Week 5-capital budgeting part 2 Flashcards
Procedural outline
- Form ideas on how to implement strategies of
the firm and increase shareholders’ wealth - Plan how to implement the ideas
- Gather information on timing and magnitude of
costs and benefits. Estimate cash flows - Apply decision criterion (rule)
OCF
Total operating cash flow
Firms’ net cash flows (inflows – outflows)
per period
relevant for the particular project =
Revenues from sales
Minus fixed and variable costs of production
In calculating OCF we need to take into account:
A. The effect of taxes on cash flows
B. The effect of depreciation on cash flows, i.e.
deductions that result in a “tax shield/benefit”
C. The changes in working capital that generate
relevant cash flows
. Effect of taxes
he company needs to pay taxes
If tax rate is 23%,
(revenues – costs) net of taxes is :
(Sales – Costs)*(1 ‐ 0.23)
Effects of depreciation
• Depreciation is not a cash expense (non‐cash expense).
• It is relevant in the calculation of cash flows only
because it affects taxes, which are cash flows
• It affect taxes because it allows to “shield” from
taxes a proportion of an initial capital
expenditure in each time period
Depreciation method
Straight Line method • A depreciation method allowing for a linear write‐off of assets over their lifetime, i.e. a fixed, equal proportion of the capital expenditure can be shielded from taxes each period.
Effects of changes in working capital
Working capital definition
•Short term current assets and liabilities generating cash
flows and necessary for the daily working of the business:
• trade receivables (sales still unpaid);
• trade payable (supplies still to pay);
• inventories (goods already paid and stored)
•At the end of a project, the sum of the changes in working
capital is often zero (i.e. it is recovered, everything paid for by
customers or paid to suppliers)
Change in Net Working Capital
•Total net increase or decrease in working capital: • + net receivable • – net payables • + inventory
Change of total Net Working Capital
is DEDUCTED from cash flows
because, looking at each item
Trade receivables (still to receive)
Need to be deducted from sales (i.e. deducted from cash flows)
because customers have not paid yet, negative cash flow
Trade payable (still to pay)
Need to be deducted from the firm’s cost (i.e. added to cash flows)
because the firms has not paid yet, positive cash flow
Inventory (already paid)
Need to be added to the firm’s cost (i.e. deducted from cash flows)
because these stocks were paid in advance, negative cash flows
OCF =
Total Operating Cash Flow =
(Sales – Costs)*(1 ‐ Tax rate)
Plus tax benefit of Depreciation
Minus change in Net Working Capital
EBIT (inflow)
• Earnings Before Interest and Taxes = EBIT Sales – Costs – Depreciation
Net income (inflow)
• EBIT – Taxes =
Sales – Costs – Depreciation ‐ Taxes
Total taxes
(outflow):
• Tax rate x (Sales – Costs)
minus Tax benefit/shield of depreciation
(i.e. tax rate x depreciation)
Four equivalent ways to calculate
Total Operating Cash Flow
- OCF= (Sales – Costs)*(1‐tax rate) + tax benefit of
depreciation ‐ Change in Net Working Capital - OCF = EBIT + Depreciation – Total Taxes = Sales –
Costs – Taxes ‐ Change in Net Working Capital - OCF = Net income + Depreciation = Sales – Costs –
Total Taxes ‐ Change in Net Working Capital - OCF= Sales – Costs – Total Taxes ‐ Change in Net
Working Capital
What are the relevant cash flows?
All incremental cash flows
• 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
undertaking the project.
• Estimate separately the future cash flows (affected
by the project) with the project and without the
project, and find the difference. This difference is a
series of timed cash flows, and this is what affects
the wealth of the shareholder
What is the stand-alone principal?
The assumption that the evaluation of a project is based on the project’s total incremental cash flows and is made in isolation from other projects or activities
