1
Cash Flows and Other
Chapter 10
Topics in Capital Budgeting
Cash Flows in General
Measure Incremental Cash Flows
Measure cash flows that change if a project is
undertaken
Sunk cost is irrelevant
Opportunity cost is relevant
Do not include allocation of existing overhead
Do subtract lost sales of other products
Include cost savings as a positive cash flow.
3
Cash Flows in General
New Project vs. Replacement Project
New project – simply addition to company
Replacement – replace and existing old machine or
plant.
Financing costs - Interest and Dividend payments.
are not considered operating cash flows. Financing
cost are used to discount the cash flows to find
NPV,etc.
Only include CASH inflows and outflows.
4
5
Estimating Cash Flows
Three Types of Cash Flows
Initial Outlay
0
Initial Outlay
1
2
3
N
6
Estimating Cash Flows
Three Types of Cash Flows
Initial Outlay
Operating (Differential) Cash Flows
0
Initial Outlay
1
2
Operating Cash Flows
3
N
7
Estimating Cash Flows
Three Types of Cash Flows
Initial Outlay
Operating (Differential) Cash Flows
Terminal Cash Flow
0
Initial Outlay
1
2
Operating Cash Flows
3
N
Terminal Cash Flow
Estimating Cash Flows
Initial Outlay
Cost of Assets
Installation and Shipping
Non-Expense Outlays (i.e. Working Capital)
Expense Outlays after tax (i.e. Training Expenses)
8
Estimating Cash Flows
Initial Outlay
Cost of Assets
Installation and Shipping
Non-Expense Outlays (i.e. Working Capital)
Expense Outlays after tax (i.e. Training Expenses)
Only for Replacement Projects
Sale of Old Machine
9
Estimating Cash Flows
Initial Outlay
Cost of Assets
Installation and Shipping
Non-Expense Outlays (i.e. Working Capital)
Expense Outlays after tax (i.e. Training Expenses)
Only for Replacement Projects
Sale of Old Machine
Taxes on Machine
10
Estimating Cash Flows
11
Initial Outlay
Example:
Gasperini Corp. is considering replacing their old production
machine with a new one. The cost of the new machine is
$48,000; installation and delivery cost $2,000. Working Capital
requirements on the new machine are $3,000 immediately,
and training costs amount to $4,000. The old machine can be
sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%.
Estimating Cash Flows
Initial Outlay
Cost of Machine
+48,000
12
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
+48,000
2,000
13
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
+48,000
2,000
3,000
14
Estimating Cash Flows
15
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
4,000(1-0.40)
16
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
17
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
Salvage Value
10,000
18
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
Salvage Value
–Taxes
10,000
– 4,000
Tax rate x (Salvage Value-Book Value)
.4(10,000 – 0)
19
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
Salvage Value
–Taxes
10,000
– 4,000
– 6,000
20
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
Salvage Value
–Taxes
Initial Outlay
10,000
– 4,000
– 6,000
+49,400
21
Estimating Cash Flows
Initial Outlay
Cost of Machine
Installation & Shipping
Working Capital
Training (after tax)
+48,000
2,000
3,000
2,400
+55,400
Less: Sale of Old Machine
Salvage Value
–Taxes
10,000
– 4,000
– 6,000
+49,400
Initial Outlay
0
-49,400
1
2
3
4
5
Estimating Cash Flows
22
Terminal Cash Flow
Example:
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease costs by $8,000/
yr. They expect to use the machine for 5 years, and expect to sell it for
$15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital +3,000
Estimating Cash Flows
23
Terminal Cash Flow
Example:
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease costs by $8,000/
yr. They expect to use the machine for 5 years, and expect to sell it for
$15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital +3,000
Sell “New” Machine
15,000
Estimating Cash Flows
24
Terminal Cash Flow
Example:
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease costs by $8,000/
yr. They expect to use the machine for 5 years, and expect to sell it for
$15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital +3,000
Sell “New” Machine
15,000
Tax on Sale
-6,000
.4(15,000-0)
Estimating Cash Flows
25
Terminal Cash Flow
Example:
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease costs by $8,000/
yr. They expect to use the machine for 5 years, and expect to sell it for
$15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line
method to depreciate assets.
Recover Working Capital +3,000
Sell “New” Machine
15,000
Tax on Sale
-6,000
Terminal Cash Flow
+12,000
Capital Rationing
In large companies, many projects are evaluated
each year
Management often imposes a limit that can be
spent on new projects adopted during the year–
Capital Rationing
 In order to allocate scarce resources, choose the
group of projects whose initial outlays are within
the capital spending limit while at the same time
maximizing NPV of the group of projects.
26
27
Capital Rationing
Example
The following independent projects are subject to a
$100,000 capital budget.
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
All Projects have NPV > 0, PI > 1
PI
1.03
1.075
1.083
1.05
1.067
28
Capital Rationing
Example
Project
Combinations
2, 3 & 4
IO
40,000
+30,000
+20,000
90,000
NPV
3,000
+2,500
+1,000
6,500
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
PI
1.03
1.075
1.083
1.05
1.067
29
Capital Rationing
Example
Project
Combinations
2, 3 & 4
5
IO
NPV
40,000
+30,000
+20,000
90,000
3,000
+2,500
+1,000
6,500
90,000
6,000
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
PI
1.03
1.075
1.083
1.05
1.067
30
Capital Rationing
Example
Project
Combinations
2, 3 & 4
IO
NPV
40,000
+30,000
+20,000
90,000
3,000
+2,500
+1,000
6,500
5
90,000
6,000
1&2
50,000
40,000
90,000
1,500
3,000
4,500
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
PI
1.03
1.075
1.083
1.05
1.067
31
Capital Rationing
Example
Project
Combinations
2, 3 & 4
IO
NPV
40,000
+30,000
+20,000
90,000
3,000
+2,500
+1,000
6,500
5
90,000
6,000
1&2
50,000
40,000
90,000
1,500
3,000
4,500
50,000
30,000
20,000
100,000
1,500
2,500
1,000
5,000
1,3 & 4
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
PI
1.03
1.075
1.083
1.05
1.067
32
Capital Rationing
Example
Project
Combinations
2, 3 & 4
IO
NPV
40,000
+30,000
+20,000
90,000
3,000
+2,500
+1,000
6,500
5
90,000
6,000
1&2
50,000
40,000
90,000
1,500
3,000
4,500
50,000
30,000
20,000
100,000
1,500
2,500
1,000
5,000
1,3 & 4
Project
1
2
3
4
5
IO
50,000
40,000
30,000
20,000
90,000
NPV
1,500
3,000
2,500
1,000
6,000
PI
1.03
1.075
1.083
1.05
1.067
33