Chapter 10
i. Modified ACRS Depreciation (MACRS)
1. Basic idea is that every asset is assigned to a particular class. A 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. a. The expected salvage value and the expected economic life are not considered in the calculation of depreciation b. Land cannot be depreciated 2. Percents add up to 100 percent, so as a result we write off 100 percent of the cost of the asset.
i. Project Operating Cash Flow
1. Operating cash flow = earnings before interest and taxes + depreciation - taxes 2. PLUS DEPRECIATION!!!!
i. A relative cash flow for a project is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take the project.
1. Referred to as incremental cash flows (any and all changes in a firm's cash flows that result from the project) 2. So, any cash flow that exists regardless of whether or not a project is taken is NOT relevant
a. Sunk Cost
i. A cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project. Do not consider.
a. Depreciation
i. A noncash deduction. Depreciation has cash flow consequences only because it influences the tax bill. Tax reform of 1986, which is a modification of the accelerate cost recovery system (ACRS).
a. Other Issues
i. Always interested in AFTERTAX cash flow because taxes are definelty a cash outflow. Remember, however, that aftertax cash flow and accounting profit, or net income, are entirely different things.
a. Bottom Up Approach
i. Because we are ignoring any financing expenses, such as interest, in our calculations of project OCF, we can write project net income as 1. Project net income = EBIT - taxes 2. Then add depreciation and we arrive at a slightly different and very common expression of OCF. ii. 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.
Project Cash Flow
i. Cash flow from assets has three components: operating cash flow, capital spending, and changes in net working capital. ii. Project Cash Flow = Project operating cash flow - project change in net working capital - project capital spending
a. Side Effects
i. Erosion - the cash flows of a new project that come at the expense of a firm's existing projects. In this case, the cash flows from the new line should be adjusted downward to reflect lost profits on other lines.
a. A Closer Look at Net Working Capital
i. Issues of sales on credit, or not having been paid yet (basically when cash flows in question haven't yet occurred) are not a problem as long as we don't forget to include changes in net working capital in our analysis. ii. In general, to find total cash flow, its 1. Total Cash Flow = Operating Cash Flow - Change in NWC - Capital Spending iii. Be careful when looking at the difference between actual cash flows and accounts receivable. So there's 500 dollars in sales, but, during the year, our accounts receivable GREW/WENT UP by 30 dollars. That means we actually had a cash flow of 470. iv. When NWC declines by 25 dollars, for example, we just say that 25 dollars was freed up during the year. v. In general, cash income is sales minus the increase in AR. Cash outflows are similarly done. If we have a cost of 310 dollars on the income statement but accounts payable increased by 55 during the year, this means that we have not yet paid 55 of the 310, so cash costs are actually 310-55=255. vi. More generally, including net working capital changes in our calcualtions has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments.
a. Net Working Capital
i. Normally a project will require that the firm invest in net working capital in addition to long term assets. For example, a project will generally need some amount of cash on hand to pay any expenses that arise. In addition, a project will need an initial investment in inventories and accounts recievable (to cover credit card sales). Some of the financing for this will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. This balance represents the investment in net working capital. Closely resembles a loan. Firm supplies working capital in the beginning and then recovers it in the end.
a. Tax Shield Approach
i. OCF = (Sales - Costs) x (1-T) + Depreciation x T 1. Where T is the corporate tax rate ii. Views OCF as having two components. 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 deprecation deduction muliptlied by the tax rate. The is called depreciation tax shield. The only cash flow effect of dudcting depreciation is to reduce our taxes, a benefit to us.
Top Down
i. OCF = Sales - Costs - Taxes ii. Along the way, we leave out any strictly noncash items such as depreciation.
PFFS
i. Pro Forma Financial Statements are a convenient and easily understood means of summarizing much of the relevant information for a project. ii. DO NOT DEDUCT ANY INTEREST EXPENSE. iii. See table on top of page 317.
The Stand Alone Principle
i. The assumption that evaluation of a project may be based on the project's incremental cash flows. ii. An important consequence, we will be evaluating the proposed project purely on its own merit, in isolation from any other activities or projects.
Opportunity
i. The most valuable alternative that is given up if a particular investment is undertaken. ii. For something bought in the past, we would say the opportunity cost of using it in a project is not the original price but what it would sell for today
a. Financing Costs
i. We will not include interest paid or any other financing costs such as dividends or principle repaid because we are interested in the cash flow generated by the assets of the project. Interest paid is a component of cash flow to creditors, not cash flow from assets.
Setting the Bid
i. Winners curse - if you win there is a good chance you underbid. Or the lowest bidder most likely made a mistake.
i. Book Value vs. Market Value
1. Under current tax law, the economic life and the future market value of the asset are not an issue. As a result, the book value can differ substantially from its actual market value. 2. Suppose we wanted to sell a 12,000 dollar car after five years. Based on historical averages, it would be worth say 25 percent purchase price, so .25 x 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. 3. 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. So, since we deducted X too much in depreciation, we paid X too little in taxes, and we simply have to make up that difference. 4. NOT a tax on capital gain. A capital gain occurs only if the market price exceeds the orginal cost. 5. If the book value exceeds the market value, then the difference is treated as a loss for tax purposes. For example, if we sell a car after two years for 4,000, then the book value exceeds the market value by 1,760. In this case, in this case, a tax saving of .34 (since that was in the example as what tax bracket we were in) x 1760 = 598.4 occurs.
i. Project Net Working Capital and Capital Spending
1. We next need to take care of the fixed asset and net working capital requirements. 2. Whenever we have an investment in networking capital, that same investment has to be recovered, in other words, the same number needs to appear at some time in the future with an opposite sign.
