Module 11 (Ch 11) Homework
Module 11 (Ch 11) Homework
Due Sunday by 11:59pm Points 10 Submitting a file upload Available until Apr 12 at 11:59pm
Submit Assignment
Create an Excel spreadsheet to organize your answers to the following problem, and submit your Excel file as an
attachment by clicking on the appropriate button on this page.
A company is evaluating the purchase of a machine to improve product quality and output levels. The new machine would cost
$1.6 million and would be depreciated for tax purposes using the straight-line method over an estimated six-year life to its
expected salvage value of $100,000. The new machine would require an addition of $70,000 to working capital at the
eginning of the project, which will of course be returned to the firm at the end of the project. In each year of the machine's life,
the machine would increase the company's pre-tax cash receipts by $400,000 from their cu
ent level. During each of the six
years, cash operating costs would increase by $15,000 from their cu
ent level. In addition, at the end of the 4th year, a major
epair of the machine costing $40,000 (pre-tax) would be required. The company has a 8% overall cost of capital and is in the
35% marginal tax
acket.
Part 1: Prepare a Cash Flow Spreadsheet that identifies the incremental cash flows for each year of the machine's life.
Part 2: Calculate the investment's net present value (NPV).
Part 3: Calculate the investment's internal rate of return (IRR).
Part 4: Should the company purchase the machine? Why or why not?
PowerPoint Presentation
Chapter 11
Capital Budgeting
Welcome to chapter 11 on capital budgeting. Having determined the cost of capital in chapter 10, we now turn to the specific steps involved in determining whether or not invest in a certain project. This process is called capital budgeting.
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Capital Budgeting Defined
The process of discovering, evaluating, and deciding whether to pursue investments in long-term assets
When we think about it, capital budgeting is at the heart of what business firms do. They get money from investors, and use this money to invest in assets that promise to yield returns higher than what they paid for the money. This chapter attempts to quantify this process in a reasonable way.
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The Importance of
Capital Budgeting
It involves large amounts of money
It has a major impact on financing needs
It has long-lasting effects on the firm’s competitive position
This is just a reminder that capital budgeting does not operate in a vacuum. Instead, it is affected by a variety of things and affects other things as well.
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Eight Rules
Use cash flow numbers only
Use incremental numbers only
Include changes in every functional area
Include changes across the full life cycle
Include forecasted inflation
Consider the impact on quality
Consider the implicit options
Do not include financing cash flows
Of these 8 rules, perhaps the last one is the most confusing for students. The point here is that we should not include the cash flows associated with principal and interest payments on bo
owed funds because these cash flows are already implicitly accounted for in the interest rate used to discount the cash flows.
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Three Categories of Cash Flows
Time Zero Cash Flows
Annual Cash Flows from Operations
Terminal Cash Flows
It is in this chapter where we start making considerable use of the cash flow spreadsheet that was introduced earlier in the course. You will notice that the spreadsheet, as presented on page 274 of the textbook, has three columns representing the three types of cash flows that might occur. Quite often, the annual cash flows will be an annuity that can be dealt with quite easily.
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Time Zero Cash Flows
Cash flows from purchasing an asset
Cash flows from selling an existing asset
Working Capital outlay
As we think about the cash flows at time zero, we need to remember that there may be tax implications of selling an old asset that may be included in this category as well. So, in other words, when we sell an asset, there are two kinds of cash flows that take place. First is the cash coming in from the sale, and second is the tax payment or benefit from the recognition of the gain or loss on the sale. Both of these need to be accounted for.
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Annual Cash Flows from Operations
Changed inflows and/or outflows over the lifetime of the new and/or old assets
Taxes paid or saved due to the changed operating cash flows
Tax savings from depreciation
On a year-to-year basis, we need to account for both the regular cash flows and the tax effects of those cash flows. And then we will also have the tax savings
ought about by the depreciation of the asset. Please remember that depreciation is not itself a cash flow, but it does save the company in taxes. Thus the depreciation times the tax rate is called a tax shield, and this amount can be added in the spreadsheet as a cash inflow on an annual basis.
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Terminal Cash Flows
Sale price of asset
Tax based on sale
Return of working capital
And then at the end of the project we typically have the items that pertain to the winding up of the project. Again, only the incremental amounts show up in the spreadsheet.
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Common Changes to Cash Flows in Capital Budgeting
Here is a very detailed account of the various cash flows associated with a typical project, along with how each of these cash flows is treated in the cash flow spreadsheet. We have pretty much addressed each of these in the previous slides. If you have trouble reading this, page 273 has a more readable table.
