MF807

Prof. Thomas Chemmanur

Topic Note-7

1. Computing Cashflows in Capital Budgeting.

Estimating the cashflows involved in a project is one of the toughest tasks

involved in capital budgeting. Cashflows are the difference between dollars

received and dollars paid out, where the amounts paid or received are taken into

account at the point where the actual transaction takes place. (This approach is

different from that taken by accountants. For example, a cashflow analysis would

take into account at t=0 the price of a bulldozer as a negative cashflow of, say,

$100,000. An accountant, on the other hand, would spread this cost over the

machine's depreciable life of, say, 5 years, showing a depreciation expense of

$20,000 per year. These two approaches would give different values of the NPV for

the project of buying the bulldozer. Thus, accounting figures, if used, should only be

a starting point for the cashflow analysis).

An important principle to be kept in mind when estimating cashflows is to

estimate cashflows on incremental, after-tax, basis. Incremental cashflows of a

project are those periodic cash outflows (negative cashflows, or costs) or inflows

(positive cashflows, or benefits) that occur if and only if that particular investment

project is accepted. Thus, the question we should ask is: what is the difference

between the cashflow with the project and without the project?

It is useful to enumerate certain principles to keep in mind when estimating

these incremental cashflows:

1. Do not confuse incremental cashflows with average cashflows: eg: If you

hire an additional employee because of taking on the project, his salary, plus any

additional salary you may pay to existing employees because of this project should

become part of the project cashflows. You should not divide the total wage bill of

the company by the total number of projects and use that as the labor component

of the project cashflows: the former is the incremental labor cost, while the latter is

average labor cost.

2. Include all incidental effects: (Including effects on other parts of the firm). eg:

If taking on the project requires the company to install a new sewage disposal

system, its cost should be included in the cashflows of the project.

3. Do not forget additional working capital requirements due to the

project:

Net working capital (sometimes just referred to as 'working capital' refers to

the difference between current (or short term) assets and current liabilities. Usually,

taking on a new project involves additional investment in this item: extra

inventories raw materials or finished goods, additional accounts receivable and so

on).

4. Forget Sunk costs: A sunk cost refers to an outlay that has already been

committed or that has already occurred (and is thus irretrievable) and hence is not

affected by the accept/reject decision under consideration. My favorite example of a

sunk cost is the cost of a marketing study undertaken to estimate the market size

for a possible new product: clearly, the cost of this study, which has already been

incurred and is irrecoverable, should not figure in the decision to go ahead with
introducing the new product or not.

5. Include opportunity costs: These are defined as the cashflows that could

could have been generated from the assets the firm already owns, if they were not

used for the project in question (ie., benefits from the opportunity foregone). For

instance, if some land already owned by the firm is to be used to set up a plant to

manufacture a product, the cashflow which could have been generated by selling

the land or putting it to some other use should be included as a cost involved in

introducing the project.

6. Beware of allocated overheads: For instance, the salary of the Chairman of

the company should not be apportioned to the project, if he would have been paid

the same salary even without the project. This point is related to (1).

2. Calculating Depreciation

Depreciation is important in cashflow estimation only because it impacts on

the incremental cashflows of the project by affecting the firm's tax bill. The IRS

allows the firm to write off a portion of every investment every year as

depreciation, reducing the taxable income of the firm by the same amount. The

benefit to the firm because of this reduction in the taxable income, which occurs

each period, is called the depreciation tax shield. (Only the incremental tax

shield due the project should be considered in computing cashflows).

Incremental depreciation tax shield in year t = T c. Dt

where Dt is the incremental depreciation due to the project in year t, and T c is the

firm's marginal corporate tax rate (ie., tax on the 'next' dollar earned).
 There are two ways of calculating depreciation:

1. Straight line depreciation:

Dt = Investment - Salvage value

N

where N is the number of years over which the capital equipment involved can be

depreciated under the tax code.

2. Accelerated Depreciation:

Dt = Investment x ACRS factor for year t, corresponding to the ACRS depreciation

class of the equipment, as specified by the tax code.

Note: The ACRS factor is available from tables such as Table 6-5, page 102, Brealey

and Myers. In the exam, I will specify these factors in any problems I give.

Under the straight line system, the depreciation is the same for each year

over the depreciable life of the equipment; under the accelerated system, it will be

different for different years, larger amounts in the earlier years and lower ones in

the later years. The same project, depreciated under the ACRS system would give

larger present values than under the straight line system, since the present values

of tax shields is larger under the ACRS system than in the straight line system.

3. Different kinds of project cashflows

Sometimes it is useful to categorize project cashflows into three groups:

1. Initial Cashflows: These are cashflows which usually occur in the beginning

stages of the project. Examples of these are: Initial investment, Additional working

capital requirements due to the project etc.

2. Operating Casflows: These are cashflows which occur during the regular

operation of the project.

OCt = (Rt - Ct)(1 - Tc) + Tc. Dt

Where Rt = Incremental Revenues due to the project at date t

Ct = Incremental Costs due to the project at date t

Dt = Incremental Depreciation available to the firm in year t because of the

project.

Notice that the second term on the right, T c.Dt represents the additional tax shield

that becomes available to the firm because of the project.

3. Terminal Cashflows: These are cashflows that occur while the project is being

wound up. Examples are salvage value, return of additional working capital, etc.

Note: Any amount of the salvage value in excess of the book value is subject to

some taxation. (The 'book value' of any capital equipment is the original cost of

the equipment minus the sum of the various amounts written off as depreciation D t

over the life of the project). It is easy to incorporate the taxation of salvage values

into our analysis: if we assume that the tax rate applicable to any amount of the

salvage value above the book value is t, then we should include the amount: Book

Value + (1 -t)(Salvage value - Book Value), in the terminal cashflow of the project

instead of the entire salvage value. (In problems, I will specify explicitly whether

you should take into account the taxation of salvage value or not, and also the

applicable tax rate: you can ignore the taxation of salvage value if I do not specify

anything.)

