# UT FIN 357 - Chapter 8. Capital Budgeting v2 (27 pages)

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## Chapter 8. Capital Budgeting v2

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- Pages:
- 27
- School:
- University of Texas at Austin
- Course:
- Fin 357 - Business Finance

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Capital Budgeting Chapter 8 Finance 357 J David Miller 2017 Incremental Cash Flows In 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 2 Other Costs When 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 3 Allocated Costs It 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 4 Baldwin Company An Example Baldwin 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 6 000 5 Baldwin 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 6 Baldwin Expansion Investments The building can be sold at the end of the project 7 Modified Accelerated Cost Recovery System 8 Revenue and Cost 9 Incremental After Tax Cash Flow Year 0 1 Sales Revenues 2 Operating costs 3 Taxes 4 OCF 1 2 3 5 Total CF of Investment 6 IATCF 4 5 Year 1 Year 2 Year 3 Year 4 Year 5 100 00 163 20 249 72 212 20 129 90 50 00 88 00 145 20 133 10 87 84 10 20 14 69 29 01 22 98 10 38 39 80 60 51 75 51 56 12 31 68 6 32 8 65 3 75 192 98 54 19 66 86 59 87 224 66 260 260 39 80 260 CFj 39 8 CFj 54 19 CFj 66 86 CFj 59 87 CFj 224 66 CFj 10 I Y Downshift PRC NPV 51 588 10 Inflation and Capital Budgeting Just 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 Rate 11 Example Shields Electric forecasts nominal cash flows for a project The discount rate is 14 and inflation is 5 Year Nominal Cash Flow 0 1 000 1 600 2 650 Year Real Cash Flow 0 1 000 1 571 43 600 1 05 2 589 57 650 1 052 NPV NPV 12 In Practice Because 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 13 Alternative OCF Definitions Operating Cash Flow is calculated different ways by different practitioners and different textbooks All the methods produce the same results Bottom Up Approach Works only when there is no interest expense OCF NI Depreciation Top Down Approach OCF Sales Costs Taxes Don t subtract non cash deductions Tax Shield Approach OCF Sales Costs 1 T Depreciation x T 14 Tax Shield Approach The tax shield approach is very useful in certain cases Use the method that works best for the information you have 15 Investments of Unequal Lives There 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 Chain 2 The Equivalent Annual Cost Method 16 Replacement Chain The replacement chain approach repeats projects until they have the same total length 400 150 150 500 100 100 100 Project B Project A 0 Project A 1 0 2 400 150 550 150 550 150 150 0 1 2 3 4 5 Project B 1 2 3 4 5 6 Find the NPV of each and select lower cost project 17 2 3 Repeated Twice 6 500 100 100 600 100 100 100 0 1 Repeated Once Equivalent Annual Cost Method The 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 18 Machine 0 1 2 3 A 500 120 120 120 B 600 100 100 100 4 100 Equivalent 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 05 Machine B Cost each year is 289 28 19 Equivalent Cost Example A 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 3 years while vehicle will last 4 The discount rate is 10 Which vehicle will be cheaper in the long run 20 Truck 0 1 2 3 A 24 000 1000 1000 1000 B 24 000 1500 1500 1500 4 1500 Equivalent Cost Example A 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 3 years while vehicle will last 4 The discount rate is 10 Which vehicle will be cheaper in the long run Truck 0 1 2 3 A 24 000 1000 1000 1000 B 24 000 1500 1500 1500 NPV of Truck A 10 26 486 85 …

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