Making Capital Investment - PowerPoint Presentation

1. Making Capital Investment Decisions: Incremental Cash FlowsModule 3.1

2. 6.1 Incremental Cash FlowsCash flows matter—not accounting earnings.Incremental cash flows matter.Changes in revenues, expenses, taxes, any cash flow as a result of the decision to invest.Opportunity costs matter (if it effects cash flows).Side effects like cannibalism and erosion matter.Taxes matter: we want incremental after-tax cash flows.Sunk costs do not matter.Sunk costs are expenses already paid

3. Cash Flows—Not Accounting IncomeConsider depreciation expense. Firms (nor yourself) ever write a check made out to “depreciation.”Much of the work in evaluating a project lies in taking accounting numbers and converting them to cash flows.

4. Incremental Cash FlowsSunk costs are not relevantJust because “we have come this far” does not mean that we should continue to throw good money after bad.Opportunity costs do matter. Just because a project has a positive NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.

5. Incremental Cash FlowsSide effects (“externalities”) matter.If our new product causes existing customers to demand less of our current products, we need to recognize that.If, however, synergies result that create increased demand of existing products, we also need to recognize that.

6. Estimating Cash FlowsCash Flow from OperationsOCF = EBIT – Taxes + DepreciationNet Capital SpendingDo not forget salvage value (after tax, of course).Changes in Net Working CapitalFor example, new projects often require an upfront investment in inventory.When the project winds down, we enjoy a return of net working capital (assuming all inventory sold).

7. Interest ExpenseLater chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value.For now, it is enough to assume that the firm’s level of debt (and, hence, interest expense) is independent of the project at hand.It is being handled through the firm’s discount rate

8. “Shark” example9-7

9. Shark Attractant ProjectEstimated sales 50,000 cansSales Price per can $4.00Cost per can $2.50Estimated life 3 yearsFixed costs $12,000/yearInitial equipment cost $90,000100% depreciated straight-line over 3 year lifeInvestment in NWC $20,000Tax rate 34%Cost of capital 20%9-8

10. Pro Forma Income StatementSales (50,000 units at $4.00/unit)$200,000- Variable Costs ($2.50/unit)125,000Gross profit$ 75,000- Fixed costs12,000- Depreciation ($90,000 / 3)30,000EBIT$ 33,000- Taxes (34%)11,220Net Income$ 21,7809-9OCF = NI + Dep = 21,780+30,000 = 51,780

11. Projected Total Cash FlowsYear0123OCF$51,780$51,780$51,780 NWC-$20,00020,000Capital Spending-$90,000 IATCF-$110,00$51,780$51,780$71,7809-10Note: Investment in NWC is recovered in final year Equipment cost is a cash outflow in year 0

12. Shark Attractant NPV and IRR9-11OCF = EBIT + Depreciation – TaxesOCF = Net Income + Depreciation (if no interest)Outside of taxes

13. Some ugly details: OCF, Depreciation, Salvage, and NWC9-12

14. The Tax Shield Approach to OCFA common approach (see equation 6.7)OCF = (Sales – costs)(1 – T) + Dep*T OCF=(200,000-137,000) x .66 + (30,000 x .34) OCF = 51,780 OCF = after-tax operating income + tax shieldOR, the same equation rearranged:OCF = (Sales – costs – Dep)(1 – T) + Dep9-13

15. Changes in NWCGAAP requirements:Sales recorded when made, not when cash is receivedCash in = Sales - ΔARCost of goods sold recorded when the corresponding sales are made, whether suppliers paid yet or notCash out = COGS - ΔAPBuy inventory/materials to support sales before any cash collected is an investment in Net Working Capital9-14

16. Depreciation & Capital BudgetingIn practice, firm’s use the most advantageous depreciation schedule allowed by the IRS. In this class, we will pretty much stick to good simple ‘straight-line’ depreciation. Depreciation is a non-cash expenseOnly relevant because of tax affectsDepreciation tax shield = D*T9-15

17. Computing DepreciationStraight-line depreciation D = (Initial cost – salvage) / number of years Straight Line depreciate  Salvage Value but sometimes market value is not equal to expected salvage value, in which case there is a taxable event when the asset is sold.MACRS Depreciate  0 Recovery Period = Class Life Multiply percentage in table by the initial cost9-16

18. After-Tax SalvageIf the salvage value is different from the book value of the asset, then there is a tax effectBook value = initial cost – accumulated depreciationAfter-tax salvage or “Net Salvage Cash Flow” = salvage – T(salvage – book value)9-17

19. Example: Depreciation and After-tax SalvageCar purchased for $12,000 5-year propertyMarginal tax rate = 34%. 9-18

20. Salvage Value & Tax Effects9-19Net Salvage Cash Flow = SP - (SP-BV)(T)If sold at EOY 5 for $3,000:Net Salvage Cash Flow = 3,000 - (3000 - 691.20)(.34) = $2,215.01 = $3,000 – 784.99 = $2,215.01If sold at EOY 2 for $4,000:Net Salvage Cash Flow = 4,000 - (4000 - 5,760)(.34) = $4,598.40 = $4,000 – (-598.40) = $4,598.40

21. Some examples over the next few slidesBase Inc Starts as a very straightforward exampleThen incorporates some breakeven analysis on the tax rateOhio Forge – just a small twistNike Ballet – some complexities added

22. Base IncBase Inc is considering an investment that should increase sales by $5.5 million per year for 10 years, and increase operating costs by $4.5 million per year for 10 years, as they will hire more people. The investment costs $5 million and will be depreciated straight-line to it’s zero salvage value over 10 years. Should they invest if r=10% APR, their tax rate is 25%, and there are no NWC adjustments?9-21

23. Base Inc NPV calculationCash flowsDep = 5/10 = 0.5 million / yearCF = (5.5-4.5)(1-.25) + .25(0.5) = 1.0+0.125 = 1.625 m/yearNPV = 1.125/.1(1 – 1/(1.1)10) – 5NPV = 6.9125-5 = +1.9125NPV>0, therefore, accept the investment9-22

24. Base Inc (a tax question)What tax rate would make the investment unacceptable?Need to find the tax rate that yields an annual relevant incremental after tax cash flow such that PV of benefits = PV of costsStep 1: Find the relevant cash flowStep 2: Find the tax rate9-23

25. Base Inc (a tax question)Find relevant cash flow with PV ann = 55 = CF/.1(1 – 1/(1.1)10) 5 = CF(6.1445)CF = 0.8137 millionFind tax rate that produces 0.8137 million CF0.8137= (5.5-4.5)(1-tax) + .tax(0.5)0.8137= 1– tax + 0.5tax = 1-0.5taxtax = (0.8137-1) / -0.5tax = 0.3726 or 37.26%Illustrates the “supply side” argument that raising taxes reduces investment (and jobs). In this case, if the firm faced a tax rate of 37.26% or higher, they should not invest. 9-24

26. Base Inc (note on subsidies)Note: if we found that an NPV would only be positive with a tax rate < 0, then it would require a “tax subsidy” in order to make the investment worthwhile (See “green” industry at-large today).It is not surprising that many firms negotiate state and local taxes, as well as straight cash grants. For example:http://news.yahoo.com/judge-eyes-challenge-delaware-bloom-154744849.html“To persuade Bloom Energy to build a manufacturing facility at a former Chrysler plant in Newark, DE, the Markell administration offered the company up to $16.5 million in strategic fund grants. It also offered the University of Delaware, which owns the site, $7 million to make it ready for Bloom's factory.”9-25