Cash Flow And Capital Budgeting

Professor Chad J. Zutter

Introduction to Finance
2
Cash Flow Versus Accounting Profit
Capital budgeting concerned with cash flow, not
accounting profit.
To evaluate a capital investment, we must know:
Incremental cash outflows of the investment
(marginal cost of investment), and
Incremental cash inflows of the investment
(marginal benefit of investment).
The timing and magnitude of cash flows and
accounting profits can differ dramatically.
3
Financing Costs
Financing costs are captured in the discounting
future cash flows to present.
Both interest expense from debt financing and
dividend payments to equity investors should be
excluded.
Financing costs should be excluded when evaluating a
projects cash flows.
4
Cash Flow and Non-Tax Expenses
Accountants charge depreciation to spread a fixed
assets costs over time to match its benefits.

Capital budgeting analysis focuses on cash inflows
and outflows when they occur.

Non-cash expenses affect cash flow through their
impact on taxes:
Compute after-tax net income and add
depreciation back, or
Ignore depreciation expense but add back its
tax savings.
5
Assume a firm purchases a fixed asset today for
$30,000
Plans to depreciate over 3 years using straight-line
method
Firm will produce
10,000 units/year
Costs $1/unit
Sells for $3/unit
Firm pays taxes at a 40% marginal rate
$6,000 Net income
$16,000
Cash flow
= NI + deprec
(4,000) Taxes (40%)
$10,000 Pre-tax income
(10,000) Depreciation
$20,000 Gross profits
(10,000) Cost of goods
$30,000 Sales
Adding non-cash expenses
back to after-tax earnings
$4,000 Depreciation
tax savings
$16,000 Cash Flow
$12,000 Aft-tax income
(8,000) Taxes (40%)
$20,000 Pre-tax income
(10,000) Cost of goods
$30,000 Sales
Find after-tax profits, add back
non-cash charge tax savings
Simplest and most common technique:
Add depreciation back in.
Two Methods of Handling
Depreciation to Compute Cash Flow
6
Depreciation
Accelerated depreciation methods (such as
MACRS) increase the present value of an
investments tax benefits.

Relative to MACRS, straight-line depreciation
results in higher reported earnings early in an
investments life.
For capital budgeting analysis, the depreciation
method for tax purposes matters most.
Many countries allow one depreciation method for
tax purposes and another for reporting purposes.
7
The Initial Investment
Initial cash flows:
Cash outflow to acquire/install fixed assets
Cash inflow from selling old equipment
Cash inflow (outflow) if selling old equipment
below (above) tax basis generates tax
savings (liability)

An example....

Tax rate = 40%

New equipment costs $10 million,
$0.5 million to install
Old equipment fully depreciated,
sold for $1 million
Initial investment: outflow of $10.5 million, and
after-tax inflow of $0.60 million from selling the
old equipment
8
Working Capital Expenditures
Many capital investments require additions to
working capital.
Net working capital (NWC) = current assets
current liabilities.
Increase in NWC is a cash outflow; decrease a
cash inflow.
An example
Operate booth from November 1 to January 31
Order $15,000 calendars on credit, delivery by Nov 1
Must pay suppliers $5,000/month, beginning Dec 1
Expect to sell 30% of inventory (for cash) in Nov; 60%
in Dec; 10% in Jan
Always want to have $500 cash on hand
9
Working Capital for Calendar
Sales Booth
(4,000) +500 +500 NA Monthly in WC
(3,000) 1,000 500 0 Net WC
5,000 10,000 15,000 0 Accts payable
0 1,500 10,500 15,000 0 Inventory
$0 $500 $500 $500 $0 Cash
Feb 1 Jan 1 Dec 1 Nov 1 Oct 1
($5,000) ($5,000) ($5,000) $0 Payments
($500) Net cash flow
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
$0 Reduction in
inventory
Jan 1 to
Feb 1
Dec 1 to
Jan 1
Nov 1 to
Dec 1
Oct 1 to
Nov 1
Payments and
inventory
($500) +$4,000 ($3,000)
0
0
+3,000
10
Terminal Value
Terminal value is used when evaluating an
investment with indefinite life-span:
Construct cash-flow
forecasts for 5 to 10
years
Forecasts more than 5 to
10 years have high
margin of error; use
terminal value instead.
Terminal value is intended to reflect the value of
a project at a given future point in time.
Large value relative to all the other cash flows
of the project.
11
Terminal Value

