2020 FM101 Lecture 5 - Ch9 - For Stud

CLASSWORK 5 (open on Moodle)
FM101
Lecture 5: Hand in your answers (no group work)
The financial decisions of firms: to the Student Information Centre of the Department of Finance
Capital Budgeting (2) (Room OLD.2.05, opening hours: 10‐ 5pm)
Making Capital Investment Decisions Attach and sign a coversheet.
Work without coversheet will not be accepted by staff at the Centre
and therefore will not be marked.
Lent Term 2020
Deadline: Monday 2nd March 2020, 11am
Dr Elisabetta Bertero
Make a copy of your work to take to class
Reading: Finance textbook, Chapter 7 In your work, show ALL of the following:
(see next slide for further info on required reading)
1. the relevant timelines;
2. the formulae you use to calculate your answer;
3. your numerical answer
4. An explanation of your answer
FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 1 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 2
Textbook reading for Lecture 5 Overview of Lecture 5:

Required reading is Chapter 7
in Finance (2020) textbook (Chapter 9 in original textbook)
Making capital investment decisions
However: 1.Project Cash Flow
In Section 9.4: only required straight line depreciation as in • Definitions
lecture handout
2.Estimating operating cash flows
In Section 9.6: only required section, as in lecture handout, is
“Evaluating Equipment Options with different lives” • A. Effect of taxes
• B. Effect of depreciation
• C. Effect of changes in Net Working Capital
For revision during week 6, use lecture handout as route map
to know important parts in the textbook 3. Relevant cash flows
4. Discounted Cash Flow special case: projects with different lives
The nature of project analysis (from Lecture 4) 2. Investment decision criteria
Procedural Outline 2.1 Net Present Value (from Lecture 4)
1. Form ideas on how to implement strategies of • A project’s net present value is the difference
the firm and increase shareholders’ wealth between an investment’s market value and its cost
all valued at the present time, i. e. the difference
between the present value of all future cash inflows
2. Plan how to implement the ideas and all future cash outflows
3. Gather information on timing and magnitude of CF1 CF2 CF3 CF4 CF5 CFt

NPV  CF0      ...
(1i) (1i)2 (1i)3 (1i)4 (1i)5 (1i)t
0
costs and benefits. Estimate cash flows (this
Lecture 5) It is the amount by which the project is expected to
increase the wealth of the firm’s current shareholders
4. Apply decision criterion (rule) (Lecture 4) i = discount rate
1. Project Cash Flows 2. OCF = Total Operating* Cash Flow
Firms’ net cash flows (inflows – outflows)
per period
Project Project
Project relevant for the particular project =
Cash
OCF CAPEX
Flow
Revenues from sales
Minus fixed and variable costs of production
Where:
* Operating cash flows: from operations (e.g. production), as opposed to investing or financing
OCF: Operating cash flows
CAPEX: Capital Expenditure as cash flow, e.g. machinery
2. OCF = Total Operating Cash Flow
A. Effect of taxes
In calculating OCF we need to take into account:
The company needs to pay taxes
A. The effect of taxes on cash flows
If tax rate is 23%,
B. The effect of depreciation on cash flows, i.e.
deductions that result in a “tax shield/benefit”
(revenues – costs) net of taxes is :
C. The changes in working capital that generate (Sales – Costs)*(1 ‐ 0.23)

relevant cash flows
B. Effects of depreciation Depreciation method
• Depreciation is not a cash expense (non‐cash expense). Straight Line method
• A depreciation method allowing for a
• It is relevant in the calculation of cash flows only linear write‐off of assets over their
because it affects taxes, which are cash flows lifetime, i.e. a fixed, equal proportion of
the capital expenditure can be shielded
• It affect taxes because it allows to “shield” from from taxes each period.
taxes a proportion of an initial capital • The textbook discusses other methods.
expenditure in each time period In this course (FM101) we only
consider the straight line method
• [Depreciation = AC100 capital allowance]
Depreciation – Straight line C. Effects of changes in working capital
Example Straight line depreciation:
Working capital definition
Since the asset’s life is five years and its
Assume that you purchase an asset
residual value is zero, the annual
(e.g. machinery, capital expenditure) depreciation will be: •Short term current assets and liabilities generating cash
for €500,000 at time 0, which has a
five year life, and at the end of its life, flows and necessary for the daily working of the business:
the asset will be worthless. Assume Annual Depreciation
that the tax rate is 28%. = €500,000/5 = €100,000
• trade receivables (sales still unpaid);
• trade payable (supplies still to pay);
Tax benefit/shield of depreciation • inventories (goods already paid and stored)
100,000 x 0.28 = €28,000
•At the end of a project, the sum of the changes in working
i.e. €28,000 fewer taxes to pay so to be capital is often zero (i.e. it is recovered, everything paid for by
added (+) to cash flows as a tax benefit customers or paid to suppliers)
Calculating the Net Working Capital

