Finance 3310
Lecture 9
Project cash flows
Relevant cash flows
We saw that capital budgeting involves discounting the
relevant cash flows at the relevant cost of capital. Here we:
Examine relevant cash flows
Work a couple of examples
Estimation of cash flows:
Must forecast cash inflows (revenues)
Must forecast cash outflows (costs)
Inflation affects cash flows differently
1. Focus on cash flows; not on accounting numbers
Differences:
Depreciation:
Affects taxes, but not a cash flow per se
In practice, use MACRS rates
Cost:
Capitalized & depreciated for accounting purposes
Cash outflow at time of purchase for capital budgeting purposes
In general: Cash flow = accounting income + depreciation
2. Focus on incremental cash flows ( in cash
flows)
What is different if project is accepted?!
A. Sunk costs - are those costs which have already been incurred and are not affected by project
decision. These are history: ignore!
Ex. Site survey which has already been done
B. Opportunity costs - the highest value use of an
asset if it were not used by the project
Ex. Piece of land & new plant site - what could
land be sold or used for?
Market value of land; not cost
Don't confuse with sunk cost - sunk cost cannot be recovered; opportunity cost reflects alternative use of an asset
Should be an after tax value
C. Externalities - less obvious costs or benefits to a
project
Ex. Opening a new store: how many 'new' customers are really
just customers of your other stores?
Costs of spreading management
D. Shipping and installation - these are costs of the
project and should be included
E. Change in working capital -
in current assets - current liabilities
in working capital is treated as cash outflow in the
first period Return ofworking capital is cash inflow at end
3. All cash flows should be after tax
Revenues - expenses, net of taxes
Do not tax effect purchase price & NWC
4. Do not include interest expense as cash flow
Separate project flows from financing flows. The discount rate
takes care of interest
5. Lay out the cash flows in time and then discount
Example 1
Consider the potential purchase of a new machine, and assume the following:
1.Cost: 108,000
2.Modification cost: 12,500
3.3 yr life; salvage value of 65,000
4. In net working capital = 5,500
5.Savings in b/4 tax operating costs = 44,000
6.tax rate = 34%
7.Cost of capital = 12%
| Time 0 | Time 1 | Time 2 | Time 3 | |
| Cost of machine | (108,000) | |||
| Modification | (12,500) | |||
| Total cost | (120,500) | |||
| in NWC | (5,500) | |||
| Depreciation tax Savings |
(33%) | (45%) | (15%) | |
| (macrs*cost * 34%) | 13,520 | 18,437 | 6,146 | |
| Net of tax cost | ||||
| Savings (1-t)*44,000 | 29,040 | 29,040 | 29,040 | |
| Salvage value | 65,000 | |||
| Tax on salvage | (19,232)* | |||
| Return of nwc | 5,500 | |||
| Net cash flow | (126,000) | 42,560 | 47,477 | 86,454 |
| pv factor 1/(1.12)i | 1/(1.12) | 1/(1.12) | 1/(1.12)2 | 1/(1.12)3 |
| Present value | (126,000) | 38,000 | 37,848 | 61,536 |
Net present value: $11,384 > 0 ==> accept project
****tax on salvage:
Salvage 65,000
Cost of 120,500 less depreciation of 112,065 ===> Book value = 8,435
==> Gain of 56,565
Tax at 34% = 19,232
Replacement analysis
Additional considerations:
1. Net of tax proceeds from sale of old asset
Treat as received at t=0
Tax is on difference between book & market
2. Be careful with incremental cash flows:
in costs
in depreciation * tax rate
Example 2
Old machine:
New machine:
Cost of capital = 16%; Tax rate = 34%
| Time 0 | Time 1 | Time 2 | Time 3 | Time 4 | Time 5 | |
| Cost | (150,000) | |||||
| Sell old | 65,000 | |||||
| Book val | 55,000 | |||||
| Gain | 10,000 | |||||
| Tax gain | (3,400) | |||||
| new | ||||||
| Macrs % | (33%) | (45%) | (15%) | (7%) | ||
| Deprec. | 49,500 | 67,500 | 22,500 | 10,500 | ||
| old | 9,000 | 9,000 | 9,000 | 9,000 | 9,000 | |
| Differ. | 40,500 | 58,500 | 13,500 | 1,500 | (9,000) | |
| Tax save | 13,770 | 19,890 | 4,590 | 510 | (3,060) | |
| Salvage | (10,000) | |||||
| cost | ||||||
| Post tax | 33,000 | 33,000 | 33,000 | 33,000 | 33,000 | |
| Net cf | (88,400) | 46,770 | 52,890 | 37,590 | 33,510 | 19,940 |
| PV factor 1/(1.16)i | 1/(1.16) | 1/(1.16) | 1/(1.16)2 | 1/(1.16)3 | 1/(1.16)4 | 1/(1.16)5 |
| Present value | (88,400) | 40,319 | 39,306 | 24,082 | 18,507 | 9,494 |
Net present value = $43,308 > 0 ==> replace machine
Remember: what is different; what is the change??