Berlin, 04.01.2006 Fußzeile 1

Cash Flowand

Capital Budgeting(Chapter 9 Textbook)

Berlin, 18th of June, 2007 Fußzeile 2

Cash Flow VersusAccounting Profit

Capital budgeting concerned with cash flow, not accounting profit.

To evaluate a capital investment, we must know:

Incremental cash outflows of the investment (marginal cost of investment), and

Incremental cash inflows of the investment (marginal benefit of investment).

The timing and magnitude of cash flows and accounting profits can differ dramatically.

What To Discount

Points to “Watch Out For”

Only incremental cash flows are relevant

Include all incidental effects Do not forget working capital

requirements Forget sunk costs Include opportunity costs Beware of allocated overhead costs

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Financing Costs

Financing costs are captured in the discounting future cash flows to present.

Both interest expense from debt financing and dividend payments to equity investors

should be excluded.

Financing costs should be excluded when evaluating a project’s cash flows.

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Cash Flow and Non-Tax Expenses

Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits.

Capital budgeting analysis focuses on cash inflows and outflows when they occur.

Non-cash expenses affect cash flow through their impact on taxes:

• Compute after-tax net income and add depreciation back, or

• Ignore depreciation expense but add back its tax savings.

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Depreciation

Accelerated depreciation methods (such as MACRS = Modi-fied Accelerated Cost Recovery System) 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. For capital budgeting analysis, the

depreciation method for tax purposes matters most.

Many countries allow one depreciation method for tax purposes and another for reporting purposes.

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The Initial Investment

Initial cash flows: • Cash outflow to acquire/install fixed assets• Cash inflow from selling old equipment • Cash inflow (outflow) if selling old equipment below

(above) tax basis generates tax savings (liability)

Initial investment: outflow of $10.5 million, and after-tax inflow of $0.60

million from selling the old equipment

An example....

Tax rate = 40%

New equipment costs $10 million,

$0.5 million to install

Old equipment fully depreciated, sold for $1

million

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Working Capital Expenditures Many capital investments require additions

to working capital.• Net working capital (NWC) = current

assets – current liabilities.• Increase in NWC is a cash outflow;

decrease a cash inflow.

• An example…• Operate 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

9

Working Capital Expenditures

(4,000)

+500+500NA/m in WC

(3,000)

1,0005000Net WC

5,00010,00015,0000Accts payable

01,50010,50015,0000Inventory

$0$500$500$500$0Cash

Feb 1Jan 1Dec 1Nov 1Oct 1

($5,000)

($5,000)

($5,000)$0Payments

($500)Net cash flow

$1,500[10%]

$9,000[60%]

$4,500[30%]

$0Reduction in inventory

Jan 1 to Feb 1

Dec 1 to Jan 1

Nov 1 to Dec 1

Oct 1 to Nov 1

Payments and inventory

($500) +$4,000 ($3,000)

0

0+3,000

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Terminal Value

Terminal value is 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 project at a given future point in time.

Large value relative to all the other cash flows of the project.

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Terminal Value

Different ways to calculate terminal values:

• Use final year cash flow projections and assume that

all future cash flow grow at a constant rate;

• Multiply final cash flow estimate by a market multiple, or

• Use investment’s book value or liquidation value.

$3.25 Billion

$2.5 Billion$1.75 Billion

$1.0 Billion$0.5 Billion

Year 5Year 4Year 3Year 2Year 1

JDS Uniphase cash flow projections for acquisition of SDL Inc.

Berlin, 18th of June, 2007 Fußzeile 12

Terminal Value of SDL Acquisition

67.48$1.1

2.68$

1.1

25.3$

1.1

5.2$

1.1

75.1$

1.1

1$

1.1

5.0$554321

$68.20.050.10

$3.41PVor ,

grCF

PV 51t

t

Assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):

• Terminal value is $68.2 billion; value of entire project is:

• $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• Warning ! : market multiples fluctuate over

time

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Incremental Cash Flow

Incremental cash flows versus sunk costs:

Capital budgeting analysis should include only incremental costs.

• An example…• Norman Paul’s current salary is $60,000 per year

and he expects it to increase at 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

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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 would have

increased to $66,150:• Yr 2 net cash inflow: $90,000 - $66,150 = $23,850• After-tax inflow: $23,850 x (1-0.35) = $15,503• Yr 3 cash inflow:• MBA has substantial positive NPV value if 30 yr analysis period

150,66$05.1000,60$ 2

032,18$35.0105.1000,60$08.1000,90$ 3

What about Norm’s opportunity cost?

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Opportunity Costs

Cash flows from alternative investment opportunities, forgone when one investment is

undertaken.

NPV of a project could fall substantially if opportunity costs are recognized!

First year: $60,000 ($39,000 after taxes)

Second Year: $63,000 ($40,950 after taxes)

If Norm did not attend MBA program, he would have

earned: