Chapter 8
Cash Flow and Capital
Budgeting
Professor XXXXX
Course Name / #
© 2007 Thomson South-Western
Cash Flow and Capital
Budgeting
 The kinds of cash flows that may appear in
almost any type of investment
 How to deal properly with the problem of
inflation in capital budgeting problems
 Special problems and situations that arise in
the capital budgeting process
 The human element in capital budgeting
2
22
Cash Flow versus Accounting
Profit
 In
preparing financial statements for
external reporting, accountants have a
different purpose in mind than financial
analysts have when they evaluate the
merits of an investment.
 Accountants
measure the inflows and
outflows of a business’s operations on an
accrual basis rather than on a cash basis.
 E.g.,
3
33
depreciation
Cash Flow versus Accounting
Profit
For capital budgeting purposes, financial
analysts focus on incremental cash in-flows
and outflows.
 This emphasis simply recognizes that no
matter what earnings a firm may show on an
accrual basis, it cannot survive for long unless
it generates cash to pay its bills.

calculating a project’s NPV, analysts should
ignore the costs of raising the money to finance
the project.
 When
4
44
The Initial Investment

Many capital budgeting problems begin with an initial
outflow to acquire/install fixed assets. Must also
consider:


Cash inflow from selling old equipment
Cash inflow (outflow) if selling old equipment below (above)
tax basis generates tax savings (liability)
An example....
Tax rate = 40%
New equipment costs $10 million,
$0.5 million to install
Old equipment has been fully
depreciated, sold for $1 million
The initial investment would then be an outflow of $10.5 million, and
an after-tax inflow of $0.60 million from selling the old equipment
5
55
Types of Cash Flows
 Depreciation
 Fixed
asset expenditures
 Working capital expenditures
 Terminal value
 Incremental cash flow
6
66
Depreciation
 Largest
noncash item for most
investment projects
 Affects the amount of taxes the firm will
pay
 Modified accelerated cost recovery
system (MACRS)
 defines
the allowable annual depreciation
deductions for various classes of assets
7
77
Depreciation



Many countries allow firms to use one depreciation
method for tax purposes and another for reporting
purposes
Accelerated depreciation methods (such as MACRS)
increase the present value of an investment’s tax
benefits
Relative to MACRS, straight-line depreciation results in
higher reported earnings early in an investment’s life
Which method would you expect companies to use when they file
their taxes, and which would they use when preparing public
financial statements?
8
For capital budgeting analysis, it is the depreciation
method for tax purposes that matters
88
Two Methods Of Handling
Depreciation To Compute Cash Flow
Adding non-cash expenses
Find after-tax profits, add back
Assume
a
firm
purchases
a
fixedcharge
asset
back to after-tax earnings
non-cash
taxtoday
savings for
Sales
$30,000
Cost of goods
(10,000)
$30,000
Sales
Cost of goods
$30,000
(10,000)
Gross profits
$20,000 over 3 years
Pre-tax income
$20,000
Plans
to depreciate
using straight-line
method
Depreciation
(10,000)
Taxes (40%)
(8,000)
Pre-tax income
$10,000
Taxes
Firm(40%)
will produce(4,000)
10,000 units/year
9
99
Net income
$6,000
Cash flow
= NI + deprec
$16,000
Aft-tax income
$12,000
Depreciation
tax savings
$4,000
Costs $1/unit
Sells for
$3/unit
Cash Flow
$16,000
and most common technique:
Firm pays taxes at Simplest
a
40%
marginal
Add depreciation
back inrate
Tax Depreciation Schedules by
Asset Class
10
10
10
Fixed Asset Expenditures

When a firm sells an old piece of equipment,
there will be a tax consequence of the sale if
the selling price exceeds or falls below the old
equipment’s book value.
 If
the firm sells an asset for more than its book
value, the firm must pay taxes on the difference.
 If a firm sells an asset for less than its book value,
then it can treat the difference as a tax-deductible
expense.
11
11
11
Working Capital Expenditures

