Capital Budgeting cash flows

Chapter 11
 Capital Budgeting Cash Flows

To evaluate investment opportunities, financial

managers must determine relevant cash flows

Financial analysts focus solely on cash flows
when evaluating potential investments

(cash basis rather than accrual basis)
 Capital Budgeting Cash Flows

Relevant cash flows – are all
incremental, after-tax, cash flows
associated with a proposed
capital expenditure

Cash flows- Outflow (investment) and

resulting subsequent inflows

Incremental Cash flows- additional

cash flows expected to result from a
proposed capital expenditure
 Relevant cash flows

Estimate relevant cash flows by:

Focusing on incremental cash flows- change in
firm’s cash flows that is a direct consequence of
its having undertaken a particular project

Ignoring financing costs- already considered in
firm’s cost of capital

Considering taxes-measure cash flow on an after-
tax basis

Adjusting for noncash expenses- tax-deductible
non-cash expenses (e.g. depreciation,
amortization and depletion)
 Relevant cash flows (cont’d)

Sunk cost- cash outlays that

have already been made (past
outlays) and therefore have no
effect on the cash flows
relevant to a current decision.

Exclude from project’s
incremental cash flows

Opportunity cost- Cash flows
that could be realized from the
best alternative use of an
owned asset (cash flow that will
not be realized due to the
project)

Included as cash outflow of the the
project
 Relevant cash flows (cont’d)

Cannibalization- Loss of sales of an existing product

when a new product is introduced

Included as cash outflow of the new product
 Relevant cash flows (cont’d)

Example: Fox Entertainment is evaluating

launching a new iPet product. Fox paid a
market research firm P120,000 last year to
test the market viability of iPet. The new
product would need an advertising
campaign costing P50,000. Marketable
securities earn around 8% per year. If iPet is
launched, Fox estimated a decline in My
Pet (older version) product totalling P75,000.
 Relevant cash flows (cont’d)

Determine whether the following cash flows should be
included or not in relevant cash flow
1. Installment costs of a new asset
2. Labor and material savings
3. Paid feasibility study
4. Interest to bondholders
5. Depreciation tax shield
6. Opportunity costs
7. Working capital investment
8. Training expense for operating a new machine
9. Book value of the old machine being replaced
10.After-tax salvage value of a project
 Capital Budgeting Cash Flows

Three basic components of project’s cash
flows:

• after-tax
• relevant • increment non-
cash al, after- operating
outflow tax cash cash flow
for a inflows occurring in
proposed resulting the final
project at from year of a
time zero implemen project. It is
tation of usually
attributable
a project to
during its liquidation
life of the
project
 Capital Budgeting Cash Flows

Three basic components of project’s cash
flows:

• after-tax
• relevant • increment non-
cash al, after- operating
outflow tax cash cash flow
for a inflows occurring in
proposed resulting the final
project at from year of a
time zero implemen project. It is
tation of usually
attributable
a project to
during its liquidation
life of the
project
 Initial Investment

Initial investment include:
• Installed cost of the new asset- cost of new asset +
installation costs. Cash outflow.

• After-tax proceeds from sale of old asset- sale

proceeds –/+ taxes/tax refunds related to sale.
Proceeds and tax savings as inflow and tax liability
as outflow.

• Working capital requirements- changes in current

assets and current liabilities due to project. Increase
in current assets or decrease in current liabilities as
outflows and vice versa.
 Initial Investment
Example: XO is considering a new project
which will require the purchase of a new
equipment costing P10 million to replace
a fully depreciated equipment. XO The
new equipment needs to be installed for
P500,000. The old equipment can be sold
for P1 million. Project would also need an
increase in net working capital of
P1,000,000. Assuming a tax rate of 40%,
compute for the initial investment.
 Initial Investment
Installed cost of new equipment
Cost of new equipment P10,000,000
+ Installation costs 500,000
Total installed cost P10,500,000
-After-tax proceeds from sale of
old equipment
Proceeds from sale P1,000,000
-Tax on gain on sale (400,000)
(40% x 1,000,000)
Total After-tax proceeds (600,000)
+Change in working capital 1,000,000
Initial Investment P10,900,000
 Initial Investment

Example:
• Operate calendar booth
• From November 1 to January 31
• Order P15,000 calendars on credit, delivery by Oct
31
• Must pay suppliers P5,000/month, beginning Nov
30
• Expect to sell 30% of inventory (for cash) in Nov;
60% in Dec; 10% in Jan
• Always want to have P500 cash on hand
throughout the sale period. Will be released on
Jan 31.
 Initial Investment
Sep Oct 31 Nov 30 Dec 31 Jan 31
Cash P0 P 500 P 500 P 500 P0
Inventories 0 15,000 10,500 1,500 0
A/P 0 15,000 10,000 5,000 0
NWC 0 500 1,000 (3,000) 0
Monthly ∆ in WC +500 +500 (4,000) +3,000

