Professor John Zietlow MBA 621 Cash Flow And Capital Budgeting Chapter 8

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Transcript of Professor John Zietlow MBA 621 Cash Flow And Capital Budgeting Chapter 8

  • Professor John ZietlowMBA 621Cash Flow And Capital BudgetingChapter 8

  • Chapter 8: Overview8.1Types of Cash Flows Cash flow vs. accounting profit Fixed asset expenditures Working capital expenditures Terminal value Incremental cash flow vs. sunk costs Opportunity costs8.2Cash Flow for Classicaltunes.com8.3Cash Flows, Discounting, and Inflation8.4Special Problems in Capital Budgeting Equipment replacement and equivalent annual cost Excess Capacity8.5Summary

  • Types of Cash FlowsFirst step in capital budgeting: determine the relevant CFsThe incremental after-tax cash outflow (investment) and resulting cash flows. Cash flows, rather than accounting values, are used. The cash flows of any project having simple cash flows can include three basic components: (1) initial investment, (2) operating CFs, and (3) terminal CF All projects have the first two componentsInitial investment includes all set up costsAlso includes incremental working capital investmentOperating cash flows are after-tax net cash flows using the firms marginal tax rateCF, not earnings, so add depreciation back inThe terminal CF usually related to liquidation of the projectInclude disposal costs and after-tax salvage values, if any

  • Cash Flow Versus Accounting Profit Capital budgeting concerned with cash flow, not accounting profitMost important distinction: non-cash chargesTwo ways to treat non-cash chargesCan compute net income and add depreciation backCan compute after-tax income, then add tax savingsDemonstrate two methods (next slide) by assuming a firm purchases a fixed asset today for $30,000Plans to depreciate over 3 years using straight-line methodUsing machine, firm will produce 10,000 units/yearProduct sells for $3/unit and costs $1/unitFirm pays taxes at a 40% marginal rate

  • Two Methods Of Handling Depreciation To Compute Cash FlowSimplest and most common technique:Add depreciation back in

  • An Overview Of DepreciationLargest non-cash charge for most projects: depreciation Firms allowed to charge off portion of assets cost each year For tax purposes, depreciation is regulated by the IR Code, as laid out most recently in the Tax Reform Act of 1986. A firm will often use different depreciation methods for financial reporting and tax purposes, which is quite legal.Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS) In US & UK, different depreciation methods can be used for taxes and financial reporting MACRS standards, which apply to both new and used assets, require a taxpayer to use as an asset's depreciable life the appropriate MACRS recovery period. There are six MACRS recovery periods--3, 5, 7, 10, 15, and 20 years--excluding real estate (not depreciable). The first four property classes defined next slide.

  • The First Four Depreciation MACRS Classes

    Property class

    Definition

    3-year

    Research equipment & certain tools

    5-year

    Computers, typewriters, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets

    7-year

    Office furniture, fixtures, most mfg equipment, railroad track, single-purpose agricultural and horticultural structures

    10-year

    Equipment used in petroleum refining or in the manufacture of tobacco and certain food products

  • MACRS Recovery PeriodsFor tax purposes, assets in the first four property classes depreciated by the double-declining balance (200%) method Also computed using the half-year convention and switching to straight-line when advantageous.The approximate percentages written off each year for the first four property classes are given in Table 8.1. Rather than using these, the firm can use either straight-line depreciation over the asset's recovery period with the half-year convention or the alternative depreciation system. We use MACRS figures as these generally provide for the fastest writeoff & thus the best CF effects for profitable firmsMACRS requires use of the half-year convention, so assets assumed to be acquired in mid-yearSo only half of first year's deprec is recovered in year 1 Final half-year of depreciation is recovered in the year immediately following the asset's stated recovery period. Deprec %s for an n-year asset thus given for n + 1 years

