978-1259709685 Chapter 6 Lecture Note Part 2

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Slide 6.9 –

Slide 6.14 The Baldwin Company

.A Which Set of Books?

Firms are allowed to keep two sets of books: one for tax purposes

and one for stockholder reporting. The tax effects represent a cash

flow that is relevant to our analysis.

.B A Note about Net Working Capital

Accounts receivable and inventory increase to support higher sales levels.

Accounts payable also tends to increase to support the higher

inventory levels; however, the cash flows associated with these

increases do no appear on the income statement. If they are not on

the income statement, they will not be part of operating cash flow.

So, we have to consider changes in NWC separately.

Lecture Tip: The NWC discussion is very important and should not be

overlooked by students. It may be helpful to reemphasize the point

of NWC and operating cash flow through accounting entries.

Example:

Consider the accounting entries for two separate sales at the end of the year;

one is a cash sale for $10,000 and the other is a credit sale for

$5,000. The cash flow from these two sales is an inflow of $10,000

received from the cash sale, but the operating cash flow will

increase by (15,000 – cost of goods sold)*(1 – T).

The same is true when inventory is purchased. If the inventory

is purchased for cash, there is an immediate cash outflow, but it

will not show up on the income statement until it is sold. Even if

the inventory is purchased on credit, there is a good chance that

the supplier will have to be paid before the items are actually sold.

Because of the matching principle associated with revenues and

expenses, the operating cash flow does not always capture when

current assets are actually “purchased.” Consequently, an

adjustment must be made for changes in net working capital.

.C A Note about Depreciation

Slide 6.15 The Baldwin Company

Depreciation is a non-cash expense. However, depreciation affects taxes,

which are a cash flow. The relevant depreciation expense is the

depreciation that will be claimed for tax purposes. Consequently,

we need to understand how the IRS requires depreciation to be

computed.

MACRS depreciation – most assets are required to be depreciated using

MACRS. Each asset is assigned to a specific property class, and

depreciation is figured based on the percentages provided by the

IRS. Note that assets are depreciated to zero, and MACRS follows

a mid-year convention. The mid-year convention causes

depreciation expense to be taken in one more year than specified

by the property class, i.e., 3-year MACRS has four years of

depreciation expense.

Lecture Tip: Ask the students why a company might prefer accelerated

depreciation for tax purposes to the simpler straight-line

depreciation. As an example, consider the purchase of a five-year,

$50,000 machine by a company with a 34% marginal tax rate.

Assume a zero salvage value at the end of year 5 and an

appropriate discount rate of 10%.

Straight-line depreciation has a tax deductible expense of $50,000 / 5 =

$10,000 every year. This provides a tax shield of $10,000(.34)

= $3,400 each year. The present value of this tax shield is

$12,888.68.

MACRS depreciation has the following tax shields:

Year 1: $50,000(.2)(.34) = $3,400

Year 2: $50,000(.32)(.34) = $5,440

Year 3: $50,000(.192)(.34) = $3,264

Year 4: $50,000(.1152)(.34) = $1,958.40

Year 5: $50,000(.1152)(.34) + (0 – .34(0 – 2,880)) = $2,937.60

(Because the salvage is expected to be 0 in year 5, you need to

compute the tax benefit received when the asset is disposed of

at the end of year 5 to be consistent with the assumptions used

in the straight-line calculation and the mid-year convention for

MACRS.)

The present value of the tax shield is $13,200.70. As you can see from

the differences in the present values, the company is better off

receiving the tax shield sooner.

.D Interest Expense

Slide 6.16 The Baldwin Company

Slide 6.17 Incremental After Tax Cash Flows

Slide 6.18 NPV of Baldwin Company

Lecture Tip: Some students may still question why we are ignoring

interest, since it is clearly a cash outflow. It should be strongly

emphasized that we do not ignore interest expense (or any other

financing expense, for that matter); rather, we are only evaluating

asset related cash flows. It should be stressed that interest expense

is a financing cost, not an operating cost. It is chiefly a reflection

of capital structure, but it is usually not an important factor when

the value of a project is being determined. Another way to see this

is to think of the project as a mini-firm with its own balance sheet.

In capital budgeting, we are trying to determine the value of the

left-hand (asset) side of the balance sheet. How a project is

financed only affects the composition of the right-hand side of the

mini-firm’s balance sheet. The impact of debt is considered in

deriving the required return. Also, firms usually finance several

projects at one time due to economies of scale. Consequently, it

would be difficult to assign financing costs to specific projects.

