4 +12,698 +11,298 5 +10,298 +9,586
+16,462 Initial Outlay
Terminal Cash Flow Operating Cash Flows The required rate of the above
project is 11%, Compute its IRR IRR = 11.71 Compute IRR P/YR N I/YR PV PMT FV
Nj CFj IRR/YR NPV Mutually Exclusive Investments
with Unequal Lives
Unequal 29 Suppose our firm is planning to expand
Suppose
and we have to select 1 of 2
machines. They differ in terms of
economic life and capacity.
economic
capacity
How do we decide which machine to
select?
select? The aftertax cash flows are:
Year
Machine 1
Machine 2
Machine
Machine
0
(45,000)
(45,000)
(45,000)
1
20,000
12,000
20,000
2
20,000
12,000
20,000
3
20,000
12,000
20,000
4
12,000
12,000
5
12,000
12,000
6
12,000
12,000
Assume a required return of 14%. 30 Step 1: Calculate NPV 31 s NPV1 = $1,432.64
$1,432.64
s NPV2 = $1,664.01
$1,664.01
s So, does this mean #2 is better?
s No! The two NPVs can’t be compared! 32 Method 1: Replacement Chain method Repeat projects using a replacement chain
Repeat
to equalize life spans.
to
Year
Machine 1
Machine
0
(45,000)
(45,000)
1
20,000
20,000
2
20,000
20,000
3 (45,000)20,000
(45,000)20,000
4 20,000
20,000
5 20,000
20,000
6 20,000
20,000 Machine 2
Machine
(45,000)
12,000
12,000
12,000
12,000
12,000
12,000 Calculate NPV
s NPV1 = $2,399.63 (with replacement chain)
chain)
s NPV2 = $1,664.01
$1,664.01
s Accept Project 1 33 ...
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