BFF5954 BUSINESS FIANNCE

TEACHING WEEK FOUR

The Application of
Project Evaluation Methods

Readings:
Chapter 7 (Pages 98 111)
n NCFt Last week: how to use
NPV
t 0 (1 k) t This week: how to construct CFs
1
 Learning Objectives

Compare mutually exclusive projects that have different lives.

Explain the principles used in estimating project cash flows.

Cash Flow Analysis Major Cash Flow Components

Cash Flow Analysis The Replacement Decision.

2
Mutually Exclusive Projects
with Different Lives

3
 Example 1
Mutually Exclusive Projects with
Different Lives
There are times when direct application of the NPV rule can lead
to a wrong decision. Consider a factory which must have an air
cleaner.

There are two choices:

Cleaner X costs $4,000 today, has annual operating costs
of $100 and lasts for 10 years.
Cleaner Y costs $1,000 today, has annual operating costs
of $500 and lasts for 5 years.
Which one should we choose?
Assume cost of capital for this investment is 10%. 4
 PVYX,0$14,00$.511011.502$849,6513.
N
Mutually Exclusive Projects with
Different Lives
At first glance, project Y appears to be best.

But Cleaner X lasts twice as long.

When we incorporate that, Cleaner X is actually cheaper.

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 Mutually Exclusiveof
Investments Projects
UnequalwithLives
Different
Lives

Matching Cycle or Replacement Chain Approach

Repeat projects until they begin and end at the same
time - like we just did with the air cleaners.
Compute NPV for the repeated projects.

The Equivalent Annual Cash Flow Method (EAC)

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Mutually Exclusive Projects with Different Lives
Matching Cycle or Replacement Chain Approach

Cleaner Xs time line of cash flows:

-$4,000 100 -100 -100 -100 -100 -100 -100
-100 -100 -100
0 1 2 3 4 5 6 7 8
9 10
Cleaner Ys time line of cash flows over ten years:
-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500
-500 -500

0 1 2 3 4 5 6 7 8
9 10

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 Matching Cycle or Replacement Chain Approach

When we make a fair comparison,

$100 1
NPV X $4,000 1 $4,614.46
0.10 1 0.1
10

$2,895.39
NPVY $2,895.39 5
$4,693.20
1.1

Decision: Cleaner X is cheaper

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Mutually Exclusive Projects with Different Lives
The Equivalent Annual Cash Flow Method
EAC method puts costs on a per-year basis.
EAC is the value of the payment annuity that has the
same NPV as our original set of cash flows.

(1 k) n
EAC0 k NPV0
n
(1 k ) 1
OR
NPV0 k
1
1
(1 k) t

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PVX$4,0$.101.0$4,61.
N
Investments of Unequal Lives: Equivalent
Annual Cash Flow Method (cont)

EAC X
$4,614.46 0.10
1
1
1 0.1010

EAC X 0.10 4614.46

$750.98

(1.10)10
$750.98
(1.10)10 1
10
 Investments of Unequal Lives: Equivalent
Annual Cash Flow Method (cont)
$500 1
NPVY $1,000 1 $2,895.39
0.10 1 0.10 5

2,895.39 0.10
EACY 763.80
1
1
1 0.10 5
(1.10)5
EACY 0.10 2895.39 $763.80
(1.10)5 1

Decision: Cleaner X is cheaper (750.98/yr vs. 763.80/yr) 11

 Is the Chain of Replacement
Method Realistic?

The assumption that the machines replaced

and the services they provide are identical
in every aspect is unrealistic.

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CASH FLOW ANALYSIS

Generating Cash Flow

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 Where Do the CFs Come From?

Sales and other revenues

Cost of sales and expenses
Depreciation
Working capital
Taxes (income and CGT)

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 Where Do the CFs Come From?
$1Rev $0.70CF
Revenue
Revenues contribute to CF positively by a
factor of (1 - tc)*

That is, every $1 increase (decrease) in revenue

means an increase (decrease) in CF of $(1 - tc)

* NB. tc represents the company tax rate

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 Where Do the CFs Come From?
$1Cost $0.70CF
Cost
Costs contribute to CF negatively by a factor of
(1 - tc)

That is, every $1 increase (decrease) in costs

means an decrease (increase) in CF of $(1 - tc)

All real CFs are multiplied by (1 - tc)

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 Where Do the CFs Come From?
Depreciation
Not a real CF $1Deprec $0.30CF

However, important because it provides a tax shelter

and tax savings

Depreciation affects CF positively by reducing taxable

income reduced taxes, which is like an increase in
CF
Every $1 increase (decrease) in depreciation means an
increase (decrease) in CF of $tc

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 In your own time: Computing Depreciation

Although there is no deduction for capital expenditures or losses there is an allowance given for the
depreciation of capital equipment which is used in the production of assessable income. Depreciation
is not actually an expenditure or loss. It is an allowance given in recognition of the fact that equipment
wears out and eventually must be replaced. Depreciation effectively allows the cost of capital
equipment to be written off (i.e. deducted) progressively over the life of the asset.

