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Chapter 10 - Cash Flows and

Other Topics in Capital Budgeting

Capital Budgeting: The process of planning


for purchases of long-term assets.
For example: Our firm must decide whether
to purchase a new plastic molding machine
for $127,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on
the investment?
The relevant project information follows:

The cost of the new machine is $127,000.


Installation will cost $20,000.
$4,000 in net working capital will be needed at

the time of installation.


The project will increase revenues by $85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
Simplified straight line depreciation is used.
Class life is 5 years, and the firm is planning to
keep the project for 5 years.
Salvage value at the end of year 5 will be $50,000.
14% cost of capital; 34% marginal tax rate.

Capital Budgeting Steps


1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
Initial outlay
Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
Terminal Cash Flows

Capital Budgeting Steps


1) Evaluate Cash Flows

...

Capital Budgeting Steps


1) Evaluate Cash Flows
Initial
outlay

...

Capital Budgeting Steps


1) Evaluate Cash Flows
Initial
outlay

Annual Cash Flows

...

Capital Budgeting Steps


1) Evaluate Cash Flows
Terminal
Cash flow

Initial
outlay

Annual Cash Flows

...

Capital Budgeting Steps


2) Evaluate the Risk of the Project
Well get to this in the next chapter.
For now, well assume that the risk of the
project is the same as the risk of the
overall firm.
If we do this, we can use the firms cost of
capital as the discount rate for capital
investment projects.

Capital Budgeting Steps


3) Accept or Reject the Project

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ ( 20,000)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
Net Initial Outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
($151,000)

Purchase price of asset


Shipping and installation
Depreciable asset
Net working capital
Proceeds from sale of old asset
Net initial outlay

Step 1: Evaluate Cash Flows


a) Initial Outlay: What is the cash flow at
time 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+
0
($151,000)

Purchase price of asset


Shipping and installation
Depreciable asset
Net working capital
Proceeds from sale of old asset
Net initial outlay

Step 1: Evaluate Cash Flows


b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?

For Each Year, Calculate:


Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
+ Depreciation reversal
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow

For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
46,461 =

Revenue
Costs
Depreciation
EBT
Taxes
EAT
Depreciation reversal
Annual Cash Flow

Step 1: Evaluate Cash Flows


c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

Step 1: Evaluate Cash Flows


c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
50,000
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

Tax Effects of Sale of Asset:


Salvage value = $50,000.
Book value = depreciable asset - total
amount depreciated.
Book value = $147,000 - $147,000
= $0.
Capital gain = SV - BV
= 50,000 - 0 = $50,000.
Tax payment = 50,000 x .34 = ($17,000).

Step 1: Evaluate Cash Flows


c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
50,000
(17,000)

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Step 1: Evaluate Cash Flows


c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
50,000
(17,000)
4,000

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Step 1: Evaluate Cash Flows


c) Terminal Cash Flow: What is the cash
flow at the end of the projects life?
50,000
(17,000)
4,000
37,000

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Project NPV:

CF(0) = -151,000.
CF(1 - 4) = 46,461.
CF(5) = 46,461 + 37,000 = 83,461.
Discount rate = 14%.
NPV = $27,721.
We would accept the project.

Capital Rationing

Suppose that you have evaluated


five capital investment projects
for your company.
Suppose that the VP of Finance
has given you a limited capital
budget.
How do you decide which
projects to select?

Capital Rationing

You could rank the projects by IRR:

Capital Rationing

You could rank the projects by IRR:


IRR
25%
20%
15%
10%
5%

1
$

Capital Rationing

You could rank the projects by IRR:


IRR
25%
20%
15%
10%
5%

2
$

Capital Rationing

You could rank the projects by IRR:


IRR
25%
20%
15%
10%
5%

3
$

Capital Rationing

You could rank the projects by IRR:


IRR
25%
20%
15%
10%
5%

4
$

Capital Rationing

You could rank the projects by IRR:


IRR
25%
20%
15%
10%
5%

5
$

Capital Rationing

You could rank the projects by IRR:


IRR

Our budget is limited


so we accept only
projects 1, 2, and 3.

25%
20%
15%
10%
5%

4
$X

5
$

Capital Rationing

You could rank the projects by IRR:


IRR

Our budget is limited


so we accept only
projects 1, 2, and 3.

25%
20%
15%
10%
5%

3
$X

Capital Rationing

Ranking projects by IRR is not


always the best way to deal with a
limited capital budget.
Its better to pick the largest NPVs.
Lets try ranking projects by NPV.

Problems with Project Ranking


1) Mutually exclusive projects of unequal
size (the size disparity problem)
The NPV decision may not agree with
IRR or PI.
Solution: select the project with the
largest NPV.

