FINE Module 7

(Project-level) Operating Cash Flows before Accounting for ∆NWC

Ignores interest expenses, as when doing project-level capital budgeting, we study financing and investment activities separately.

Cash Flow Approach (right approach)

Discoun the actual cash flows to their present value

Accounting Approach (wrong approach)

Can lead to erroneous descions

Consider accou

Capital budgeting focuses on…

The investment decision, not financing

Assume 100% equity financing

We will not subtract any interest when calculating operating cash flows

We will not account for a possible interest tax shield

We will consider effects of interest when we separately consider financing decisions

Depreciation

Straight-line depreciation

Annual depreciation = (investment - salvage value) - expected value

Bonus depreciation

Tax incentive that allows businesses to immediately deduct the cost of qualifying assets, such as equipment, instead of over time

This is a bonus for the firm because tax savings is front-loaded

How to account for depreciation when calculating project-level Operating Cash Flows before Accounting for ∆NWC

Revenue from the project - cash expenses for the project - depreciation for project-specific capital investment

Project specific EBIT - Taxes = Project net income

Alternate methods

Cash in / cash out: revenue - cash expenses - taxes

Adjusted accounting profits: net income + depreciation

Add back depreciation tax shield: (revenue - cash expenses) x (1-tax rate) + (depreciation x tax rate)

What does “Incremental” mean in the context of capital budgeting?

Ask yourself this question:

“Would the cash flow still exist if the project did not exist?”

If yes, DON’T include it in the analysis

If no, include it

Incremental cash flow = cash flow with project - cash flow without project

Total Cash Flow from a Project

Cash Flow from Capital Investments (mostly at t = 0) + Operating Cash Flows before Accounting for ∆NWC + Cash Flow from Changes in Working Capital

Cash Flow from Capital Investments:

f the project requires spending money on investment to get started (e.g., purchasing a building), then that represents a negative cash flow

Usually capitalized and depreciated over time from an accounting perspective.

Operating Cash Flow before Accounting for ∆NWC:

We hope to get (mostly) positive cash flows from the project during the time the project is operated

Need to be careful to properly account for depreciation (and the associated tax shield)

Cash Flow from Changes in Working Capital

Almost every project requires some working capital: e.g., before you start production, you need buy an

inventory of raw materials, A/R increases as you start selling, etc.

This build-up of working capital represents a negative cash flow

Over the project’s life, NWC can continue to go up (or start to go down), resulting in additional negative (or positive) cash flow effects in future years beyond t=0

Working capital often recovered at the end of the project (e.g., inventories consumed, customers pay bills)

Capital investment:

Investment of $100,000 at t=0 (negative cash flow), and a positive cash flow of $20,000 at t=5 from the sale of the machine.

Working capital

Increase in WC at t=0 of $10,000 (negative cash flow), and a positive cash flow of $10,000 at t=5 from the reduction in WC. While these are exactly opposite cash flows, we cannot ignore them because of the time value of money.

Operating cash flows before accounting for ∆NWC e.g.:

n years 1-5, the company’s

expenses will decrease by $20,000, adding to gross profits. Depreciation will go up by $16,000 per year, resulting in a net $4,000 higher EBIT. After subtracting taxes and adding back depreciation, operating cash flows in each year will increase by $19,160.

Putting it all together, NPV=-$13,082 → Lily Copies should not buy the new machine

Identifying Incremental Cash Rule Flows:

Include all indirect effects

Ignore sunk costs

Recognize opportunity costs

Recognize investments in working capital

Remember terminal cash flows

Beware of allocated overhead costs

Sunk Costs

Expenses that have already been paid and/or which cannot be changed by investment decision

These do not affect incremental cash flows, they therefore do not affect the NPV of a

decision so ignore them

Working capital

Continues to change during the course of a project, and is often recovered at the end of the project.

Forgetting about working capital entirely.

Forgetting that working capital may change during the life of the project

Forgetting that working capital is often recovered at the end of the project

Terminal cash flows

Cash flows when shutting down the project (can be negative)

Sell machines, equipment, etc related to the project → These would result in a positive cash flow!

Need to keep track of tax consequences:

If capital is sold for more than the depreciated book value, there will be a tax bill, and vice versa

Example:

Suppose in the Lily Copies example, the machine could be sold for $50,000 at t=5. It has already been depreciated to $20,000. So when selling, the company would need to pay taxes on the gains of 50,000 − 20,000 × 21% =$6,300. So the net (after-tax) proceeds from the sale would be 50,000-6,300=43,700 → Now the NPV would be positive (+$3,048).

Overhead

Ongoing administrative expenses of a business which cannot be attributed to any specific business activity, but are still necessary for the business to function.

A firm is considering an investment in a new manufacturing plant. The site already is owned by the company, but existing buildings would need to be demolished. Which of the following should be treated as incremental cash flows?

1. The market value of the site.

2. The market value of the existing buildings.

3. Demolition costs and site clearance.

4. The cost of a new access road put in last year.

5. Lost cash flows on other projects due to executive time spent on the new facility.

6. Future depreciation of the new plant.

7. The reduction in the firm's tax bill resulting from depreciation of the new plant.

8. The initial investment in inventories of raw materials.

9. Money already spent on engineering design of the new plant.

a, b. The site and buildings could have been sold or put to another use. Their values are opportunity costs, which should be treated as incremental cash outflows.

1. Demolition costs are incremental cash outflows.

2. The cost of the access road is sunk and not incremental.

3. Lost cash flows from other projects are incremental cash outflows (though not easily estimated).

4. Depreciation is not a cash expense and should not be included, except as it affects taxes. (Taxes are discussed later in this chapter.)

5. The reduction in tax due to depreciation is an addition to cash flow.

6. The initial investment in inventories is a cash outflow.

7. The expenditure on design is a sunk cost and not an incremental cash flow.