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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.
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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.
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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
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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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ANSWERS TO
END-OF-CHAPTER QUESTIONS
10-1. We focus on cash flows rather than accounting profits because these are the flows
that the firm receives and can reinvest. Only by examining cash flows are we able to
correctly analyze the timing of the benefit or cost. Also, we are only interested in
these cash flows on an after tax basis as only those flows are available to the
shareholder. In addition, it is only the incremental cash flows that interest us,
because, looking at the project from the point of the company as a whole, the
incremental cash flows are the marginal benefits from the project and, as such, are
the increased value to the firm from accepting the project.
10-2. Although depreciation is not a cash flow item, it does affect the level of the
differential cash flows over the project’s life because of its effect on taxes.
Depreciation is an expense item and, the more depreciation incurred, the larger are
expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are
a cash flow item.
10-3. If a project requires an increased investment in working capital, the amount of this
investment should be considered as part of the initial outlay associated with the
project’s acceptance. Since this investment in working capital is never “consumed,”
an offsetting inflow of the same size as the working capital’s initial outlay will occur
at the termination of the project corresponding to the recapture of this working
capital. In effect, only the time value of money associated with the working capital
investment is lost.
10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are
interested in only the incremental after-tax cash flows to the company as a whole.
Regardless of the decision made on the investment at hand, the sunk costs will have
already occurred, which means these are not incremental cash flows. Hence, they
are irrelevant.
10-5. Mutually exclusive projects involve two or more projects where the acceptance of
one project will necessarily mean the rejection of the other project. This usually
occurs when the set of projects perform essentially the same task. Relating this to
our discounted cash flow criteria, it means that not all projects with positive NPV’s,
profitability indexes greater than 1.0 and IRRs greater than the required rate of return
will be accepted. Moreover, since our discounted cash flow criteria do not always
yield the same ranking of projects, one criterion may indicate that the mutually
exclusive project A should be accepted, while another criterion may indicate that the
mutually exclusive project B should be accepted.
10-6. There are three principal reasons for imposing a capital rationing constraint. First,
the management may feel that market conditions are temporarily adverse. In the
early- and mid-seventies, this reason was fairly common, because interest rates were
at an all-time high and stock prices were at a depressed level. The second reason is a
manpower shortage, that is, a shortage of qualified managers to direct new projects.
The final reason involves intangible considerations. For example, the management
may simply fear debt, and so avoid interest payments at any cost. Or the common
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stock issuance may be limited in order to allow the current owners to maintain strict
voting control over the company or to maintain a stable dividend policy.
Whether or not this is a rational move depends upon the extent of the rationing. If it
is minor and noncontinuing, then the firm’s share price will probably not suffer to
any great extent. However, it should be emphasized that capital rationing and
rejection of projects with positive net present values is contrary to the firm‘s goal of
maximization of shareholders’ wealth.
10-7. When two mutually exclusive projects of unequal size are compared, the firm should
select the project with the largest net present value, when there is no capital
rationing. If there is capital rationing, then the firm should select the set of projects
with the highest net present value. The firm needs to consider alternative uses of
funds if the project with the lowest net present value is chosen.
10-8. The time disparity problem and the conflicting rankings that accompany it result
from the differing reinvestment assumptions made by the net present value and
internal rate of return decision criteria. The net present value criterion assumes that
cash flows over the life of the project can be reinvested at the required rate of return;
the internal rate of return implicitly assumes that the cash flows over the life of the
project can be reinvested at the internal rate of return.
10-9. Masalah ketidakterbandingan proyek-proyek dengan umur yang berbeda tidak secara
langsung disebabkan oleh proyek-proyek yang memiliki umur yang berbeda tetapi fakta
bahwa proposal investasi yang menguntungkan di masa depan dipengaruhi oleh keputusan
yang sedang dibuat. Sekali lagi, kuncinya adalah: “Apakah keputusan investasi yang dibuat
hari ini memengaruhi proposal investasi yang menguntungkan di masa depan?” Jika
demikian, proyek tersebut tidak bisa dibandingkan. Meskipun pendekatan yang paling tepat
secara teoritis adalah membuat asumsi tentang peluang investasi di masa depan, metode ini
mungkin terlalu sulit untuk dinilai dalam banyak kasus. Jadi, metode paling umum yang
digunakan untuk mengatasi masalah ini adalah pembuatan rantai pengganti untuk
menyamakan masa hidup. Akibatnya, peluang reinvestasi di masa depan diasumsikan serupa
dengan yang ada saat ini. Pendekatan lain adalah menghitung anuitas tahunan yang setara
untuk setiap proyek.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
10-1A.
(a) Tax payments associated with the sale for $35,000
Recapture of depreciation
= ($35,000-$15,000) (0.34) = $6,800
(b) Tax payments associated with sale for $25,000
Recapture of depreciation
= ($25,000-$15,000) (0.34) = $3,400
(c) No taxes, because the machine would have been sold for its book value.
(d) Tax savings from sale below book value:
Tax savings = ($15,000-$12,000) (0.34) = $1,020
10-2A.
New Sales $25,000,000
Less: Sales taken from
existing product lines – 5,000,000
$20,000,000
10-3A. Change in net working capital equals the increase in accounts receivable and
inventory less the increase in accounts payable = $18,000 + $15,000 – $24,000 =
$9,000.
The change in taxes will be EBIT X marginal tax rate = $475,000 X .34 = $161,500.
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
= $475,000
– $161,500
