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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 stand-alone principle allows us to The stand-alone 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 Non-Expense 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(1-0.40) +55,400 Less: Sale of Old Machine Salvage Value –Taxes 10,000 – 4,000 – 6,000 +49,400 Initial Outlay Tax rate x (Salvage Value-Book 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 non-cash 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 Straight-line depreciation D = (Initial cost ) / number of years Very few assets are depreciated straight-line 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 Mid-year 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 3-year Equipment used in research 5-year Autos, computers 7-year Most industrial equipment 15 MACRS Depreciation Allowances (Table 10.7) Year Property Class Property 3-Year 5-Year 7-Year 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 Bottom-Up Approach Works only when there is no interest expense OCF = NI + depreciation Top-Down Approach OCF = Sales – Costs – Taxes Don’t subtract non-cash 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 After-tax salvage = salvage – T(salvage – book After-tax 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(15,000-11,155) 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 after-tax 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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