Change in Net Working Capital
NET WORKING CAPITAL Stock Stock Flow
Beginning of year End of year Change over the year
•Total net increase or decrease Trade receivables (still to receive +)
Trade payable (still to pay ‐)
100
100
140
120
Plus 40
Minus 20
in working capital: Inventory (already paid +) 100 110 Plus 10
• + net receivable Net Working Capital Stock
Change in Total Net Working Capital
100 130
Plus 30
• – net payables
• + inventory The total change: (+40 – 20 +10) = +30 needs to be deducted
from overall cash flows (-30)
Change of total Net Working Capital Example of Net Working Capital calculations
For 2020 added: Suppose that in addition to an initial Working Capital of 100
is DEDUCTED from cash flows in Year 0, the stock of NWC is kept at 10% of sales
at the end of every subsequent year
because, looking at each item: NET WORKING CAPITAL
Change in cash flow from
Stock of previous year to be
Trade receivables (still to receive) NWC End of DEDUCTED (negative sign)
Need to be deducted from sales (i.e. deducted from cash flows) Sales year from cash flows From cash flows:
because customers have not paid yet, negative cash flow
Year 0 100 100 Deduct 100 (‐100)
Year1 800 80 ‐20 Deduct ‐20 (+20)
Trade payable (still to pay) Year 2 1000 100 20 Deduct 20 (‐20)
Need to be deducted from the firm's cost (i.e. added to cash flows) Year 3 1500 150 50 Deduct 50 (‐50)
because the firms has not paid yet, positive cash flow Year 3 And at the end of year 3 recover (add) all remaining NWC Add 150 (+150)
Inventory (already paid) In Year 3 we also recover ALL remaining working capital, ie the stock at the end of Year 3 (150).
Need to be added to the firm's cost (i.e. deducted from cash flows) The total cash flow at the end of Year 3 is therefore: minus (150-100) plus 150: -50 +150 = +100
because these stocks were paid in advance, negative cash flows
Finally, make sure you discount each cash flow appropriately according to their “time tag”
OCF =
Some definitions
Total Operating Cash Flow =
• Earnings Before Interest and Taxes =
EBIT (inflow): Sales – Costs – Depreciation
(Sales – Costs)*(1 ‐ Tax rate)
Net Income • EBIT – Taxes =
(inflow): Sales – Costs – Depreciation ‐ Taxes
Plus tax benefit of Depreciation
Total taxes • Tax rate x (Sales – Costs)
minus Tax benefit/shield of depreciation
Minus change in Net Working Capital (outflow): (i.e. tax rate x depreciation)
Four equivalent ways to calculate 2.1 What are the relevant cash flows?
Total Operating Cash Flow
All incremental cash flows
1. OCF= (Sales – Costs)*(1‐tax rate) + tax benefit of • The incremental cash flows for project evaluation
depreciation ‐ Change in Net Working Capital consist of any and all changes in the firm’s future
cash flows that are a direct consequence of
2. OCF = EBIT + Depreciation – Total Taxes = Sales – undertaking the project.
Costs – Taxes ‐ Change in Net Working Capital
• Estimate separately the future cash flows (affected
3. OCF = Net income + Depreciation = Sales – Costs –
by the project) with the project and without the
Total Taxes ‐ Change in Net Working Capital
project, and find the difference. This difference is a
series of timed cash flows, and this is what affects
4. OCF= Sales – Costs – Total Taxes ‐ Change in Net the wealth of the shareholder
Working Capital FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 21 FM101 – Finance – Dr Elisabetta Bertero - 2020 - Page 22
Relevant cash flows to INCLUDE
The
Stand‐ Side effects cash flows
Alone The assumption that the
• Cash flow that arise as a consequence of the new
evaluation of a project is
Principal based on the project’s
project on existing projects. They are incremental
cash flows and needs to be estimated and
total incremental cash INCLUDED
flows and is made in
isolation from other • For example: a proposed project will generate
projects or activities £10,000 in revenue, but causes another product line
to lose £3,000 in revenues. The incremental cash
flow is £7,000
Cash flows to INCLUDE Cash flows NOT to INCLUDE
Opportunity Cost
• Cost of a resource that affects the project even if it has no cash flow, the most
valuable alternative that is given up if the project is undertaken. Financing
Sunk Cost A cost that has already
costs been incurred and cannot
be removed and therefore
• It is an incremental cash flow and needs to be ESTIMATED and INCLUDED For example interests should not be considered in
or dividends an investment decision. For
example, a consultant’s fee
• For example: the project may use a piece of land the firm already owns. If not to study an initial feasibility
of the project.
used, the land could be sold or used for something else, so“given up cash flow
from land” (opportunity cost of land) should be included
They are NOT It is not an
INCLUDED in cash incremental cash
• Importance of evaluation of projected cash flows with and without the project and flow and should NOT
find the difference flows calculations
be INCLUDED
Example: Majestic Mulch and Compost Ltd (MMC)
At home, adjusting the example to use straight line depreciation**, 4. Discounted cash flows special case: projects with

