Cash

Flows and Capital

Budge3ng

Chapter 11 1
Capital budgeting revision
Most Common methods employed:
•  Net Present Value (NPV)
•  Internal Rate of Return (IRR)
•  Payback Period
•  Discounted Payback Period
•  Accoun;ng Rate of Return (ARR)

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Capital budgeting method-recap
NPV: net present value
•  Calcula;on procedure
•  Es;mate future cash flows
•  Determine the investor’s cost of capital or required rate of return
•  Calculate the present value of the future cash flows

3
Capital budgeting method-recap
IRR: internal rate of return
•  The IRR is the discount rate that gives us a zero NPV.
•  The IRR is an important and legi;mate alterna;ve to the NPV
method
•  The two methods will always agree when the projects are
independent and the projects’ cash flows are conven;onal. The IRR
and NPV methods can produce different accept/reject decisions if a
project either has unconven;onal cash flows or the projects are
mutually exclusive
Decision Rule: IRR > Cost of capital ] Accept the project.
IRR < Cost of capital ] Reject the project.
Key Advantages Key Disadvantages
(1) intuitively easy to understand (1) with non conventional cash flows, IRR
(2) based on discounted cash flow generates no or multiple answers 4
technique (2) with mutually exclusive projects, IRR
may provide incorrect investment
decisions
Capital budgeting method-recap
The payback period
Remaining cost to recover
PB = Years to recover cost +
Cash flow during the year
The discounted payback period
•  The discounted payback period calcula;on uses discounted future
cash using company’s cost of capital
Summary of Payback Method
Decision Rule: Payback period ≤ Payback rule ] Accept the project.
Payback period > Payback rule ] Reject the project.
Key Advantages Key Disadvantages
1. Easy to calculate and understand 1. Most common version does not
for people without strong finance account for time value of money.
backgrounds. 2. Does not consider cash flows
2. A simple measure of a project’s past the payback period
liquidity. 3. Bias against long-term projects
such as research and 5
development and new products.
4. Arbitrary cut-off point.
Capital budgeting method-recap
ARR: The accoun3ng rate of return
•  This method calculates the return on a capital project using
accoun;ng numbers—the project’s net income (NI) and book value
(BV) rather than cash flow data
Average NI
ARR =
Average BV
•  It has a number of major flaws as a tool for evalua;ng capital
expenditure decisions.
–  First, the ARR is not a true rate of return. ARR simply gives us a number
based on average figures from the income statement and balance sheet
–  It ignores the ;me value of money
–  There is no economic ra;onale that links a par;cular acceptance
criterion to the goal of maximising shareholders’ wealth
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 Calculating project cash 8lows
The Importance of capital budge3ng
•  In capital budge;ng, we es3mate the NPV of the cash
flows that a project is expected to produce in the
future
•  All of the cash flow es;mates
are forward-looking.

7
 Calculating project cash 8lows
Incremental aFer-tax free cash flows
•  The cash flows we discount in an NPV analysis are
the incremental aTer-tax free cash flows
–  These cash flows reflect the amount by which the
company’s total aTer-tax free cash flows will change if the
project is adopted.

FCFproject = FCFwith project – FCF without project

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Calculating project cash 8lows
Incremental aFer-tax free cash flows
•  Companies are free to distribute these cash
flows to creditors and shareholders as these are
the cash flows that are leT over aTer a company
has made necessary investments in working
capital and long term assets

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 Calculating project cash 8lows
Incremental aFer-tax free cash flows
•  First calculate the incremental cash flow
from opera;ons (CF Opns), which is the
cash flow that the project is expected to
generate aTer all opera;ng expenses and
tax have been paid
•  Then subtract the incremental capital
expenditures (Cap Exp) and incremental
addi;ons to working capital (Add WC)
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Calculating project cash 8lows
The FCF calcula3on
•  FCF is a measure of the aTer-tax cash flows from
opera;ons over and above what is necessary to
make any required investments.
•  The idea that we can evaluate the cash flows
from a project independently of the cash flows
for the company is known as the stand-alone
principle.
–  i.e. treat the project as if it is a stand-alone company
that has its own revenue, expenses, and investment 11
requirements.
 Calculating project cash 8lows
Cash flows from opera3ons
•  We exclude interest expenses when
calcula;ng NOPAT because the cost of
financing a project is reflected in the
discount rate that is used in the NPV
calcula;on
•  We use the company’s marginal tax rate
(t) to calculate NOPAT because the profits
from a project are assumed to be
incremental to the company.
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 Calculating project cash 8lows
Cash flows from opera3ons
•  Note that the incremental cash flow from
opera;ons, CF Opns, equals the incremental
net opera;ng profits aTer tax (NOPAT) plus
the incremental deprecia;on and
amor;sa;on (D&A) associated with the
project

