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Lesson 1: Project Cash Flows Scenario: Should the Project Continue? ● Last year TMI invested in the artificial hip market, but the numbers are not lining up with what was expected. Should TMI continue in the artificial hip market? → This decision involves sunk costs : costs that have already been incurred. Must be careful to properly identify what cash flows are relevant to our decisions--the incremental cash flows Key Concepts: Rules for Project Cash Flow Estimates ● Capital budgeting analysis evaluates the incremental after-tax cash flows of a project. Incremental cash flows are those that would occur if a project is selected. ● Rule 1: Include cash flows, and only cash flows, in your calculations ○ Project analysis is based on incremental cash flows which consist of all changes in the firm's future cash flows that are a direct consequence of adopting a project. Accounting revenues and expenses are not incremental cash flows. Only the direct cash inflows and outflows created by the project are included. Overhead cannot be allocated to a project unless it is specifically integral to that project. ■ For example, a company may have five accountants on staff. The salaries for these accountants are not allocated to the project unless an accountant is hired as a direct result of taking on the project ○ What cash flow would you have to give up to obtain productive assets? What cash inflows would result if you were to take on the project? ● Rule 2 : Include the impact of the project on cash flows from other product lines ○ Economic interdependencies occur when the project would change the cash flows in other parts of the company. ■ For example, many grocery stores are installing gas pumps. Evaluation of these pumps must include not only gas sales, but also the increased sale of groceries to people who are filling up. ■ This positive effect where the project would increase the cash flows from existing operations is called synergy. ○ Economic interdependencies can also occur when the project decreases the cash flows in other parts of the company. ■ A bricks-and-mortar store that introduces on-line shopping may suffer a loss in sales from its physical stores. ■ This reduction in the cash flows of existing operations is called erosion. ○ A project may increase the cash flows or decrease the cash flows from your existing business operations. These synergies and erosions must be considered. ● Rule 3: Include all opportunity costs ○ Even if a company already owns an asset, the asset must be included in the project evaluation. ○ For example, imagine a company is evaluating a plant expansion that would use a vacant lot the company already owns. This lot could be sold for a considerable
amount of money. Thus, the cost of the alternate use of the lot (its sale price) must be included as a project cash outflow. ○ The cost of any asset used in the project is a cost and should be included. ● Rule 4: Forget sunk costs ○ Sunk costs are costs that have already been incurred. As such they are not incremental cash flows and are irrelevant for capital budgeting decisions. Only future inflows and outflows should be considered. Imagine that last week you put new tires on your car. This week, the transmission went out. Your previous expenditure on tires is irrelevant. The only cash flows you should consider are the costs of a new transmission compared to the current value of the vehicle. ○ Get over it! Only future cash flows count. ● Rule 5: Include only after-tax cash flows in the cash flow calculation ○ You can only spend what you keep. As the project being evaluated is in addition to the other activities of a company, each project should be evaluated using marginal tax rates ○ Taxes are a cost and if the project doesn’t work on an after-tax basis don’t do it Application: Elements of Cash Flow Analysis
- Opportunity Cost. In the context of capital budgeting, what is an opportunity cost? a. In general we’ve seen the opportunity cost as the discount rate used in valuing future cash flows. b. In capital budgeting, the opportunity cost is a much broader concept that helps us sort out what is relevant in our capital budgeting decision.In capital budgeting we are not evaluating the entire company. Rather, we are looking as to what specific project managers are considering. We must therefore sort out what would change if the project were undertaken—how adopting the project would change the company’s cash flows and wealth. Key Concepts: Project Cash Flow Estimates ● A capital budgeting project is nothing more than doing things: developing a project to accomplish some goal. ● However, it's not enough to get the idea: you must also get the resources. And to get these resources you must convince your boss, your investors, your donors, the foundations issuing grants, that your plan is a good one--that the benefits of your plan exceed the costs. ● Every project, regardless of the organization pursuing it, involves money--cash must be expended to get the benefits. ● There are four categories of capital budgeting projects: ○ Revenue enhancing projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign. ○ Cost reduction projects focus on reducing costs. Outsourcing of business functions, outsourcing production, improving supply chains, employing machine
produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the company's security holders, so the projected capital expenditures must be subtracted from the operating cash flow. ● Additions to Net Working Capital are investments in the project's short-term assets. A project may require investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders. ● SUMMARY: the project may produce positive cash flow from its operations, but these cash flows would occur only if the company made the necessary investments in the short- and long-term assets required. The investors get what is left over--the free cash flow. Free Cash Flow and the Project Timeline ● Not all elements of free cash flow appear in every time period. At the start of the project often only short- and long-term investments appear. During the life of the project in some periods only operating cash flows show up. And, if the project has a definite ending period, all three elements of free cash flow may appear ● Initial Cash Flows : Projects generally require an initial investment. Projects often take several years of planning and construction before Operating Free Cash Flows appear. There are two types of capital expenditures we should include in initial cash flows: ○ Direct expenditures are those directly connected with obtaining the capital asset. ○ Indirect expenditures which result from our decision to purchase the asset should also be included at the project's inception. ● Operating Cash Flows : Managerial decisions affect cash flows received and the cash cost of production. The specific nature of these inflows and outflows will depend on the type of project. Revenue enhancing products will focus on cash inflows, cost reduction projects will focus on reducing cash outflows. If you cut your costs by $10, you in effect have received an inflow of $10! ● Terminal Cash Flows: Given the framework of incremental analysis, at the conclusion of a project, management will restore the company to its original condition without the project. There are several types of cash flows connected with closing the project down. Important Details: Clarify Capital Budgeting Process ● Initial Cash Flows: Many of our capital budgeting examples contain an economic miracle: plant and equipment appear in an instant at time = 0. In fact, capital assets and working items take time to get in place. ○ As an example, consider Austin's urban rail system. The Capital Metro line took
approximately five years to build. A realistic timeline would have five years of outflows before the inflows began in year six. ○ To introduce you to an evaluation structure, assume that the initial project capital investments occur at time zero. In reality this would be a nice miracle, but in these problems it is an assumption that lets the overall logic unfold in a more understandable manner. ● Net Working Capital: The short-term working capital items do not depreciate. They recycle through the production cycle. Cash is converted to raw materials, then to work in progress, then to finished inventory then to accounts receivable then back to cash. Working capital, if present in a project, is treated in the following way. ○ If a project requires a working capital investment, the firm should account for this as a cash outflow. A revenue-increasing project may require additional inventory, more workers, and higher accounts receivable. The company must make these short-term investments to make the project operational. Imagine expanding the production line but not having enough workers! ○ If a project requires a lower working capital investment, the firm should account for this as a cash inflow. With the robotic factory there will be fewer workers. The robots may also be more efficient and not produce as much scrap or fewer imperfect units. Reducing costs by outsourcing production, customer service, and other functions would also reduce the working capital investment. ○ Ex: Consider a company that makes a major change in its production process by introducing robotic assembly lines. As many workers are laid off, and the machines don't make as many mistakes that cause waste in resources or defective output the need for working capital would be reduced. This would cause a cash inflow at time zero ● Terminal Cash Flows: There is nothing that says projects can only exist for a defined period; however, the future is uncertain and to act as if we know what will happen in ten years is not realistic. So projects may be limited to a length that managers feel is reasonable, or use some sort of perpetuity analysis after a few years. These techniques are more sophisticated than needed for our course ● Interest Expense: Equip us to make the major managerial decisions ○ **** Capital budgeting decision:** What productive assets should the firm obtain? This decision is guided by the customers the corporation seeks to satisfy. ○ Capital Structure decision: Productive assets are not cheap! The corporation must raise capital from investors by issuing financial securities to finance its operations. ○ Net Working Capital decision: The corporation must be able to manage its short-term expenses. ○ *** Focus on the first decision, with working capital included as appropriate. We are not concerned at this time with how the project is financed. If a project is acceptable from an operating point of view then managers would decide on how
The Knee Cushion Project - Terminal Cash Flows Example: ● Nathan now works through the terminal value of the project and calculates the project's NPV. TMI's project has a finite life and thus may experience special costs to close the project down.
Application: Project NPV Analysis
- Cash flow and depreciation. “When evaluating projects, we're only concerned with the relevant incremental after tax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects.” Critically evaluate this statement. a. Depreciation is a noncash expense charged against accounting earnings to write off the cost of an asset during its estimated useful life. While you can throw these terms around to impress your friends at a bar, it’s more important to understand what depreciation actually is and is not! b. Depreciation is not a cash flow and is not relevant for capital budgeting EXCEPT that depreciation is a tax-deductible expense and therefore reduces taxes, which are a cash flow. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced and thus increases the net cash flow. This is the reason that we compute net income and then add back the depreciation expense.