Lecture Tip: Capital spending at the time of project inception (i.e., the

“initial outlay”) includes the following items:

+ purchase price of the new asset

– selling price of the asset replaced (if applicable)

+ costs of site preparation, setup and startup

+/- increase (decrease) in tax liability due to sale of old asset at other than

book value

= net capital spending

6.2. Alternative Definitions of Operating Cash Flow

Slide 6.19 Alternative Definitions of OCF

Suppose that sales = $1,000; operating costs = $600; depreciation = $200

and the tax rate = 34%

With our standard definition of OCF = EBIT – taxes + depreciation, we

compute the following:

EBIT = $1,000 – $600 – $200 = $200

Taxes = $200(.34) = $68

OCF = $200 – $68 + $200 = $332

.A The Top-Down Approach

OCF = Sales – Costs – Taxes

OCF = $1,000 – $600 – $68 = $332

.B The Bottom-Up Approach

OCF = NI + depreciation

NI = $200 – $68 = $132

OCF = $132 + $200 = $332

It is extremely important to remember that this definition will only

work when there is no interest expense. For that reason, it is often

ideal for capital budgeting problems, but not for finding historical

OCF.

.C The Tax Shield Approach

OCF = (Sales – Costs)*(1 – T) + Depreciation * T

OCF = ($1,000 – $600)(1 – .34) + $200(.34)

OCF = $264 + $68 = $332

Under this approach we consider the cash flow without any noncash

deductions and then add back the depreciation tax shield. If we had

other noncash deductions, we would need to compute the tax

shield associated with each one and add those back as well.

.D Conclusion

6.3. Some Special Cases of Discounted Cash Flow Analysis

Slide 6.20 Special Cases of Discounted Cash Flow Analysis

.A Evaluating Cost-Cutting Proposals

Slide 6.21 Cost-Cutting Proposals

The primary issue is whether the cost savings from a project are

large enough to justify the cost of the investment.

The cost savings will increase pretax income, but we have to pay

taxes on this amount. Depreciation will reduce our tax liability.

The net effect allows us to find our relevant yearly cash flows.

.B Setting the Bid Price

Slide 6.22 Setting the Bid Price

Under a competitive bid scenario, the winner is the one who bids

the lowest. To determine the bid price, the common approach is to

“work backwards.” What this means is that the firm should first

determine what yearly operating cash flow is necessary to generate

a zero NPV.

With this number, the analysts can work backwards through the

income statement to determine what price must be charged to

generate the required cash flow, making sure to control for

depreciation:

OCF = NI + Depr.

NI = (Sales – Costs – Depr) * (1-T)

.C Investments of Unequal Lives: The Equivalent Annual Cost

Method

Slide 6.23 –

Slide 6.25 Investments of Unequal Lives

With unequal lives, NPV may give incorrect decisions.

The Equivalent Annual Cost (EAC) method calculates the annuity

payment associated with the projects’ original NPVs.

Slide 6.26 Equivalent Annual Cost (EAC)

Slide 6.27 Cadillac EAC with a Calculator

Slide 6.28 Cheapskate EAC with a Calculator

6.4. Inflation and Capital Budgeting

.A Interest Rates and Inflation

Slide 6.29 –

Slide 6.30 Inflation and Capital Budgeting

Nominal rates = quoted interest rates

Real rates = inflation adjusted to reflect actual change in

purchasing power

The Fisher equation is:

(1 + nominal) = (1 + real) * (1 + inflation)

This suggests that real rates can be calculated as:

real = [(1 + nominal) / (1 + inflation)] – 1

For low rates of interest and inflation, the real rate can be

approximated as:

real = nominal – inflation

.B Cash Flow and Inflation

Nominal cash flow = actual dollars received

Real cash flow = the purchasing power of the dollars received (i.e.,

inflation adjusted)

.C Discounting: Nominal or Real?

The key point is to remember the matching principle:

Nominal cash flows should be discounted at nominal rates

Real cash flows should be discounted at real rates

Lecture Tip: First, market rates (which underlie the discount rate) include an

inflation premium; using a market-based discount rate implies that

we should be using nominal cash flows. Second, inflation can

impact different cash flows differently, and adjustments should be

made accordingly. Finally, while the depreciation expense is

known, small firms must consider that inflation may push them

into a higher tax bracket in the future.

Slide 6.31 Quick Quiz