Capital Budgeting I

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Topic 5

• Capital Budgeting I

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Learning Objectives

• LO 5.1 Explain and apply the incremental
  approach to cash flow analysis.
• LO 5.2 Develop an Excel model to calculate and
  value the net cash flows of a firm incorporating
  sunk costs, opportunity costs, side effects,
  depreciation, inflation, salvage value, and
  working capital.
• LO 5.3 Explain the meaning of the results of
  these calculations in the context of an
  investment decision.

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Excel Features Project Criteria

• Project Criteria
• IRR(values,guess)
• XIRR(values,dates,guess)
• NPV(rate,value1,value2, ...)
• XNPV(rate,values,dates)
• MIRR(values,finance_rate,reinvest_rate) Values
  begin in period zero
• Dates are used if cash flows are not periodic
• Finance_rate is the discount rate
• Reinvest_rate is the reinvestment rate

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Outline

• Capital Budgeting Principles
• Principle One Use Increments
• Principle Two Use Real Cash Flows
• Cash Flow Factors Sunk Costs, Opportunity Costs,
  Side Effects, Taxes, Inflation, Salvage Value,
  Depreciation, and Working Capital
• Steps in Estimating Cash Flows
• Project Cash Flow Example
• Investments of Unequal Lives

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Capital Budgeting Principles

• Principle One Use Increments.
• The Incremental Approach to Cash Flow Analysis
• Principle Two Use Real Cash Flows.
• Real versus Accounting Cash Flows

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Principle 1

• The Incremental Approach to Cash Flow Analysis
• The incremental approach is to analyze how real
  cash flows ______ as the result of a new project,
  i.e., what is the change in the value.
• The alternate view is to look at averages, i.e.,
  what is the new average value.

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Principle 1

• Your firm is considering the development of a new
  division to add to the two current divisions.
  Consider the following overhead costs and how
  that cost should be allocated to the new division

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Principle 1

• The first possibility would be to average the new
  costs among the three divisions and apply that
  average to the new division. For some accounting
  purposes this may be the appropriate method

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Principle 1

• An alternate possibility would be to apply to the
  new division the change in costs, i.e., the
  increment, associated with developing the new
  division
• Note We normally think of an increment as a
  positive addition, but in this usage it could be
  a negative amount (though that would be unusual).

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Principle 2

• In this section we must distinguish real from
  accounting cash flows.
• Real cash flows are actual transfers of value,
  e.g., money, assets, etc.
• In accrual accounting, a recorded cash flow may
  not represent an actual transfer of value or it
  may record the transfer in a different period
  than that in which the transfer in fact occurs.
• For clarity, I will refer to accounting cash
  flows that are not real cash flows as non-real
  cash flows.

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Principle 2

• As a simple example, consider paying 6,000 for
  insurance over the next three years. The real
  cash flows versus the accounting cash flows are
  as follows

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Principle 2

• Other examples of accounting (but not necessarily
  real) cash flows are
• ______
• Depreciation
• Sometimes a non-real cash flow has an effect on a
  real cash flow.
• In this case, we need to incorporate the effect
  on the real cash flow, but not the non-real cash
  flow itself.
• Our treatment of depreciation will show an
  example of this type.

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Cash Flow Factors

• Sunk Costs
• Opportunity Costs
• Side Effects
• Taxes
• Inflation
• Salvage Value
• Depreciation
• Working Capital

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Factors in Cash Flow Analysis

• You have a good grasp on the principles of
  discounting cash flows.
• In this section, we address a range of practical
  issues that arise when you are calculating the
  cash flows to be associated with a project.
• We shall focus on those types of cash flows that
  are often either overlooked or improperly
  calculated.

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Sunk Costs

• Sunk costs are not relevant
• Just because we have come this far does not
  mean that we should continue to throw good money
  after bad.
• Sunk costs are past expenditures associated with
  the project that have no value either to the
  ongoing project or as ______.

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Opportunity Costs

• Opportunity costs do matter. Just because a
  project has a positive NPV, that does not mean
  that it should also have automatic acceptance.
  Specifically, if another project with a higher
  NPV would have to be passed up, then we
  should/should not proceed.

