Chapter 11

Cash Flows and

Other Topics
in Capital
Budgeting

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All rights reserved.
 Learning Objectives

1. Identify guidelines by which we measure

cash flows.
2. Explain how a projects benefits and costs
that is, its free cash flows are calculated.
3. Explain the importance of options or flexibility
in capital budgeting.
4. Explain what the appropriate measure of risk
is for capital-budgeting purposes.
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 Learning Objectives

5. Determine the acceptability of a new project

using the risk-adjusted discount method of
adjusting for risk.
6. Explain the use of simulating for imitating
the performance of a project under
evaluation.
7. Explain why a multinational firm faces a
more difficult time estimating cash flows
along with increased risks.
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 Slide Contents

Guidelines for Capital Budgeting

Free Cash Flow calculations
Options in Capital Budgeting
Risk and the Investment Decision
Measurement of Systematic Risk
The Multinational Firm

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 1. Guidelines for
Capital Budgeting

To evaluate investment proposals, we

must first set guidelines by which we
measure the value of each proposal.
In effect, we are deciding what is and
what isnt relevant cash flow.

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 Guidelines for
Capital Budgeting

1. Use free cash flows, not accounting profits

2. Think Incrementally
3. Beware of cash flows diverted from existing
products
4. Look for incidental or synergistic effects
5. Work in working-capital requirements

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 Guidelines for
Capital Budgeting

6. Consider incremental expenses

7. Sunk costs are not incremental cash flows
8. Account for opportunity costs
9. Decide if overhead costs are truly
incremental cash flows
10. Ignore interest payments and financing
flows
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 Use Free Cash Flows

Free cash flow accurately reflects the

timing of benefits and costswhen
money is received, when it can be
reinvested, and when it must be paid
out.
Accounting profits do not reflect actual
money in hand.
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 Incremental Cash Flows

After-tax free cash flows must be

measured incrementally.
Determining incremental free cash flow
involves determining the cash flows with
and without the project. Incremental is
the additional cash flows (inflows or
outflows) that occur due to the project.
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 Beware of Diverted
Cash Flows

Not all incremental free cash flow is relevant.

Thus new product sales achieved at the cost
of losing sales from existing product line are
not considered a benefit.
However, if the new product captures sales
from competitors or prevents loss of sales to
new competing products, it would be a
relevant incremental free cash flows.
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 Incidental or
Synergistic Effects

Although some projects may take sales

away from a firms current projects, in
other cases new products may add
sales to the existing line. This is called
synergistic effect and is a relevant cash
flow.

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 Working Capital Requirement

New projects require infusion of working

capital (such as inventory to stock the
shelves), which would be an outflow.
Generally, when the project terminates,
working capital is recovered and there
is an inflow of working capital.

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 Sunk Costs

Sunk costs are cash flows that have already

occurred (such as marketing research) and
cannot be undone. Sunk costs are considered
irrelevant to decision making.
Managers need to ask two basic questions:
Will this cash flow occur if the project is accepted?
Will this cash flow occur if the project is rejected?
If the answer is Yes to #1 and No to #2, it
will be an incremental cash flow.
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 Opportunity Costs

Opportunity cost refers to cash flows

that are lost because of accepting the
current project.
For example, using the building space
for the project will mean loss of potential
rental revenue.

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 Overhead Costs

Must include incremental overhead

costs or costs that were incurred as a
result of the project and relevant to
capital budgeting
Note, not all overhead costs may be
relevant (example, utilities bill may have
been the same with or without the
project)
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 Interest Payments and Financing
Costs

Interest payments and other financing

cash flows that might result from raising
funds to finance a project are not
relevant cash flows.
Reason: Required rate of return
implicitly accounts for the cost of raising
funds to finance a new project.
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 2. Free Cash Flow Calculations

Three components of free cash flows:

The Initial outlay
The differential flows over the projects life
The Terminal cash flow

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 2.1 Initial Cash Outlay

The initial cash outlay is the immediate cash

outflow necessary to purchase the asset and
put it in operating order.
This includes: (1) Purchase cost, Set-up cost,
Installation, Shipping/Freight (2) increased
working-capital requirements (3) sale of
existing asset and tax implications (if the
project replaces an existing project/asset)

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 Sale and Taxes

If Sale = Book Value ==> No tax effect

If sale > BV (but less than cost)
==> recaptured depreciation, taxed as
ordinary income
If sale > BV (greater than cost)
==> anything above cost, taxed as capital
gain, rest taxed as recaptured depreciation
If sale < BV ==> capital loss
==> tax savings
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 2.2 Annual Free Cash Flows

Annual free cash flows is the incremental

after-tax cash flows resulting form the project
being considered.
Free Cash flow considers the following:
Cash flow from operations
Cash flows from working capital requirements
Cash flows from capital spending

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 Calculating Operating
Cash Flows

Step 1: Measure the projects change in

after-tax operating cash flows
Operating cash flows
= Changes in EBIT
Changes in taxes
+ Change in depreciation

Note, depreciation is a non-cash expense but

influences the cash flows through impact on
taxes (see next two slides).
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 Depreciation and Cash Flow

Earnings before Tax and Dep. 40,000

Depreciation 25,000
Earnings before tax (EBT) 15,000
If the corporation is taxed at 30%,
taxes = .3*15000 = $4,500
If the depreciation was $0,
EBT = $40,000 and
taxes = .3*40000 = $12,000
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 Depreciation and Cash Flow

==> Depreciation is a non-cash

expense BUT affects Cash Flow
through its impact on taxes;
Depreciation ==> in Expense
==> in taxes
=> CF

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 Change in Net
Working Capital

Step 2: Calculate the cash flows from

the change in net working capital

This refers to additional investment in

current assets minus any additional
short-term liabilities that were
generated.

