Ch10 Finance

Total cashflow calculation

15800 at year 5 is the salvage value after tax of selling the equipment

Example

Because book value is more than market value tax savings occur on the difference between the two values

PROJECTED TOTAL CASH FLOW AND VALUE

Calculate NPV using cashflows after deducting changes in nwc and adding at the and and deducting capital spending Based on these projections, the project creates over $10,000 in value and should be accepted. Also, the return on this investment obviously exceeds 20 percent (because the NPV is positive at 20 percent). After some trial and error, we find that the IRR works out to be about 25.8 percent.

Modified ACRS Depreciation (MACRS)

Calculating depreciation is normally mechanical. Although there are a number of ifs, ands, and buts involved, the basic idea under MACRS is that every asset is assigned to a particular class. An asset's class establishes its life for tax purposes. Once an asset's tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage

Cash Flow and Depreciation [ LO1] "When evaluating projects, we're concerned with only 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.

Depreciation is a noncash 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. 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.

Depreciation [ LO1] Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?

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.

AAR and payback

In addition, if required, we could calculate the payback and the average accounting return, or AAR. Inspection of the cash flows shows that the payback on this project is a little over two years (verify that it's about 2.1 years) From the last chapter, we know that the AAR is average net income divided by average book value. The net income each year is $21,780. The average (in thousands) of the four book values (from for total investment is ($110 + 80 + 50 + 20)/4 = $65. So the AAR is $21,780/$65,000 = .3351, or 33.51 percent . The fact that the AAR is larger illustrates again why the AAR cannot be meaningfully interpreted as the return on a project. For AAR book value calculate book values from years 1-4 = depreciation of that year plus 20,000

Opportunity Cost [ LO1] In the context of capital budgeting, what is an opportunity cost?

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire the asset.

Another way to calculate operating cf

It might be somewhat more enlightening to calculate operating cash flow using a different approach. What is actually going on here is very simple. First, the cost savings increase our pretax income by $22,000. We have to pay taxes on this amount, so our tax bill increases by .21 × $22,000 = $4,620. In other words, the $22,000 pretax saving amounts to $22,000 × (1 − .21) = $17,380 after taxes. Second, the extra $16,000 in depreciation isn't really a cash outflow, but it does reduce our taxes by $16,000 × .21 = $3,360. The sum of these two components is $17,380 + 3,360 = $20,740, as we had before. Notice that the $3,360 is the depreciation tax shield we discussed earlier, and we have effectively used the tax shield approach here.

Net Working Capital [ LO1] In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?

It's probably only a mild oversimplification. 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. 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 one another.

Capital Budgeting [ LO1] 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?

One company may be able to produce at lower incremental cost or may be able to better market the vehicle. Also, of course, one of the two may have made a mistake!

Relevant Cash Flows [ LO1] Winnebagel Corp. currently sells 20,000 motor homes per year at $103,000 each and 14,000 luxury motor coaches per year at $155,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 25,000 of these campers per year at $19,000 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 2,700 units per year and reduce the sales of its motor coaches by 1,300 units per year. What is the amount to use as the annual sales figure when evaluating this project? Why?

Sales due solely to the new product line are: 25,000($19,000) = $475,000,000 Increased sales of the motor home line occur because of the new product line introduction; thus: 2,700($103,000) = $278,100,000 in new sales is relevant. Erosion of luxury motor coach sales is also due to the new campers; thus: 1,300($155,000) = $201,500,000 loss in sales is relevant. The net sales figure to use in evaluating the new line is thus: $475,000,000 + 278,100,000 - 201,500,000 = $551,600,000

EVALUATING COST-CUTTING PROPOSALS calculating operating cashflow

Suppose we are considering automating some part of an existing production process. Thenecessary equipment costs $80,000 to buy and install. The automation will save $22,000 peryear (before taxes) by reducing labor and material costs. For simplicity, assume that the equipment has a five-year life and is depreciated to zero on a straight-line basis over that period. It will actually be worth $20,000 in five years. Should we automate? The tax rate is 21 percent, and the discount rate is 10 percent. As always, the first step in making such a decision is to identify the relevant incremental cash flows. First, determining the relevant capital spending is easy enough. The initial cost is $80,000. The aftertax salvage value is $20,000 × (1 − .21) = $15,800 because the book value will be zero in five years. Second, there are no working capital consequences here, so we don't need to worry about changes in net working capital Operating cash flows are the third component to consider. Buying the new equipment affects our operating cash flows in two ways. First, we save $22,000 before taxes every year. In other words, the firm's operating income increases by $22,000, so this is the relevant incremental project operating income. Second (and it's easy to overlook this), we have an additional depreciation deduction. In this case, the depreciation is $80,000/5 = $16,000 per year. Because the project has an operating income of $22,000 (the annual pretax cost saving) and a depreciation deduction of $16,000, taking the project will increase the firm's EBIT by $22,000 − 16,000 = $6,000, so this is the project's EBIT. Finally, because EBIT is rising for the firm, taxes will increase. This increase in taxes will be $6,000 × .21 = $1,260. With this information, we can compute operating cash flow in the usual way:

Relevant Cash Flows [ LO1] Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce garden tools. The company bought some land six years ago for $2.8 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net $3.2 million. The company wants to build its new manufacturing plant on this land; the plant will cost $14.3 million to build, and the site requires $825,000 worth of grading before it is suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?