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Opportunity Costs

• The opportunity cost of an asset is what you
  ______ by using it in this project.
• More technically, it is the next most valuable
  use for the asset.
• The next most valuable use could be
• The value from selling or renting it,
• The value it would have for another project,
• Nothing,
• Etc.

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Opportunity Costs

• Examples
• We will use factory space for our project that
  could otherwise be rented for 10,000/year.
• Opportunity cost 10,000/year.
• We will use factory space for our project that
  would otherwise go unused.
• Opportunity cost 0/year.
• Nothing (or very little is free), so include all
  opportunity costs.

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Side Effects

• Erosion and cannibalism are both bad things. If
  our new product causes existing customers to
  demand less of current products, we need to
  recognize that.
• If, however, synergies result that create
  increased demand of existing products, we also
  need to recognize that.
• By the incremental principle, all synergies must
  be applied to the new project, for the synergies
  are changes in value due to the new project.

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Depreciation

• Depreciation is not a real cash flow!
• We are concerned with depreciation in cash flow
  analysis, only to the extent that it affects a
  ______, i.e., ______.
• If a firm had no taxable income, then we could
  ignore depreciation.
• The calculation must incorporate the tax effect
  of depreciation, but not the depreciation itself.

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Depreciation

• Costs Some expenditures are expensed, i.e.,
  the entire expenditure is subtracted from taxable
  income in ______.
• In theory, the value is exhausted during that one
  period
• E.g. Stationary, production materials, etc.
• Deductible Investments Some expenditures are
  deducted, i.e., the expenditure is subtracted
  from taxable income over ______.
• In theory, the value is exhausted over multiple
  periods.
• E.g. Factory equipment, computers, etc.
• Non-Deductible Investments Some expenditures are
  non-deductible, i.e., the expenditure is never
  subtracted from taxable income.
• In theory, the value is never exhausted
• E.g. Land

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Depreciation

• Different types of capital investment are
  depreciated according to different methods
  (schedules) and over different lengths of time.

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Inflation and Capital Budgeting

• While the nominal rate in the U.S. has fluctuated
  with inflation, the ______ has generally
  exhibited far less variance than the nominal
  rate.
• In capital budgeting, one must compare real cash
  flows discounted at real rates or nominal cash
  flows discounted at nominal rates.
• Basic Rule Be ______!

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Real versus Nominal Rates

• Inflation is an important fact of economic life
  and must be considered in capital budgeting.
• Consider the relationship between interest rates
  and inflation, referred to as the Fisher equation

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Real versus Nominal Cash Flows

• This is the relationship between real and nominal
  cash flows

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Salvage Value

• When a project is terminated, any residual value
  in capital investment is regarded as ______
• This is somewhat analogous to the release of the
  remaining working capital in the final period.
• Salvage value is a ______ and an estimate of the
  market (or liquidation) value of equipment, etc.

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Salvage Value

• The salvage value is a real cash flow the book
  value is not, but is need to determine the taxes
  on the salvage value.
• The firm will be taxed on the salvage value less
  any remaining ______ book value
• Taxable Salvage Value
• 1,000 576 424.00
• Tax Payment on Salvage Value (T 35)
• 424 0.35 148.40

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Working Capital

• All the working capital that you invest in a
  project is eventually ______.
• You can think of the investment in working
  capital as a loan to the project.
• But since there is a time value to money, there
  is a cost to tying up value in working capital.
• Whenever there is a need for more working
  capital, there is a ______ cash flow, and
  whenever working capital is released, there is a
  ______ cash flow.

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Steps in Estimating Cash Flows

• Get input parameters.
• Determine investment.
• Determine operating cash flow.
• Determine working capital needs.
• Incorporate after tax salvage value
• Find annual, net project cash flows.
• Apply decision criteria.

