10

3 methods for computing OCF

1. Bottom-up approach 2. Top-down approach 3. Tax-Shield Approach

Steps for the EAC method

1. Calculate all of the CFFAs for the two assets. 2. Calculate the NPV(total cost) for the two assets. 3. Annuitize(annualize) the NPV for each project for their given lives. This is the EAC. 4. Select the asset with the lowest EAC

Process of setting the bid price

1. Get the present value of Net Capital Spending(NCS) and changes in Net Working Capital(NWC) using the bidder's discount rate. 2. Once you have the lump sum, you annuitize it over the number of years specified in the contract to get the operating cash flows (OCF) 3. With operating cash flows in hand, you plug in the fixed costs, variable costs, depreciation, tax rate, and quantity produced, then solve for price

3 steps in capital budgeting process

1. create pro forma financial statements 2. extract the cash flows from the pro formas for each forecasted point in time that the project will be in operation 3. use capital budgeting decision rules to ultimately decide whether to accept or reject the project

Accruals change estimated OCF because

1. sales are recorded on the income statement when made, not when cash is received 2. we record cost of goods sold when the corresponding sale is made, not when cash is paid to suppliers 3. we have to buy inventory to support sales although the cash from selling it comes later

All MACRS rates have __ significant digits

4

Putting cash income and cash costs together, cash flow =

= Cash inflow - cash outflow = operating cash flow(OCF) - change in NWC(net working capital)

OCF and NWC

=OCF - change in accounts receivable + change in account payable =OCF - (change AR - Change AP) =OCF - change NWC

sunk cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future. costs that have accrued in the past

Equivalent Annual Cost (EAC)

An asset's average cost per period that appropriately adjusts for the time value of money EX: what amount, paid each year over the life of the machine, have the same PV of costs

Taxes =

EBIT * corporate tax rate

Operating Cash Flow (OCF) =

EBIT + Depreciation - Taxes

Projected Net Income (ignoring financing expenses, such as interest) =

EBIT - Taxes if we add depreciation to both sides, OCF = Net income + depreciation

T/F: Depreciation is an incremental cash flow that we should take into account

False

T/F: Net working capital creates incremental cash flows and therefore should be included when applying the stand alone principle

False

T/F: Pro formas are the accounting statements that will result if a company pursues and investment.

False

T/F: The money company spent on research and development is an incremental cash flow.

False

T/F: Time zero changes in net working capital(NWC) are outflows

False

T/F: We have to consider changes in net working capital separately because of depreciation and amortization.

False

T/F: We only care about the non-cash expense called amortization in so far as it can change a project's cost of goods sold

False

calculating EAC involves finding an unknown payment amount: EX

For machine A, we need to find a two year ordinary annuity with a PV of $117.36 at 10 percent PV of costs = -117.36 = EAC * Annuity factor annuity factor = 1.7355 EAC = 117.36/1.7355 = -67.62

When you spend money on net working capital (NWC), the balance sheet

Goes up a NWC outflow (NWC up) means the balance sheet goes up When the balance sheet falls, there is an inflow from NWC

Source of operating cash flows(OCF)

Income statements

Pro Forma financial statements are used by

Internal information users

If there is an increase in competition, erosion becomes

Less relevant You will not lose sales to your own product, but rather to competitors, so it is no longer erosion and you are more likely to do the project to avoid losing sales to competitors

Would a firm prefer to use MACRS or straight line depreciation

MACRS, It provides larger depreciation deductions earlier, which reduces taxes total depreciation is the same, only timing differs

At every point in time, cash flow from assets (CFFA) =

OCF - change in NWC - NCS

The tax shield approach

OCF = (Sales - Costs)*(1 - T) + Depreciation*T T = corporate tax rate Views OCF as having two components. the first part is what the projects cash flow would be if there was no depreciation expense. The second part in this approach is the depreciation deduction multiplied by the tax rate, this is called the depreciation tax shield

bottom-up approach

OCF = Net Income + Depreciation -start at the accountants bottom line(net income) and add back any non cash deductions such as depreciation

top-down approach

OCF = Sales - Costs - Taxes start at the top of the income statement with sales and work our way down to net cash flow by subtracting costs, taxes, and other expenses Don't subtract non-cash deductions (such as depreciation)

Why might a company choose to proceed with a project while others do not?

One company may be able to produce at lower incremental cost or may be able to better market the project

capital budgeting relies on

Pro-forma, projected accounting statements

EBIT (Earnings before interest and taxes) =

Sales - Costs - Depreciation

If the book value is zero, After-Tax Salvage Value

Salvage Value×(1 - t)

Bid price

The minimum price at which a business is willing to provide a good or service. It must take into account all fixed costs, variable costs, and the opportunity cost of capital

Operating cash flow(OCF) is the same as EBIT when

There are no taxes or depreciation

recovering all of the NWC is a mild over simplification because

There will likely be shrinkage some receivables might not be collected, and some inventory might go unsold

Taxes

These are included, they are incremental

T/F: Amoritization is a non-cash expense that is not an incremental cash flow

True

T/F: Changes in net working capital create incremental cash flows.

