Fin Test 1

Net Working Capital (NWC)

Net working capital is defined as the difference between current assets and current liabilities.

Incremental Cash Flows

- Cash flows matter—not accounting earnings. - Sunk costs do not matter. - Incremental cash flows matter. - Opportunity costs matter. - Side effects like cannibalism and erosion matter. - Taxes matter: we want incremental after-tax cash flows. - Inflation matters

Bottom Up Approach to OCF

Bottom-Up Approach Works only when there is no interest expense OCF = NI + depreciation OCF 5 (Sales - Cash costs - Depreciation) (1 - tc ) + Depreciation This is the bottom-up approach .Here we start with the accountant's bottom line (net income) and add back any noncash deductions such as depreciation. It is crucial to remember that this definition of operating cash flow as net income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income

Estimating Cash Flow

Cash Flow from Operations Recall that: OCF = EBIT - Taxes + Depreciation Net Capital Spending - Do not forget salvage value (after tax, of course). Changes in Net Working Capital -Recall that when the project winds down, we enjoy a return of net working capital.

Cost Cutting Proposals (Special Case)

Cost savings will increase pretax income - But, we have to pay taxes on this amount Depreciation will reduce our tax liability Does the present value of the cash flow associated with the cost savings exceed the cost? - If yes, then proceed. !! Essentially you need to see what the cost savings is going to be less tax and add that figure to the additional depreciation on investing in the new equipment. that total will give you the cash flow which if you NPV it should be positive and if it is then proceed

Setting the Bid Price (Special Case)

Find the sales price that makes NPV = 0 Step 1: Use known changes in NWC and capital to estimate "preliminary" NPV Step 2: Determine what yearly OCF is needed to make NPV = 0 Step 3: Determine what NI is required to generate the OCF - OCF = NI + Depreciation Step 4: Identify what sales (and price) are necessary to create the required NI NI = (Sales - Costs - Depreciation)*(1 - T)

Inflation and Capital Budgeting

For low rates of inflation, this is often approximated: Real Rate ~= Nominal Rate - Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, the real rate has generally exhibited far less variance than the nominal rate. In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates. - A nominal cash flow refers to the actual dollars to be received (or paid out). - A real cash flow refers to the cash flow's purchasing power.

Allocated Costs

Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects when determining income. However, 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.

Top Down Approach to OCF

OCF = Sales - Costs - Taxes -Do not subtract non-cash deductions We call this the top-down approach because we start at the top of the income statement and work our way down to cash flow by subtracting costs, taxes, and other expenses. Along the way, we left out depreciation. Why? Because depreciation is not a cash outflow. That is, the owner is not writing a $600 check to any Mr. Depreciation! While depreciation is an accounting concept, it is not a cash flow. Nevertheless, does depreciation play a part in the cash flow calculation? Yes, but only indirectly. Under current tax rules, depreciation is a deduction, lowering taxable income. A lower income number leads to lower taxes, which in turn leads to higher cash flow.

Investment in Working Capital

Required working capital appears in Line 5. Working capital rises over the early years of the project as expansion occurs. However, all working capital is assumed to be recovered at the end, a common assumption in capital budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer 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. Hence, these increases are viewed as cash outflows . To reiterate, it is the increase in working capital over a year that leads to a cash outflow in that year. Even if working capital is at a high level, there will be no cash outflow over a year if working capital stays constant over that year. An investment in net working capital arises whenever (1) inventory is purchased, (2) cash is kept in the project as a buffer against unexpected expenditures, and (3) sales are made on credit, generating accounts receivable rather than cash. (The investment in net working capital is reduced by credit purchases, which generate accounts payable.) This investment in net working capital represents a cash outflow because cash generated elsewhere in the firm is tied up in the project.

Tax Shield Approach to OCF

Tax Shield Approach OCF = (Sales - Costs)(1 - T) + Depreciation*T simplifies to... OCF = (Sales − Cash costs) x (1 − tc ) + Depreciation x tc The first part is what the project's cash flow would be if there were no depreciation expense. The second part of OCF in this approach is the depreciation deduction multiplied by the tax rate. This is called the depreciation tax shield.

Equivalent Annual Cost (EAC)

The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows. For example, the EAC for the Cadillac air cleaner is $750.98. The EAC for the Cheapskate air cleaner is $763.80, thus we should reject it. In order to do this you take the PV of the payments from each choice and divide by the PV of an annuity of the same amount of years in each case. PVIT (.10,3) means annuity paying $1 a year for 3 years at 10%..calc the PV and then take the PV of the project and divide by this PVIT. This will give you the annual payment paid by year and whichever has a small annual payment is cheaper and should be chosen.

Income & Taxes

The determination of income is presented in the bottom segment of Table 6.1 . While we are ultimately interested in cash flow—not income—we need the income calculation to determine taxes.

Investment of Unequal Lives (Special Case)

There are times when application of the NPV rule can lead to the wrong decision. Consider a factory that must have an air cleaner that is mandated by law. There are two choices: - The "Cadillac cleaner" costs $4,000 today, has annual operating costs of $100, and lasts 10 years. - The "Cheapskate cleaner" costs $1,000 today, has annual operating costs of $500, and lasts 5 years. Assuming a 10% discount rate, which one should we choose? We cant do just regular NPV because the years are different so we need to use Equivalent Annual Cost (EAC)

Salvage Value

When selling an asset, one must pay taxes on the difference between the asset's sales price and its book value.