Chapter 10: Making Capital Investment Decisions Flashcards
Incremental cash flows
The difference between a firm’s future cash flows with a project and without the project.
Orrrr
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.
The general principle is simple enough; a relevant 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 that project
Incremental cash flows General Definition
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.
Important implication to the incremental cash flow
Any cash flow that exists regardless of whether or not a project is undertaken is not relevant in our project evaluation.
Stand-alone principle
Evaluation of a project based on the project’s incremental cash flows
In summary: once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of mini firm with its own future revenues and costs, its own assets, and its own cash flows
Sunk Costs
A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.
The firm has to pay this no matter what
Example: Plane tickets already purchased, non-refundable items
Sometimes overhead cost is a sunk cost
NOT RELEVANT TO DECISION MAKING
Opportunity Costs
The most valuable alternative that is given up if a particular investment is undertaken.
Example: Going to school means giving up working for 8 hours and getting paid
Erosion
The portion of cash flows of a new project that come at the expense of a firm’s existing operations.
Example: Shoppers Drug Mart adding a fresh food section knowing customers of Super Store may stop shopping there and going to Shopper (even though both are owned by the same company)
Erosion is relevant only when the sales would not otherwise be lost.
For example, one of Walt Disney’s concerns when it built Euro Disney was that the new park would drain visitors from the Florida park, a popular vacation destination for Europeans.
Beneficial Side Effects
To see Negative Side Effects visit the Erosion Slide
For example, you might think that Hewlett-Packard (HP) would have been concerned when the price of a printer that sold for $500 to $600 in 2003 declined to below $100 by 2014, but they weren’t.
What HP realized was that the big money is in the consumables that printer owners buy to keep their printers going, such as ink-jet cartridges, laser toner cartridges, and special paper. The profit margins for these products are substantial.
Net Working Capital
For example, a project generally needs some amount of cash on hand to pay any expenses that arise.
In addition, a project needs an initial investment in inventories and accounts receivable (to cover credit sales)
The firm supplies working capital at the beginning and recovers it toward the end.
Financing Costs
In analyzing a proposed investment, we DO NOT include interest paid or any other financing costs such as dividends or principal repaid
Why? Because we are interested in the cash flow generated by the assets from the project
Inflation
Because capital investment projects generally have long lives, price inflation or deflation is likely to occur during the project’s life
Rates including inflation premiums are called nominal rates
Given that nominal rates include an adjustment for expected inflation, cash flow estimates must also be adjusted for inflation
Capital Budgeting and Business Taxes in Canada
In Canada, various levels of government commonly offer incentives to promote certain types of capital investment that will stimulate the economy. These include grants, investment tax credits, more favourable rates for capital cost allowance (CCA), and subsidized loans
Capital cost allowance (CCA)
Depreciation for tax purposes, not necessarily the same as depreciation under IFRS; depreciation method under Canadian tax law allowing for the accelerated write-off of property under various classifications.
Other Issues
First, we are interested only in measuring cash flow, and more specifically, measuring it when it actually occurs, not when it arises in an accounting sense.
Second, we are always interested in after-tax cash flow since tax payments are definitely a relevant cash outflow.
In calculating the cash flows, we make several simplifying assumptions to avoid bogging down in technical details at the outset
First, we use straight-line depreciation as opposed to capital cost allowance. We also assume that a full year’s depreciation can be taken in the first year.
In addition, we construct the example so the project’s market value equals its book cost when it is scrapped
Pro forma financial statements
Projections
Financial statements projecting future years’ operations.
To prepare these statements, we need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We also need to know the total investment required, including any investment in net working capital.
Example of a pro forma financial statement
Sales (50,000 units at $4.30/unit) 215,000
Variable costs (50,000 units at $2.50/unit) 125,000
————-
Gross profit $ 90,000
Fixed costs $ 12,000
Depreciation ($90,000/3) 30,000
————-
EBIT $ 48,000
Taxes (40%) 19,200
————–
Net income $ 28,800
*Do NOT deduct any interest, it is a financing expense and not an operating cash flow component
Cash flow from assets has three components:
1) operating cash flow,
2) capital spending,
3) additions to net working capital
Project cash flow =
equation
Project Operating Cash Flow - Project additions to net working capital - Project capital spending
PROJECT OPERATING CASH FLOW
Operating cash flow =
Earnings before interest and taxes (EBIT) + Depreciation - Taxes
To determine the operating cash flow associated with a project, recall the definition of operating cash flow:
If net working capital is negative, what does this mean?
We had freed up $XX during the year
Therefore, you would add this to your total cash flow
In general, cash income is
equation
sales - increase in accounts receivable.
Accounting depreciation is a _____________
non-cash deduction
Remember that an increase in net working capital is a cash ________ and a decrease in net working capital is a cash _______
outflow
inflow
a negative sign shows working capital returning to the firm
As we see, the different definitions of operating cash flow all measure the ________
same thing.