- Capital budgeting considerations. A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to produce an “essentialized” version, meaning a shorter (and lower-priced) book. What are some of the considerations
This amount would occur in Kenny, Inc.’s Balance Sheet, but it does not reflect what the land is worth today. c. The $7.4 million current net (after-tax) value of the land is an opportunity cost if the land is used rather than sold off. As you could get $7.4 million for the land, you should include the use of the land as part of the incremental cash flows for the project. d. The $26.5 million cash outlay is a direct cost of the project. The $1,320,000 for the access road is a necessary cost and part of the project expenses as it is needed to get the plant ready for use. No road, no operating cash flows from the plant! e. Therefore, the proper year zero cash flow to use in evaluating this project is: Cash flow = $7,400,000 + 26,500,000 + 1,320,000 → Cash flow = $35,220,
- Relevant cash flows: Economic interdependencies. Winnebagel Corp. currently sells 1,800 motor homes per year at $77,000 each and 600 luxury motor coaches per year at $120,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 800 of these campers per year at $23,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 90 units per year and reduce the sales of its motor coaches by 10 units per year. What is the amount to use as the annual sales figure when evaluating this project? Why? a. New product line: Sales due solely to the new portable campers are: 800 x $23,500 = $18,800, i. The company should take economic interdependencies into account: how would the introduction of this new product affect their existing sales? b. Synergy : The new portable loop campers are expected to attract additional new customers to its existing motor home line, producing an increase in sales of: 90 x $77,000 = $6,930,000 increase in sales c. Erosion : As with many new products, existing customers may switch from existing lines to the new product. The introduction of the portable camper is expected to decrease Wommebagels sales of luxury motor coach sales → 10 x $120,000 = $1,200,000 loss in sales d. The net sales figure to use in evaluating the new line is thus: Net sales = Sales of portable camper + increase in sales of motorhomes – loss of sales of motor coaches → Net sales = $18,800,000 + $6,930,000 – $1,200,000 → Net sales = $24,530,
- Calculating projected net income. A proposed new investment has projected sales of $645,000. Variable costs are 40 percent of sales, and fixed costs are $168,000; depreciation is $83,000. Prepare a pro forma income statement assuming a tax rate of 21 percent. What is the projected net income?
a. NI = 107,440 → (EBIT - taxes 21%) → # for Taxes @ 21% = 21% of EBIT b. EBIT = All Income Statement #’s subtracted c. To calculate the operating cash flows, we would add back depreciation. Depreciation served its purpose to reduce taxes, but once taxes have been calculated, we add depreciation to net income to get net cash flow. → Net cash flow = Net Income + Depreciation = $107,440 + $83,000 = $190,
- Calculating Project OCF. H. Cochran, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $1,950,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,145,000 in annual sales, with costs of $1,205,000. If the tax rate is 21 percent, what is the OCF for this project? a. Calculate depreciation: We calculate depreciation using the straight-line method. Annual depreciation expense = (Fixed asset investment)/Project life = $1,950, - 0/3 = $650, b. Calculate Net Income : With these inputs we can now calculate NI. Net sales = $2,145,000 → Costs = 1,205,000 → Depreciation = 650,000 → EBT = $290, → Tax 21% = 60,900 → Net income = $229, c. Calculate Operating Cash Flow: Using the methods → developed, Cochran’s OCF is → OCF = NI + Depreciation = $229,100 + $650,000 = $879, d. Calculate OCF using the tax shield approach: We can also use the tax shield approach to calculating OCF. Remember that the final answer will be the same no matter which of the methods you use. → OCF = (Sales – Costs)(1 – Tc) + Depreciation(Tc) = ($2,145,000 – 1,205,000)(1 – .21) + $650,000(.21) = 879, L2: Special Capital Budgeting Cash Flow Situations Scenario: What About Inflation? ● Dianne's mom researches the market and continues to manage her finances. Her research shows that inflation should remain low, but Nathan thinks otherwise. → Inflation is one of the major factors to consider when estimating cash flows for capital budgeting decisions. However, inflation is difficult to measure. Key Concepts: Capital Budgeting and Inflation ● Money is a means of facilitating economic transactions. ● The Three Functions of Money: ○ Exchange → An exchange is where economic assets are traded among buyers and sellers. Money facilitates economic activity in that the price of each economic asset is specified in terms of money. Without money exchange would consist of barter , where the buyer and seller must negotiate a swap of physical goods and
Inflation ● Prices rise with inflation & The purchasing power of money declines over time ● Measure with: Prices & Assets ● Use price indices → EX: CPI Real Discount Rate Example: ● The Fisher Effect, named after the famous economist Irving Fisher, describes how the nominal interest rate is made up of two components, the real interest rate and the rate of inflation. ○ The nominal interest rate is the rate we see reported in business news, is used in contracts and valuing securities, and generally used in capital budgeting projects. This is the rate we use in this course. ○ The real interest rate measures the real increase in the purchasing power of amount over time: how much actual purchasing power of money is expected to increase. ○ The inflation rate is the rate by which prices are expected to increase due to a loss of purchasing power of money. ○ Equation: (1 + Nominal rate ) = (1 + real rate)(1 + inflation rate) ● The Fisher Effect posits that investors who feel that their purchasing power will decrease will demand an increase in the nominal interest rate earned -- an inflation risk premium
- - in order to give them their required real rate of return.