Different ways to calculate terminal values:
Use final year cash flow projections and assume that
all future cash flow grow at a constant rate;
Multiply final cash flow estimate by a market multiple, or
Use investments book value or liquidation value.
$3.25 Billion $2.5 Billion $1.75 Billion $1.0 Billion $0.5 Billion
Year 5 Year 4 Year 3 Year 2 Year 1
JDS Uniphase cash flow projections for acquisition of
SDL Inc.
12
Terminal Value of SDL Acquisition
67 . 48 $
1 . 1
2 . 68 $
1 . 1
25 . 3 $
1 . 1
5 . 2 $
1 . 1
75 . 1 $
1 . 1
1 $
1 . 1
5 . 0 $
5 5 4 3 2 1

$68.2
0.05 0.10
$3.41
PV or ,
g r
CF
PV
5
1 t
t

Assume that cash flow continues to grow at 5% per
year (g = 5%, r = 10%, cash flow for year 6 is $3.41
billion):

Terminal value is $68.2 billion; value of entire project is:
$42.4 billion of total $48.7 billion from terminal value
Using price-to-cash-flow ratio of 20 for companies in the
same industry as SDL to compute terminal value
Terminal Value = $3.25 x 20 = $65 billion
Caveat : market multiples fluctuate over time
13
Incremental Cash Flow
Incremental cash flows versus sunk costs:
Capital budgeting analysis should include only
incremental costs.
An example
Norman Pauls current salary is $60,000 per year and he
expects it to increase at 5% each year.
Norm pays taxes at flat rate of 35%.
Sunk costs: $1,000 for GMAT course and $2,000 for
visiting various programs
Room and board expenses are not incremental to the
decision to go back to school
14
Incremental Cash Flow
At end of two years assume that Norm receives a salary offer of
$90,000, which increases at 8% per year
Expected tuition, fees and textbook expenses for next two years
while studying in MBA: $35,000
If Norm worked at his current job for two years, his salary would
have increased to $66,150:
Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
After-tax inflow: $23,850 x (1-0.35) = $15,503
Yr 3 cash inflow:
MBA has substantial positive NPV value if 30 yr analysis period
150 , 66 $ 05 . 1 000 , 60 $
2

