Chapter 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk (Intermediate Financial Management)

Replacement Projects: The new machine would result in sales of $40,000 per year versus old sales of $25,000, so the incremental revenue would be ____, and the new costs would be $10,000 versus old costs of $15,000.

$15,000

Opportunity Costs: In this case, the land could be sold to yield ____ after taxes.

$150,000

Opportunity Costs: Note that the proper land cost in this example is the _____, irrespective of whether Northeast originally paid $50,000 or $500,000 for the property.

$150,000 market-determined value

Replacement Projects: Moreover, the firm would receive $40,000 after taxes for the old machine, reducing the incremental investment to _____

$60,000.

Identifying the Relevant Cash Flows: Analysts often make errors in estimating cash flows, but two cardinal rules can help you minimize mistakes: --->

(1) Capital budgeting decisions must be based on cash flows, not accounting income. (2) Only incremental cash flows are relevant

Estimating Cash Flows: A proper analysis includes ____

(1) obtaining information from various departments such as engineering and marketing, (2) ensuring that everyone involved with the forecast uses a consistent set of realistic economic assumptions, and (3) making sure that no biases are inherent in the forecasts.

Replacement Projects: Finally, the old machine was being depreciated at the rate of $8,000 per year, but the new machine would have $20,000 of annual depreciation, so the incremental depreciation would be ____

-$12,000

Replacement Projects: The example demonstrates the fundamentals of _____ and the importance of focusing on _____

-a replacement analysis -incremental cash flows

Changes in Net Operating Working Capital: Normally, ____ are required to support a new operation, and ____ tie up additional funds in accounts receivable.

-additional inventories -expanded sales

Changes in Net Operating Working Capital: Toward the end of a project's life, ____ will be used but not replaced, and ____ will be collected without corresponding replacements

-inventories -receivables

Replacement Projects: If we looked only at the cash flows for the replacement machine without considering the old machine, then the NPV would be ____ and the IRR ____

-negative -less than the WACC

Estimating Cash Flows: Many ____ are involved, and many _____ participate in the process

-variables -individuals and departments

Incremental Cash Flows: Three special problems in determining incremental cash flows are discussed next. --->

1. Sunk Costs 2. Opportunity Costs 3. Effects on Other Parts of the Firm: Externalities

Timing of Cash Flows: _____ are for periods such as years or months, so they do not reflect exactly when during the period cash revenues or expenses occur.

Accounting income statements

Identifying the Relevant Cash Flows: _____ is the cash flow available for distribution to investors

Free cash flow

Interest Expenses Are Not Included in Project Cash Flows: This process is very complicated, and we do not recommend it. Here is one final caution: --->

If someone subtracts interest, then it is definitely wrong to discount the resulting cash flows by the WACC, and no amount of care can correct that error.

Evaluating Capital Budgeting Projects: 1). Initial Investment Outlay ---> This includes the cost of the fixed assets associated with the project plus any initial investment in net operating working capital (NOWC), such as raw materials.

Initial investment outlay

Noncash Charges (NCC): Therefore, depreciation must be added to ____ when estimating a project's cash flow.

NOPAT

Opportunity Costs: To illustrate, Northeast BankCorp already owns a piece of land that is suitable for the branch location. When evaluating the prospective branch, should the cost of the land be disregarded because no additional cash outlay would be required?

The answer is no, because there is an opportunity cost inherent in the use of the property

Sunk Costs: To illustrate, in 2006, Northeast BankCorp was considering whether to establish a branch office in a newly developed section of Boston. To help with its evaluation, Northeast had, back in 2005 hired a consulting firm to perform a site analysis; the cost was $100,000, and this amount was expensed for tax purposes in 2005. Is this 2005 expenditure a relevant cost with respect to the 2006 capital budgeting decision?

The answer is no— the $100,000 is a sunk cost, and it will not affect Northeast's future cash flows regardless of whether or not the new branch is built

Interest Expenses Are Not Included in Project Cash Flows: why is this a mistake?

