Chapter 11
May 04
1
2
Chapter Outline
™ Cash Flows in General
™ Estimating Cash Flows
™ Compute Project’s NPV
Cash Flow Estimation
Cash Flows in General
3
Measuring Incremental Cash Flows
™Cash flows should be measured on an incremental
basis
™Incremental cash flows are cash flows that will occur
if a capital budgeting project is accepted, but that will
not occur if the investment is rejected.
™The cash flows of the firm with the project minus the
cash flows of the firm without the project.
™Cash flows should be measured after-tax
™All the indirect effects of a project should be included
in the cash flow calculations
™Sunk costs should NOT be considered
™The value of resources used in the project should be
measured in terms of their opportunity costs.
™Ignore interest payments. Separate the investment
and the financing decision.
Asking the Right Question
4
You should always ask yourself “Will this cash
flow 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 because of the
project
Chapter 11
May 04
5
Depreciation
™Total amount to be depreciated over the accounting life
of the asset.
™Equal to cost of the asset plus any setup and delivery
costs incurred.
Depreciation is a non-cash expense
™Only relevant because affects taxes
™We will use MACRS
™All US companies use MACRS for tax purposes
MACRS (Modified Accelerated Cost Recovery System)
™ Specified percent charged each year.
7
MACRS Depreciation
1
2
3
4
5
6
7
8
9
Depreciation
MACRS Example
™Modified Accelerated Cost Recovery System
™Assets assigned to a class based on estimated
economic life
™Depreciation expense is the depreciable basis (cost) of
the asset times the MACRS% for the current year of
service
Year
6
Depreciable basis
Definition: “the means by which an asset’s value is expensed
over its useful life for federal tax purposes.”
Depreciation
Calculation of Depreciation
3 yr
33.33%
44.44%
14.82%
7.41%
Class
5yr
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
7yr
14.29%
24.49%
17.49%
12.49%
8.93%
8.93%
8.93%
4.45%
Crawley Enterprises recently purchased a new
delivery truck for $100,000. The truck is
assigned to the 5 year MACRS class
Class
5yr
Year
1
2
3
4
5
6
7
8
33.33%
44.44%
14.82%
7.41%
Depreciable Basis
$100,000 = $20,000
20.00% x14.29%
$100,000 = $32,000
32.00% x24.49%
x
$100,000 = $19,200
19.20% 17.49%
$100,000 = $11,520
11.52% x12.49%
11.52% x $100,000
8.93% = $11,520
5.76% x $100,000
8.93% = $ 5,760
8.93%
$100,000 Truck has been fully
4.45%
depreciated over 6 years
Chapter 11
May 04
10
Depreciation
Why the additional year? An asset in the 3 year class is
MACRS Example
depreciated over 4 years
Crawley Enterprises recently purchased a new
delivery truck for $100,000. The truck is
assigned to the 5 year MACRS class
Year
1
2
3
4
Book Value = Basis – Accumulated Depreciation
1
2
3
4
5
6
7
8
33.33%
44.44%
14.82%
7.41%
$100,000 =
20.00% x14.29%
$100,000 =
32.00% x24.49%
$100,000 =
19.20% x17.49%
x
$100,000 =
11.52% 12.49%
11.52% x $100,000
8.93% =
5.76% x $100,000
8.93% =
8.93%
4.45%
Estimating Cash Flows
Three Types of Cash Flows
™Capital Spending
™Operating Cash Flows
™Net Working Capital
Class
3 yr
33.3%
44.5%
14.8%
7.4%
Book Value
Class
5yr
Year
11
Depreciation
$20,000
$32,000
$19,200
$11,520
$11,520
$ 5,760
Table is prepared using the ½ YEAR CONVENTION
80,000
48,000
28,800
17,280
5,760
0
01/01/01
01/01/02
01/01/03
01/01/04
01/01/05
1st year depreciation 2nd year depreciation 3rd year depreciation
On average asset is placed into service 6 months into year.
The annual depreciation expense affects 4 tax years.
12
13
Estimating Cash Flows
Capital Spending
™Capital spent and recovered for the purchase/sale of
fixed assets
0
1
Time
2
3
Source
0
Cash Flow for the purchase
of Machine
N
Cash Flow from the sale of
“used” Machine, net of Taxes
Ν
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May 04
14
Estimating Cash Flows
Net Working Capital
™Working Capital Investments required to support the
project
0
1
2
Time
Source
0
Initial NWC
1 → N-1
N
3
Estimating Cash Flows
Operating Cash Flow
™Annual Cash flows realized from the operation of the
project
Where t = 1 → N:
Ν
Incremental Revenuet
– Incremental Variable Costst
– Incremental Fixed Costst
– Depreciationt
EBITt
– Tax Rate x EBITt
+ Depreciationt
Operating Cash Flowt
Changes in NWC
Recover Sum of NWC for yrs 0→N
Estimating Cash Flows
Total Project Cash Flow
™Sum of the Cash Flows by Year
Where t = 0 → N:
Operating Cash Flowt
+ NWCt Cash Flow
+ Capital Spendingt Cash Flow
Total Project Cash Flowt
15
16
Estimating Cash Flows
17
Example:
Click & Clack are considering a new project producing self-help
car repair manuals. They are expecting to sell 10,000 units the
first year for $20 each, then increasing production to 12,500 units
in years 2 and 3. Variable costs are $4 a unit and fixed costs are
$15,000. To produce these manuals Tom & Ray will buy a new
printing press costing $300,000 today. This machine will be
depreciated according to the MACRS 3 year schedule. The
machine will be sold for $30,000 upon termination in 3 years.