Note
The useful life of the asset is estimated for depreciation purposes. The useful life bears no necessary
relation to the actual life of the asset. Once the full cost has been written off, no further allowance can
be made.

Depreciation in Australia

The two most common methods of depreciation used in Australia are the prime cost (or straight line)
and reducing balance (diminishing value) methods.

The straight line method is an annual allowance calculated at a fixed percentage of the historical cost
of the asset. The straight line method was historically applied to buildings and other permanent
structures.

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 In your own time: Computing Depreciation

The diminishing value basis is an accelerated allowance. With the exception of the final
year of the useful life, depreciation is a percentage of the written down value of the asset.
(The written down value or book value is the original cost less depreciation deducted in
previous years.) In the final year of its useful life the balance of the un-deducted cost, less
any residual or salvage value, may be deducted.

This basis is used for nearly all assets. A constant rate (r) is applied to assets beginning of
year book value (BVt-1) to identify allowance deduction each year (in this case, Dt isi a
variable amount which declines over time)

Dt = r BVt-1

The ATO provides a schedule which indicates the rate of depreciation appropriate to a
given asset for straight line depreciation and diminishing value.

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In your own time: Computing Depreciation

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 Where Do the CFs Come From?
Working Capital
WC is cash employed to run day-to-day operations of a
firm (e.g., investment in inventory)
Not consumed but rather employed for a period of time
Increase in WC during a period means more cash is
employed, i.e., cash outflow
Decrease in WC during a period means less cash is
employed, i.e., cash inflow

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 Where Do the CFs Come From?
Working Capital
Why consider changes in NWC separately?
Sales must be recorded on income statement when
made, not when cash is received
Have to record COGS when corresponding sales are
made, regardless of whether our suppliers have been
paid yet
Finally, have to buy inventory to support sales
although havent collected cash yet

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 Where Do the CFs Come From?
Working Capital
Suppose WC required for a project, increases from period
t - 1 to period t
Then change (increase) in WC is a negative CF to project

Suppose WC required for a project, decreases from period

t - 1 to period t
Then change (decrease) in WC is a positive CF to project

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 Where Do the CFs Come From?
Taxation
Three major impacts:

1. Income tax represents a cash outflow

2. Tax shield - depreciation provides a tax deduction which results
a tax saving
3. Capital gains tax (CGT)
Lowers the net profit made from the sale of an asset
May result in a tax saving when a loss is made from the sale of an asset

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 CASH FLOW ANALYSIS

Major Components What to discount?

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 Major Components What to
discount?

When faced with this problem, stick to four general rules

1. Only cash flow is relevant (leave accounting income to the

accountants)
2. Always estimate the cash flows on an incremental basis
3. Watch out for
4. Be consistent in your treatment of inflation 26
Major Components What to discount?
Rule 1 (Relevant cash Flows)

The only relevant CFs are the ones we get to keep!

Relevant CFs to be included in a capital budgeting

analysis are those that will only occur if project is
accepted

These are called incremental CFs

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Major Components What to discount?
Rule 2 (Estimate Cash Flows on an Incremental Basis)

To identify an incremental cash flow ask the following

question

Will this CF occur ONLY if project accepted?

Yes, then include in analysis because it is incremental

No, then exclude because it will occur anyway
Part of it, then include part that occurs because of project
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Major Components What to discount?
Rule 3 (Watch out for)

Ignore Sunk Costs

Costs already incurred are irrelevant to future decision

making.

Decisions on whether to continue a project should be

based only on expected future costs and benefits

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Major Components What to discount?
Rule 3 (Watch out for)

Beware of Allocated overheads

Dont allocate existing overheads (fixed costs)

Only assign any change in fixed costs to a proposed
project
Examples: - increase/decrease salaries
- increase/decrease rent
- increase/decrease power etc
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Major Components What to discount?
Rule 3 (Watch out for)

Include Opportunity Costs

If project uses a resource which could be put to some

other use (i.e., has an opportunity cost), then $ value of
alternative use must be included as cash outflow
If accepting a project means foregoing some revenue,
then this should be charged to the current project
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Major Components What to discount?
Rule 3 (Watch out for)

Exclude Financing Costs

The required rate of return used to discount cash

flows incorporates the cost of equity and debt.