Size Disparity Example


Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%
NPV = $9,110
PI = 1.07

Size Disparity Example


Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%
NPV = $9,110
PI = 1.07

Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
required return = 12%
IRR = 23.38%
NPV = $6,027
PI = 1.20

Size Disparity Example


Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%
NPV = $9,110
PI = 1.07

Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
required return = 12%
IRR = 23.38%
NPV = $6,027
PI = 1.20

Problems with Project Ranking


2) The time disparity problem with mutually
exclusive projects.
NPV and PI assume cash flows are
reinvested at the required rate of return for
the project.
IRR assumes cash flows are reinvested at
the IRR.
The NPV or PI decision may not agree with
the IRR.
Solution: select the largest NPV.

Time Disparity Example


Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
required return = 12%
IRR = 18.10%
NPV = $9,436
PI = 1.20

Time Disparity Example


Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
required return = 12%

Project B
year cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%

IRR = 18.10%
NPV = $9,436
PI = 1.20

IRR = 25.51%
NPV = $8,455
PI = 1.18

Time Disparity Example


Project A
year cash flow
0
(48,000)
1
1,200
2
2,400
3
39,000
4
42,000
required return = 12%

Project B
year cash flow
0
(46,500)
1
36,500
2
24,000
3
2,400
4
2,400
required return = 12%

IRR = 18.10%
NPV = $9,436
PI = 1.20

IRR = 25.51%
NPV = $8,455
PI = 1.18

Mutually Exclusive Investments


with Unequal Lives

Suppose our firm is planning to expand


and we have to select one of two machines.
They differ in terms of economic life and
capacity.
How do we decide which machine to select?

The after-tax cash flows are:


Year
Machine 1
Machine 2
0
(45,000)
(45,000)
1
20,000
12,000
2
20,000
12,000
3
20,000
12,000
4
12,000
5
12,000
6
12,000
Assume a required return of 14%.

Step 1: Calculate NPV


NPV1 = $1,433
NPV2 = $1,664
So, does this mean #2 is better?
No! The two NPVs cant be
compared!

Step 2: Equivalent Annual


Annuity (EAA) method

If we assume that each project will be


replaced an infinite number of times in the
future, we can convert each NPV to an
annuity.
The projects EAAs can be compared to
determine which is the best project!
EAA: Simply annuitize the NPV over the
projects life.

EAA with your calculator:

Simply spread the NPV over the life


of the project

Machine 1: PV = 1433, N = 3, I = 14,


solve: PMT = -617.24.

Machine 2: PV = 1664, N = 6, I = 14,


solve: PMT = -427.91.

EAA1 = $617
EAA2 = $428
This tells us that:
NPV1 = annuity of $617 per year.
NPV2 = annuity of $428 per year.
So, weve reduced a problem with
different time horizons to a couple of
annuities.
Decision Rule: Select the highest EAA.
We would choose machine #1.

Step 3: Convert back to NPV

Step 3: Convert back to NPV

Assuming infinite replacement, the


EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

Step 3: Convert back to NPV

Assuming infinite replacement, the


EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

NPV 1 = 617/.14 = $4,407

Step 3: Convert back to NPV

Assuming infinite replacement, the


EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required
rate of return.

NPV 1 = 617/.14 = $4,407


NPV 2 = 428/.14 = $3,057

Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs


are actually perpetuities. Get the PV by
dividing the EAA by the required rate of
return.

NPV 1 = 617/.14 = $4,407

NPV 2 = 428/.14 = $3,057

This doesnt change the answer, of course;


it just converts EAA to an NPV that can be
compared.

Practice Problems:
Cash Flows & Other Topics
in Capital Budgeting

Project Information:
Problem 1a
Cost of equipment = $400,000.
Shipping & installation will be $20,000.
$25,000 in net working capital required at setup.
3-year project life, 5-year class life.
Simplified straight line depreciation.
Revenues will increase by $220,000 per year.
Defects costs will fall by $10,000 per year.
Operating costs will rise by $30,000 per year.
Salvage value after year 3 is $200,000.
Cost of capital = 12%, marginal tax rate = 34%.

Problem 1a
Initial Outlay:
(400,000)
+ ( 20,000)
(420,000)
+ ( 25,000)
($445,000)

Cost of asset
Shipping & installation
Depreciable asset
Investment in NWC
Net Initial Outlay

For Years 1 - 3:
220,000
10,000
(30,000)
(84,000)
116,000
(39,440)
76,560
84,000
160,560 =

Problem 1a

Increased revenue
Decreased defects
Increased operating costs
Increased depreciation
EBT
Taxes (34%)
EAT
Depreciation reversal
Annual Cash Flow

Problem 1a
Terminal Cash Flow:
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

Terminal Cash Flow:

Problem 1a

Salvage value = $200,000.