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 Steps in Calculating Operating
Cash Flows

Step 3: Determine the cash flows from

the change in capital spending

This refers to any capital spending

requirements during the life of the
project.

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 Putting it all together

Step 4: Project free cash flows

= change in EBIT
changes in taxes
+ change in depreciation
change in net working capital
change in capital spending

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 2.3 Terminal Cash Flow

Terminal cash flows are flows

associated with the project at
termination.
It may include:
Salvage value of the project
Any taxable gains or losses associated
with the sale of any asset
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 Refer to Example 11.2

Initial outlay = $200,000 + $30,000 = $230,000

Operating cash flow
= EBIT + Depreciation
= $155,600
(see Tables 11-1, 11-2)
Terminal free cash flows
= Operating cash flow
+ net working capital
= $185,600
(See Table 11-3)
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 Table 11-1

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 Table 11-2

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 Table 11-3

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 3. Options in
Capital Budgeting

Options add value to capital budgeting

project by being able to modify the
project based on future developments
(that are currently unknown). Some
common options are:
Option to delay a project
Option to expand a project
Option to abandon a project
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 Option to Delay

Almost every project has a mutually exclusive

alternativewaiting and pursuing at a later
time.
It is conceivable that a project with a negative
NPV now may have a positive NPV if
undertaken later on. This could be due to
various reasons such as favorable changes in
fashion, technology, economy, or borrowing
costs.

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 Option to Expand

Even if a project is currently

unprofitable, it may be useful to
determine whether the profitability of the
project will change if the company is
able to expand in the future.
Example: Firms investing in negative
NPV projects to gain access to new
markets
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 Option to Abandon

It may be necessary to abandon the project

before its estimated life due to inaccurate
project analysis models or cash flow forecasts
or due to changes in market conditions.
When comparing two projects with similar
NPVs, project that is easier to abandon may
be more desirable (example, temporary
versus permanent workers, lease versus buy)

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 4. Risk and the
Investment Decision

Two main issues:

What is risk and how should it be
measured?
How should risk be incorporated into a
capital budgeting analysis?

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 Three Perspectives on Risk

Project standing alone risk

Projects contribution-to-firm risk
Systematic risk

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 Project Standing Alone Risk

This is a projects risk ignoring the fact

that much of the risk will be diversified
away as the project is combined with
other projects and assets.
This is an inappropriate measure of risk
for capital budgeting projects.

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 Contribution-to-Firm Risk

This is the amount of risk that the project

contributes to the firm as a whole;
This measure considers the fact that some of
the projects risk will be diversified away as
the project is combined with the firms other
projects and assets but ignores the effects of
diversification of the firms shareholders.

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 Systematic Risk

Risk of the project from the viewpoint of a

well-diversified shareholder;
This measure takes into account that some of
the risk will be diversified away as the project
is combined with the firms other projects and
in addition, some of the remaining risk will be
diversified away by the shareholders as they
combine this stock with other stocks in their
portfolios.

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 Relevant risk

Theoretically, the only risk of concern to

shareholders is systematic risk.
Since the projects contribution-to-firm
risk affects the probability of bankruptcy
for the firm, it is a relevant risk measure.
Thus we need to consider both the
projects contribution-to-firm risk and the
projects systematic risk.
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 Incorporating Risk into Capital
Budgeting

We know that investors demand higher

returns for more risky projects.
As the risk of a project increases, the required
rate of return is adjusted upward to
compensate for the added risk.
This risk adjusted discount rate is then
used for discounting free cash flows (in NPV
model) or as the benchmark required rate of
return (in IRR model)
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 5. Measurement of Systematic
Risk

Estimating risk of a project can be difficult

Historical stock return data relates to an
entire firm, rather than a specific project or
division. Risk must be estimated. Options to
estimate risk include:
Accounting Beta
Pure Play Method
Simulation
Scenario Analysis
Sensitivity Analysis
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 Beta

Accounting Beta Method

Can be estimated via time-series
regression on a divisions return on assets
on the market index
Pure Play Method
Identifies publicly traded firms engaged
solely in the same business as the project,
using that firms return data to judge the
project.
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 Simulation

Involves the process of imitating the

performance of the project under
evaluation (See Figure 11-6)
Done by randomly selecting observations
from each of the distributions that affect the
outcome of the project and continuing with
this process until a representative record of
the projects probable outcome is
assembled.
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 Scenario Analysis

Identifies the range of possible

outcomes under the worst, best, and
most likely cases.

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 Sensitivity Analysis

Determining how the distribution of

possible net present values or internal
rate of return for a particular project is
affected by a change in one particular
input variable while holding all other
input variables constant (also known as
what-if analysis).

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 6. The Multinational Firm

Process of measuring the incremental

after-tax cash flows to the company as a
whole gets more difficult when dealing with
competition from abroad.
Calculating the right base case (i.e. incremental
cash flows if project not taken) is difficult
International opportunities come with risks such as
currency fluctuations that can distort cash flow
projections.
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 Figure 11-1

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 Figure 11-2

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 Figure 11-3

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 Figure 11-4

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 Figure 11-5

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 Figure 11-6

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 Figure 11-6 (cont.)

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 Figure 11-7

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 Table 11-4

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 Table 11-5

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 Table 11-5 (cont.)

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 Key Terms

Contribution-to-firm risk
Incremental after-tax free cash flows
Initial outlay
Project standing alone risk
Pure play method

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 Key Terms

Risk-adjusted discount rate

Scenario analysis
Sensitivity analysis
Simulation
Systematic risk

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