Chapter 11 Cash Flows and Other Topics in Capital Budgeting

1. Chapter 11 Cash Flows and Other Topics in Capital Budgeting

2. Learning Objectives 1. Identify guidelines by which we measure cash flows. 2. Explain how a project’s benefits and costs— that is, its free cash flows—are calculated. 3. Explain the importance of options, or flexibility, in capital budgeting. 4. Understand, measure, and adjust for project risk.

3. GUIDELINES FOR CAPITAL BUDGETING

4. Guidelines for Capital Budgeting • To evaluate investment proposals, we must first set guidelines by which we measure the value of each proposal. • We must know what is and what isn’t relevant cash flow.

5. Use Free Cash Flows Rather than Accounting Profits • Free cash flow accurately reflects the timing of benefits and costs—when money is received, when it can be reinvested, and when it must be paid out. • Accounting profits do not reflect actual money in hand.

6. Think Incrementally • After-tax free cash flows must be measured incrementally. • Determining incremental free cash flow involves determining the cash flows with and without the project. Incremental is the “additional cash flows” (inflows or outflows) that occur due to the project.

7. Beware of Cash Flows Diverted From Existing Products • Not all incremental free cash flow is relevant. • Thus new product sales achieved at the cost of losing sales from existing product line are not considered a benefit. • However, if the new product captures sales from competitors or prevents loss of sales to new competing products, it would be a relevant incremental free cash flows.

8. Look for Incidental or Synergistic Effects • Although some projects may take sales away from a firm’s existing projects (such as a new flavor of ice cream), in other cases new projects may add sales to the existing line (such as adding a coffee store to an existing retail store). This is called synergistic effect and is a relevant cash flow.

9. Work in Working-Capital Requirements • New projects require infusion of working capital (such as inventory to stock the shelves), which would be an outflow. • Generally, when the project terminates, working capital is recovered and there is an inflow of working capital.

10. Consider Incremental Expenses • Similar to cash inflows, cash outflows must also be considered on an incremental basis. • For example, replacing an existing equipment may require training expense (an incidental expense) for current employees on the new equipment.

11. Sunk Costs Are Not Incremental Cash Flows • Sunk costs are cash flows that have already occurred (such as marketing research) and cannot be undone. Any cash flows that are not affected by the accept/reject criterion should not be included in the analysis. • Managers need to ask two basic questions: • Will this cash flow occur if the project is accepted? • Will this cash flow occur if the project is rejected? • If the answer is “Yes” to #1 and “No” to #2, it will be an incremental cash flow.

12. Account for Opportunity Costs • Opportunity cost refers to cash flows that are lost because of accepting the current project. • For example, using the building space for the project will mean loss of potential rental revenue.

13. Decide If Overhead Costs Are Truly Incremental Cash Flows • Must include incremental overhead costs or costs that were incurred as a result of the project and relevant to capital budgeting • Note, not all overhead costs may be relevant (for example, utilities bill may have been the same with or without the project).

14. Ignore Interest Payments and Financing Flows • Interest payments and other financing cash flows that might result from raising funds to finance a project are not relevant cash flows. • Reason: Required rate of return implicitly accounts for the cost of raising funds to finance a new project.

15. CALCULATING A PROJECT’S FREE CASH FLOWS

16. Free Cash Flow Calculations • Three components of free cash flows: • The initial outlay, • The annual free cash flows over the project’s life, and • The terminal free cash flow

17. Initial Cash Outlay • The initial cash outlay is the immediate cash outflow necessary to purchase the asset and put it in operating order. • This includes: (1) purchase cost, set-up cost, installation, shipping/freight, training cost (2) increased working-capital requirements (3) sale of existing asset and tax implications (if the project replaces an existing project/asset)

18. Sale of Asset and Taxes • If Sale = Book Value (BV) ==> No tax effect • If sale > BV (but less than cost) ==> recaptured depreciation, taxed as ordinary income • If sale > BV (greater than cost) ==> anything above cost, taxed as capital gain, rest taxed as recaptured depreciation • If sale < BV ==> capital loss ==> tax savings

19. Annual Free Cash Flows • Annual free cash flows is the incremental after-tax cash flows resulting form the project being considered. • Free cash flow considers the following: • Cash flow from operations • Cash flows from working capital requirements • Cash flows from capital spending

20. Calculating Operating Cash Flows • Step 1: Measure the project’s change in after-tax operating cash flows • Operating cash flows= Changes in EBIT– Changes in taxes+ Change in depreciationNote, depreciation is a non-cash expense but influences the cash flows through impact on taxes (see next two slides).

