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Discounted Cash Flows, Not Profits Incremental Cash Flows Cash flow from capital investment Cash flow from investment in working capital Cash flow from operations
Case Study: Blooper Industries Exercise: Project Evaluation A New Fad Product Exercise: Projects with Unequal Lives (EAC)
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Project Implementation
Only Cash Flow and Time Value of Money matter: CF matters, not accounting profit or Net Income CF must be relevant and incremental to the new project: Does CF occur when project is accepted or rejected? In discounting CF, treat inflation consistently The separation of financing and investment
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted incremental cash flows.
Ask yourself would the cash flow still exist if the project does not exist?
Sunk costs have accrued in the past and do not affect project NPV. Example: A firm want to re-evaluate a project. The project already cost the firm $50K. A further investment $40K is required. The PV of future cash flows is $60K. Should the firm continue the project? Example: A new product will generate a cash flow of $10million a year. However, the introduction of the new product will reduce the cash flow of the existing projects by $4 million. What is the cash flow we should use when evaluating the new product?
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Opportunity Costs (yes / no) Opportunity costs are costs of lost options. Example: A firm owns a land. The firm can either use the land for a project or sell it for $100K. Suppose the NPV of the project is $80K. Should the firm accept the project?
Dont forget Net Working Capital (NWC or WC) WC=current assetscurrent liability Non-cash working capital Examples of current assets are, accounts receivable (unpaid bills), inventories Example of current liabilities are accounts payable.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Total cash flow = cash flow from capital investment (fixed assets) + cash flow from investments in working capital + cash flow from operations
Two types of cash flows related to the initial investments. The costs of fixed assets The cash flow from selling off the fixed assets, or the after tax salvage value of fixed assets.
Salvage value is the estimated value of an asset at the end of its useful life (how much the assets can be sold), and can be different from the book value of the asset. Book value = initial cost accumulated depreciation After-tax salvage = salvage tax rate (salvage book value)
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Note: only pay tax on the difference between salvage and book value.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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Question: what if the equipment is only sold for $200K at the end of year 5? Year 5:
Selling at a loss
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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Depreciation
A non-cash expense, which only affects taxes (both after-tax salvage value and after-tax operating cash flows) Straight-line depreciation
Depreciation expense = (initial cost-residual value)/number of years MACRS (modified accelerated cost recovery system) Depreciation expense = Multiply percentage given in table by the initial cost Depreciate to zero
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5
6 7 8
11.52
5.76
8.93
8.93 8.93 4.45
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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 companys marginal tax rate is 40%. What is the depreciation expense each year and the after-tax cash flow in year 6?
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Depreciation
Answer:
Suppose the appropriate depreciation schedule is straight-line and we depreciate the equipment to $17,000 in 6 years.
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Example cont. Answer the previous questions by assuming that the firm will use MACRS with a 3-year tax life.
Year 1 2 3 4 MACRS percent .3333 .4444 .1482 .0741 Depreciation Expense
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For most projects, working capital =inventories + accounts receivable - accounts payable.
The cash flow is measured by the change in working capital, not the level of working capital. Increase (Decrease) in working capital=negative (positive) cash flow
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Example: Calculate the CF from investment in working capital in the following example.
0 10 1 30 2 25 3 0
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Sales (50,000 units at $4.00/unit) Variable Costs ($2.50/unit) Gross profit Fixed costs
Depreciation ($90,000 / 3)
EBIT Taxes (34%) Net Income
30,000
$ 33,000 11,220 $ 21,780
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Example A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year. Tax rate is 35%. Calculate the cash flow from operations.
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2.
3.
CF from operations
Calculate the net income Adjust for the depreciation
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The project requires an investment of $10 million. The equipment may be sold for $2 million by the end of year 5. The company applies straight-line depreciation over 5 years. (Depreciation exp. is $10/5=2 million per year) The company expects to sell 750,000 pounds of product a year at a price of $20 a pound in year 1. Total expense is $10 million in year 1. The inflation rate is 5%. (Revenue and expense go up with inflation.) Account receivables are 1/6 of revenues. Inventories are 15% of following years expense. The companys tax rate is 35%. The discount rate is 12%.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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In-Class Examples
2. Evaluating a new fad product 3. Compare projects with unequal lives (EAC)
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Homework Assignments
Problems are posted at eLearn. For problem 3: Invest. In WC is made today and will be recovered in year 5. Note: All problems in the textbook assume that WC is recovered in the last year of the project.
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