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FI 3300 - Corporate Finance Zinat Alam 1 FI3300 Corporation Finance – Chapter 11 Cash Flow & Capital Budgeting

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Page 1: FI 3300 - Corporate Finance Zinat Alam 1 FI3300 Corporation Finance – Chapter 11 Cash Flow & Capital Budgeting

FI 3300 - Corporate Finance Zinat Alam 1

FI3300 Corporation Finance – Chapter 11

Cash Flow & Capital Budgeting

Page 2: FI 3300 - Corporate Finance Zinat Alam 1 FI3300 Corporation Finance – Chapter 11 Cash Flow & Capital Budgeting

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Learning Objectives

Find project cash flows

Describe the difference between independent and mutually exclusive projects.

Compare projects with different lives using the equivalent annual series technique.

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Estimating project cash flows 1

For this chapter, we focus on the NPV, IRR and PI capital budgeting rules.

To apply these rules, we need the project’s cash flows and the appropriate discount rate.

In this chapter, you will learn how to estimate a project’s cash flows. The discount rate will still be given to you.

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Estimating project cash flows 2

Guidelines:Add back depreciation to net income.Ignore interest expense.All project cash flows must be

incremental. Ignore allocated costs and sunk costs.Include opportunity costs.Net working capital.

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Add back depreciation

Depreciation is a non-cash charge and must be added to net income to estimate cash flow.

Cash flow

= net income + depreciation expense

= (revenue – cost)x(1-tc) + (tc x depreciation)

tc: corporate tax rateNote: Cost = all costs except depreciation

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Ignore interest expense

A project’s value (desirability) is determined by the cash flows that generates, not by how the project is financed.

In determining a project’s cash flows, we ignore it’s financing cost, i.e., the interest expense.

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All project cash flows must be incremental

To evaluate a project, we look at the cash flows which it contributes towards the firm’s existing cash flows. In other words, we look at project’s incremental cash flows.

How to determine incremental cash flows? Look at the firm’s cash flows without the

project. Look at the firm’s cash flows with the project. The difference is the incremental cash flows.

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Ignore allocated costsand sunk costs

Allocated costs: rent, supervisory salaries, administrative costs, and various overhead expenses.• These costs are not incremental. They don’t

change even if the project is undertaken. Thus, they should not be considered in estimating the project’s incremental cash flows.

Sunk (irrecoverable) costs: costs which cannot be recovered regardless of whether the firm undertakes the project. • Examples: R&D expenses, consultant fees.

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Include opportunity costs

Suppose the project requires the use of some asset owned by the firm.

If the asset is not used by the project, the firm can sell the asset for $X. This $X is the opportunity cost of the asset. Such a cost should be included in the project’s cost.

An asset’s opportunity cost is the money that the firm can receive if the asset is put to the next best use. The ‘next best’ use may be to sell the asset.

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Net working capital 1

Very often, a project will require an initial increase in net working capital. This increase in net working capital must be added to the project’s costs.

Assume that this additional working capital is liquidated (sold for cash) at the end of the project’s life.

This liquidation is a cash inflow in the last period.

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Net working capital 2

The opposite pattern is also possible.In other words, if taking on a project

REDUCES the net working capital, then the size of this reduction is subtracted from • the project’s initial cost.• the last period cash inflow.

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Capital budgeting example

Problem 11.6You are given the responsibility of

conducting the project selection analysis in your firm. You have to calculate the NPV of a given project. The appropriate cost of capital is 12 percent and the firm is in the 30 percent tax bracket. You are provided the following pieces of information regarding the project:

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Details

The project is going to be built on a piece of land that the firm already owns. The market value of the land is $1 million.

If the project is undertaken, prior to construction, an amount of $100,000 would have to be spent to make the land usable for construction purposes.

In order to come up with the project concept, the company had hired a marketing research firm for $200,000.

The firm has spent another $250,000 on R&D for this project.

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Details

The project will require an initial outlay of $20 million for plant and machinery.

The sales from this project will be $15 million per year of which 20 percent will be from lost sales of existing products.

The variable costs of manufacturing for this level of sales will be $9 million per year.