  • Depreciation Percentages By Year

    Depreciation percentage by recovery year

    Recovery year

    3-year

    5-year

    7-year

    10-year

    1

    33%

    20%

    14%

    10%

    2

    45

    32

    25

    18

    3

    15

    19

    18

    14

    4

    7

    12

    12

    12

    5

    12

    9

    9

    6

    5

    9

    8

    7

    9

    7

    8

    4

    6

    9

    6

    10

    6

    11

    4

    Totals

    100%

    100%

    100%

    100%

  • Finding Initial Cost of Fixed Asset PurchaseCap budget decisions usually entail acquiring fixed asset.Initial cost typically measured as net cash outflowIf new asset, net initial cost fairly simple to computeJust purchase price plus installation costsIf new asset purchased to replace existing asset, finding net initial cost much more complicatedMust account for purchase and installation cost of new assetPlus after-tax inflow or outflow from old asset = sale price net of removal costs, plus or minus tax impact of saleTax impact from sale of old asset depends on assets sale price and book valueSale price below book value capital loss (tax benefit)Sale price above book value, but below purchase price firm must pay tax on recaptured depreciationSale price above purchase price firm must pay tax on recaptured depreciation plus capital gain

  • Calculating Net Initial Cost Of New Computers For Electrocom MfgElectrocom Mfg wants to replace computers purchased three years ago for $100,000 with newer, faster machinesOld computers have been deprec with 5-year MACRS ruleAccum deprec = $71,200 (71.20%); so book value = $28,800If Electrocom sells its old computers for $10,000, what is net after-tax cash flow from sale? Assume tax rate = 40%Capital loss, sale of old computer = book value - sale price = $28,800 - $10,000 = $18,800 Tax benefit of capital loss (assuming firm has other profits) = capital loss x tax rate = $18,800 x 0.40 = $7,520Net inflow from sale = sale price + tax benefit = $17,520Net initial cost of new computers thus the purchase and installation cost of new computers minus $17,520

  • Working Capital ExpendituresMany cap investments require additions to working capitalNet working capital (NWC) = curr assets curr liabilitiesIncrease in NWC is a cash outflow; decrease a cash inflowSome curr assets (A/R) can be acquired thru trade credit, but curr liab will go up if credit extended (A/P)Demonstrate impact of WC investment on cash flow with calendar sales booth in mall over Christmas seasonOperate booth from November 1 to January 31 (close Feb1)Order $15,000 calendars on credit, delivery by Nov 1Must pay suppliers $5,000/month, beginning Dec 1 Expect to sell 30% of inventory (for cash) in Nov; 60% in Dec; 10% in Jan; close up shop Feb 1Always want to have $500 cash on hand; invest cash Nov 1, receive it back Jan 31.

  • Working Capital For Calendar Sales Booth($500)+$4,000($3,000)$0$0+$3,000

  • Terminal ValueSome investments have a well-defined life, determined by:Physical life of a piece of equipmentPeriod until a patent expiresPeriod of time covered by a leasing or licensing agreementTerminal value used when evaluating an investment with indefinite life-span1. Construct cash-flow forecasts for 5 to 10 years2. Forecasts more than 5 to 10 years high margin of error; use terminal value insteadTerminal value intended to reflect the value of a project at a given future point in timeLarge value relative to all the other cash flows of the project

  • Terminal Value of SDL AcquisitionJDS Uniphase projections for acquisition of SDL Inc.

    Different ways to calculate terminal values assumptions used to calculate terminal value are very importantUse final year cash flow projections and assume that all future cash flow grow at a constant rateMultiply final cash flow estimate by a market multipleUse investments book value or liquidation valueEstimate recovery of no more than 20 50 percent of original purchase cost (Asplund, 2002)Possibly negative terminal value if high disposal costs

  • Terminal Value of SDL Acquisition (Continued)If 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 valueTerminal Value = $3.25 x 20 = $65 billionCaveat : market multiples fluctuate over time

  • Incremental Cash FlowIncremental cash flows vs. sunk costsCap budgeting analysis should include only incremental costsFor example, decision to pursue MBA can be based on incremental cash flowsNorman Pauls current salary is $60,000 per year and expect to increase at 5% each yearAssume that Norm pays taxes at flat rate of 35%Sunk costs: $1,000 for GMAT course and $2,000 for visiting various programsRoom and board expenses not incremental to the decision to go back to school (assume the same expenses for room and board in both cases)

  • Incremental Cash Flow (Continued)At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per yearExpected tuition, fees and textbook expenses for next two years while studying in MBA: $35,000If Norm worked at his current job for two years, his salary would hav