This is a mistake because the cost of debt is already embedded in the WACC, so subtracting interest payments from the project's cash flows would amount to double counting interest costs.

Effects on Other Parts of the Firm: Externalities: For example, some of Northeast's customers who would use the new branch are already banking with Northeast's downtown office. The loans and deposits, hence profits, generated by these customers would not be new to the bank; rather, they would represent ____

a transfer from the main office to the branch

Interest Expenses Are Not Included in Project Cash Flows: Recall from Chapter 12 that we discount a project's cash flows by its cost of capital, and that the cost of capital is ____

a weighted average (WACC) of the costs of debt, preferred stock, and common equity, adjusted for the project's risk

Identifying the Relevant Cash Flows: Relevant cash flow is the cash flow that is ____

above and beyond what the company could expect if it doesn't implement the project

Project Cash Flow versus Accounting Income: We illustrate the estimation of project cash flow later in the chapter with a comprehensive example, but it is important for you to understand that project cash flow differs from ___

accounting income.

Timing of Cash Flows: Of course, there must be a compromise between ____ and ____

accuracy and feasibility

Changes in Net Operating Working Capital: If this change is positive, as it generally is for expansion projects, then ____

additional financing, over and above the cost of the fixed assets, will be needed.

Opportunity Costs: What Northeast paid would, of course, have an effect on taxes, hence on the ____

after-tax opportunity cost

Replacement Projects: If a project involves replacing existing assets with new ones, then we must estimate cash flows on ____

an incremental basis

Opportunity Costs: Use of the site for the branch would require forgoing this inflow, so the $150,000 must be charged as ____

an opportunity cost against the project.

Effects on Other Parts of the Firm: Externalities: Rather than focusing narrowly on the project at hand, analysts must _____, which requires imagination and creative thinking.

anticipate the project's impact on the rest of the firm

Cost of Fixed Assets: Note that the full cost of fixed assets includes ____ and ____ costs.

any shipping and installation

Effects on Other Parts of the Firm: Externalities: In this case, the additional income that would actually flow to the downtown office should be _____

attributed to the branch

Effects on Other Parts of the Firm: Externalities: A few young firms, including Dell Computer, have been successful selling their products only over the Internet. Many firms, however, had established retail channels long before the Internet became a reality. For these firms, the decision to _____

begin selling directly to consumers over the Internet is not a simple one

Effects on Other Parts of the Firm: Externalities: When a new project takes sales from an existing product, this is often called _____

cannibalization.

Effects on Other Parts of the Firm: Externalities: However, Internet sales would probably ____ sales through its retailer network

cannibalize

Estimating Cash Flows: Both problems cause _____ which make bad projects look good—on paper.

cash flow forecast biases

Interest Expenses Are Not Included in Project Cash Flows: If someone subtracted interest (or interest plus principal payments) from the project's cash flows, then they would be calculating the _____, and these cash flows should be discounted at the cost of equity

cash flows available to the equity holders

Changes in Net Operating Working Capital: The difference between the required increase in operating current assets and the increase in operating current liabilities is the ____

change in net operating working capital.

Tax Effects: Therefore, it is critical that taxes be ____

dealt with correctly.

Cost of Fixed Assets: Instead, they ____

deduct a depreciation expense each year throughout the life of the asset.

Cost of Fixed Assets: Then, the full cost of the equipment, including shipping and installation costs, is used as the _____ when depreciation charges are being calculated

depreciable basis

Cost of Fixed Assets: Even though the acquisition of assets results in a cash outflow, accountants ____

do not show the purchase of fixed assets as a deduction from accounting income.

Estimating Cash Flows: Similarly, the capital outlays associated with a new product are generally obtained from the _____ while operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing agents, and so forth.

engineering and product development staffs,

Intro: In the first part of the chapter, we develop procedures for ____

estimating the cash flows associated with capital budgeting projects.

Effects on Other Parts of the Firm: Externalities: Although they are often difficult to quantify, _____ should be considered.

externalities (which can be either positive or negative)

Effects on Other Parts of the Firm: Externalities: The third potential problem involves the effects of a project on other parts of the firm, which economists call ____

externalities.