032 , 18 $ 35 . 0 1 05 . 1 000 , 60 $ 08 . 1 000 , 90 $
3

What about Norms opportunity cost?
15
Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken.
NPV of a project could fall substantially if
opportunity costs are recognized!
First year: $60,000 ($39,000
after taxes)
Second Year: $63,000
($40,950 after taxes)
If Norm did not attend MBA program, he would have
earned:
16
Initial Investment for Jazz CD
Project
Classicaltunes.com is considering adding jazz
recordings to its offerings.
Firm uses 10% discount rate to calculate NPV and 40%
tax rate.
The average selling price of Classicaltunes CDs is
$13.50; price is expected to increase at 2% per year.
Sales expected to begin when new fiscal year begins.
Initial
investment
transactions:
$50,000 for computer equipment (MACRS 5-
year)
$4,500 for inventory ($2,500 of which
purchased on credit)
$1,000 increase in cash balances
17
Projections for Jazz CD Proposal
6 5 4 3 2 1 0 Year
28057
120646
39840
105160
145000
80806
47696
29810
3300
25214
122903
50048
79952
130000
72855
42864
26790
3200
29810 17978 11016 4320 2500
Accounts
Payable
117179 86585 56132 45934 45500 Total assets
31328 33920 23200 32000 40000 Net P&E
123672 56080 41800 28000 10000
Accumulated
Depreciation
155000 90000 65000 60000 50000 Gross P&E
85851 52665 32932 13934 5500
Current
Assets
50677 30563 18727 7344 4500 Inventory
31673 19102 11705 4590 0
Accounts
Receivable
3500 3000 2500 2000 1000 Cash
Abbreviated Project Balance Sheet
6 5 4 3 2 1 0 Year
24,000
$14.91
22,000
$14.61
25,000 16,000 10,000 4,000 0 Units
$15.20 $14.33 $14.05 $13.77 $13.50 Price per unit
37393
25208
35772
98374
259349
357722
27565
23872
35363
86800
234682
321482
49903 15519 1649 -13043 -10000 Pretax profit
18512 14280 13800 18000 10000 Depreciation
38008 29799 19664 8262 0
SG&A
Expense
106422 59597 35114 13219 0 Gross profit
273657 169623 105341 41861 0
Cost of goods
sold
380080 229221 140454 55080 0 Revenue
Abbreviated Project Income Statement
Annual Cash Flow Estimates for Classicaltunes.com
-3291 -5109 -12953 -12771 -12302 -6614 -3000
Change in
working capital
-10000 -15000 -40000 -25000 -5000 -10000 -50000
New Fixed
Assets
6 5 4 3 2 1 0 Year
27535
47644
-12542
40411
35163 -14180 -2512 -6440 -49000 Net cash flow
48454 23591 14790 10174 4000
Operating cash
flow
18
Year Zero Cash Flow
Initial cash outlay of $50,000 for computer equipment
Half-year of MACRS depreciation can be taken in year zero:
20% x $50,000 = $10,000; non cash expense
Depreciation expense are deducted from the firms classical-
music CD profits. Savings of $4,000 (40% x $10,000) in taxes
Changes in working capital are result of following
transactions:
Purchase of $4,500 in inventory and $1000 cash balance
Accounts payable of $2,500 partially finance the $5,500 outlay
Increase in gross fixed assets
- $50,000
Change in working capital
- $3,000
Operating cash inflow
+ $4,000
Net cash flow
- $49,000
Net Cash Flow:
19
Year One Cash Flow
Purchase of additional $10,000 in fixed assets
2nd year depreciation expenses for MACRS 5-year asset
class is 32%. An additional 20% depreciation deduction for
assets purchased this year
32% x $50,000 + 20% x $10,000= $18,000
Non cash expense; has to be added back when computing cash
flow for the year
Net working capital for year one is:
NWC = Current Assets Current Liabilities = $13,934 - $4,320 =
$9,614



Increase in NWC; cash outflow of $6,614
614 , 6 $ 000 , 3 $ 614 , 9 $ NWC NWC NWC
0 year 1 year

20
Year One Cash Flow
Pretax loss of $13,043 in year 1 of Jazz CD project generates
tax savings for other operations of Classicaltunes.com.
Tax savings = 40% x $13,043 = $5,217
Net operating cash inflow = pretax loss + tax savings +
depreciation
Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174

Increase in gross fixed assets
- $10,000
Change in working capital
- $6,614
Operating cash inflow
+ $10,174
Net cash flow
- $6,440
Net Cash Flow:
21
Year Two Cash Flow
Purchase of additional $5,000 in fixed assets
Assets purchased at the onset of the project have allowable
depreciation of 19.2% (19.2% x $50,000 = $9,600)
An additional 32% depreciation deduction for assets purchased in
year 1 and 20% depreciation of assets purchased this year
Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000=
$4,200 = $13,800
Changes in working capital are result of following
transactions:
Increases in current assets:
$500 increase in cash balance
$7,115 increase in accounts receivables
$11,383 increase in inventory
Increase in current liabilities:
$6,696 increase in account payables
Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)
22
Year Two Cash Flow
Increase in gross fixed assets - $5,000
Change in working capital - $12,302
Operating cash inflow +$14,790
Net cash flow - $2,512
Pretax profit in year two is $1,649.
The company must pay taxes of $660 (40% x $1,649-- cash
outflow.
Net operating cash inflow = pretax profit + tax + depreciation
Operating cash inflow = $1,649 - $660 + $13,800 = $14,789
Net Cash Flow:
23
Terminal Value for Jazz CD
Investment
If we assume that cash flow continue to grow at 2% per
year (g = 2%, r = 10%,):




Second approach used by Classicaltunes.com to compute
terminal value for the project: use the book value at end of year
six:
Plant and Equipment (P&E) at end of year six is $31,328.
The firm liquidates total current assets and pays off current
debts:
$85,850 - $29,810 = $56,040
Terminal value = $31,328 + $56,040 = $87,368.