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Sheet1
Cash flow Treatment
Cash flows from purchasing an asset Initial cost Cash outflow when purchased
Tax savings due to depreciation Cash inflow (reduced outflow) each year depreciation may be taken
Terminal value Cash inflow when the asset is sold (adjusted by tax if a capital gain or loss is reported)
Cash flows from selling an existing asset Sale price Cash inflow when sold
Tax on sale Cash outflow if a gain on sale is reported; cash inflow (reduced outflow) if a loss on sale is reported
Tax savings forgone due to no longer being able to depreciate the asset Cash outflow (increased taxes) each year depreciation would have been taken if the asset were not sold
Terminal value forgone from no longer having the asset to sell on its original termination date Cash outflow (lost cash inflow)
Cash flows from operations Changed recepits or payments from having the new asset and/or not having the old asset Cash inflows and/or outflows over the lifetime of the new and/or old asset(s)
Taxes paid or saved as changed receipts and payments enter the tax return as changes to income Cash inflows and/or outlfows over the lifetime of the new and/or old asset(s)
Cash flows from the investment in supporting working capital The cost of acquiring additional working capital when a new asset is puchased Cash outflow when the asset, and hence the supporting working capital, is purchased
The cash from selling working capital no longer required when an asset is sold Cash inflow when the asset, and hence the supporting working capital, is sold
Sheet2
Sheet3
B S O W
Time 0 Years
1-X Year
X
Buy
Sell
Operating Flows
Working Capital
In an attempt to help us remember the items to think about in the cash flow spreadsheet, I have devised this short memory aid. These are the major headings of the items that may need to go into the spreadsheet. The depreciation tax shield would normally go in the Buy or Sell categories. The spreadsheet can, of course, by used for analyzing the purchase of a new asset or a proposal to replace an old asset with a new asset.
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NPV Method
The present value of all benefits less the present value of all costs
Decision rule:
Accept if NPV > 0
Reject if NPV < 0
NPV measures the change to the firm’s value from accepting the proposed investment
It is important to recognize that the numbers that are used in the NPV calculation come directly from the bottom of the cash flow worksheet. The ending number that is obtained from the NPV process is a dollar amount that represents an increase or decrease in the net value of the firm if the project is accepted.
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IRR Method
The discount rate that equates the present value of inflows to the present value of outflows
Decision rule:
Accept if IRR > cost of capital
Reject if IRR < cost of capital
IRR measures the rate of return from the proposed investment
The IRR method also uses the very same numbers from the bottom of the cash flow worksheet. The internal rate of return method gives us the answer in terms of an interest rate that can then be compared against other alternative investments.
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Choosing a Discount Rate
Each project has its own level of risk, hence one cost of capital may not be appropriate for the analysis of all a firm’s projects
Here we are recognizing the possibility that we may want to adjust the required rate of return in order to account for projects that appear to be more risky that the projects ordinarily accepted by the firm.
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The Appropriate Cost of Capital is a Function of Beta
Interestingly, there is a risk associated with not accepting projects that do meet the requirements of the firm, and another risk for accepting projects that do not meet the requirements. The firm does a sort of balancing act between these two risks.
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Category Cash flow Treatment
Initial cost
Cash outflow when purchased
Tax savings due to depreciation
Cash inflow (reduced outflow) each year
depreciation may be taken
Terminal value
Cash inflow when the asset is sold (adjusted
y tax if a capital gain or loss is reported)
Sale priceCash inflow when sold
Tax on sale
Cash outflow if a gain on sale is reported; cash
inflow (reduced outflow) if a loss on sale is
eported
Tax savings forgone due to no longer
eing able to depreciate the asset
Cash outflow (increased taxes) each year
depreciation would have been taken if the
asset were not sold
Terminal value forgone from no longer
having the asset to sell on its original
termination date
Cash outflow (lost cash inflow)
Changed recepits or payments from
having the new asset and/or not having
the old asset
Cash inflows and/or outflows over the lifetime
of the new and/or old asset(s)
Taxes paid or saved as changed receipts
and payments enter the tax return as
changes to income
Cash inflows and/or outlfows over the lifetime
of the new and/or old asset(s)
The cost of acquiring additional working
capital when a new asset is puchased
Cash outflow when the asset, and hence the
supporting working capital, is purchased
The cash from selling working capital no
longer required when an asset is sold