21. Depreciation and Cash Flow • Earnings before tax and dep. $40,000 • Depreciation $25,000 • Earnings before tax (EBT) $15,000 • If the corporation is taxed at 30%, taxes = 0.3*$15,000 = $4,500 • If the depreciation was $0, EBT = $40,000 and taxes = 0.3*$40,000 = $12,000

22. Depreciation and Cash Flow • Depreciation is a “non-cash expense” BUTaffects cash flow through its impact on “taxes.” • Depreciation ==> in expense ==> in taxes => cash flows

23. Calculating Operating Cash Flows • Step 2: Calculate the cash flows from the change in net working capital.This refers to additional investment in current assets minus any additional short-term liabilities that were generated.

24. Calculating Operating Cash Flows • Step 3: Determine the cash flows from the changes in capital spending.This refers to any capital spending requirements during the life of the project.

25. Putting It All Together • Step 4: Project free cash flows = change in EBIT– changes in taxes+ change in depreciation– change in net working capital– changes in capital spending

26. Terminal Cash Flow • Terminal cash flows are flows associated with the project at termination. • It may include: • Salvage value of the project • Any taxable gains or losses associated with the sale of any asset

27. Refer to Example 11.2 • Initial outlay = $200,000 + $30,000 = $230,000 • ∆ Operating cash flow = Net Income + Depreciation = $155,600(see Tables 11-1, 11-2) • Terminal free cash flows = ∆ Operating cash flow + ∆ Net working capital = $185,600 (See Table 11-3)

28. Table 11-1

29. Table 11-2

30. Table 11-3

31. Putting It All Together

32. Options in capital budgeting

33. Options in Capital Budgeting • Options add value to capital budgeting project by being able to modify the project based on future developments (that are currently unknown). Some common options are: • Option to delay a project • Option to expand a project • Option to abandon a project

34. The Option to Delay a Project • Almost every project has a mutually exclusive alternative—waiting and pursuing at a later time. • It is conceivable that a project with a negative NPV now may have a positive NPV if undertaken later on. This could be due to various reasons such as favorable changes in fashion, technology, economy, or borrowing costs.

35. The Option to Expand • Even if a project is currently unprofitable, it may be useful to determine whether the profitability of the project will change if the company is able to expand in the future. • For example, a firm may choose to invest in a negative NPV projects to gain access to new market.

36. The Option to Abandon • It may be necessary to abandon the project before its estimated life due to inaccurate project analysis models or cash flow forecasts or due to changes in market conditions. • When comparing two projects with similar NPVs, a project that is easier to abandon may be more desirable (for example, hiring temporary versus permanent workers, leasing versus buying a car). The option to abandon infuses flexibility, which is desirable.

37. Risk and the investment decisions

38. Risk and the Investment Decisions Two main issues: • What is risk in capital-budgeting decisions, and how should it be measured? • How should risk be incorporated into a capital-budgeting analysis?

39. Three Perspectives on Risk • Project standing alone risk • Project’s contribution-to-firm risk • Systematic risk

40. Project Standing Alone Risk • This is a project’s risk ignoring the fact that much of the risk will be diversified away as the project is combined with other projects and assets. • This is an inappropriate measure of risk for capital-budgeting projects.

41. Contribution-to-Firm Risk • This is the amount of risk that the project contributes to the firm as a whole. • This measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets but ignores the effects of the diversification of the firm’s shareholders.

42. Systematic Risk • Risk of the project from the viewpoint of a well-diversified shareholder. • This measure takes into account that some of the risk will be diversified away as the project is combined with the firm’s other projects and in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolios.

43. Figure 11-4

44. Relevant Risk • Theoretically, the only risk of concern to shareholders is systematic risk. • Since the project’s contribution-to-firm risk affects the probability of bankruptcy for the firm, it is a relevant risk measure. • Thus we need to consider both the project’s contribution-to-firm risk and the project’s systematic risk.

45. Incorporating Risk into Capital Budgeting • We know that investors demand higher returns for more risky projects. • As the risk of a project increases, the required rate of return is adjusted upward to compensate for the added risk. • This risk-adjusted discount rate is then used for discounting free cash flows (in NPV model) or as the benchmark required rate of return (in IRR model).

46. Measuring a Project’s Systematic Risk • Estimating risk of a project can be difficult. Historical stock return data relates to an entire firm, rather than a specific project or division. Risk must be estimated. Options to estimate risk include: • Accounting Beta • Pure Play Method • Simulation • Scenario Analysis • Sensitivity Analysis

47. Accounting Beta • Accounting beta can be estimated via time-series regression on a division’s return on assets on the market index. • How good is this measure? The correlation between accounting beta and the beta calculated on historical stock return data is only about 0.6.

48. Pure Play Method • Pure play method identifies publicly traded firms engaged solely in the same business as the project or division. • The systematic risk of the proxy firm or pure play firm is used as a proxy for the project or division’s level of systematic risk.

49. Simulation • Simulation involves the process of imitating the performance of the project under evaluation. (See Figure 11-6.) • Done by randomly selecting observations from each of the distributions that affect the outcome of the project and continuing with this process until a representative record of the project’s probable outcome is assembled.

50. Figure 11-6