325 , 448 $
02 . 0 10 . 0
866 , 35 $
or ,
866 , 35 $ 163 , 35 $ 02 . 1 1
6
1
1

PV
g r
CF
PV
CF g CF
t
t
t t
24
NPV for Jazz CD Project
Using assumption that cash flow grow at a steady rate
past year 6:





Using book value assumption for terminal value:





NPV is positive with both methods: investing in Jazz CD
project increases shareholders wealth.
862 , 213 $
1 . 1
325 , 448 $
1 . 1
163 , 35 $
1 . 1
535 , 27 $
1 . 1
562 , 12 $
1 . 1
180 , 14 $
1 . 1
513 , 2 $
1 . 1
440 , 6 $
000 , 49 $
6 6 5
4 3 2 1

NPV
111 , 10 $
1 . 1
368 , 87 $
1 . 1
163 , 35 $
1 . 1
535 , 27 $
1 . 1
562 , 12 $
1 . 1
180 , 14 $
1 . 1
513 , 2 $
1 . 1
440 , 6 $
000 , 49 $
6 6 5
4 3 2 1

NPV
25
Capital Rationing
Can a firm accept all investment projects with
positive NPV?
Reasons why a company would not accept all
projects:
Limited availability of skilled personnel to be
involved with all the projects;
Financing may not be available for all projects.
Companies are reluctant to issue new shares to
finance new projects because of the negative signal
this action may convey to the market.
26
Capital Rationing
Capital rationing: project combination that
maximizes shareholder wealth subject to funding
constraints
1. Rank the projects using the Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds still available, select the second-highest
PI, and so on, until the capital is exhausted.
1. Rank the projects using the Profitability Index (PI)
The steps above ensure that managers select the
combination of projects with the highest NPV.
27
Equipment Replacement and
Unequal Lives
A firm must purchase an electronic control device:
First alternative is a cheaper device, higher maintenance costs,
shorter period of utilization
Second device is more expensive, smaller maintenance costs,
longer life span
Expected cash outflows:



Maintenance costs are constant over time. Use real discount rate
of 7% for NPV
- 1500 1500 1500 12000 A
1200 1200 1200 1200 14000 B
4 3 2 1 0 Device
$15,936 A
$18,065 B
NPV Device
Cash outflow device A < cash outflow device B
select A?
28
Equivalent Annual Cost (EAC)
EAC converts lifetime costs to a level annuity; eliminates the
problem of unequal lives
1. Compute NPV for operating devices A and B for their
lifetime:
NPV device A = $15,936
NPV device B = $18,065
2. Compute annual expenditure to make NPV of annuity
equal to NPV of operating device:
$6,072 X
07 1 07 1 07 1
936 15
3 2 1

. . .
, $
X X X
Device A
$5,333 Y
07 1 07 1 07 1 07 1
065 18
4 3 2 1

. . . .
, $
Y Y Y Y
Device B
29
Excess Capacity
Excess capacity is not a free asset as traditionally
regarded by managers.
Company has excess capacity in a distribution
center warehouse.
In two years, the firm will invest $2,000,000 to
expand the warehouse.
The firm could lease the excess space for
$125,000 per year for the next two years.
Expansion plans should begin immediately in
this case to hold inventory for stores that will
come on line in a few months.
Incremental cost: investing $2,000,000 at
present vs. two years from today
Incremental cash inflow: $125,000
30
Excess Capacity
NPV of leasing excess capacity (assume 10%
discount rate):



NPV negative: reject leasing excess capacity at $125,000 per
year.
The firm could compute the value of the lease that would
allow break even.



X = $181,818
Leasing the excess capacity for a price above $181,818
would increase shareholders wealth.
471 , 108 $
1 . 1
000 , 000 , 2
10 . 1
000 , 125
000 , 000 , 2 000 , 125
2
NPV
0
1 . 1
000 , 000 , 2
10 . 1
000 , 000 , 2
2

X
X NPV
31
The Human Face of Capital Budgeting
Managers must be aware of optimistic bias in
these assumptions made by project supporters.

Companies should have control measures in place
to remove bias:
Investment analysis should be done by a group
independent of individual or group proposing
the project.
Project analysts must have a sense of what is
reasonable when forecasting a projects profit
margin and its growth potential.
Storytelling: Best analysts not only provide
numbers to highlight a good investment, but also
can explain why the investment makes sense.
Certain types of cash flows are common to many
investments
Opportunity costs should be included in cash flow
projections

Consider human factors in capital budgeting
Cash Flow and Capital Budgeting