Including financing charges in the cash flows

would be double counting.
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Major Components What to discount?
Rule 3 (Watch out for)
Do not forget Net Working Capital
Most projects involve some degree of investment in
NWC
Recognise this increase in cash flow forecasts

When a project comes to an end you usually recover

some of the investment in NWC.
For the purpose of AFX9540 we assume 100% recovery
unless told otherwise. 33
Major Components What to discount?
Rule 4 (Treat inflation consistently)
Inflation is an important fact of economic life, and it
must be considered in capital budgeting.

Interest rates can be expressed in either nominal or real

terms.

Nominal cash flows must be discounted at the nominal

rate.

Real cash flows must be discounted at the real rate. 34

 Rule 4 (Treat inflation consistently)

Example 2: Nominal with Nominal

Shields Electric forecasts the following nominal cash flows on a

particular project:
Year 0 1 2
CF -$1,000 $600 $650

The nominal interest rate is 14%, and the inflation rate is

forecast to be 5%. What is the value of the project?

NPV = -$1,000 + $600/1.14 + 650/(1.14)2

= $26.47 35
 Rule 4 (Aside)

Example 2: Real with Real

Year Real Cash Flows Working

0 ($1000)
1 $571.43 600/1.05
2 $589.57 650/(1.05)2

R = 1.14/1.05 1
= 0.085714 or 8.5714%
NPV = -$1,000 + $571.43/1.085714 +589/(1.085714)2
= $26.47 36
Rule 4 (Treat inflation consistently)
Example 3: Real with Real
Assume that an investment of $10,000 is expected to generate
real cash flows of $5,000 at the end of each year for next three
years; the inflation rate is 10% per annum; and that the
nominal required rate of return is 15% per annum. What is the
projects NPV?

Real rate = (1.15)/1.10 - 1 =0.0455 = 4.54545%

$5,000 1
NPV $10,000 1
0.0454545
1 0.0454545 3
$3,733.05
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 Rule 4 (Aside)
Example 3: Nominal with Nominal
YEAR Nominal Cash Flow Working
0 (10,000)
1 5,500 5000(1.10)1
2 6,050 5000(1.10)2
3 6,655 5000(1.10)3

5500 6050 6655

NPV $10,000
1.15 1.15 2 1.153
$3,733.05
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 Formalising Effect of Inflation
- Fisher Relation

Let n = nominal interest rate (nominal rate of return),

r = real interest rate (real rate of return),
i = inflation rate

(1 + n) = (1 + r) (1 + i)

1 n
Rearranging, r 1
1 i
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 CASH FLOW ANALYSIS

THE
REPLACEMENT DECISION

a standard cash flow consists of 3 parts:

Part 1) The initial investment
Part 2) The operating cash flows
Part 3) The terminal cash flow

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 (1) Calculating
Incremental Initial Cash Flows

Include (when appropriate)

Purchase Price
Additional Capital Expenditure
Net Working Capital Contributions
Disposal of Asset
=> taxation implications (i.e., MV v. BV)

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 (2) Calculating
Incremental Operating Cash Flows

Two methods available

Add back depreciation method (method 1)

Depreciation tax shield method (method 2)

42
 Example 4
Suppose Splash Ltd plans to replace
equipment which will result in additional
revenues of $9,000 but will also increase costs
by $4,000 per annum.
Splash is able to claim additional depreciation
of $3,000.
What will its after-tax cash flow be if the
company tax rate, Tc is 30%?
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 Example 4 (Method 1)
YEAR
REVENUE $9,000
LESS EXPENSES (or Cash Costs) $4,000
LESS DEPRECIATION $3,000
EBT (Earnings before tax) $2,000
LESS TAX (@ 30%) $600
EAT (Earnings after tax) $1,400
ADD BACK DEPRECIATION $3000
CASH FLOW $4,400
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 Example 4 (Method 2)
YEAR
REVENUE $9,000
LESS EXPENSES (or Cash Costs) $4,000
EBTD (Earnings before tax and depreciation) $5,000
LESS TAX (@ 30%) $1,500
EATBD (Earnings after tax before depreciation) $3,500
ADD DEPRECIATION TAX SHIELD $900
Depreciation tax shield =
Depreciation expense corporate tax rate = $3,000 0.30

CASH FLOW $4,400

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 (3) Calculate Incremental
Terminal Cash Flows

Include (when appropriate)

Final years operating cash flow

Recovery of Net Working Capital Contributions
Disposal of Asset
=> taxation implications (i.e., SV v. BV)

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 Cash Flow Analysis
Comprehensive Example

The typical Replacement Decision:

When should an old machine be discarded in favour
of a new one?