Book value = depreciable asset - total
amount depreciated.
Book value = $168,000.
Capital gain = SV - BV = $32,000.
Tax payment = 32,000 x .34 = ($10,880).

Problem 1a
Terminal Cash Flow:
200,000
(10,880)
25,000
214,120

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Problem 1a Solution
NPV and IRR:
CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160,560 + 214,120 = 374,680
Discount rate = 12%
IRR = 22.1%
NPV = $93,044. Accept the project!

Problem 1b
Project Information:
For the same project, suppose we
can only get $100,000 for the old
equipment after year 3, due to
rapidly changing technology.
Calculate the IRR and NPV for the
project.
Is it still acceptable?

Problem 1b
Terminal Cash Flow:
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

Terminal Cash Flow:

Problem 1b

Salvage value = $100,000.


Book value = depreciable asset - total
amount depreciated.
Book value = $168,000.
Capital loss = SV - BV = ($68,000).
Tax refund = 68,000 x .34 = $23,120.

Problem 1b
Terminal Cash Flow:
100,000
23,120
25,000
148,120

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Problem 1b Solution
NPV and IRR:
CF(0) = -445,000.
CF(1), (2) = 160,560.
CF(3) = 160,560 + 148,120 = 308,680.
Discount rate = 12%.
IRR = 17.3%.
NPV = $46,067. Accept the project!

Automation Project:
Problem 2
Cost of equipment = $550,000.
Shipping & installation will be $25,000.
$15,000 in net working capital required at setup.
8-year project life, 5-year class life.
Simplified straight line depreciation.
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Salvage value after year 8 is $40,000.
Cost of capital = 14%, marginal tax rate = 34%.

Problem 2
Initial Outlay:

+
+

(550,000)
(25,000)
(575,000)
(15,000)
(590,000)

Cost of new machine


Shipping & installation
Depreciable asset
NWC investment
Net Initial Outlay

For Years 1 - 5:
240,000
(115,000)
125,000
(42,500)
82,500
115,000
197,500 =

Problem 2

Cost decrease
Depreciation increase
EBIT
Taxes (34%)
EAT
Depreciation reversal
Annual Cash Flow

For Years 6 - 8:
240,000
(
0)
240,000
(81,600)
158,400
0
158,400 =

Problem 2

Cost decrease
Depreciation increase
EBIT
Taxes (34%)
EAT
Depreciation reversal
Annual Cash Flow

Problem 2
Terminal Cash Flow:
40,000
(13,600)
15,000
41,400

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Problem 2 Solution
NPV and IRR:
CF(0) = -590,000.
CF(1 - 5) = 197,500.
CF(6 - 7) = 158,400.
CF(10) = 158,400 + 41,400 = 199,800.
Discount rate = 14%.
IRR = 28.13%
NPV = $293,543.
We would accept the project!

Problem 3
Replacement Project:
Old Asset (5 years old):
Cost of equipment = $1,125,000.
10-year project life, 10-year class life.
Simplified straight line depreciation.
Current salvage value is $400,000.
Cost of capital = 14%, marginal tax
rate = 35%.

Replacement Project:

Problem 3

New Asset:
Cost of equipment = $1,750,000.
Shipping & installation will be $56,000.
$68,000 investment in net working capital.
5-year project life, 5-year class life.
Simplified straight line depreciation.
Will increase sales by $285,000 per year.
Operating expenses will fall by $100,000 per year.
Already paid $15,000 for training program.
Salvage value after year 5 is $500,000.
Cost of capital = 14%, marginal tax rate = 34%.

Problem 3: Sell the Old Asset

Salvage value = $400,000.


Book value = depreciable asset - total
amount depreciated.
Book value = $1,125,000 - $562,500
= $562,500.
Capital gain = SV - BV
= 400,000 - 562,500 = ($162,500).
Tax refund = 162,500 x .35 = $56,875.

Initial Outlay:

Problem 3

(1,750,000) Cost of new machine


+ ( 56,000) Shipping & installation
(1,806,000) Depreciable asset
+ ( 68,000) NWC investment
+ 456,875 After-tax proceeds (sold
old machine)
(1,417,125) Net Initial Outlay

For Years 1 - 5:
385,000
(248,700)
136,300
(47,705)
88,595
248,700
337,295 =

Problem 3

Increased sales & cost savings


Extra depreciation
EBT
Taxes (35%)
EAT
Depreciation reversal
Differential Cash Flow

Problem 3
Terminal Cash Flow:
500,000
(175,000)
68,000
393,000

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Problem 3 Solution
NPV and IRR:
CF(0) = -1,417,125.
CF(1 - 4) = 337,295.
CF(5) = 337,295 + 393,000 = 730,295.
Discount rate = 14%.
NPV = (55,052.07).
IRR = 12.55%.
We would not accept the project!