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Chapter outline. Cash flows and other Topics

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CHAPTER 10

Cash Flows and Other Topics

In Capital Budgeting

CHAPTER ORIENTATION

Capital budgeting involves the decision-making process with respect to the investment in fixed assets; specifically, it involves measuring the free cash flows or incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the estimation of those cash flows based on various decision criteria, and how to deal with capital rationing and mutually exclusive projects.

 

 

CHAPTER OUTLINE

 

I. What criteria should we use in the evaluation of alternative investment proposals?

A. Use free cash flows rather than accounting profits because free cash flows allow us to correctly analyze the time element of the flows.

B. Examine free cash flows on an after-tax basis because they are the flows available to shareholders.

C. Include only the incremental cash flows resulting from the investment decision. Ignore all other flows.

D. In deciding which free cash flows are relevant we want to:

1. Use free cash flows rather than accounting profits as our measurement tool.

2. Think incrementally, looking at the company with and without the new project. Only incremental after tax cash flows, or free cash flows, are relevant.

3. Beware of cash flows diverted from existing products, again, looking at the firm as a whole with the new product versus without the new product.


4. Bring in working capital needs. Take account of the fact that a new project may involve the additional investment in working capital.

5. Consider incremental expenses.

6. Do not include stock costs as incremental cash flows.

7. Account for opportunity costs.

8. Decide if overhead costs are truly incremental cash flows.

9. Ignore interest payments and financing flows.

II. Measuring free cash flows. We are interested in measuring the incremental after-tax cash flows, or free cash flows, resulting from the investment proposal. In general, there will be three major sources of cash flows: initial outlays, differential cash flows over the project's life, and terminal cash flows.

A. Initial outlays include whatever cash flows are necessary to get the project in running order, for example:

1. The installed cost of the asset

2. In the case of a replacement proposal, the selling price of the old machine minus (or plus) any tax gain (or tax loss) offsetting the initial outlay

3. Any expense items (for example, training) necessary for the operation of the proposal

4. Any other non-expense cash outlays required, such as increased working-capital needs

B. Differential cash flows over the project's life include the incremental after-tax flows over the life of the project, for example:

1. Added revenue (less added selling expenses) for the proposal

2. Any labor and/or material savings incurred

3. Increases in overhead incurred

4. Changes in taxes.

5. Change in net working capital.

6. Change in capital spending.

7. Make sure calculations reflect the fact that while depreciation is an expense, it does not involve any cash flows.

8. A word of warning not to include financing charges (such as interest or preferred stock dividends), for they are implicitly taken care of in the discounting process.


C. Terminal cash flows include any incremental cash flows that result at the termination of the project, for example:

1. The project's salvage value plus (or minus) any taxable gains or losses associated with the project

2. Any terminal cash flow needed, perhaps disposal of obsolete equipment

3. Recovery of any non-expense cash outlays associated with the project, such as recovery of increased working-capital needs associated with the proposal.

III. Measuring the cash flows using the pro forma method

A. A project’s free cash flows =

project’s change in operating cash flows

- change in net working capital

- change in capital spending

B If we rewrite this, inserting the calculations for the project’s change in operating cash flows (OCF), we get:

A project’s free cash flows =

Change in earnings before interest and taxes

- change in taxes

+ change in depreciation

- change in net working capital

- change in capital spending

C. In addition to using the pro forma method for calculating operating cash flows, there are three other approaches that are also commonly used. A summary of all the different approaches follows,

D. OCF Calculation: The Pro Forma Approach:

Operating Cash Flows = Change in Earnings Before Interest and Taxes - Change in Taxes + Change in Depreciation

E. Alternative OCF Calculation 1: Add Back Approach

Operating Cash Flows = Net income + Depreciation

E. Alternative OCF Calculation 2: Definitional Approach

Operating Cash Flows = Change in revenues - Change in cash expenses - Change in Taxes


F. Alternative OCF Calculation 3: Depreciation Tax Shield Approach

Operating Cash Flows = (Revenues – cash expenses) X (1 – tax rate) + (change in depreciation X tax rate)

You’ll notice that interest payments are no where to be found, that’s because we ignore them when we’re calculating operating cash flows. You’ll also notice that we end up with the same answer regardless of how we work the problem.

IV. Mutually exclusive projects: Although the IRR and the present-value methods will, in general, give consistent accept-reject decisions, they may not rank projects identically. This becomes important in the case of mutually exclusive projects.

A. A project is mutually exclusive if acceptance of it precludes the acceptance of one or more projects. Then, in this case, the project's relative ranking becomes important.

B. Ranking conflicts come as a result of the different assumptions on the reinvestment rate on funds released from the proposals.

C. Thus, when conflicting ranking of mutually exclusive projects results from the different reinvestment assumptions, the decision boils down to which assumption is best.

D. In general, the net present value method is considered to be theoretically superior.

V. Capital rationing is the situation in which a budget ceiling or constraint is placed upon the amount of funds that can be invested during a time period.

– Theoretically, a firm should never reject a project that yields more than the required rate of return. Although there are circumstances that may create complicated situations in general, an investment policy limited by capital rationing is less than optimal.

VI. Options in Capital Budgeting. Options in capital budgeting deal with the opportunity to modify the project. Three of the most common types of options that can add value to a capital budgeting project are: (1) the option to delay a project until the future cash flows are more favorable – this option is common when the firm has exclusive rights, perhaps a patent, to a product or technology, (2) the option to expand a project, perhaps in size or even to new products that would not have otherwise been feasible, and (3) the option to abandon a project if the future cash flows fall short of expectations.

 

 


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