Chapter 8: Fundamentals of Capital Budgeting, Lecture notes of Banking and Finance

Download Chapter 8: Fundamentals of Capital Budgeting and more Lecture notes Banking and Finance in PDF only on Docsity! Chapter 8: Fundamentals of Capital Budgeting - 1 Supplement to Text Chapter 8: Fundamentals of Capital Budgeting Note: Read the chapter then look at the following. Fundamental question: How do we determine the cash flows we need to calculate the net present value of a project? Key: most managers estimate a project’s cash flows in two steps: 1) Impact of the project on the firm’s incremental earnings 2) Use incremental earnings to determine the project’s incremental cash flows Notes: 1) incremental = change as a result of the investment decision 2) revenues and expenses occur throughout the year, but we will treat them as if they come at end of the year => this is a standard assumption used by the text 8.1 Forecasting Earnings Basic Question: How do firm’s unlevered earnings change as result of an investment decision? A. Excel => for real projects, difficult to do by hand => use Excel Note: don’t hardcode (enter numbers) directly into formulas. Have your formulas refer to the section of your spreadsheet where you input the numbers (the text makes this point on p. 245). Chapter 8: Fundamentals of Capital Budgeting - 2 Supplement to Text B. Calculating by hand: 𝑈𝑁𝐼 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏𝑐) = (𝑅 − 𝐸 − 𝐷)(1 − 𝜏𝑐) (8.2) where: UNI = incremental unlevered net income => counting only incremental operating cash flows, but no financing cash flows EBIT = incremental earnings before interest and taxes c = firm’s marginal corporate tax rate R = incremental revenues E = incremental expenses (or costs) Note: Book uses costs, I will use “expenses” so can have an “E” instead of a “C” in the equation. Will use “C” for cash in new working capital in section 8.2 D = incremental depreciation C. Identifying Incremental Earnings 1. General Principles Basic question: How do the earnings (and cash flows) for the entire firm differ with the project verses without the project? => count anything that changes for the firm => count nothing that remains the same Example of costs that often don’t change with new project: fixed overhead expenses => don’t count previous or committed spending unless can get some back if don’t proceed => part can’t get back is called sunk costs Ex. money already spent to research and develop a product Ex. completed feasibility studies Ex. money spent on a partially completed building that can be sold Chapter 8: Fundamentals of Capital Budgeting - 5 Supplement to Text 8.2 Determining Free Cash Flow and NPV A. Calculating Free Cash Flow from Earnings Keys: 1) start with incremental unlevered net income 2) back out non-cash items in UNI 3) add cash items not in UNI FCF = UNI + D – CE - NWC (8.5a) where: CE = incremental after-tax capital expenditures NWC = change in net working capital associated with project NWCt = NWCt – NWCt-1 (8.4) NWC = CA – CL = C + AR + I – AP (8.3) CA = incremental current assets CL = incremental current liabilities C = incremental cash AR = incremental accounts receivable I = incremental inventory AP = incremental accounts payable 𝐹𝐶𝐹 = (𝑅 − 𝐸 − 𝐷) × (1 − 𝜏𝑐) + 𝐷 − 𝐶𝐸 − ∆𝑁𝑊𝐶 (8.5b) 𝐹𝐶𝐹 = (𝑅 − 𝐸) × (1 − 𝜏𝑐) − 𝐶𝐸 − ∆𝑁𝑊𝐶 + 𝜏𝑐 × 𝐷 (8.6) Note: 𝜏𝑐 × 𝐷 is the depreciation tax shield => reduction in taxes that stem from deducting deprecation for tax purposes => depreciation increases cash flows because reduce tax payments B. Notes 1. Depreciation (D) => add back to FCF since subtracted from UNI but doesn’t involve a cash outlay Chapter 8: Fundamentals