Tax Effects: Our tax laws are _____

extremely complex, and they are subject to interpretation and to change.

Effects on Other Parts of the Firm: Externalities: Therefore, when considering externalities, the _____ should be taken into account.

full implications of the proposed new project

Sunk Costs: However, on an incremental basis, the project may be a good one because the ____ are large enough to produce a positive NPV on the incremental investment.

future incremental cash flows

Effects on Other Parts of the Firm: Externalities: As the IBM and Nautica examples illustrate, it is critical to ____ when evaluating a proposed project.

identify and account for all externalities

Replacement Projects: For example, suppose a more efficient machine would cost $100,000, but it would lead to _____

increased output, higher sales, and lower costs.

Incremental Cash Flows: These cash flows, called ____, represent the change in the firm's total cash flow that occurs as a direct result of accepting the project.

incremental cash flows

Effects on Other Parts of the Firm: Externalities: Thus, the net income produced by these customers should not be treated as ____ in the capital budgeting decision

incremental income

Replacement Projects: However, if we properly considered the incremental cash flows, then we would see that the NPV on the _____ is positive, so the old machine should be replaced

incremental investment

Intro: Unfortunately, cash flows are rarely just given—rather, managers must estimate them based on ____

information collected from sources both inside and outside the company.

Interest Expenses Are Not Included in Project Cash Flows: Therefore, you should not subtract ____ when finding a project's cash flows.

interest expenses

Changes in Net Operating Working Capital: As these changes occur, the firm will receive cash inflows, and as a result, the _____ will be returned by the end of the project's life.

investment in net operating working capital

Effects on Other Parts of the Firm: Externalities: To illustrate, IBM for years refused to provide full support for its PC division because it did not want to steal sales from its highly profitable mainframe business. That turned out to be a huge strategic error, because _____

it allowed Intel, Microsoft, Dell, and others to become dominant forces in the computer industry.

Effects on Other Parts of the Firm: Externalities: Naturally, firms do not like to cannibalize their existing products, but ____

it often turns out that if they do not, someone else will

Interest Expenses Are Not Included in Project Cash Flows: This technique can give the correct answer, but in order for it to work you must be very careful to adjust the amount of debt outstanding each year in order to ____

keep the riskiness of the equity cash flows constant

Tax Effects: Taxes have a major effect on cash flows, and in many cases tax effects will ____

make or break a project

Timing of Cash Flows: However, for some projects, it may be useful to assume that cash flows occur at _____

mid-year, or even quarterly or monthly.

Cost of Fixed Assets: Most projects require assets, and asset purchases represent ____ cash flows.

negative

Sunk Costs: It often turns out that a particular project has a ____ if all the associated costs, including sunk costs, are considered.

negative NPV

Sunk Costs: Since sunk costs are not incremental costs, they should ___

not be included in the analysis

Incremental Cash Flows: In evaluating a project, we focus on those cash flows that ____

occur if and only if we accept the project.

Opportunity Costs: A second potential problem relates to ____, which are cash flows that could be generated from an asset the firm already owns if it is not used for the project in question.

opportunity costs

Changes in Net Operating Working Capital: However, ____ and ____ increase as a result of the expansion, and this reduces the cash needed to finance inventories and receivables

payables and accruals

Intro: The basic principles of capital budgeting were covered in Chapter 12. Given a project's expected cash flows, it is easy to calculate its _____

payback, discounted payback, NPV, IRR, MIRR, and PI.

Effects on Other Parts of the Firm: Externalities: For example, Nautica Enterprises Inc. is an international company that designs, sources, markets, and distributes sportswear. Nautica sells its products to traditional retailers such as Saks Fifth Avenue and Parisian, who then sell to consumers. If Nautica opens its own online Internet store, it could _____

potentially increase its profit margin by avoiding the substantial markup added by dealers

Interest Expenses Are Not Included in Project Cash Flows: However, _____ is the cash flow available for all investors, bondholders as well as stockholders, so interest expenses are not subtracted.

project cash flow

Intro: Then, in the second part, we discuss techniques used to measure and take account of ____

project risk.