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Example Data

• Production
• Units/year
• Costs
• Fixed 50,000 (real)
• Variable 150.00/unit (nominal)
• Revenue
• Initial Price 300.00/unit (nominal)
• Increase in Price 2/year

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Example Data

• Capital Spending
• Investment 20,000,000 (nominal)
• Set Up Costs 500,000 (nominal,
  non-depreciable)
• Opportunity Cost
• Factory Capacity 5,000,000 (nominal)
• Project Feasibility Study 2,000,000 (nominal)
• Salvage Value 2,000,000 (nominal)

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Example Data

• Nominal Discount Rate 15
• Inflation Rate 5
• Working Capital
• Initial 250,000 (Nominal)
• Thereafter 12 (of sales)
• Corporate Tax Rate 38

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Example 1-Input Parameters
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Example 2-Capital Spending

• Total Investment 25,500,000
• Set-up and opportunity costs are not depreciable.
• Opportunity cost is returned at project end.

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Example 3-Operating CF Year 1
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Example 3-Operating CF Year 2-5

• Changes in Sales Revenue
• Production changes
• Price increases at 2 per year
• Changes in Depreciation
• Follows MARCS

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Example 3-Operating CF Year 2-5

• Changes in Variable Costs
• Production changes
• Changes in Fixed Cost
• Fixed cost are stated in real terms, so inflation
  needs to be taken into account

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Example 3-Operating CF Year 2-5
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Example 4-Working Capital

• Initial Working Capital (250,000)
• Change in Working Capital
• -(New WC Requirement Old WC Requirement)
• Year 1 -(1,200,000 - 250,000) (950,000)
• Year 3 -(1,997,568 - 2,448,000) 450,532
• In final year all working capital is returned.

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Example 5-Salvage Value

• Remaining Book Value
• 20,000,000 x 5.76 1,152,000
• Undepreciated Salvage Value
• 2,000,000 - 1,152,000 848,000
• Tax on Undepreciated Salvage Value
• 848,000 x 38 322,240
• After Tax Salvage Value
• 2,000,000 - 322,240 1,677,760

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Example 6-Net Project Cash Flows

• Annual, net project cash flows are sum of
  operating cash flows, changes in working capital,
  salvage value and change in capital spending.

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Example 7-Decision Criteria
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Complete Example

• You cannot read thisbut you can paste it into a
  word document and expand it!
• It is also available at
• http//home.ubalt.edu/ntsbschr/FIN20640/FIN640_Mi
  sc/FIN640_Cash_Flow_Example.doc

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Other Methods for Computing OCF

• Bottom-Up Approach
• Works only when there is no interest expense
• OCF NI depreciation
• Top-Down Approach
• OCF Sales Costs Taxes
• Dont subtract non-cash deductions
• Tax Shield Approach
• OCF (Sales Costs)(1 T) (Depreciation T)

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Investments of Unequal Lives

• There are times when application of the NPV rule
  can lead to the wrong decision. Consider a
  factory that must have an air cleaner that is
  mandated by law. There are two choices
• The Cadillac cleaner costs 4,000 today, has
  annual operating costs of 100, and lasts 10
  years.
• The Cheapskate cleaner costs 1,000 today, has
  annual operating costs of 500, and lasts 5
  years.
• Assuming a 10 discount rate, which one should we
  choose?

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Investments of Unequal Lives

• This overlooks the fact that the Cadillac cleaner
  lasts ______ as long.
• When we incorporate that, the Cadillac cleaner is
  actually ______ (i.e., has a higher NPV).

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Investments of Unequal Lives

• Replacement Chain
• Repeat projects until they begin and end at the
  same time.
• Compute NPV for the repeated projects.
• The Equivalent Annual Cost Method

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Replacement Chain Approach

• The Cadillac cleaner time line of cash flows

The Cheapskate cleaner time line of cash flows
over ten years
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Equivalent Annual Cost (EAC)

• Applicable to a much more robust set of
  circumstances than the replacement chain
• The EAC is the value of the level payment annuity
  that has the same PV as our original set of cash
  flows.
• For example, the EAC for the Cadillac air cleaner
  is 750.98.
• The EAC for the Cheapskate air cleaner is
  763.80, which confirms our earlier decision to
  reject it.