of Capital Budgeting - 6 Supplement to Text 2. Capital Expenditures (CE) => incremental capital spending creates an outflow of cash that isn’t counted in UNI Note: cost is recognized in UNI over the life of the asset through depreciation => incremental asset sales are entered as a negative CE => creates a cash inflow => positive impact through equations as subtract a negative CE => must also consider tax implications of any asset sales 3. Change in Net Working Capital (NWC) 1) sales on credit generate revenue but no cash flow 2) the collection of receivables generates a cash inflow but no revenue 3) the sale of inventory generates an expense but no cash outflow 4) the purchase of inventory generates a cash outflow but no expense => subtracting the change in net working capital adjusts for these issues Notes on changes in net working capital: 1. recovery of net working capital => Changes in net working capital are usually reversed at the end of the project Ex. Cash put into cash registers is no longer needed when close a store 2. taxability => changes in net working capital are not taxable => buying inventory doesn’t create taxable income, selling inventory for a profit does D. Calculating NPV 𝑃𝑉(𝐹𝐶𝐹𝑡) = 𝐹𝐶𝐹𝑡 (1+𝑟)𝑡 = 𝐹𝐶𝐹𝑡 × 1 (1+𝑟)𝑡 (8.7) Note: We really don’t need this equation. It is essentially (4.2) Chapter 8: Fundamentals of Capital Budgeting - 7 Supplement to Text 8.3 Choosing Among Alternatives A. Evaluating Manufacturing Alternatives Note: To decide between alternatives, can compare the NPVs of alternatives. However, can also decide by calculating the NPV of the difference in cash flows. Example from text (p. 247): Differences in Cash Flows (In-House – Outsourced): Yr 0 = –3000 = – 3000 – 0 Yr 1 = –117 = – 5067 – (– 4950) Yr 2 – 4 = +900 = – 5700 – (– 6600) Yr 5 = +1017 = – 633 – (– 1650) NPV (differences) = −3000 − 117 1.12 + 900 .12 (1 − ( 1 1.12 ) 3 ) ( 1 1.12 ) + 1017 (1.12)5 = −597 Note: Same result as text Difference in text = – 20,107 – (– 19,510) = – 597 Video Solution Concept Check: all 8.4 Further Adjustments to Free Cash Flow 1. Other non-cash items => should back out (from UNI) any other non-cash items 2. Timing of Cash Flows => cash flows likely spread throughout year instead of at end of year => might increase accuracy if estimate cash flows over smaller time periods 3. Accelerated Depreciation Key issue: accelerated depreciation allows earlier recognition of depreciation => get cash flows from tax shield earlier => present value of tax shield higher Chapter 8: Fundamentals of Capital Budgeting - 10 Supplement to Text Example 2: Assume you are trying to decide whether to rent a building for $30,000 a year for the next 2 years (payments are due at the end of the year). A year from today you plan to purchase inventory for $50,000 that you will sell immediately for $110,000. Two years from today you plan to purchase inventory for $70,000 that you will sell immediately for $150,000. Assume also that need to hold cash balances (to facilitate operations) of $1000 a year from today and $1500 two years from today. Calculate the store’s incremental unlevered net income and free cash flow for each year of operation if the corporate tax rate is 35%. Note: You would probably take the cash out of the store when you close your doors two years from today…but I am assuming you leave it to better demonstrate changes in net working capital. 