CHAPTER 6 NOTES

Top- Down Approach

1. OCF= Sales- Cash Costs- Taxes - top down because we start at top of income statement and work our away down tot cash flow by subtracting costs, taxes, and other expenses *do NOT consider depreciation: it is not an outflow (we don't write checks to depreciation)

Books

1. Tax Books --> IRS - follow FASB - interest on municipal bonds is ignored for tax purposes (while FASB treats interest as income) - companies use accelerated depreciation for their toes and straight line for their stockholders books 2. Stockholder's Books --> annual reports - these rules permit income on the stockholders' books to be higher than income on the tax books - stockholder's books are relevant for accounting (but NOT used for capital budgeting)

An investment in net working capital arises when...

1. inventory is purchased 2. cash is kept in the project as a buffer against unexpected expenditures 3. sales are made on credit, generating accounts receivable, rather than cash - investment in net working capital represents a cash outflow because cash generated elsewhere in the firm is tied up in the project

Taxes break down

= (Sales - Cash Costs - Deprecation) (t%) - in capital budgeting we assume

Stockouts

=running out of inventory

Example comparing capital budgeting v. accounting : company paid $1 million in cash for a building as part of a new capital budgeting project. This is an immediate cash outflow. Assume straight line depreciation over 20 years.

This is considered an accounting expense in the current year. Current earnings are thereby reduced by only $50,000. BUT IN CAPITAL BUDGETING, the relevant outflow at Date ) is the full 1 M

Synergy

- a type of side effect = occurs when a new project increases the cash flows of existing projects ex: shaving supplies firm may appear to lose money on its new razor, but the increase in sales of the blades may make the razor an overall winner

Erosion

- a type of side effect =occurs when a new project increases the CFs of existing projects ex: concerns from opening a disney park in Paris taking business away from the Florida location

Opportunity Costs

- if the asset is used in a new project, potential revenues from alternative uses are lost - by taking a project, the firm forgoes other opportunities for using the same assets

Depreciation in cash flow calculations

- indirect consideration - under current tax rules, depreciation is a deduction, lowering taxable income - a lower income numbers leads to lower taxes, which in turn leads to a higher cash flow

EX: X company is evaluating the NPV of launching a new product. As part of this evaluation, the company paid a consulting firm $100,000 a year for a test marketing analysis. Is this cost relevant for the capital budgeting decision of the new product?

- no, because the $100,000 is not recoverable - the expenditure is a sunk cost

Working capital

- rises over the early years of the project as expansion occurs - all inventory is sold by the end, the cash balance maintained as a bugger is liquidated, and all accounts receivable are collected - increases in working capital in the early years must be funded by cash generated elsewhere in the firm - these increases are viewed as cash outflows *it is the increase in working capital over a year that leads to a cash outflow in that year* - decreases in working capital in the later years are viewed as cash inflows

Depreciation conventions

- all real estate is depreciated on a straight line basis - calculations of depreciation include a half-year convention (which treats all property as if it were placed in service at midyear) - the IRS allows half a year of depreciation for the year in which property is disposed of or retired: the spreads the deductions for property over one year more than the name of its class ex: 6 tax years for 5 year property

Corporate finance vs. Financial accounting

- corporate finance uses cash flows - financial accounting uses income or earnings numbers - when considering a project, we discount the CFs that the firm receives from the project - when valuing the firm as a whole, we discount dividends (not earnings) because dividends are the cash flows that an investor receives - earnings do not represent real money - in calculating the NPV of a project, only cash flows that are incremental to the project should be used

MACRS

- depreciation for tax purposes for U.S. companies is based on this - we need the income calculation to determine taxes

EBT

- earnings before taxes EBT= Sales - Cash Costs - Deprecation

Opportunity Cost examples

- the estimated aftertax sales price of a warehouse and land would be opportunity cost in Year 0 (if you decide to use the land and not sell it) *opportunity costs are treated as cash outflows for purposes of capital budgeting* - if a project is accepted, management assumes that the warehouse will be sold for $150,000 in the final year (the price it could of been sold at in Year 0) - test marketing costs are NOT included

Cash Flow

CF from operations= sales - operating costs- taxes - firms typically calculate a project's cash flows under the assumptions that the project is financed only with equity

Operating Cash Flow

OCF= Sales- Cash Costs- Taxes

Straight line depreciation

S-L Deprec. over 20 years with a $1 M investment: 1,000,000/20 = $500,000 depreciates a year

EX:Company has an empty warehouse that can be used to store pinballs. the company hopes to sell these pinballs to affluent consumers. should the warehouse be considered a cost in the decision to sell the machine?