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 Estimating cash 8lows in
practice
Tax and deprecia3on
•  Australian companies have a flat tax rate of 30
per cent.
•  Deprecia;on is an important considera;on in
cash flow analysis (although not a cash item).
We have to add it back to NOPAT in order to
get the cash flow from opera;ons correct.
•  Can be claimed as a deduc;on in determining
company taxable income
•  Produces tax savings (tax shield): D&A charges
reduce the company’s tax obliga;on
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•  Allowable methods: straight-line or reducing-balance
Calculating project cash 8lows
Cash flows associated with investments
•  Once we have es;mated CF Opns, we simply
subtract cash flows associated with required
investment to obtain FCF for a project in a
par;cular period
•  Investments may be required to purchase long-
term tangible assets, intangible assets, or to
fund current assets

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Calculating project cash 8lows
Change in Working Capital
Add WC = Change in cash + Change in account receivable
+ Change in inventories – Change in account payable
•  At the beginning of a project, typically the
company invests in inventories and/or cash,
which leads to an increase in net WC. The FCF will
be reduced by the size of the change.
•  In the final year of a project, the assets acquired
during the life of the project may be sold and the
working capital that has been invested may be
16
recovered.
Estimating cash 8lows in
practice
Calcula3ng the terminal-year FCF
•  The FCF in the last, or terminal year of a project
oTen includes cash flows that are not typically
included in the calcula;ons for other years.
•  In addi;on to the Add WC, we must also include the
salvage value realised from the sale (net of any tax
consequences) of the asset and the impact of the
sale on the company’s tax in the terminal-year FCF
calcula;ons.
•  The capital gain tax discount is not covered in this
course. We assume the capital gain from the sale of 17
the asset is taxed at the corporate tax rate.
Estimating cash 8lows in practice
Calcula3ng the terminal-year FCF
•  If the salvage value (selling price) exceeds the book value,
the company realises a gain on the sale and needs to pay
tax:

Tax on sale of asset = ( Salvage value – book value) * t

Where book value is calculated as:

Book value = purchase price – accumulated deprecia;on 18
 Calculating project cash 8lows
FCF versus accoun3ng earnings
•  The impact of a project on a company’s overall value or on
its share price does not depend on how the project affects
the company’s accoun;ng earnings; only on how the
project affects the company’s free cash flows
•  Accoun;ng earnings can differ from cash flows for a
number of reasons, making accoun;ng earnings an
unreliable measure of the costs and benefits of a project.
•  Accoun;ng earnings also reflect non-cash charges, such as
deprecia;on and amor;sa;on, which are intended to
account for the costs associated with deteriora;on of the 19
assets in a business as those assets are used.
Free Cash 8low Example

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Estimating cash 8lows in practice
Five general rules for incremental cash flow
calcula3ons
•  Rule 1: Include cash flows and only cash flows in
your calcula;ons
•  Rule 2: Include the impact of the project on cash
flows from other product lines
•  Rule 3: Include all opportunity costs
•  Rule 4: Forget sunk costs
•  Rule 5: Include only aTer-tax cash flows in the cash
21
flow calcula;ons.
Estimating cash 8lows in
practice
Nominal versus real cash flows
•  Nominal dollars represent the actual dollar
amounts that we expect a project to generate in
the future, without any adjustments.
•  When prices are going up, a given nominal dollar
amount will buy less and less over ;me.
•  Real dollars represent dollars stated in terms of
constant purchasing power.
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Estimating cash 8lows in practice
Nominal versus real cash flows
•  We can write the cost of capital, k as:
1 + k = (1 + ∆Pe)(1 + r)
Where:
k is the nominal cost of capital
(∆Pe) is the expected rate of infla;on
(r) is the real rate of return
It is important to make sure that all cash flows are
stated in either nominal dollars or real dollars! 23
 Forecasting cash 8lows
Expected cash flows
•  Forecasts represent the expected FCFs for each year of
the project
–  OTen forecasts are wrong as there are many unpredictable
events that can influence a project’s cash flows.
•  Forecast should include the probability weighted
outcomes of the possibili;es iden;fied by the company.

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Expected FCFs example

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Projects with different lives
•  A problem that arises quite oTen in capital
budge;ng involves choosing between two
mutually exclusive investments where the
investments have different lives.
•  In a situa;on like this, we can effec;vely make
the lives of the projects the same by assuming
repeated investments over some iden;cal
period and then comparing the NPVs of their
costs. (1 + k ) n
NPV∞ = NPV0
(1 + k ) n − 1 26
Projects with different lives
•  A less cumbersome and more powerful method to
handle the problem is to calculate the equivalent
annual cost (EAC) with the following formula:
⎡ (1 + k )n ⎤
EACi = k NPV0 ⎢ n ⎥
⎢⎣ (1 + k ) − 1 ⎥⎦

Where:
k is the opportunity cost of capital,
NPV0 is normal NPV of the investment i,
n is the life of the investment
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Projects with different lives
EAC simply reflects the annuity that has the same
present value as the ∆FCFs of an investment over
the investment period we are considering.