Example Problem to be worked out in class

You have been asked by the president of your company to evaluate the proposed
acquisition of a new milling machine. The machine's basic price is $100,000, and it
would cost another $20,000 for special use by your firm. The machine falls into the
ACRS 3 yr class. The machine would be sold after 3 yrs for $50,000. Use of the
machine would require an investment in net working capital (milling blanks) of
$5000 which can be recouped at project end. The machine would have no effect on
revenues, but it is expected to save the firm $40,000 per year in before-tax
operating costs, mainly labor. The firm's marginal tax-rate is 36% (Assume that the
salvage value is not taxed).

a. Compute the cashflows over the life of the machine.

b. What is the NPV of this project if the firm's cost of capital is 10%? Should the firm
buy this machine?

4. How should we handle inflation?

There is a positive rate of inflation in most real world economies. We can

define the inflation rate per period, denoted by p, as:

(1)                   

price of a basket of goods in the next period

p = ──────────────────────────────────────── - 1.
price of the same basket in the current period

The inflation rate is already built into the nominal (or "money") discounting

rate r, which is what we observe. The relationship between the nominal (or money)

rate of return r, the inflation rate p, and the real rate of return r c is given by:

If we use the nominal rate of return to discount a given cashflow stream, we should

also adjust the cashflows we use in our investment analysis for inflation. This is

particularly important in the case of projects lasting for longer periods, where this

can make a significant difference in our accept/reject decision. Let us denote by CF t

the cashflow at date t in current prices (i.e., cashflows which are not adjusted for

inflation). Then the cashflows adjusted for inflation for date t, denoted by ACF t, is
given by:

(2)                     

The NPV of the project under consideration is then given by:

n n
ACFt CFt (1  p ) t
(3)                 NPV   (1  r ) t
  (1  r ) t
t0 t0

where, as usual, 0 is the beginning date of the project and n is the ending date of

the project.

Sometimes, it is convenient to adjust the interest rate at which the cashflows

are discounted, keeping the cashflows at current prices. To see how we can do this,

replace the nominal discount rate in the above expression for NPV (3), by the real

discount rate using equation (1) above. Then,

n n n
CFt (1  p ) t CFt (1  p ) t CFt
(4)       NPV   [(1  rc )(1  p )]t
  (1  rc ) t (1  p ) t
  (1  rc ) t
t 0 t0 t0

Thus, another way to handle inflation is to discounting cashflows at current

prices at the real discounting rate (ie., use unadjusted cashflows, but adjust the

discount rate).

Example problem to be worked out in class

The Fischer corporation is considering setting up a mineral water project that

has a cost of $150,000. The project will produce 1000 cases of mineral water
indefinitely. The current sales price is $138 per case, and the current costs per case
manufactured (assume all costs are variable costs) is $105. The company is taxed
at a rate of 36%. Both prices and costs are expected to rise at a rate of 6% per year.
Assume that cashflows consist only of after-tax profits, and there is no depreciation
allowed, since the project is expected to have an indefinite life. Assume, further,
that the nominal cost of capital appropriate to this project is 15%. Should the
company set up the plant?

5. Project Interactions

So far, we have assumed that the investment opportunities available to the

company are 'cleanly' separable into nice little packages of 'independent' projects.

This let us analyze each project separately, on its own merits, on an accept/reject

basis. However, in practice, projects are interconnected: further, the decision may

not be one of accept/reject, but instead that of accept/reject/delay. For example,

consider a company deciding whether it should drill for oil in a certain tract of land.

Since the oil price today is relatively low, the project may have negative NPV at

today's prices if the chances of finding oil are not very high. But the NPV will

become positive if oil prices shoot up, and the right choice may be to buy an option

on the land in the hope of a future rise in oil prices (thus the NPV of the project of

drilling for oil today is negative, but the NPV of the project of buying the land on

which the company may drill at some point in the future is positive, given the

probability distribution of future oil prices). A simpler example is the problem of

when to harvest a crop of timber, given that the trees are growing and there will be

more timber as time goes along (assume for simplicity that timber prices are

constant). The answer here is not to wait for ever, since there is a time value for

money, but to harvest the timber at a certain optimal point in time.

Another example of project interactions arises when we have to decide

between two mutually exclusive projects with unequal lives. Consider a company

having to decide between two machines, on having a life of five years, one having a

life of seven years. Assume further that the NPV of the buying the machine with a
shorter life is larger. The solution here is not necessarily to buy the first machine:

remember, the company has to buy a new machine sooner (after five years) in this

case: so we have to take into account the cashflow consequences of this next

purchase as well, etc.

The concept of equivalent annual cost is useful in solving the kind of

problem mentioned above. The equivalent annual cost of a project is the annual

amount of an annuity with the same present value as that of the project under

consideration. In the problem of choosing between two machines with different

lives, the firm should buy the machine with the lower equivalent annual cost.

Equivalent annual cost can also be thought of the fair rental value of the machine. If

the machine has excess capacity, this is the rent the company should charge per

period to break-even.

Example problem to be worked out in class

The Borstal Company has to choose between two machines which do the
same job but have different lives. The two machines have the following costs:

Year Machine A Machine B

0 40,000 50,000
1 10,000 8,000
2 10,000 8,000
3 10,000 + replace 8,000
4 8,000 + replace

a. If the real discount rate is 6%, which machine should the firm buy? (Assume that
the cashflows given above are not adjusted for inflation. Ignore all taxes and
salvage values).

b. If there is a third alternative of renting a machine, what is the highest rent per
year at which the firm should prefer renting to buying?