The company uses straight-line depreciation. The project has an economic life of ten years and will have a salvage value of $3 million at the end.

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Details

Because of the project the company will need additional working capital of $1 million which can be liquidated at the end of ten years.

The project will require additional supervisory and managerial manpower that will cost $200,000 per year.

The accounting department has allocated $350,000 as allocated overhead cost for supervisory and managerial salaries.

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Calculate initial cost

Initial cost is the sum of:• Market value of land: $1 mil (opportunity cost)• Land improvement $100 k• Plant & machinery: $20 mil• Incremental working capital: $1 mil

Initial cost = 1,000,000 + 100,000 + 20,000,000 + 1,000,000

= $22,100,000

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Calculate the annual incremental cash flow: step 1

Calculate the annual depreciation expense

For this project, fixed assets refer to $20mil plant & machinery. Therefore,

Depreciation

= (20,000,000 – 3,000,000)/10

= $1,700,000

Calculate incremental sales

Incremental sales = 0.8 x 15,000,000 = $12,000,000

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Calculate the annual incremental cash flow: step 2

Draw up the incremental income statement

Incremental sales 12,000,000

Less Incremental variable cost 9,000,000

Less Incremental managerial salaries 200,000

Less Incremental depreciation 1,700,000

Equals Incremental taxable income 1,100,000

Less Incremental tax @30% 330,000

Equals Incremental net income 770,000

Add back depreciation 1,700,000

Incremental cash flow $2,470,000

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Consider other cash flows

At the end of project’s life (t=10), company• Recovers $1 mil additional working capital

(item 9)• Receives $3 mil salvage value from plant &

machinery (item 8)

Additional cash flows at end of project

= 1,000,000 + 3,000,000

= $4,000,000

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Let’s bring all the cash flows together 1

CF0 (initial cost) = $22,100,000

Annual incremental after-tax cash flow (Year 1 through Year 10) = $2,470,000

Additional cash flow in Year 10 = $4,000,000 So in year 10, the company receives a total of

= 2,470,000 + 4,000,000 = $6,470,000

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Let’s bring all the cash flows together 2

To compute NPV, enter cash flows in this way:

CF0 = -22,100,000

C01 = 2,470,000, F01=9

C02 = 6,470,000, F02=1

Then press NPV, enter I = 12, press CPT and NPV.

NPV = -$6,856,056.17

Decision: reject the project.

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Mutually Exclusive Projects

Projects are mutually exclusive if accepting one implies that the other projects will be foregone.

When projects are mutually exclusive and have equal lives, you have to rank the projects based on their NPVs choose the best project, provided the project’s NPV

is positive With mutually exclusive projects, choosing

the project with the highest NPV is always correct.

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Question

Consider the following mutually exclusive projects, for a firm using a discount rate of 10%:

Project NPV IRR PI

A $100,000 10.2% 1.04

B $1 11% 1.11

C $70,000 23% 1.32

D $24,000 13% 1.44

Which project(s) should the firm accept and why?

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Comparing projects with unequal lives: Equivalent annual series (EAS)

When projects are mutually exclusive but have unequal lives We construct the equivalent annual series (EAS) of

each project and We choose the project with the highest EAS

A project’s EAS is the payment on an annuity whose life is the same as that of the project and whose present value, using the discount rate of the project, is equal to the project’s NPV.

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Calculating EAS

Consider Projects J & K, with the following cash flows. The discount rate is 10%.

Project C0 C1 C2 C3 C4

J -12000 6000 6000 6000

K -18000 7000 7000 7000 7000

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EAS for Project J

To compute Project J’s EAS, do the following: Compute Project J’s NPV

• Verify that NPV(J) = $2,921.11

Find the payment on the 3-year (life of project J) annuity whose PV is equal to $2,921.11.

Enter the following values:N=3, I/Y=10, PV=-2921.11, FV=0, Then CPT, PMT.PMT = 1,174.62, which is Project J’s EAS. So, finding EAS is nothing more than finding the payment of

an annuity.

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EAS for Project K

Verify that Project K’s NPV= $4,189.06 Find the payment on the 4-year (life of project K)

annuity whose PV is equal to $ 4,189.06.