Example:
You need to purchase a mower and you are
presented with two choices. Mower A can be used
for 2 years with a total cost of 250. Mower B can
be used for 3 years with a total cost of 360. Use
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EAC and decide which mower to choose.
Projects with different lives

⎡ (1 + k )n ⎤
EACi = k NPV0 ⎢ n ⎥
⎢⎣ (1 + k ) − 1 ⎥⎦
⎡ 1.12 ⎤
EAC A = 0.1 ( −250 ) ⎢ 2 ⎥ = −$144.05
⎣1.1 − 1 ⎦
⎡ 1.13 ⎤
EACB = 0.1 ( −360 ) ⎢ 3 ⎥ = −$144.76
⎣1.1 − 1 ⎦
Therefore, choose Mower A as it has the lower EAC.

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 Comprehensive Example
A firm is considering the following project which will
produce a new produc;on line. Should it proceed
with the project?
Project life 10 years
Ini3al investment in factory $10m
Expected sale price of the factory at end of the project $1.7m
Unit sales per year 0.9m
Sale price per unit $10
Variable cost per unit $6
Fixed costs per year, paid at the end of each year $1.5m
Tax rate 30% 30
Comprehensive Example
•  An inventory (current assets) purchase of $0.1m
will occur at the very start of the first year (t=0),
and inventories will be kept at that level for the
life of the project. At the very end of the project
(t=10), all inventories will be sold at cost.
•  The project will not affect the firm’s other
current assets and liabili;es.
•  The factory will be fully depreciated using the
straight-line method.
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Comprehensive Example
•  The factory that the project will use is temporarily
empty, but in the past the business owner next door
has rented it from you. This year he offered you
$0.5m/yr to use it as a warehouse. This year, your
grandma also made an offer! She offered you $100/
yr to use it as a car park for her friends.
•  All cash flows occur at the start or end of the year as
appropriate.
•  All rates and cash flows are real. The infla;on rate is
3% pa. All rates are given as effec;ve rates. 32
Answer
•  The opportunity cost of ren;ng the factory to the
next door business owner should included. Note
that only the highest opportunity cost is included.
•  You grandma’s offer is not included since you can’t
rent the factory to her and the next door business
owner at the same ;me, so we only include the
higher opportunity cost.
•  Note that if we did rent the factory, then the $0.5m
would have been added to revenue and thus would
be taxed. Therefore, the opportunity cost should 33
be the aTer-tax amount, not the whole $0.5m.
Answer
•  CapExp is only incurred at the very beginning
which is the ‘ini;al investment in factory’, and at
the end when the factory is sold. There is no
yearly capital expenditure.
•  The increase in WC will be $0.1m at t=0, and
then a decrease (nega;ve increase) of 0.1m at
t=10.

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 Year 0 Year 1 to 9 Year 10
Revenue 0.9m*10= 9m 0.9m*10=9m
- Variable cost 0.9m*6= 5.4m 0.9m*6=5.4m
- Fixed cost 1.5m 1.5m
- Opportunity cost 0.5m 0.5m
- D&A 1m 1m
EBIT 0.6m 0.6m
* ( 1 – t ) 0.7 0.7
NOPAT 0.42m 0.42m
+ D&A 1m 1m
CF Opns 1.42m 1.42m
Salvage Value 1.7m
Tax 1.7*0.3=0.51m
- Cap Exp 10m - (1.7m-0.51m)= -1.19m
- Add WC 0.1m -0.1m 35
FCF -10.1m 1.42m 2.71m
NPV @ 10% -0.887m
Answer
•  Since all cash flows are real, and the discount rate is also
real, there is no need to convert rates. If the cash flows
and discount rate were nominal, that would also be fine
and no need to convert rates or cash flows. So
NPV = PV ( FCF(t=0) ) + PV( FCF(t=1,2,…9) ) + PV ( FCF(t=10) )
= FCF(t=0) + FCF(t=1,2…9)*1/r*(1-(1+r)^(-N))
+ FCF(t=10)/(1+r)^T
= -10.1m + 1.42m *1/0.1*(1-(1+0.1)^(-9))
+ 2.71m/(1+0.1)^10 (Note this uses the annuity formula
for cash flows in periods 1 to 9)
= -0.877m
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Since the NPV is nega;ve, reject the project.