True

T/F: Depreciation and amortization are accrual accounting allocation schemes that can indirectly impact a project's incremental cash flows

True

T/F: Depreciation is not an incremental cash flow.

True

T/F: Owners putting cash into a project to smooth over the current accounts is an incremental cash flow.

True

T/F: Pro formas represent the best guess by a treasury department as to what the accounting statements of a project will look like if the business accepts the investment.

True

T/F: The depreciation tax shield is an incremental cash inflow.

True

T/F: We have to consider changes in networking capital separately because of accruals.

True

Evaluating Equipment Options with Different Lives

USE EAC, which is only necessary when: 1) different economic lives 2) we will need whatever we buy more or less indefinitely(when it wears out, we buy another one)

other things to watch out for, 1

We are interested only in measuring cash flow. Moreover, we are interested in measuring it when it actually occurs, not when it accrues in an accounting sense

can a damaged reputation ever be considered erosion?

Yes, especially (If) when it causes a reduction in existing sales

Accelerated Cost Recovery System (ACRS)

a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications

Bonus Depreciation

additional depreciation allowed in the acquisition year for new tangible personal property with a recovery period of 20 years or less.

including net working capital(NWC) changes in our calculations has the effect of

adjusting for the discrepancy between accounting sales and costs, and actual cash receipts and payments

The incremental cashflows for a project evaluation consist of

any and all changes in the firms future cash flows that are a direct consequence of taking the project

shrinkage

bad debt, or something that won't sell that will affect the balance sheet EX: we estimate that 3% of receivables will go unpaid

Source of changes in net working capital(NWC)

balance sheet

source of net capital spending

balance sheet

If the firm does not properly account for changes in net working capital(NWC), the estimated operating cashflows(OCF) will potentially

be biased because of accruals

Changes in Net Working Capital (NWC)

cash flows associated with cash on hand to smooth over accounts (change current assets- change current liabilities), (ending - beginning)

Net Capital Spending (NCS)

cash flows associated with the long-term tangible and intangible assets of a project

When extracting information from the pro forma financial statements, the ultimate goal is to determine the

cash flows from assets (CFFA)

The depreciation tax shield is a

cash inflow

An increase in Net working Capital(NWC) is a

cash outflow

costs = OCF +

change in accounts payable not all costs are cash

Revenue = OCF -

changes in accounts receivable

The EAC approach is appropriate when

comparing mutually exclusive projects with different lives that will be replaced when they wear out.

Book Value=

cost - accumulated depreciation

Generally, cash costs =

costs - increase in accounts payable

change in net working capital =

current assets - current liabilities Change in NWC = ending balance - beginning balance

Land cannot be

depreciated

increasing ____________will increase the operating cash flow at any point of time

depreciation expense, sales NOT taxes, fixed costs, or variable costs

Which method should be used when you see MACRS

depreciation tax shield

The book value of an asset can

differ substantially from its market value EX: when an asset is sold, we would have to pay taxes at the ordinary income tax rate on the difference between the sale price and the book value

The basic idea under the Modified ACRS Depreciation (MACRS) is that

every asset is assigned to a particular class. An assets class establishes its life for tax purposes. Once an assets tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage

side effects

externalities Positive: benefits to other projects Negative: costs to other projects these are included

pro forma financial statements

financial statements projecting future years' operations

interest paid is a

financing expense, not a component of operating cash flow

When you spend money on Net Capital Spending (NCS), the balance sheet

goes up when you sell the asset, the balance sheet falls, and there is a cash inflow

A decrease in net working capital results in a(n) _______________ in the cash flow from assets

increase

the balance sheet going down indicates an

inflow

In analyzing a proposed investment, we will not include

interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cashflow generated by the assets of the project

financing costs

interest paid to debt holders or dividends paid to stockholders do not directly change the analysis of the project we are evaluating, not incremental not included

All else equal, whatever the firm recovers in net working capital(NWC) earlier, it

invests later

Sunk costs are ______ to a decision using incremental cashflows

irrelevant, not included EX: consultant to decide whether to launch a product

Taxes must be paid if the difference between the market value(when the asset is sold) and the book value

is "excess" depreciation, and it must be "recaptured" when the asset is sold This would mean that we over depreciated the asset, we deducted too much depreciation, and we have to make up the difference

accounting depreciation is a noncash deduction. as a result, depreciation has cash flow consequences only because

it influences the tax bill depreciation procedures are governed by tax law

Once an assets tax life is determined, the depreciation for each year is computed by

multiplying the cost of the asset by a fixed percentage

Why is the EAC method used?