Many capital investments require additions to
working capital
 Net
working capital (NWC) = current assets minus
current liabilities
 Increase in NWC is a cash outflow; decrease a cash
inflow
• An example…
–
–
–
–
12
12
12
Operate booth from November 1 to January 31
Order $15,000 calendars on credit, delivery by Nov 1
Must pay suppliers $5,000/month, beginning Dec 1
Expect to sell 30% of inventory (for cash) in Nov;
60% in Dec; 10% in Jan
– Always want to have $500 cash on hand
Working Capital For Calendar
Sales Booth
Oct 1
Nov 1
Dec 1
Jan 1
Feb 1
Cash
$0
$500
$500
$500
$0
Inventory
$0
$15,000
$10,500
$1,500
$0
Accts payable
$0
$15,000
$10,000
$5,000
$0
Net WC
$0
$500
$1,000
($3,000)
$0
Monthly  in WC
NA
+$500
+$500
($4,000) +$3,000
Payments and
inventory
13
13
13
Oct 1 to
Nov 1
Nov 1 to
Dec 1
Dec 1 to
Jan 1
Jan 1 to
Feb 1
Reduction in
inventory
$0
$4,500
[30%]
$9,000
[60%]
$1,500
[10%]
Payments
$0
($5,000)
($5,000)
($5,000)
($500)
($500)
+$4,000
($3,000)
Net cash flow
Terminal Value
Terminal value used when evaluating an investment
with indefinite life-span
Construct cash-flow
forecasts for 5 to 10 years
Forecasts more than 5 to 10
years have high margin of
error; use terminal value
instead
• Terminal value is intended to reflect the value of
a project at a given future point in time
14
14
14
– Large value relative to all the other cash flows
of the project
Terminal Value
Different ways to calculate terminal values
– Use final year cash flow projections and assume that
all future cash flows grow at a constant rate
– Multiply final cash flow estimate by a market multiple
– Use investment’s book value or liquidation value
JDS Uniphase cash flow projections for acquisition
of SDL Inc.
Year 1
$0.5 Billion
15
15
15
Year 2
$1.0 Billion
Year 3
$1.75 Billion
Year 4
$2.5 Billion
Year 5
$3.25 Billion
Terminal Value of SDL Acquisition

If we assume that cash flow continues to grow at 5% per year
(g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):
CFt 1
$3.41
PVt 
, or PV5 
 $68.2
rg
0.10  0.05

Terminal value is $68.2 billion; value of entire project is
$0.5
$1
$1.75 $2.5 $3.25 $68.2





 $48.7
1
2
3
4
5
5
1.1
1.1
1.1
1.1
1.1
1.1


16
16
16
$42.4 billion of total $48.7 billion from terminal value
Using price-to-cash-flow ratio of 20 for companies in the same
industry as SDL to compute terminal value
 Terminal Value = $3.25 x 20 = $65 billion
 Caveat : market multiples fluctuate over time
Incremental Cash Flow
Incremental cash flows versus sunk costs
Capital budgeting analysis should include only
incremental costs
• An example…
17
17
17
– Norman Paul’s current salary is $60,000 per year and expect
increases of 5% each year
– Norm pays taxes at flat rate of 35%
– Sunk costs: $1,000 for GMAT course and $2,000 for visiting
various programs
– Room and board expenses are not incremental to the decision
to go back to school
Incremental Cash Flow

At end of two years assume that Norm receives a salary offer of
$90,000, which increases at 8% per year
 Expected tuition, fees and textbook expenses for next two
years while studying in MBA: $35,000
 If Norm worked at his current job for two years, his salary
2
would have increased to $66,150: $60,000 1.05  $66,150
 Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
 After-tax inflow: $23,850 x (1-0.35) = $15,503
3
 Yr 3 cash inflow: $90,000 1.08  $60,000 1.05  1  0.35  $18,032
 MBA has substantial positive NPV value if 30 yr analysis
period
What about Norm’s opportunity cost?
18
18
18
Opportunity Cost
 In
capital budgeting, the opportunity
costs of one investment are the cash
flows on the alternative investment that
the firm decides not to make.
19
19
19
Opportunity Costs
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken
If Norm did not attend MBA, he would have
earned:
First year: $60,000 ($39,000
after taxes)
20
20
20
Second Year: $63,000 ($40,950
after taxes)
NPV of a project could fall substantially if opportunity costs are
recognized
Cash Inflows, Discounting, and
Inflation

If inflation is in the numerator, be sure that it is also
in the denominator.