Estimating Cash Flows: The most important, but also the most difficult, step in capital budgeting is estimating ______—the investment outlays and the annual net cash flows after a project goes into operation

projects' cash flows

Effects on Other Parts of the Firm: Externalities: Even worse, retailers might react adversely to Nautica's Internet sales by ____

redirecting the marketing effort and display space they now provide Nautica to other brands that do not compete over the Internet.

Identifying the Relevant Cash Flows: In a nutshell, the _____ for a project is the additional free cash flow that the company can expect if it implements the project

relevant cash flow

Interest Expenses Are Not Included in Project Cash Flows: This WACC is the rate of return necessary to ____

satisfy all of the firm's investors, both stockholders and debtholders.

Replacement Projects: Thus, the incremental costs would be $5,000, which means a ____

saving.

Estimating Cash Flows: This last point is extremely important, because ____

some managers become emotionally involved with pet projects, and others seek to build empires.

Effects on Other Parts of the Firm: Externalities: On the other hand, having a suburban branch would help the bank attract new business to its downtown office, because ____

some people like to be able to bank both close to home and close to work

Noncash Charges (NCC): So, while accountants do not subtract the purchase price of fixed assets when calculating accounting income, they do _____

subtract a charge each year for depreciation.

Noncash Charges (NCC): In calculating net income, accountants usually ____

subtract depreciation from revenues.

Interest Expenses Are Not Included in Project Cash Flows: A common mistake made by many students and financial managers is to ____

subtract interest payments when estimating a project's cash flows.

Sunk Costs: A ____ is an outlay that has already occurred, hence is not affected by the decision under consideration

sunk cost

Noncash Charges (NCC): Depreciation shelters income from _____, and this has an impact on cash flow, but depreciation itself is not a cash flow.

taxation

Timing of Cash Flows: Therefore, in most cases, we simply assume _____

that all cash flows occur at the end of every year.

Interest Expenses Are Not Included in Project Cash Flows: This is completely analogous to the procedures used in the corporate valuation model of Chapter 11, where ____

the company's free cash flows are discounted at the WACC

Cost of Fixed Assets: Note too that fixed assets can often be sold at _____. If this is the case, then the after-tax cash proceeds represent a positive cash flow.

the end of a project's life

Estimating Cash Flows: For example, the forecasts of unit sales and sales prices are normally made by ____ , based on their knowledge of price elasticity, advertising effects, the state of the economy, competitors' reactions, and trends in consumers' tastes

the marketing group

Interest Expenses Are Not Included in Project Cash Flows: Note that this differs from the procedures used to calculate accounting income. As Accountants measure _____

the profit available for stockholders, so interest expenses are subtracted.

Cost of Fixed Assets: When a firm acquires fixed assets, it often must incur substantial costs for shipping and installing the equipment. These charges are added to the price of the equipment when ____

the project's cost is being determined

Identifying the Relevant Cash Flows: The first step in capital budgeting is to identify the relevant cash flows, defined as _____

the specific set of cash flows that should be considered in the decision at hand.

Timing of Cash Flows: Because of _____, capital budgeting cash flows should in theory be analyzed exactly as they occur

the time value of money

Project Cash Flow versus Accounting Income: Just as a firm's value depends on its free cash flows, so does ____

the value of a project.

Timing of Cash Flows: A ______ would in theory be most accurate, but daily cash flow estimates would be costly to construct, unwieldy to use, and probably no more accurate than annual cash flow estimates because we simply cannot forecast well enough to warrant this degree of detail

time line with daily cash flows

Timing of Cash Flows: We must account properly for the ____.

timing of cash flows

Intro: Moreover, _____ surrounds the cash flow estimates, and some projects are riskier than others.

uncertainty

Effects on Other Parts of the Firm: Externalities: Nautica, and many other producers, must determine ____

whether the new profits from Internet sales will compensate for lost profits from existing channels