necessary so that the projects have a common life span over which they can be compared; We cannot use total cost(NPV) because it does not account for the short lifespan of the equipment that needs to be replaced repeatedly in effect, each project is assumed to exist over an infinite horizon of N-year repeating projects.

the expected salvage value and the expected economic life are

not explicitly considered in the calculation of depreciation

any cashflow that exists regardless of whether a project is taken or not is

not relevant

Project Cash Flow =

operating cash flow - change in net working capital - capital spending

cash flow from assets (CFFA) has three primary components:

operating cash flow, capital spending, changes in net working capital

the balance sheet going up indicates an

outflow

In setting the bid price, the price is _______________ and operating cash flows (OFC) are ______________

price is variable of interest operating cash flows are unknown

Assumptions under the EAC method

project cash flows remain the same forever, thus ignoring the possible effects of: (a) inflation, (b) changing economic conditions, (c) the increasing unreliability of cash flow estimates that occur far into the future (d) the possible effects of future technology improvement that could alter the project cash flows.

Net Working Capital

projects need some amount of cash on hand to pay any expenses as they arise. In addition, it will need an initial investment in inventories and accounts receivable (to cover credit sales)

Because of accruals, (and the 3 things previously), we must

put cash in the project to smooth over accounts (NWC) these are incremental cash flows

to prepare pro forma financial statements, we will need estimates of

quantities such as: -unit sales, -the selling price per unit, -the variable cost per unit, -total fixed costs. -total investment required, including any investment in working capital

A taxable gain occurs when an asset is sold for more than its book value. For capital budgeting purposes, the taxes on the sale are treated as a _______________

reduction in cash, and this amount deducted from the selling price

Operating Cash Flow (OCF)

regularly generated cash flows from the ongoing activities of a project

Generally, Cash Income =

sales - increase in accounts receivable

By assumption, net working capital requirements change as

sales change Year 1: sales 360,000, NWC $54,000 Year 2: sales $600,000, NWC $90,000, cash flow -$36,000

after-tax salvage value =

salvage - t*(salvage-book) sale inflow - tax outflow = net cashflow

In general, MACRS rates start _______, then _________, then________over time

start low, jump in the second year, then drop off over time

Whenever we have an investment in net working capital,

that same investment has to be recovered. The same number needs to appear at some time in the future with the opposite sign

stand-alone principle

the assumption that evaluation of a project will be based on the project's incremental cash flows -once we have determined incremental cashflows, the project can be viewed as a "mini firm"

The bid price will just cover

the bidder's opportunity costs, no more and no less in practice, the bidder will try to win the contract at a higher price, thus generating a higher return than the next best project of similar risk

Erosion

the cash flows of a new project that come at the expense of a firm's existing projects EX: substituting one flavor of oatmeal for another example of a side effect

incremental cash flows

the difference between a firm's future cash flows with a project and those without the project

If book value exceeds market value...

the difference is treated as a loss for tax purposes -you get to reduce your taxes by t* the difference between book value and selling price NCS cash flow = t*difference + sale price*(1-t)

The tax shield approach views OCF as having two components:

the first part is what the projects cash flow would be if there was no depreciation expense. The second part in this approach is the depreciation deduction multiplied by the tax rate, this is called the depreciation tax shield

In setting a bid price, we used a zero NPV as our benchmark. Explain why this is appropriate.

the lowest possible price we can profitably charge will result in a zero NPV at the given discount rate OCF is now an unknown ordinary annuity amount

opportunity cost

the most desirable alternative that is given up if a particular investment is undertaken these are included

common types of cash flows

- sunk costs - opportunity costs - changes in NWC - financing costs - taxes

Since each approach yields the same result, why are there different ways to calculate the OCF

The different approaches are useful in different situations.

Erosion is relevant only when

the sales would not otherwise be lost EX: not relevant if they would have been lost to competitors anyways

depreciation tax shield

the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate Depreciation*t

cash flow from assets (CFFA)

the total net cash flow per period associated with a project these are the cash flows you evaluate using chapter 9 tools = operating cash flow - net capital spending - change in net working capital

the firm supplies working capital at the beginning and

then recovers it toward the end

all three approaches only work when

there is no interest expense

When Net Working Capital declines by $25

this means that $25 was freed up

When deciding whether an investment adds value to a firm, the first and most important step is

to decide which cashflows are relevant

The only cash flow effect of deducting depreciation is

to reduce our taxes at the current 21% corporate tax rate, every dollar in depreciation expense saves us 21 cents in taxes

evaluating cost-cutting proposals

use tax shield approach

other things to watch out for, 2

we are always interested in after tax cash flow because taxes are definitely a cash outflow

consequence of stand alone principle

we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects

Relevant Cash Flows, the cash flows that should be included in a capital budgeting analysis are those that

will only occur if the project is accepted -called incremental cash flows