𝑈𝑁𝐼 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏𝑐) = (𝑅 − 𝐸 − 𝐷)(1 − 𝜏𝑐) NWC = C + AR + I – AP FCF = UNI + D – CE - NWC UNI1 = (110,000 – (30,000+50,000) – 0)(1 – .35) = $19,500 UNI2 = (150,000 – (30,000+70,000) – 0)(1 – .35) = $32,500 Note: holding cash doesn’t affect UNI Net Working Capital: t = 0 t = 1 t = 2 t = 3 Cash 0 1000 1500 0 A/R - - - - Inventory - - - - A/P - - - - NWC 0 1000 1500 0 NWC 0 1000 500 – 1500 FCF1 = 19,500 – 1000 = 18,500 FCF2 = 32,500 – 500 = 32,000 FCF3 = 0 – (–1500) = 1500 Key: don’t have access to all of the cash flows generated by sales since must hold some cash at the store. Video Solution Chapter 8: Fundamentals of Capital Budgeting - 11 Supplement to Text Example 3: Assume you are trying to decide whether to rent a building for $30,000 a year for the next 2 years (payments are due at the end of the year). A year from today you plan to purchase inventory for $50,000 that you will sell immediately for $110,000. Two years from today you plan to purchase inventory for $70,000 that you will sell immediately for $150,000. Seventy-five percent of sales will be on credit that you will collect one year after the sale. Assume also that need to hold cash balances (to facilitate operations) of $1000 a year from today and $1500 two years from today. Calculate the store’s incremental unlevered net income and free cash flow for each year of operation if the corporate tax rate is 35%. 𝑈𝑁𝐼 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏𝑐) = (𝑅 − 𝐸 − 𝐷)(1 − 𝜏𝑐) NWC = C + AR + I – AP FCF = UNI + D – CE - NWC UNI1 = (110,000 – (30,000+50,000) – 0)(1 – .35) = $19,500 UNI2 = (150,000 – (30,000+70,000) – 0)(1 – .35) = $32,500 Note: doesn’t change from Examples 1, 2, or 3 Net Working Capital: AR1 = .75(110,000) = 82,500 AR2 = .75(150,000) = 112,500 t = 0 t = 1 t = 2 t = 3 Cash 0 1000 1500 0 A/R 0 82,500 112,500 0 Inventory - - - - A/P - - - - NWC 0 83,500 114,000 0 NWC 0 83,500 30,500 –114,000 FCF1 = 19,500 – 83,500 = – 64,000 FCF2 = 32,500 – 30,500 = 2,000 FCF3 = 0 – (–114,000) = 114,000 Video Solution Keys: => sales on credit generate revenue but not cash flow => collections of receivables generate cash flows but not revenues => UNI overstates early cash flow and understates late cash flow Chapter 8: Fundamentals of Capital Budgeting - 12 Supplement to Text Example 4: Assume you are trying to decide whether to rent a building for $30,000 a year for the next 2 years (payments are due at the end of the year). Today you plan to purchase inventory for $50,000 that you will sell a year from today for $110,000. A year from today you plan to purchase inventory for $70,000 that you will sell two years from today for $150,000. Sixty percent of all inventory purchases will be on credit due one year after you buy it. Seventy-five percent of sales will be on credit that you will collect one year after the sale. Assume also that need to hold cash balances (to facilitate operations) of $1000 a year from today and $1500 two years from today. Calculate the store’s incremental unlevered net income and free cash flow for each year of operation if the corporate tax rate is 35%. 𝑈𝑁𝐼 = 𝐸𝐵𝐼𝑇 × (1 − 𝜏𝑐) = (𝑅 − 𝐸 − 𝐷)(1 − 𝜏𝑐) NWC = C + AR + I – AP FCF = UNI + D – CE - NWC UNI1 = (110,000 – (30,000+50,000) – 0)(1 – .35) = $19,500 UNI2 = (150,000 – (30,000+70,000) – 0)(1 – .35) = $32,500 Note: doesn’t change from previous examples Net Working Capital: AP0 = .6(50,000) = 30,000 AP1 = .6(70,000) = 42,000 t = 0 t = 1 t = 2 t = 3 Cash 0 1000 1500 0 A/R 0 82,500 112,500 0 Inventory 50,000 70,000 0 0 A/P 30,000 42,000 0 0 NWC 20,000 111,500 114,000 0 NWC 20,000 91,500 2500 –114,000 FCF0 = 0 – 20,000 = – 20,000 FCF1 = 19,500 – 91,500 = – 72,000 FCF2 = 32,500 – 2,500 = 30,000 FCF3 = 0 – (–114,000) = 114,000 Video Solution Keys: => purchases on credit offset to some extent the differences between UNI and Cash Flow associated with buying inventory