978-1259709685 Chapter 6 Lecture Note Part 2

subject Type Homework Help
subject Pages 6
subject Words 1427
subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

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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

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