AFIN1002 Capital Budgeting: Incremental Cash Flows

Overview of Capital Budgeting and Investment Decision Rules

  • Capital budgeting is the process firms use to evaluate and select projects to invest in, aiming to optimize scarce resources and increase firm value.

  • The primary investment decision rule is Net Present Value (NPV), which measures the dollar change in firm value: NPV=PV(Benefits)−PV(Costs)NPV = PV(\text{Benefits}) - PV(\text{Costs}).

  • The NPV decision rule states: Accept a project if NPV>0NPV > 0 (increases firm value) and reject if NPV<0NPV < 0 (decreases firm value).

  • Internal Rate of Return (IRR) is the discount rate that results in an NPV=0NPV = 0. A project is accepted if IRR>opportunity cost of capitalIRR > \text{opportunity cost of capital}.

  • Limitations of IRR include its inability to distinguish between borrowing and investing, the potential for multiple or non-existent IRRs, and difficulties in comparing projects of different scales.

Incremental Free Cash Flows (FCF) Framework

  • Decision-making should only include incremental cash flows, defined as the direct changes to a firm's cash flow resulting from the project choice.

  • FCFproject=FCFFwith project−FCFFwithout projectFCF_{\text{project}} = FCFF_{\text{with project}} - FCFF_{\text{without project}}

  • Free cash flow represents the cash available to all funding providers (debt and equity holders) after reinvestment in real assets and working capital.

Rules for Estimating Project Cash Flows

  • Rule 1: Discount Cash Flows, Not Profits: Accounting profits involve arbitrary recognition rules. Free cash flows adjust earnings by adding back non-cash expenses like Depreciation and subtracting Capital Expenditure and changes in Net Operating Working Capital (NOWC).

  • Rule 2: Include Only Incremental Flows:

    • Ignore Sunk Costs (unrecoverable past costs).

    • Include Opportunity Costs (value of the next-best alternative use of resources).

    • Include Side Effects (impact on existing business lines, such as cannibalization).

    • Include Salvage Value (after-tax cash from asset disposal at the end of the project).

    • Exclude Allocated Overhead (unless the investment causes a direct change in overhead expenses).

  • Rule 3: Consistent Inflation Treatment: Discount nominal cash flows with nominal interest rates and real cash flows with real interest rates.

    • Real Discount Rate=1+Nominal Discount Rate1+Inflation Rate−1\text{Real Discount Rate} = \frac{1 + \text{Nominal Discount Rate}}{1 + \text{Inflation Rate}} - 1

  • Rule 4: Separate Investment and Financing: Cash flows related to financing (interest, loan repayments) are ignored in FCF because the cost of capital is captured in the discount rate.

  • Rule 5: Forecast After-Tax Flows: Taxes are cash outflows. Tax shields, created by non-cash expenses like depreciation, reduce tax liability and must be included in cash flow estimates.

Key Working Capital and Tax Formulas

  • Net Operating Working Capital calculation:

    • NOWC=Current Assets (excluding Cash)−Current Liabilities (excluding short-term financing)NOWC = \text{Current Assets (excluding Cash)} - \text{Current Liabilities (excluding short-term financing)}

    • NOWC=Inventory+Receivables−Payables−Accruals & ProvisionsNOWC = \text{Inventory} + \text{Receivables} - \text{Payables} - \text{Accruals \& Provisions}

  • Incremental Free Cash Flow calculation:

    • FCF=(EBIT×(1−tC))+Depreciation−CapEx−Change in NOWCFCF = (EBIT \times (1 - t_C)) + \text{Depreciation} - \text{CapEx} - \text{Change in NOWC}

    • The corporate tax rate (tCt_C) in Australia is noted as 30%30\%.

  • After-tax Salvage Value calculation:

    • Book Value=Purchase Price−Accumulated Depreciation\text{Book Value} = \text{Purchase Price} - \text{Accumulated Depreciation}

    • Capital Gain=Sale Price−Book Value\text{Capital Gain} = \text{Sale Price} - \text{Book Value}

    • After-tax Salvage Value=Sale Price−(tC×Capital Gain)\text{After-tax Salvage Value} = \text{Sale Price} - (t_C \times \text{Capital Gain})

Comprehensive Project Example Analysis

  • In a 10-year project evaluation, essential factors include the initial investment (10 million10\,\text{million}), salvage value (1.7 million1.7\,\text{million} before tax), and opportunity costs (0.5 million0.5\,\text{million} per year for rental income).

  • Sunk costs like test marketing (0.2 million0.2\,\text{million}) and non-incremental overhead codes (0.1 million0.1\,\text{million}) must be excluded from the analysis.

  • Free cash flows are discounted using the after-tax opportunity cost of capital (10%10\% for this instance).

  • Calculated results for the example project yielded an NPV of −0.877 million-0.877\,\text{million}, leading to a recommendation to reject the project.