Net Working Capital requirements on the new
machine are 10% of sales, so $20,000 in time
0 for sales in year 1 and increases of $5,000
in year 1 for sales in years 2 and 3. All
working capital will be recovered in year 3.
Tom & Ray have a marginal tax rate of 40%.
Chapter 11
May 04
19
Estimating Cash Flows
Capital Spending
Net Working Capital
“This machine will be depreciated according to the MACRS 3
year schedule. The machine will be sold for $30,000 in 3 years”
0
1
2
3
– 300,000
+26,892
0
3
“Net Working Capital requirements on the new machine are 10%
of sales, so $20,000 in time 0 for sales in year 1 and increases of
$5,000 in year 1 for sales in years 2 and 3. All working capital will
be recovered in year 3”
0
Cash Flow
Time
1
–20,000
Selling Price $30,000
Book Value
22,230
Gain on Sale
7,770
Tax on Gain
3,108
Net Cash Flow 26,892
22
Estimating Cash Flows
Operating Cash Flow
1
200,000
– 40,000
– 15,000
– 99,990
45,010
– 18,004
+ 99,990
126,996
3
+25,000
Cash Flow
0
NWC ↑ $20,000
1
NWC ↑ $5,000
3
Recover NWC of $25,000
23
Estimating Cash Flows
Operating Cash Flow
“They are expecting to sell 10,000 units the first year for $20 each, then
increasing production to 12,500 units in years 2 and 3. Variable costs are
$4 a unit and fixed costs are $15,000. To produce these manuals Tom &
Ray will buy a new printing press costing $300,000 today. This machine
will be depreciated according to the MACRS 3 year schedule. The
machine will be sold for $30,000 upon termination in 3 years”
0
2
–5,000
Time
$300,000
∆ Revenuet
– ∆ Variable Costst
– ∆ Fixed Costst
– Depreciationt
EBITt
– Tax Rate x EBITt
+ Depreciationt
Operating Cash Flowt
21
Estimating Cash Flows
2
3
“They are expecting to sell 10,000 units the first year for $20 each, then
increasing production to 12,500 units in years 2 and 3. Variable costs are
$4 a unit and fixed costs are $15,000. To produce these manuals Tom &
Ray will buy a new printing press costing $300,000 today. This machine
will be depreciated according to the MACRS 3 year schedule. The
machine will be sold for $30,000 upon termination in 3 years”
0
∆ Revenuet
– ∆ Variable Costst
– ∆ Fixed Costst
– Depreciationt
EBITt
– Tax Rate x EBITt
+ Depreciationt
Operating Cash Flowt
1
–
–
–
–
+
2
250,000
50,000
15,000
133,320
51,680
20,672
133,320
164,328
3
Chapter 11
May 04
24
Estimating Cash Flows
Operating Cash Flow
Total Project Cash Flow
“They are expecting to sell 10,000 units the first year for $20 each, then
increasing production to 12,500 units in years 2 and 3. Variable costs are
$4 a unit and fixed costs are $15,000. To produce these manuals Tom &
Ray will buy a new printing press costing $300,000 today. This machine
will be depreciated according to the MACRS 3 year schedule. The
machine will be sold for $30,000 upon termination in 3 years”
0
1
∆ Revenuet
– ∆ Variable Costst
– ∆ Fixed Costst
– Depreciationt
EBITt
– Tax Rate x EBITt
+ Depreciationt
Operating Cash Flowt
2
3
250,000
50,000
15,000
44,460
140,540
56,216
44,460
128,784
–
–
–
–
+
26
Evaluate Project
Total Project Cash Flow
0
–320,000
1
121,996
The required rate of the above
project is 15%, Compute its NPV
25
Estimating Cash Flows
0
1
2
3
164,328
128,784
Operating Cash Flowt
126,996
Change in NWCt
–20,000
–5,000
+25,000
Capital Spendingt
– 300,000
+26,892
Total Project Cash Flowt
–320,000
121,996
164,328
180,676
27
Evaluate Project
Cash Flows from Project
2
3
0
164,328
180,676
–320,000
29,116.73
N
xP/YR
INPUT
I/YR
NOM
%
PV
PMT
FV
IRR/Y
R
NPV
BEG/END
EFF%
CFj
Nj
P/YR
1
121,996
The required rate of the above
project is 15%, Compute its NPV
2
3
164,328
180,676
IRR = 20.06%
N
xP/YR
Compute IRR
INPUT
I/YR
NOM
%
PV
PMT
FV
IRR/Y
R
NPV
BEG/END
EFF%
CFj
Nj
P/YR