so results different from the book:
different lives
MMC is investigating the feasibility of a new line of power mulching tools aimed at the growing
number of home composters. Based on exploratory conversations with buyers for large garden
shops, MMC projects unit sales as shown in the next slide.
The new power mulcher will sell for £120 per unit to start. When the competition catches up
after three years, however, MMC anticipates that the price will drop to £110.
The power mulcher project will require £20,000 in net working capital at the start. Subsequently, Example of cost reduction projects:
total net working capital at the end of each year will be about 15 per cent of sales for that year.
The variable cost per unit is £60, and total fixed costs are £25,000 per year. mutually exclusive and with different lives
It will cost about £800,000 to buy the equipment necessary to begin production. This investment
is primarily in industrial equipment, which (**) should be depreciated using the straight line
method to zero. The equipment will actually be worth about 20 per cent of its cost in eight
years, or .20  £800,000 = £160,000. The revenue from the scrap value, the salvage
… is taxed. The relevant tax rate is 28 per cent, and the required return is 15 per cent.
Based on this information, should MMC proceed?
Cost reduction projects:
PV of costs: are they comparable?
mutually exclusive and with different lives
Suppose discount rate = 6%
Suppose that you have to choose between two
mutually exclusive production methods,
producing exactly the same good, with same
capacity and same revenue, but with different A
costs and different lives:
B
Machine A: costs £15,000, costs £5,000 per year to
run and lasts 5 years Years: 0 1 2 3 4 5
• Machine B: costs £10,000, costs £6,000 per year Project A PV of costs = £36,062 over 5 years

to run and lasts 3 years Project B PV of costs = £ 26,038 over 3 years
Projects with Different Lives
2 possible methods
Decision based on minimization of costs. A. Equalise the lives and compare NPV of projects. In this

But how do you compare the two case repeat project A three times and project B five
projects? times (NB: make sure you discount repeated costs all
the way to Year 0)
If you compare the PV of costs and choose B. Use equivalent annual cost (EAC)
the lower (machine B), you do not take • Calculate PV of all costs
• Using annuity formula, calculate the annualised
into account that you would need to capital cost (the annuity payment) that would
replace machine B earlier than machine A generate that PV
(and therefore many more times)
Using Annuity formula from Lecture 3
Equivalent Annual Cost (EAC)
PV = C x Annuity Factor (n, r)
We solve for C:
C = PV / Annuity Factor (n, r)
The present value of a project’s costs Notation:
calculated on an annual basis, as if the
PV = the present value of the annuity
project were to be repeated forever.
r = interest rate (constant over the period) to be earned
n = the number of payments
C = the payment per period
Example summary
Equivalent Annual capital Cost:
Payment = PV of costs / annuity factor
Machine A Machine B
Project A: £ 8,560 per year (annuity factor 4.2124)
Project B: £9,741 per year (annuity factor 2.6730)
• NPV = £36,062 • NPV = £ 26,038
• Life is 5 Years • Life is 3 Years
Accept the project with the lowest Equivalent
Annual Cost
You can think of EAC as the fair rental for the
machine
Activities for this Lecture
Reading
Machine A: Machine B: • Finance textbook, Chapter 7 (in Section 7.4 only
required straight line depreciation; in Section 9.6 only
EAC =£ 8,560 EAC = £9,741 required section “Evaluating Equipment Options with
different lives”)
Assignment
Choose Machine A • Classwork 5: to hand in by Monday, 2nd March 2020 11am

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CLASSWORK 5 (open on Moodle)

Textbook reading for Lecture 5 Overview of Lecture 5:

3. Gather information on timing and magnitude of CF1 CF2 CF3 CF4 CF5 CFt

C. The changes in working capital that generate (Sales – Costs)*(1 ‐ 0.23)

Calculating the Net Working Capital

At home, adjusting the example to use straight line depreciation**, 4. Discounted cash flows special case: projects with

• Machine B: costs £10,000, costs £6,000 per year Project A PV of costs = £36,062 over 5 years

Decision based on minimization of costs. A. Equalise the lives and compare NPV of projects. In this

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