Lecture 6

Project Cash Flows

1. Relevant cash flows

• Sunk costs

• Opportunity Costs

• Externalities

2. Example

3. Replacement problem

4. Replacement example

5. Projects with different lives

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

The relevant cash flows for a project are the incremental cash flows associated with the project. Incremental cash flows represent the difference between the cash flows with the project and the cash flows without the project. Rather than literally compute the cash flows to the firm without the project and the cash flows to the firm with the project, you can usually identify the specific incremental cash flows related to the project.

One way to estimate cash flows is to prepare pro-forma financial statements for the project, and then to calculate cash flows from the project (assets). Oftentimes it is easier to identify the specific cash flows rather than to forecast full financial statements.

Some General Rules:

1. Focus on cash flows; not on accounting numbers

The primary difference between cash flow and accounting numbers involves fixed assets. This difference is summarized below:

Depreciation

• not a cash flow

• affects cash flows through effect on taxes

• in practice, use MACRS rates

Cost

• capitalized & depreciated for accounting purposes

• cash outflow at time of purchase for capital budgeting purposes

• typically treated as cash outflow at time 0

 

Other Accounting items: Be careful not to mix the accounting perspective, which is backward, with the finance perspective, which is forward. In particular, be suspicious of any item called a 'charge' or an 'allocation.' These items will likely reflect sunk costs, which are described below.

 

2. Focus on incremental cash flows ( in cash flows) The question to ask is: "What is different if project is accepted?"

a. Sunk costs - are those costs which have already been incurred and are not affected by the project decision. These are history so ignore them!

ex. Research and development expenditures

b. Opportunity costs - the highest value use of an asset if it were not used by the project.

ex. Suppose a company owns a piece of land & is considering a new plant site. The land cost $100,000 and can be sold for $75,000, net of taxes. What cost, if any, should be assigned to the land?

• 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. Your book calls these side effects or spillover effects.

ex. Opening a new store: how many 'new' customers are really just customers of your other stores? Also, what are the costs of spreading existing management over more stores?

d. Change in working capital -

•  in current assets -  current liabilities

•  in working capital is treated as a cash outflow at time 0 (an investment: opportunity cost of $)

• return of  in working capital is cash inflow at end

3. All cash flows should be after tax

• revenues - expenses, net of taxes. Multiplying a revenue or expense by (1-t) converts it to a net of tax number.

• do not tax effect purchase price & NWC; be careful with tax on gains or losses associated with asset disposals

4. Do not include interest expense as cash flow

• separate project flows from financing flows

• the discount rate takes care of interest

• exception: real estate projects, which compute CF's to equity

 

Example 1 : Consider whether to purchase the following machine.

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%

Net Present Value: $11,384 > 0 ==> accept project

****Tax on salvage: Salvage 65,000

Replacement analysis

Should the company keep an existing asset, or replace it with a new one? The analysis of these decisions is exactly as before, except that you have to more careful with incremental cash flows.

1. Net of tax proceeds from sale of old asset

• treat as received at t=0

• tax on gain or loss

2. Be careful with incremental cash flows:

•  in costs and revenues

•  in depreciation x tax rate

• `loss' of salvage value and related tax effect on old asset at end

 

Example 2

Suppose you are considering replacing an old machine with a new machine. Some of the relevant facts are:

Old machine:

• Estimated useful life of 10 years

• Purchased 5 yrs ago at cost of 100,000

• Straight-line depreciation (9,000 /yr)

• Estimated salvage value of 10,000 at end of useful life

• Can be sold now for $65,000

New machine:

• Cost = 150,000

• 5 yr life; 3 yr MACRS ( 33%,45%,15%)

• Will reduce cash operating expenses by $50,000 / yr

• worthless at end

The cost of capital for the machines is 16%. The tax rate is 34%.

net present value = $43,308 > 0 ==> replace machine

Projects with Different Lives

All of the above analysis assumed mutually exclusive projects have the same life. When projects have different lives, there are a couple of ways to do the comparison.

1. Common denominator: Find the lowest common denominator in `lives' for each of the projects, and then assume each project is repeated the number of times necessary to reach that denominator. As an example, suppose one project has a 4 year life and another project has a 3 year life. The lowest common denominator is 12, so we assume the first project is repeated 3 times and the second project is repeated 4 times. We compare the NPV's of the `12 year' projects.

2. Compute equivalent annual cost: Compute the NPV of each project first. Then calculated the annual `annuity' that results in that same NPV. Select the project with the highest equivalent annual annuity (lowest if we are talking about a cost).