Inflation Adjusted Cash Flows & NPV Example:
Working Words
- Incremental Cash Flows After Taxes (ICFAT) are the periodic cash outflows and inflows that occur if, and only if, an investment project is accepted. Incremental cash flow focuses on the project, not the company as a whole.
- Economic interdependencies: Adopting a project would change the cash flows in other parts of the company.
- Synergy : The positive effect where adopting the project would increase the cash flows from existing operations.
- Erosion: The negative effect where adopting the project would decrease the cash flows from existing operations.
- Sunk costs: Costs that have already been incurred. As such they would not be affected by the capital budgeting decision and are thus not incremental cash flows.
- Revenue enhancing project : These projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign.
- Cost reduction project: These projects focus on reducing costs. Outsourcing of business functions or production, improving supply chains, employing machine learning lead to lower costs and thus higher income.
- Corporate Social Responsibility project: The ExxonMobil project is an example of corporations contributing to society. While the corporation's function in society is to efficiently produce goods and services, corporations are expected to be good citizens. These projects do help society, and also enhance the reputation of the company.
- Regulatory requirements project: Governments regulate economic activity to protect
society from harmful effects. The most cost-effective way to handle toxic waste from a production process is to dump it into Lake Lady Bird. These projects are undertaken because they are required.
- Free cash flow (FCF)/Cash flow from assets: The amount of cash generated by a company that is available to distribute to the firm's creditors and owners.
- Operating cash flow is earnings before interest plus depreciation minus taxes. And, its important to remember that these cash flows have not yet occurred--we estimate what they would be if the project were to be adopted.
- Capital spending is the cash that must be invested in the project's capital assets to produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the company's security holders, so the projected capital expenditures must be subtracted from the operating cash flow.
- Additions to Net Working Capital are investments in the project's short-term assets. A project may require investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders.
- Capital spending is the cash that must be invested in the project's capital assets. Operating cash flow is earnings before interest plus depreciation - taxes. In capital budgeting OCF measures the cash flows from operating the project, but does not include the cash flows related to capital spending or changes in NWC.
- Initial cash flows: Expenditures that are undertaken to obtain assets and begin a capital budgeting project.
- Direct expenditures are those directly connected with obtaining the capital asset.
- Indirect expenditures, which result from our decision to purchase the asset, should also be included at the project's inception.
- Operating cash flows : Cash flows received from the operating of the capital budgeting project.
- Terminal cash flows: Cash flows incurred in closing down a capital budgeting project.
- Fiat money: Money issued by a government that is not backed by a physical commodity such as gold or silver.
- Specie money: A metallic money that possesses an intrinsic value and is naturally limited in supply.
- Inflation : A decrease in the purchasing power of a unit of a currency.
- Deflation : An increase in the purchasing power of a unit of a currency.
- Nominal interest rate: An interest rate that is not adjusted for inflation.
- Real interest rate: An interest rate reflecting the real change in purchasing power of a currency.
- Inflation premium: The extra rate of return required by investors to compensate them for the loss of purchasing power of the currency.
