Unit 11: Key Concepts
What are terminal cash flows?
At the conclusion of a project, management will restore the company to its original condition without the project. In other words, managers must account for terminal cash flows.
Cash Flow and Depreciation: "When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.
1. Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield TCD. 2. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows
What 3 tasks must be completed for terminal cash flows?
1. Dispose of assets involved in the project. Project capital assets may have a residual value that should be included in FCF. 2. Account for changes in working capital due to the project: -If a project requires a working capital investment, the firm should recover this investment. -If the project frees up working capital during its life, the company must pay the cash back. 3. Account for other inflows/outflows connected to ending the project. For example, if the production process involves toxic chemicals, there may be substantial disposal costs when the project is concluded.
Would a firm prefer to use MACRS depreciation or straight-line depreciation?
1. For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs. 2. Straight-line depreciation is a more conservative technique, as it is not accelerated, with the big cash flows front-loaded on the timeline. It thus does not produce as high a present value of the tax benefit of depreciation.
In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project: 1. Is this a reasonable assumption? 2. When might it not be valid?
1. It's probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables won't be collected, and some inventory will not be sold, of course. 2. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project's life) acts to increase working capital. These effects tend to offset.
Capital Budgeting: In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely they will be maintained as the market becomes more competitive, or will Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne?
1. Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense. 2. This basic short example on Porsche's SUV decision thus brings up some major issues. -A positive NPV project is quite valuable. If a company is doing something neat—like the iPhone—other companies will muscle in on that lucrative market. Companies must thus constantly innovate, and seek to reduce costs, to stay up with the competition!
A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to produce an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play?
A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher's perspective) or new books (not good). The concern arises any time that there is an active market for used product.
Erosion: In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. In evaluating the Cayenne, would you consider the possible damage to Porsche's reputation?
Definitely. The damage to Porsche's reputation is definitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines.
Capital Budgeting: In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. Porsche was one of the last manufacturers to enter the sports-utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?
This brief discussion of Porsche's decision cannot give you all of the facts, but rather introduces issues for you to consider. One company may have an advantage in that they might be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake!
What are operating cash flows?
To get operating cash flows you must evaluate the operating characteristics of projects. There may be incremental investments in capital assets or changes in working capital, but the big cash flows come from producing and selling goods and services. These operating characteristics are the capital budgeting decisions. These decisions are separate from the debt and equity a company uses to raise capital.