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
Relevant cash flows to INCLUDE
Side effects cash flows
• Cash flow that arise as a consequence of the new
project on existing projects. They are incremental
cash flows and needs to be estimated and
INCLUDED
• For example: a proposed project will generate
£10,000 in revenue, but causes another product line
to lose £3,000 in revenues. The incremental cash
flow is £7,000
Cash flows to INCLUDE
Opportunity Cost
• Cost of a resource that affects the project even if it has no cash flow, the most
valuable alternative that is given up if the project is undertaken.
• It is an incremental cash flow and needs to be ESTIMATED and INCLUDED
• For example: the project may use a piece of land the firm already owns. If not
used, the land could be sold or used for something else, so“given up cash flow
from land” (opportunity cost of land) should be included
• Importance of evaluation of projected cash flows with and without the project and
find the difference
Cash flows NOT to INCLUDE
1) financing cost: For example interests or dividends They are NOT INCLUDED in cash flows calculations
2) sunk cost:
A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. For example, a consultant’s fee to study an initial feasibility of the project. It is not an incremental cash flow and should NOT be INCLUDED
Cost reduction projects:
mutually exclusive and with different lives
Decision based on minimization of costs. But how do you compare the two projects? If you compare the PV of costs and choose the lower (machine B), you do not take into account that you would need to replace machine B earlier than machine A (and therefore many more times)
2 possible methods
A. Equalise the lives and compare NPV of projects. In this
case repeat project A three times and project B five
times (NB: make sure you discount repeated costs all
the way to Year 0)
B. Use equivalent annual cost (EAC)
• Calculate PV of all costs
• Using annuity formula, calculate the annualised
capital cost (the annuity payment) that would
generate that PV
Equivalent Annual Cost (EAC)
The present value of a project’s costs
calculated on an annual basis, as if the
project were to be repeated forever.
Using Annuity formula from Lecture 3
PV = C x Annuity Factor (n, r) We solve for C: C = PV / Annuity Factor (n, r) Notation: PV = the present value of the annuity r = interest rate (constant over the period) to be earned n = the number of payments C = the payment per period
