Chapter 10 Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will only occur or not occur if the project is accepted These cash flows are called incremental cash flows o Additional cash flow a firm receives from taking on a new project firm simply by focusing on incremental cash flows The stand alone principle allows us to analyze each project in isolation from the o Once the incremental CF s from under taking a project are identified we can view the project as a mini firm with its own future revenues and costs its own assets and of course its own CF s Asking the Right Question You should always ask yourself Will this cash flow occur ONLY if we accept the project If the answer is yes it should be included in the analysis because it is incremental If the answer is no it should not be included in the analysis because it will occur anyway If the answer is part of it then we should include the part that occurs because of the project Common Types of Cash Flows Sunk costs costs that have accrued in the past The firm will have to pay these no matter what Exclude these from the analysis because they are not relevant to the decision Opportunity costs costs of lost options Giving up a benefit Side effects Positive side effects benefits to other projects 1 Negative side effects costs to other projects Erosion negative impact on the existing product from the introduction of a new product In accounting for erosion it is important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition Erosion is relevant only when the sales would not otherwise be lost Changes in net working capital Financing costs are not included Interest paid dividends principal repaid are not included because we are only interested in the cash flows generated by the assets of the project Our goal is to compare the cash flow from a project to the costs of acquiring that project in order to estimate NPV Taxes must consider cash flows on an after tax basis We are always interested in after tax cash flow because they are definitely a cash outflow Incremental cash flows after tax incremental cash flows Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements particularly income statements Computing cash flows Operating Cash Flow OCF EBIT depreciation taxes Net income depreciation when there is no interest expense 2 EBIT sales variable coats fixed cost depreciation Cash Flow From Assets CFFA OCF net capital spending NCS changes in NWC Table 10 1 Pro Forma Income Statement Table 10 2 Projected Capital Requirements 3 Table 10 5 Projected Total Cash Flows Now that we have the cash flows we can apply the techniques that we learned in Making The Decision 4 Chapter 9 Enter the cash flows into the calculator and compute NPV and IRR CF0 110 000 C01 51 780 F01 2 C02 71 780 F02 1 NPV I 20 CPT NPV 10 648 CPT IRR 25 8 Should we accept or reject the project Accept because NPV is positive 10 648 Also the IRR is greater is greater than the required return 25 8 20 Why do we have to consider changes in NWC separately More on NWC GAAP requires that sales be recorded on the income statement when made not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made whether we have actually paid our suppliers yet Finally we have to buy inventory to support sales although we haven t collected cash yet The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation Depreciation itself is a non cash expense consequently it is only relevant because it affects taxes which means it effects cash flows Depreciation tax shield DT D depreciation expense T marginal tax rate Straight line depreciation Computing Depreciation D Initial cost salvage number of years 5 Very few assets are depreciated straight line for tax purposes M odified Accelerated Cost Recovery System MACRS Need to know which asset class is appropriate for tax purposes 3 5 or 7 year classes Multiply percentage given in table by the initial cost Mid year convention i e 3 year MACRS has four years of depreciation Depreciate to zero expense After tax Salvage If the salvage value is different from the book value of the asset then there is a tax effect Book value initial cost accumulated depreciation After tax salvage salvage T salvage book value Accumulated depr Cost of years depreciation Example Depreciation and After tax Salvage You purchase equipment for 100 000 and it costs 10 000 to have it delivered and installed Based on past information you believe that you can sell the equipment for 17 000 when you are done with it in 6 years The company s marginal tax rate is 40 What is the depreciation expense each year and the after tax salvage in year 6 for each of the following situations Suppose the appropriate depreciation schedule is straight line Example Straight line D 110 000 17 000 6 15 500 every year for 6 years BV in year 6 110 000 6 15 500 17 000 After tax salvage 17 000 4 17 000 17 000 17 000 Example Three year MACRS 6 BV in year 6 110 000 36 663 48 895 16 291 8 151 0 After tax salvage 17 000 4 17 000 0 10 200 7 Example Seven Year MACRS BV in year 6 110 000 15 719 26 939 19 239 13 739 9 823 9 812 14 729 After tax salvage 17 000 4 17 000 14 729 16 091 60 Example Replacement Problem Old Machine Initial cost 100 000 Annual depreciation 9 000 Purchased 5 years ago Book Value 55 000 Salvage today 65 000 Salvage in 5 years 10 000 New Machine Initial cost 150 000 5 year life Salvage in 5 years 0 Cost savings 50 000 per year 8 3 year MACRS depreciation Required return 10 Tax rate 40 Replacement Problem Computing Cash Flows Remember that we are interested in incremental cash flows If we buy the new machine then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years Replacement Problem Pro Forma Income Statements 9 Replacement Problem Incremental Net Capital Spending Cost of new machine 150 000 outflow After tax salvage on old machine 65 000 4 65 000 55 000 61 000 inflow Incremental net capital spending 150 000 61 000 89 000 outflow Year 0 Year 5 After tax salvage on old machine 10 000 4 10 000 10 000 10 000 outflow because we no longer receive this Replacement Problem Cash Flow From Assets 10 Replacement Problem Analyzing the Cash Flows Now
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