Topic 5 - Capital Budgeting Applications

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 224-293.

Estimating Cash Flows

In reality, projected cash flows are difficult to estimate. Free Cash Flow is the actual cash flow available for distribution to all investors after the firm has made all investments (in fixed assets, new products & working capital (WC) necessary for operations).

Free Cash Flow = Operating Income After Tax (OPAT) + Depreciation - Capital Expenditure - Changes in Net Operating Working Capital (NOWC)

Identifying Relevant Cash Flows

[1]

Cash Flows & Not Accounting Income

Costs of fixed assets are negative cash flows. Analysts must account for non cash charges & depreciation tax shields in determining free cash flow.

We include changes in net operating working capital '∆NOWC= ∆CA (Current Assets) - ∆CL (Current Liabilities) which is influenced by inventory, the firm’s cash buffer, receivables (increases lower cash flow) & payables (increases help cash flow - since you are not paying out the cash).

Incremental Cash Flows & Other Considerations

Incremental Cash Flows are those cash flows that will only occur if the project is undertaken. Will the CF occur if accepted? Any & all cash flows that are a direct consequence of taking the project. (Stand-Alone Principle)

Include

  • Opportunity Costs - Any income that can be generated if the project is rejected
  • Externalities - A project may impact on cash flows in other parts of the firm, can be positive or negative (erosion)

Ignore

  • Sunk Costs - Outlays that have already taken place (or incurred liability to pay) & are not affected by the project
  • Financing Costs, as it is accounted for in determining the cost of capital & we are only interested in CF’s from assets

Timing of Cash Flows

Cash flows are assumed to be received at the end of the period (saves on info costs)

Inflation

Convert nominal rate of return into real rate of return & discount real cash flows (CF’s). You will get the same result as discounting nominal cash flows with a nominal discount rate.

Real Rate = (1 + Nominal Rate) / (1 + Inflation Rate)

Taxation

Depreciation impacts on cash flow indirectly via taxation.

The Consistency Principle states that after-tax cash flows discounted using an after tax required rate of return. Additionally, taxes can arise from gains or losses on sale (if sale price differs from book value) & will affect cash flows.

Evaluating Capital Budgeting Projects (page 276 Example)

  • Initial Investment Outlay - Up Front Costs + Working Capital Requirements
  • Operating Cash Flows - Incremental Cash Flows Over The Project’s Economic Life + Changes in NOWC
  • Terminal Cash Flows - CF’s That Occur at the End of the Projects Life (net salvage value, returning NOWC)

Net cash flows each year are determined by the sum of 1, 2 & 3. Note:

Operating Cash Flows (OCF) = EBIT + Depreciation - Tax = (Revenue-Costs-Depreciation)(1-t)+ Depreciation

Operating Cash Flows (OCF) = (Revenue-Costs)(1-t)+ Depreciation × Tax (t) → Tax Shield Approach

Expansionary Project Example

A firm wishes to expand by building a new factory with machinery; it will produce for 4 years & will be sold after.

FINS161351.jpg

  • Initial Cost = $20,000 + $6,000 + $5,000 = $31,000
  • Operating Cash Flows = $40,000 - $15,000 - $5000 - $7,400 = $12,600
    • Revenue = $40,000
    • Variable Costs = -$15,000
    • Fixed Costs = -$5,000
    • Depreciation = -$1,500
    • NPBT = $18,500
    • Tax = 40% * $18,500 = $7,400
    • NPAT = $11,100
    • Depreciation Tax Shield = ($500 + $1000*40% = $600 (depends if you use the formula otherwise NPAT + Depreciation)
      • (40,000 – 20,000)(60%)+(1500*40%) = $12,600
  • Terminal Cash Flows = $18,000 + $1,000 + $6,000 = $25,000
    • Net Salvage Values (No Tax) + Return of NOWC

FINS161352.jpg

Mutually Exclusive Projects with Different Lives

This situation occurs when a projects ends before another, they are mutually exclusive & they are likely to be replaced/continued. Thus, the constant chain of replacement assumption can be used. Methods of evaluation include:

  • Constant Chain of Replacement in Perpetuity
    • FINS161353.jpg
  • Equivalent Annual/Annuity Value – assume indefinite replacement
    • Involves calculating the annual cash flow of an annuity that has the same life as the project & whose PV = NPV of the project
    • FINS161354.jpg
    • E.g. Project A – Costs $3000, $1000 for the next 4 years, Project B – Costs $5000, $1075 for next 7 years. K =10%
      • Project A NPV = $170, PVIFA = 3.1699, EAV = $53.59
      • Project B NPV = 233.55, PVIFA = 4.8684, EAV = $47.94
  • Equivalent Horizon Approach (Lowest Common Multiple)

FINS161355.jpg [2]

Deciding When to Abandon/Retire or Replace a Project

Retirement Decisions

Situations where assets have been used for a while & the firm must decide if they should discontinue operations & sell assets. If the NPV < 0 a project should be retired. Required to compare future CF’s with current salvage value. Example:

FINS161356.jpg [3]

Replacement Decisions

Situations where an operation is to be continue indefinitely & the company must decide whether to replace existing assets.

Project Timing & Decision Trees – Managerial Options (Contingency Planning)

In some situations the firm is able to choose when it will invest. Often it is preferable to wait & see how the situation develops before deciding whether to invest in the project. Each branch of the decision tree is associated probabilities allowing an expected value to be calculated.

Example

A project has a cost of $1000 & market conditions dictate 2 outcomes of cash flows.

FINS161357.jpg

What if the firm has the option to wait a year?

  • Conditions Good – Firm Invests
  • Conditions Bad – No Investment

FINS161358.jpg [4] However, there is often a cost with delaying – i.e. 1st mover advantage Management can expand, abandon, delay or remodify projects depending on events & outcomes.

Qualitative Factors

Qualitative Factors such as corporate image & employee satisfaction can be important for project selection but they are difficult to value & are used to support quantitative analysis.

Project Selection with Resource Constraints

[5] Capital Rationing is where a firm has limited resources available for investment & must reduce the number &/or size of projects chosen because of this limitation (e.g. shortage of funds). This can be internal (imposed by management) due to unwillingness to borrow or issue shares or scepticism in forecasted CF’s causing not all positive NPV projects to be undertaken. It can be external where capital markets are unwilling to supply funds. Soft Rationing occurs when divisions in a firm are allocated a certain amount of funds (try get a larger allocation). Hard Rationing is when the firm unable to raise financing under any circumstances.

End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 261-274
  2. ASB, UNSW
  3. UNSW, ASB
  4. ASB, UNSW
  5. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 285
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