The replacement decision will be examined this you

can be assured!

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Example 5: Comprehensive Example
(from past exam)

Nutson Bolz is an assembly business run by a sole proprietor whose

marginal tax rate is 47%. The owner is considering the purchase of a new
fully automated machine to replace an older, manually operated one. The
machine being replaced, now five years old, originally had an expected
life of ten years, and it was being depreciated using the straight-line
method from a cost of $20,000 down to zero, and could be sold for
$15,000 . The old machine was operated by one operator who earned
$15,000 per year in salary and $2,000 per year in fringe benefits. The
annual costs of maintenance and defects associated with the old machine
were $7,000 and $3,000 respectively. The replacement machine being
considered has a purchase price of $50,000, a salvage value after five
years of $10,000, and would be fully depreciated over five years using the
straight-line depreciation method. To get the automated machine in
running order, there would be a $3,000 shipping fee and a $2,000
installation charge. 48
 Example 5 continued
In addition, because the new machine would work faster than the old one,
investment in raw materials and goods-in-progress inventories would need to
be increased by a total of $5,000. The annual costs of maintenance and
defects of the new machine would be $2,000 and $4,000, respectively. The
new machine also requires maintenance workers to be specially trained;
fortunately, a similar machine was purchased three months ago, and at that
time, the maintenance workers went through the $5,000 training program
needed to familiarize themselves with the new equipment. The firms
management is uncertain whether to charge half of this $5,000 training fee to
the new project. Finally, to purchase the new machine, it appears the firm
would have to borrow an additional $20,000 at 10% interest from its local
bank, resulting in additional interest payments of $2,000 per year. The
required rate of return on projects of this kind is 20%.

49
 Example 5

Required:
(a) What is the projects initial investment?
(b) What are the incremental cash flows over the
projects life?
(c) What is the terminal cash flow?
(d) What is the NPV? The IRR?
(e) Should the project be accepted? Yes/No? Why?
Why not?
50
 Example 5 Solution

(a)
Initial Investment (Time = 0)

New unit ($55,000)

Old unit $15,000 BV(t=0) = $10,000
Less Tax ($2,350)
NWC ($5,000)
($47,350)

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 Example 5 - Solution
(b)
Operational Cash Flows T = 1to 4 T=5
Incremental Revenue (New-Old) $0 $0
Salary Saving $17,000 $17,000
Incremental Saving $4,000 $4,000
Less Depreciation (new) ($11,000) ($11,000)
Plus Depreciation (old) $2,000 $2,000
EBIT $12,000 $12,000
Tax ($5,640) ($5,640)
EAT $6,360 $6,360
Add back Depreciation $9,000 $9,000

Operating Cash Flow $15,360 $15,360

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 Example 5 - Solution

(c)
Terminal Cash Flows T=5

Salvage Value $10,000

Tax paid on Capital Gain -$4,700
Recovery of NWC $5,000
Final year operating Cash Flow $15,360

Net Terminal Cash Flow $25,660

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 Example 5 Solution

(d) NPV $2,725.14

1 1 $25,660
NPV $47,350 $15,360 4
5
0 . 2 0 . 2 (1 . 2 ) 1 . 2
IRR 22.41%

(e)The project should be accepted as it generates wealth

for shareholders
(i) NPV > 0
(ii) IRR > Cost of Capital
54
 Capital Rationing

Capital rationing is a limit set on funds available

for investment.
Soft rationing limits imposed by top management
Hard rationing - Firm is unable raise the money it
requires to undertake all profitable projects.
Under 'hard' rationing the firm may be forced to
pass up positive NPV projects, whereas 'soft'
rationing should never cost the firm anything as top
management can relax capital control at any time.

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 Recommended Text Book Problems to be
attempted

Chapter Eleven (Parrino et al)

Self Study Problems 11.1 11.4 (Solutions in text book)
Problems 11.1, 11.4, 11.5, 11.10, 11.14, 11.15, 11.16, 11.17, 11.21,
.

Solutions to all questions are available on Blackboard in the folder

named Solutions to End of Chapter Text Book Problems

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