Using transactions Oct Nov Dec Jan

(Set-up) Release Cash Fund P (500) P 0 P 0 P 500
Sale of inventory 0 4,500 9,000 1,500
Payment to suppliers 0 (5,000) (5,000) (5,000)
Net Cash Flow (500) (500) 4,000 (3,000)
 Capital Budgeting Cash Flows

Three basic components of project’s cash
flows:

• after-tax
• relevant • increment non-
cash al, after- operating
outflow tax cash cash flow
for a inflows occurring in
proposed resulting the final
project at from year of a
time zero implemen project. It is
tation of usually
attributable
a project to
during its liquidation
life of the
project
 Operating Cash flows

Benefits expected to result from proposed project
must be measured on an after-tax basis, because
the firm will not have the use of any benefits until it
has satisfied the government’s tax claims.

All benefits expected from a proposed project must

be measured on a cash flow basis.

Cash inflows represent pesos that can be spent, not merely
“accounting profits.”

The basic calculation for converting after-tax net profits into
operating cash inflows requires adding noncash expenses
like depreciation, amortization and depletion (which were
deducted as expenses on the firm’s income statement)
back to net profits after taxes.
Operating Cash Flows
 Operating Cash flows

Depreciation- largest noncash item that affect cash

flow through taxes

Compute after-tax net income and add depreciation back,
or

Ignore depreciation expense but add back its tax savings.

Example: Assume a firm purchases a fixed asset

today for P30,000 and plans to depreciate over 3
years using straight-line method. Firm will produce
10,000 units/year costing P1/ unit with selling price of
P3/ unit. Firm pays taxes at 40% marginal rate.
Compute for the operating cash flow.
Operating Cash flows
Method 1
Method 2
Adding non-cash expenses
back to after-tax earnings Find after-tax profits, add back
non-cash deduction tax
Sales P30,000 savings
Sales P30,000
Cost of goods (10,000)
Cost of goods (10,000)
Gross profits P20,000
Pre-tax income P20,000
Depreciation (10,000)
Taxes (40%) (8,000)
Pre-tax income P10,000
Aft-tax income P12,000
Taxes (40%) (4,000)
Depreciation 4,000
Net income after tax
P6,000 tax savings
Cash Flow P16,000
Cash flow P16,000
= NI + deprec
 Capital Budgeting Cash Flows

Three basic components of project’s cash
flows:

• after-tax
• relevant • increment non-
cash al, after- operating
outflow tax cash cash flow
for a inflows occurring in
proposed resulting the final
project at from year of a
time zero implemen project. It is
tation of usually
attributable
a project to
during its liquidation
life of the
project
 Terminal cash flows

Terminal cash flow includes:

After-tax proceeds from sale of the new asset- salvage value
or proceeds from sale net of any removal or cleanup costs
+/- tax savings/liability

After-tax proceeds from sale of the old asset, as applicable

(e.g. replacement projects)

Release of net working capital- reversion of any initial net

working capital investment; cash inflow for reduction in net
working capital or vice versa
Terminal cash flows
 Terminal cash flows (cont’d)

A corporation is evaluating the relevant cash flows
for a capital budgeting decision and must estimate
the terminal cash flow. The proposed machine will
be disposed of at the end of its usable life of five
years at an estimated sale price of P15,000. The
machine has an original purchase price of P80,000,
installation cost of P20,000, and will be depreciated
using straight-line method for five years assuming
P5,000 salvage value. Net working capital is
expected to decline by P5,000. The firm has a 30
percent tax rate. The terminal cash flow is
 Terminal Cash Flow
After-tax proceeds from sale of
proposed machine
Proceeds from sale P15,000
-Tax on gain on sale (3,000)
(30% x (15,000-5,000))
Total After-tax proceeds P 12,000
+Change in working capital 5,000
Terminal Cash flow P17,000
 Project Cash Flows
DSSS Corporation is considering a new project to
manufacture widgets. The cost of the manufacturing
equipment is P125,000. The cost of shipping and
installation is an additional P10,000. The asset will fall into
the 3-year depreciation class. The year 1- 4 depreciation
percentages are 33.33%, 44.45%, 14.81%, and 7.41%,
respectively. Sales are expected to be P225,000 per
year. Cost of goods sold will be 60% of sales. The project
will require an increase in net working capital of P10,000.
At the end of three years, DSSS plans on ending the
project and selling the manufacturing equipment for
P25,000. The marginal tax rate is 40%.
 Project Cash Flows (cont’d)
Initial Investment Outlay
Cost of Machine P(135,000)
Net Working Capital (10,000)
P(145,000)
Depreciation
Basis P135,000