Enter the following values:

N=4, I/Y=10, PV=- 4,189.06, FV=0, Then CPT, PMT.

PMT = 1,321.53, which is Project K’s EAS.

Recall that Project J’s EAS=1174.62

So, choose Project K since it has the higher EAS.

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Another application of EAS

We can use the EAS concept to choose between two machines that do the same job but have different costs and lives.

Consider the following problem.

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Problem 11.9

Suppose that your firm is trying to decide between two machines, that will do the same job. Machine A costs $90,000, will last for ten years and will require operating costs of $5,000 per year. At the end of ten years it will be scrapped for $10,000. Machine B costs $60,000, will last for seven years and will require operating costs of $6,000 per year. At the end of seven years it will be scrapped for $5,000. Which is a better machine? (discount rate is 10 percent)

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Step 1: compute the PV of the costs of each machine

PV of costs (A)

= $90,000 + PV of $5,000 annuity for ten years - PV of the scrap (at t = 10) value of $10,000

= 90000 + 30722.84 – 3855.43 = $116,867.41

PV of costs (B)

= $60,000 + PV of $6,000 annuity for seven years - PV of the scrap (at t = 7) value of $5,000

= $60,000 + $29,210.51 - $2,565.79 =$86,644.72

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Step 2: compute equivalent annual cost (EAC) series of each machine

The equivalent annual cost series is the payment of an annuity that has the same present value as the PV of the machine’s cost.

EAC of machine A, EAC(A): N = 10, I/Y = 10, PV = -116867.41, FV = 0. Then

CPT, PMT. This yields EAC(A) = $19,019.63.

EAC of machine B, EAC(B): N = 7, I/Y = 10, PV = -86644.72, FV = 0. Then CPT,

PMT. This yields EAC(B) = $17,797.30. Choose machine B because it has the lower cost.

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Summary

Estimating a project’s after-tax incremental cash flows.

Choosing between mutually exclusive projects.

Comparing projects with unequal lives using the EAS technique.

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Another problem (Based on Spring 2001 Final Exam)

ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO has collected the following information about the proposed product.

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Details

1) The project has an anticipated economic life of 5 years.

2) The company will have to purchase a new machine to produce the screens. The machine has an up front cost (t = 0) of $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (that is, it will be worthless).

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Details

3) If the company goes ahead with the proposed product, it will have to increase inventory by $280,000 and accounts payable by $80,0000. At t = 5, the net working capital will be recovered after the project is completed.

4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue.

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Details

5) The company’s interest expense each year will be $350,000.

6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year.

7) The company’s cost of capital is 12%.

8) The company’s tax rate is 30%.

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Questions

What is the initial investment for the project?

What is the 3rd year expected incremental operating cash flow? (i.e., the incremental after tax cash flow)

What is the 5th year incremental non-operating cash flow?

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Q1: initial investment

To answer Q1, you need points 2 & 3.

Initial investment= machine cost + change in net working capital

= 4,000,000 + (change in current assets

– change in current liabilities)

= 4,000,000 + (280,000 – 80,000)

= $4,200,000

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Q2: 3rd incremental operating cash flow

To answer Q2, you need points 2,4,6,8.

Steps:

1) Incremental sales

= 4,500,000 – 500,000 = 4,000,000

2) Annual depreciation = (4,000,000)/5 = 800,000

3) Incremental operating cost for 3rd year

= 0.5 x 4,500,000 = 2,250,000

Next, draw up the incremental income statement

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Draw up the incremental income statement

Incremental sales 4,000,000

Less Incremental operating cost 2,250,000

Less Incremental depreciation 800,000

Equals Incremental taxable income 950,000

Less Incremental tax @30% 285,000

Equals Incremental net income 665,000

Add back depreciation 800,000

Incremental cash flow $1,465,000

Q2: 3rd incremental operating cash flow

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Q3: 5th year incremental non-operating cash flow

Very simple. The only incremental non-operating cash flow is the cash flow from liquidating the increase in net working capital (point 3).

5th incremental non-operating cash flow = $200,000