YES - because the company could sell the warehouse if the firm decides not to market the pinballs. *the sales price of the warehouse is an opportunity cost in the pinball decision

Net working capital broken down

accounts receivable - accounts payable + inventory + cash - because the $ can be used elsewhere in the firm, one must view the investment in net working capital as a cash outflow - changes in net working capital from year to year represent further cash flows, as indicated by the negative numbers for the first few years - in the declining years, net working capital is reduced ultimately to 0

Depreciate property

- the 3 yr. class includes certain specialized short-lived property: tractor units, racehorses - the 5 yr, class includes cars, trucks, computers and peripheral equipment, office machinery - 7 yr. class includes office furniture and fixtures - 10 yr. class includes vessels, barges and tugs - 15 yr. class includes improvements to land - the 20 yr. class is farm buildings and utility plants *real property is separated into 2 classes: residential and nonresidential property over 39 years*

Purchase of a machine for new products

- the purchase requires an immediate cash outflow - the firm realizes a cash inflow when the machine is sold

Example: X Corp is contemplating the formation of a racing team. the team is forecast to lose money, with an NPV of - $35 million. the team will likely generate great publicity for all of X Corp's products. increase in CF elsewhere has a NPV of $65 million. What's the NPV of the team? Should the team be formed?

- this is synergy NPV = $ 60 M + - $ 35 M= $ 30 M they should form the team

Salvage Value

- when selling an asset, one must pay taxes on difference between the asset's sales price and its book value ex: Company plans on selling a machine for $30,000. The book value would be $5,760. --> the company would pay taxes on the difference between the two numbers: (30,000-576) x (tax rate) -the aftertax salvage value of the equipment (a cash inflow) = sales price- taxes * if the book value exceeds the market value, the difference is treated as a loss for tax purposes* (the amount of taxes that would of been based on the sales price vs. book value is money that is saved)

Three investments in the bowling ball example

1. bowling ball machine 2. opportunity cost of the warehouse 3. changes in working capital

Bottom - Up Approach

1. calculate income INCOME= EBT- TAXES 2. add depreciation back OCF= Net Income +Depreciation 3. OCF= (Sales - Cash Costs - Depreciation) (1-t) + Depreciation

Ex: Sales= $1500 Cash Costs= 700 Depreciation= $600 (t= corporate tax rate= 34%)

1. find EBIT EBT= Sales - Cash Costs - Deprecation = $1500- $700- $600= $200 2. find Taxes = (Sales - Cash Costs - Deprecation) (t%) = ($200) (.34= $68

Allocated Costs

= because a single expenditure can benefit a number of projects, accountants often allocate this cost across different projects when determining income *for capital budgeting purposes, this allocated cost should be viewed as a cash outflow of a project only if it is an incremental cost of the project*

Incremental Cash Flows

= cash flows that are the changes in the firm's cash flows that occur as a direct consequence of accepting the project

Sunk Cost

= cost that has already occurred - they cannot be changed by the decision to accept or reject the project - we should ignore sunk costs

Net Working Capital

= difference between current assets and current liabilities - in the final year of a project, net working capital will decline to 0 as the project is wound down - in other words, the investment n working capital is to be completely recovered by the end of the project's life - cash flows are assumed to occur at the end of the year

Ex: X Corp. donates one wing of its office to a library, which requires a cash outflow of $100,000 a year in upkeep. A proposed capital budgeting project is expected to generate revenue equal to 5% of the overall firm's sales. An exec at the firm argues that $5,000 (.05 x 100,000) should be viewed as the project's share of the library's costs. Is this appropriate capital budgeting?

NO - the firm will spend $100,000 on the library upkeep whether or not the proposal project is accepted - bad if you reject the project because you considered allocated costs

Example: X Corp is determining the NPV of a new car. Some of the would be purchasers are owners of X Corp's compact sedans. Are all sales and profits from the new car incremental?

NO. THESE SALES AND PROFITS ARE NOT INCREMENTAL - this is because some of the CF represents transfers from other elements of their product line - this is erosion--> INCLUDED IN NPV CALCULATION (if erosion is not considered, IMC might erroneously calculate NPV)