Year %
1 33.33% P 44,996
2 44.45% P 60,008
3 14.81% P 19,994
4 7.41% P 10,004
100.00% P135,000
Project Cash Flows (cont’d)
Project Cash Flows (cont’d)

P71,998 P78,003

P71,998 P78,003
 Replacement vs Expansion

Expansion project- investment proposal that
increases the scope of the firm’s operations,
including addition of both revenues and costs,
but does not replace any existing assets or
operations; relevant cash flows are cash flows
associated with the project only

Replacement- investment proposal that is a

substitute for an existing investment; relevant cash
flows are incremental cash flows resulting from the
replacement
Replacement vs Expansion
 Replacement Project Cash Flow

Powell Corporation, a large diversified manufacturer
of aircraft components, is trying to determine the
initial investment required to replace an old machine
with a new, more sophisticated model. The
machine’s purchase price is P380,000 and an
additional P20,000 will be necessary to install it. It will
be depreciated for 5 years using straight-line method.
The firm has found a buyer willing to pay P280,000 for
the present machine with Book value of P69,600. The
firm expects that a P35,000 increase in current assets
and an P18,000 increase in current liabilities will
accompany the replacement. Both ordinary income
and capital gains are taxed at 40%.
Year 0 New Machine Old Machine
Purchase price (P380,000)
Installation cost (20,000)
Working Capital (17,000)
(35,000)+18,000
Total cost of New (P417,000)

Sale Price P280,000

Less: Tax on gain P210,400*.40 (84,160)
Net cash flow P195,840

Initial investment (P221,160)

outlay
 Replacement Project Cash Flow
Powell Corporation’s estimates its annual revenues and
expenses (excluding depreciation and interest) for five
years with new machine is P2,570,000 and P2,300,000,
respectively; while that of the old machine is shown in the
table below:
Year Revenue Expenses
1 P 2,200,000 P 1,990,000
2 2,300,000 2,110,000
3 2,400,000 2,230,000
4 2,400,000 2,250,000
5 2,250,000 2,120,000
Both the expected usable life of the proposed machine
and the remaining usable life of the existing machine are 5
years with P50,000 and P10,000 salvage. New machine can
be sold for P100,000 while old machine can be sold at
salvage value at the end of year 5.
 Analysis of 1 2 3 4 5
Incremental
Cash Flows
Increase in revenue P370,000 P270,000 P170,000 P170,000 P320,000
Increase in (310,000) (190,000) (70,000) (50,000) (180,000)
expenses
Increase in (58,080) (58,080) (58,080) (58,080) (58,080)
depreciation
EBIT P1,920 P21,920 P41,920 P61,920 P81,920
Taxes (768) (8,768) (16,768) (24,768) (32,768)
NOPAT P1,152 P13,152 P25,152 P37,152 P49,152
Depreciation 58,080 58,080 58,080 58,080 58,080
Operating cash P59,232 P71,232 P83,232 P95,232 P107,232
flows
Release of WC 17,000
Diff. Sale of mach 70,000
Free Cash Flow P59,232 P71,232 P83,232 P95,232 P194,232
 Inflation and Capital
Budgeting Cash Flows

Inflation generally affects revenues and costs

Nominal cash flows- account for future inflation

Real cash flows- cash flows that would occur in the

absence of inflation

Use real rate of return if we calculate real cash flows

generated by a project

Since we use nominal interest return, we need to

incorporate inflation in our cash flow calculation
 Inflation and Capital
Budgeting Cash Flows
In 2015, Sunny Electronics expects to sell 100,000 3-
D television sets for an average price of P1,000.
Expected production costs are P600 per unit. In
2016, volume is expected to increase by 10%,
while inflation will increase both the sales price
and the cost per unit by 3%. Compute for
expected gross profit for 2016 in (a) real pesos
and (b) nominal pesos
 Key Points

Financial analyst evaluate investments on a
cash-basis

Increase in net working capital represent cash
outflow, whereas decrease represents inflow

Only incremental after-tax cash flows should be
included, hence, sunk costs are ignored

Since cash flows will be discounted, we ignore
financing costs such a interest and dividends
 Key Points (cont’d)

Depreciation is a noncash item that affects

cash flows through taxes

Calculation of Replacement Project Cash
flows is more complicated than that of
Expansion Project Cash Flows

Nominal cash flows may increase or fall as a
result of inflation
End of Chapter 11
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