The $2.8 million acquisition cost of the land six years ago is a sunk cost. The $3.2 million current aftertax value of the land is an opportunity cost if the land is used rather than sold. The $14.3 million cash outlay and $825,000 grading expenses are the initial fixed asset investments needed to get the project going. Therefore, the proper Year 0 cash flow to use in evaluating this project is: $3,200,000 + 14,300,000 + 825,000 = $18,325,000

Example

To illustrate how depreciation is calculated, we consider an automobile costing $12,000. Suppose we wanted to sell the car after five years. Based on historical averages, it would be worth, say, 25 percent of the purchase price, or .25 × $12,000 = $3,000. If we actually sold it for this, then we would have to pay taxes at the ordinary income tax rate on the difference between the sale price of $3,000 and the book value of $691.20. For a corporation in the 21 percent bracket, the tax liability WOULD BE 0.21 TIMES 2308= 484 dollars The reason taxes must be paid in this case is that the difference between market value and book value is "excess" depreciation, and it must be "recaptured" when the asset is sold. What this means is that, as it turns out, we overdepreciated the asset by $3,000 − 691.20 = $2,308.80. Because we deducted $2,308.80 too much in depreciation, we paid $484.85 too little in taxes, and we have to make up the difference. Finally, if the book value exceeds the market value, then the difference is treated as a loss for tax purposes. For example, if we sell the car after two years for $4,000, then the book value exceeds the market value by $1,760. In this case, a tax savings of .21 × $1,760 = $369.60 occurs.

Pro Forma Example

To illustrate, suppose we think we can sell 50,000 cans of shark attractant per year at a price of $4 per can. It costs us about $2.50 per can to make the attractant, and a new product such as this one typically has only a three-year life (perhaps because the customer base dwindles rapidly). We require a 20 percent return on new products. Fixed costs for the project, including such things as rent on the production facility, will run $17,430 per year. Further we will need to invest a total of 90,000 in manufacturing equipment. this $90,000 will be 100 percent depreciated over the three-year life of the project. Furthermore, the cost of removing the equipment will roughly equal its actual value in three years, so it will be essentially worthless on a market value basis as well. Finally, the project will require an initial $20,000 investment in net working capital, and the tax rate is 21 percent.

Another example

We are considering the purchase of a $200,000 computer-based inventory management system. It will be depreciated straight-line to zero over its four-year life. It will be worth $30,000 at the end of that time. The system will save us $60,000 before taxes in inventory-related costs. The relevant tax rate is 21 percent. Because the new setup is more efficient than our existing one, we will be able to carry less total inventory and thus free up $45,000 in net working capital. What is the NPV at 16 percent? What is the DCF return (the IRR) on this investment? We can first calculate the operating cash flow. The aftertax cost savings are $60,000 × (1 − .21) = $47,400. The depreciation is $200,000/4 = $50,000 per year, so the depreciation tax shield is $50,000 × .21 = $10,500. Operating cash flow is $47,400 + 10,500 = $57,900 per year. The capital spending involves $200,000 up front to buy the system. The aftertax salvage is $30,000 × (1 − .21) = $23,700. Finally, and this is the somewhat tricky part, the initial investment in net working capital is a $45,000 inflow because the system frees up working capital. Furthermore, we will have to put this back in at the end of the project's life. What this really means is simple: While the system is in operation, we have $45,000 to use elsewhere.

Project Net Working Capital and Capital Spending

We next need to take care of the fixed asset and net working capital requirements. Based on our balance sheets, we know that the firm must spend $90,000 up front for fixed assets and invest an additional $20,000 in net working capital. The immediate outflow is a total of $110,000. At the end of the project's life, the fixed assets will be 6 worthless, but the firm will recover the $20,000 that was tied up in working capital. $20,000 inflow in the last year. This will lead to a On a purely mechanical level, notice that whenever we have an investment in net working capital, that same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.

Equivalent Annual Cost [ LO4] When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.

he EAC approach is appropriate when comparing mutually exclusive projects with different lives that will be replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared; in effect, each project is assumed to exist over an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid implies that the project cash flows remain the same forever, thus ignoring the possible effects of, among other things: (a) inflation, (b) changing economic conditions, (c) the increasing unreliability of cash flow estimates that occur far into the future, and (d) the possible effects of future technology improvement that could alter the project cash flows.