The nominal return reflects the actual dollar return.
The real return measures the increase in purchasing
power gained by holding a certain investment.
In general, when the inflation rate is high, so too will
be the nominal rate of return offered by various
investments:


21
21
21
If the numerator ignores inflation, so too must the
denominator.
Investors will demand a return that not only keeps pace with
inflation,
but also offers a positive real return.
Inflation Rule 1
 Nominal
cash flows reflect the same
inflation rate that the interest rate does
 Inflation Rule 1 — When we discount
cash flows at a nominal interest rate,
embedded in the discount rate is an
estimate of expected inflation.
22
22
22
Inflation Rule 2
 Occasionally
an investment’s cash flow
projections may be stated in real terms.
 Real cash flows only reflect current
prices and do not incorporate upward
adjustments for expected inflation.
 Inflation Rule 2 — When project cash
flows are stated in real rather than in
nominal terms, the appropriate discount
rate is the real rate.
23
23
23
Equipment Replacement and
Unequal Lives


A firm must purchase an electronic control device
 First alternative is a cheaper device, higher maintenance costs,
shorter period of utilization
 Second device is more expensive, smaller maintenance costs,
longer life span
Expected cash outflows
Device
A
B

1
1500
1200
2
1500
1200
3
1500
1200
4
1200
Maintenance costs are constant over time. Use real discount
rate of 7% for NPV
Device
A
B
24
24
24
0
12000
14000
NPV
$15,936
$18,065
Cash outflow device A < cash outflow device B  select A?
Equivalent Annual Cost (EAC)

25
25
25
EAC converts lifetime costs to a level annuity; eliminates the
problem of unequal lives
 1. Compute NPV for operating devices A and B for their lifetime
 NPV device A = $15,936
 NPV device B = $18,065
 2. Compute annual expenditure to make NPV of annuity equal to
NPV of operating device
Device A
X
X
X
$15,936 


1
2
1.07 1.07
1.07 3
Device B
$18,065 
Y
Y
Y
Y



1.071 1.07 2 1.07 3 1.07 4
X  $6,072
Y  $5,333
Capital Budgeting and Inflation
26
26
26
Special Problems in Capital
Budgeting
 Equipment
replacement and equivalent
annual cost
 Excess capacity
27
27
27
Operating and Replacement Cash
Flows for Two Devices
28
28
28
Excess Capacity
When firms operate at less than full capacity,
managers encourage alternative uses of the
excess capacity because they view it as a free
asset.
 The marginal cost of using excess capacity is
zero in the very short run, but using excess
capacity today may accelerate the need for
more capacity in the future.
 When this is so, managers should charge the
cost of accelerating new capacity development
against the current proposal for using excess
capacity.

29
29
29
Excess Capacity

Excess capacity – not a free asset as
traditionally regarded by managers
 Company
has excess capacity in a distribution
center warehouse
 In two years the firm will invest $2,000,000 to
expand the warehouse

The firm could lease the excess space for
$125,000 per year for the next two years
 Expansion
plans should begin immediately in this
case to hold inventory for stores that will come on
line in a few months
 Incremental cost – investing $2,000,000 at present
vs. two years from today
 Incremental cash inflow - $125,000
30
30
30
Excess Capacity

NPV of leasing excess capacity (assume 10% discount rate)
125,000 2,000,000
NPV  125,000  2,000,000 

 $108,471
2
1.10
1.1


NPV negative – reject to lease excess capacity at $125,000 per
year
The firm could compute the value of the lease that would allow to
break even
X
2,000,000
NPV  X  2,000,000 

0
2
1.10
1.1


31
31
31
X = $181,818
Leasing the excess capacity for a price above $181,818 would
increase shareholders wealth
Human Face of Capital
Budgeting
 The
best financial analysts can provide
not only the numbers to highlight the
value of a good investment, but also can
explain why the investment makes
sense, highlighting the competitive
opportunity that makes one investment’s
NPV positive and another’s negative.
32
32
32