Key Concepts and Skills - Understand how to determine the relevant cash flows for various types of proposed investments
- Be able to compute the CCA tax shield
- Understand the various methods for computing operating cash flow
- Understand how to analyze different capital budgeting decisions
Chapter Outline - Project Cash Flows: A First Look
- Incremental Cash Flows
- Pro Forma Financial Statements and Project Cash Flows
- More on Project Cash Flow
- Alternative Definitions of Operating Cash Flow
- Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project
- Some Special Cases of Cash Flow Analysis
Relevant Cash Flows 10.1 - The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted
- These cash flows are called incremental cash flows
- The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
Asking the Right Question - You should always ask yourself “Will this cash flow occur (or not occur) ONLY if we accept the project?”
- If the answer is “yes”, it should be included in the analysis because it is incremental
- If the answer is “no”, it should not be included in the analysis because it will occur anyway
- If the answer is “part of it”, then we should include the part that occurs (or does not occur) because of the project
Common Types of Cash Flows 10.2 - Sunk costs – costs that have been incurred in the past
- Opportunity costs – costs of lost options
- Side effects
- Positive side effects – benefits to other projects (existing operations)
- Negative side effects – costs to other projects
- Changes in net working capital (keep this in mind)
- Financing costs (interest, dividends excluded)
- Inflation (adjust cash flows for it)
- Capital Cost Allowance (CCA) - consider cash flows on an after-tax basis
Pro Forma Statements and Cash Flow 10.3 - Capital budgeting relies heavily on pro forma accounting statements, particularly income statements
- Computing cash flows – refresher
- Operating Cash Flow (OCF) = EBIT + depreciation – taxes
- Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC
Example: Pro Forma Income Statement - Sales (50,000 units at $4.00/unit)
| | - Variable Costs ($2.50/unit)
| | | | | | | | - Depreciation ($90,000 / 3)
| | | | | | | | | | | Example: Projected Capital Requirements Example: Projected Total Cash Flows Making The Decision - Now that we have the cash flows, we can apply the techniques that we learned in chapter 9
- Assume the required return is 20%
- Enter the cash flows into Excel and compute NPV and IRR
- Should we accept or reject the project?
More on NWC 10.4 - Why do we have to consider changes in NWC separately?
- GAAP requires that sales be recorded on the income statement when made, not when cash is received
- GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet
- Finally, we have to buy inventory to support sales although we haven’t collected cash yet
Capital Cost Allowance (CCA) - CCA is depreciation for tax purposes
- The depreciation expense used for capital budgeting should be calculated according to the CCA schedule dictated by the tax code
- Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes
- Depreciation tax shield = DT
- D = depreciation expense
- T = marginal tax rate
Computing Depreciation - Need to know which asset class is appropriate for tax purposes
- Straight-line depreciation
- Declining Balance
- Multiply percentage given in CCA table by the undepreciated capital cost (UCC)
- Half-year rule
- Can use PV of CCA Tax Shield Formula:
PV of CCA Tax Shield Formula - Where:
- C = Cost of asset
- d = CCA tax rate
- Tc = Corporate Tax Rate
- k = discount rate
- S = Salvage value
- n = number of periods in the project
Example: Depreciation and 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 company’s marginal tax rate is 40%. If the applicable CCA rate is 20% and the required return on this project is 10%, what is the present value of the CCA tax shield?
Example: Depreciation and Salvage continued Other Methods for Computing OCF 10.5 - Bottom-Up Approach
- Works only when there is no interest expense
- OCF = NI + depreciation
- Top-Down Approach
- OCF = Sales – Costs – Taxes
- Don’t subtract non-cash deductions
- Tax Shield Approach
- OCF = (Sales – Costs)(1 – T) + Depreciation*T
Salvage Value versus UCC 10.6 - Using the methods described in the previous slide will give incorrect answers when the salvage value differs from its UCC
- If the asset is depreciated using a declining balance method, then the CCA tax shield formula is the most accurate approach, since it takes into account the future CCA impact
Example: Cost Cutting 10.7 - Your company is considering a new production system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated at a CCA rate of 20%. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%.
- Click on the Excel icon to work through the example
Example: Replacement Problem - Original Machine
- Initial cost = 100,000
- CCA rate = 20%
- Purchased 5 years ago
- Salvage today = 65,000
- Salvage in 5 years = 10,000
- New Machine
- Initial cost = 150,000
- 5-year life
- Salvage in 5 years = 0
- Cost savings = 50,000 per year
- CCA rate = 20%
- Required return = 10%
- Tax rate = 40%
Example: Replacement Problem continued - Remember that we are interested in incremental cash flows
- If we buy the new machine, then we will sell the old machine
- What are the cash flow consequences of selling the old machine today instead of in 5 years?
Example: Replacement Problem continued - If we sell the old equipment today, then we will receive $65,000 today. However, we will also NOT receive $10,000 in 5 years
- The appropriate number to use in the NPV analysis is the net salvage value
- Always consider after-tax cash flows
- You can use your calculator for the cash flows and salvage, but there are no short cuts for finding the PV of the CCA tax shield
Example: Replacement Problem continued - Net present value of the project is:
- Therefore, the old equipment should be replaced.
Example: Equivalent Annual Cost Analysis - Machine A
- Initial Cost = $150,000
- Pre-tax operating cost = $65,000
- Expected life is 8 years
- Machine B
- Initial Cost = $100,000
- Pre-tax operating cost = $57,500
- Expected life is 6 years
- The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required.
- The required return is 10%, the applicable CCA rate is 20% and the tax rate is 40%.
- Which machine should you buy?
Example: Setting the Bid Price - Consider the example in the textbook:
- Need to produce 5 modified trucks per year for 4 years
- We can buy the truck platforms for $10,000 each
- Facilities will be leased for $24,000 per year
- Labor and material costs are $4,000 per truck
- Need $60,000 investment in new equipment, depreciated at 20% (CCA class 8)
- Expect to sell equipment for $5000 at the end of 4 years
- Need $40,000 in net working capital
- Tax rate is 43.5%
- Required return is 20%
Quick Quiz - How do we determine if cash flows are relevant to the capital budgeting decision?
- What are the different methods for computing operating cash flow and when are they important?
- What is the basic process for finding the bid price?
- What is equivalent annual cost and when should it be used?
Summary 10.8 - You should know:
- How to determine the relevant incremental cash flows that should be considered in capital budgeting decisions
- How to calculate the CCA tax shield for a given investment
- How to perform a capital budgeting analysis for:
- Replacement problems
- Cost cutting problems
- Bid setting problems
- Projects of different lives
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