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UT FIN 357 - Chapter 8. Capital Budgeting v2

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Slide 1Incremental Cash FlowsOther CostsAllocated CostsBaldwin Company: An ExampleBaldwin ExpansionBaldwin Expansion InvestmentsModified Accelerated Cost Recovery SystemRevenue and CostIncremental After-Tax Cash FlowInflation and Capital BudgetingExampleIn PracticeAlternative OCF DefinitionsTax Shield ApproachInvestments of Unequal LivesReplacement ChainEquivalent Annual Cost MethodEquivalent Annual Cost Method (con’t)Equivalent Cost ExampleEquivalent Cost ExampleReplacement ExampleReplacement Example – Replace NowReplacement Example – Wait 1 YearReplacement Example (con’t)Alternative OCF Definitions© J. David Miller 2017Capital BudgetingChapter 8Finance 357Incremental Cash FlowsIn finance, cash flows are what determines the value of projects and companies. When we analyze a project, it is important to only use cash flows that are incremental to the project. In other words, if we would normally get a cash flow without doing the project, don’t include that cash flow when analyzing the project.Costs that have already occurred are called sunk costs, and should never be used to value a new project.2Other CostsWhen considering a project, we should consider opportunity costs. For example, if our company is considering selling a warehouse that we own, but instead we use the warehouse for a new project, the cost of the warehouse should be included as a cost in our project analysis. It is an opportunity cost.It is also important to consider indirect costs to a project, such as erosion. Erosion occurs when a project will cause the cash flows of another project to decrease. In marketing, this is often called cannibalism. Synergy occurs when a new project increases the cash flows of an existing project.3Allocated CostsIt is common that a single expenditure will benefit multiple projects. Accountants will spread the cost of this expenditure over the projects that benefit form it. However, this allocated cost should only be viewed as a cash outflow of a project if it is an incremental cost of the project.4Baldwin Company: An ExampleBaldwin Company is considering an investment in machinery for bowling ball production.•Costs of test marketing (already spent): $250,000•Current market value of proposed factory site (which we own): $150,000•Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year)•Increase in net working capital: $10,000•Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,0005Baldwin Expansion•Price during first year is $20; price increases 2% per year thereafter.•Production costs during first year are $10 per unit and increase 10% per year thereafter.•Annual inflation rate: 5%•Working Capital: initial $10,000 changes with sales. NWC will be maintained at 10% of sales.6Baldwin Expansion Investments 7The building can be sold at the end of the projectModified Accelerated Cost Recovery System 8Revenue and Cost 9Incremental After-Tax Cash Flow 10 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5(1) Sales Revenues $100.00 $163.20 $249.72 $212.20 $129.90(2) Operating costs -50.00 -88.00 -145.20 133.10 -87.84(3) Taxes -10.20 -14.69 -29.01 -22.98 -10.38(4) OCF(1) – (2) – (3) 39.80 60.51 75.51 56.12 31.68(5) Total CF of Investment–260. –6.32 –8.65 3.75 192.98(6) IATCF[(4) + (5)]–260. 39.80 54.19 66.86 59.87 224.66260 CFj, 39.8 CFj, 54.19 CFj, 66.86 CFj, 59.87 CFj, 224.66 CFj, 10 I/YDownshift PRCNPV=51.588Inflation and Capital BudgetingJust as with rates of return, Inflation affects the analysis of cash flows. Cash flows can be express in either nominal or real terms.A nominal cash flow refers to the actual dollars to be received. Nominal cash flows must be discounted at the nominal rate.A real cash flow refers to the cash flow’s purchasing power. Real cash flows must be discounted at the real rate.Fisher Equation: (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)Approximation: Real Rate  Nominal Rate – Inflation Rate11ExampleShields Electric forecasts nominal cash flows for a project. The discount rate is 14% and inflation is 5%. NPV = NPV =Year Nominal Cash Flow0 - $1,0001 $ 6002 $ 650Year Real Cash Flow0 - $1,0001 $ 571.43 (600 / 1.05)2 $ 589.57 (650 / 1.052)12In PracticeBecause both methods of NPV calculation arrive at the same answer, use the method that is the easiest.When values are presented in nominal form, use the nominal cash flows to calculate NPV.13Alternative OCF DefinitionsOperating Cash Flow is calculated different ways by different practitioners and different textbooks. All the methods produce the same results.Bottom-Up ApproachWorks only when there is no interest expenseOCF = NI + DepreciationTop-Down ApproachOCF = Sales – Costs – TaxesDon’t subtract non-cash deductionsTax Shield ApproachOCF = (Sales-Costs)(1-T) + (Depreciation x T)14Tax Shield ApproachThe tax shield approach is very useful in certain cases.Use the method that works best for the information you have15Investments of Unequal LivesThere are times when we have two projects to choose from, but they have unequal lives. This means that regular NPV could provide a misleading result.There are two methods that we can use to determine the best project if we can assume that the items from the project will be replaced forever:1) The Replacement Chain2) The Equivalent Annual Cost Method16Replacement ChainThe replacement chain approach repeats projects until they have the same total length.170 12 3-500 -100-100 -1000 12-400-150-150Project AProject BProject A0 12-400-150-55034-150-55056-150-150Repeated Twice0 12 3-500-100-100 -600Project B45 6-100-100 -100Repeated OnceFind the NPV of each and select lower cost project.Equivalent Annual Cost MethodThe Equivalent Annual Cost Method spreads the first year cost across the life of the project and gives you an annual value that is used to compare projects.Country club considering the purchase of a tennis ball machine. Costs are below.Machine 0 1 2 3 4A $500 $120 $120 $120B $600 $100 $100 $100 $10018Equivalent Annual Cost Method (con’t)NPV appears to suggest that machine A is cheaper.Create an annuity to determine the average annual cost over the life of each machine.Machine A Cost each year is $321.05Machine B Cost each year is $289.2819Equivalent Cost ExampleA company is considering the purchase of a new delivery vehicle. The costs for each vehicle are listed below. Because of the constant use, vehicle A will last


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UT FIN 357 - Chapter 8. Capital Budgeting v2

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