Acronyms explained
OCF = Project Operating Cash Flow S = Sales C = Operating Costs D = Depreciation for tax purposes (I.E CCA) Tc = Corporate Tax Rate
Given OCF, S, C, D, and Tc, how do you find EBIT?
EBIT = S - C - D
Project operating cash flow (OCF) =
Equation
EBIT + D - Taxes
Project Net Income =
Equation
EBIT - Taxes
Bottom-Up Approach
Bottom Up
OCF = (S - C - D) + D - (S - C- D) x Tc
= (EBIT) x (1-Tc) + d
= Project net income + Depreciation
The Top-Down Approach
Top Down
OCF = (S - C) - (S - C - D) x Tc
= Sales - Costs - Taxes
The Tax Shield Approach
OCF = (S - C - D) + D - (S - C - D) x Tc
= (S - C) x (1 - Tc) + D x Tc
The Tax Shield Approach views OCF as having two components
The first part, (S - C ) x (1 - Tc) is what the project’s cash flow would be if there were no depreciation expense
The second part of OCF in this expression, D x Tc , is called the depreciation (CCA) tax shield
Depreciation (CCA) tax shield
Tax saving that results from the CCA deduction, calculated as depreciation multiplied by the corporate tax rate.
Present Value of the Tax Shield on CCA
Further time savings are possible by using a formula that replaces the detailed calculation of yearly CCA.
The formula is based on the idea that tax shields from CCA continue in perpetuity as long as there are assets remaining in the CCA class
The formula applies when the CCA asset class (or pool) will remain open when the project is completed
If, however, in a special case, we find that the pool will be closed out at the end of the project’s life, we should not use this formula
If there is a terminal _____ (i.e., the salvage value is less than this UCC), then there is a further tax shield when the asset is sold.
loss
If there is a ____ (i.e., the salvage value is greater than this UCC), then there will be a recapture of a portion of the tax savings
Gain
To use the Present Value of the Tax Shield on CCA you need the following
I = Total Capital investment in the asset that is added to the pool
d = CCA Rate for the asset class Tc = Company's marginal tax rate r = Discount Rate Sn = Salvage or disposal value of the asset in year n Mn = Asset life in years
Salvage Value versus UCC
When an asset is sold, the difference between its salvage value and ending UCC is not realized as gain or loss on the statement of comprehensive income immediately
Hence, the formula solution is more accurate as it takes into account the future CCA on this difference.
Evaluating Cost-Cutting Proposals
One decision we frequently face is whether to upgrade existing facilities to make them more cost-effective. The issue is whether the cost savings are large enough to justify the necessary capital expenditure.
As always, the initial step in making this decision is to identify the relevant incremental cash flows.
First, determining the relevant capital spending is easy enough
Second, there are no working capital consequences here, so we don’t need to worry about additions to net working capital.
Operating cash flows are the third component
Replacing an Asset
Instead of cutting costs by automating a manual production process, companies often need to decide whether it is worthwhile to enhance productivity by replacing existing equipment with newer models or more advanced technology
Evaluating Equipment with Different Lives
The next problem we consider involves choosing among different possible systems, equipment, or procedures with different lives
As always, our goal is to maximize net present value
Equivalent annual cost (EAC) is often used as a decision-making tool in capital budgeting when comparing projects of unequal life spans.
This approach is necessary only when two special circumstances exist.
1) First, the possibilities under evaluation have different economic lives.
2) Second, and just as important, we need whatever we buy more or less indefinitely. As a result, when it wears out, we buy another one.
Equivalent annual cost (EAC).
The present value of a project’s costs calculated on an annual basis.
Setting the Bid Price
A somewhat different and very common scenario arises when we must submit a competitive bid to win a job. Under such circumstances, the winner is whoever submits the lowest bid.
Winner’s curse
In other words, if you win, there is a good chance that you underbid.
Do we include side effects?
Hell yeah
Do we include changes in net working capital?
Hell yeah
Do we include changes in financing costs?
Are not included, no sir!
How we choose to finance the project is a separate questions
Do we include changes in inflation?
Not directly taken into account - we do not include it directly
But is taken into account in the required return
Do we include depreciation?
We don’t include it as it is non-cash
Do we include Capital Cost Allowance (CCA)
AKA the Tac shield
This is depreciation for tax purposes, so yes
This is an incremental cash flow we take into account for NPV
Pro Forma Statement Run Down
Cash Flow From Assets (CFFA) = Operating Cash Flow - Net Capital Spending - Changes in NWC
Operating cash flow (OCF) =
EBIT + Depreciation - Taxes
Changes in NWC =
Ending NWC - Beginning NWC
Net Capital Spending (NCS)
Ending fixed assets - beginning net fixed assets + depreciation
Declining Balance
Multiplying percentage given in CCA table by the undepreciated capital cost (UCC), consider half-year rule
Straight-line depreciation
(Initial cost - salvage) / number of years
No half year rule
