Financial Management

Financial Management

This course contains the basics of Financial Management

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Financial Management

Capital Budgeting and Cash Flow Analysis

Key Chapter Concepts

  1. Capital budgeting is the process of planning for purchases of assets whose cash flows are expected to continue beyond one year.
  2. The cost of capital is defined as the cost of funds supplied to a firm. It represents the required rate of return a firm must earn on its investments and thus is an important input in the capital budgeting process.
  3. There are four key steps in the capital budgeting process:
    a. Generating investment project proposals
    b. Estimating cash flows
    c. Evaluating alternatives and selecting projects to be implemented
    d. Reviewing a project’s performance after it has been implemented and postauditing its performance after termination
  4. Investment projects can be generated by growth opportunities, by cost reduction opportunities, and to meet legal requirements and health and safety standards.
  5. The initial outlay required to implement a project is called the net investment. It includes
    a. The installed cost of the assets
    b. Plus any initial net working capital requirements
    c. Less any cash inflows from the sale of replacement assets
    d. Plus or minus the tax consequences associated with the sale of existing assets and/or the purchase of new assets.
  6. The net operating cash flow from a project is equal to the change in net operating earnings after tax plus the change in depreciation minus the change in net working capital investment requirements associated with the adoption of a project. In the last year of a project’s life, this net cash flow definition may have to be modified to reflect the recapture of the accumulated net working capital investment and any after -tax salvage value received.
  7. The economic viability of a project can be affected by special tax considerations, such as the use of accelerated depreciation methods like the Modified Accelerated Cost Recovery System (MACRS) of depreciation.

Capital Investment Opportunities During a Business Downturn:The Case of Cleveland Cliffs Inc.

Financial Challenge

When the economy enters a period of low or negative economic growth, many firms cut back on the capital investments they had planned to make. With low or no growth in demand for their products, many firms postpone expansions. During business downturns, other firms become strapped for cash and look to sell off surplus assets so that they can acquire the cash that will be needed to survive the downturn. Still others are forced to enter bankruptcy proceedings and often liquidate assets as part of that process.

It is in times like these, such as late 2001 and early 2002, that opportunities present themselves to firms that are well positioned with strong balance sheets and ample cash balances.

In some cases, the acquisition of another firm’s assets may be driven by the fact that the assets being acquired may be a better strategic fit for the acquiring firm than for the seller. For example, in late 2001 Mead Corporation sold its Western Graphics poster-making unit to Rose Art Industries (the second largest maker of crayons).

Rose aims to dominate the art -and-crafts market in the United States. Similarly, Eaton Corporation recently sold its air- conditioning business unit to Parker-Hannifin. Eaton wanted to exit the air -conditioning business, whereas Parker-Hannifin, armed with $825 million in cash, wanted to grow this sector of its business.

In other cases, the acquisitions represent moves of desperation by firms that are short of cash. Under these circumstances,“fire-sale” prices can be found by those with abundant liquid resources. For example, in 2001, Cleveland Cliffs Inc., a firm that controls half of the nation’s iron-ore production, used the business downturn and the financial woes of many steel producers to pick up additional iron mines at bargain prices. Nearly a third of Cleveland Cliffs’ customers were in bankruptcy proceedings in late 2001, and many of these firms have ownership interests in iron mines that they were willing to unload.

WHX (parent company of Wheeling-Pittsburgh Steel), for example, agreed to sell Cleveland Cliffs its 12.5 percent share in a Michigan mine for no cash. Cleveland Cliffs merely had to assume the debt on the mine. Similar acquisitions of mining properties owned by bankrupt Bethlehem Steel and bankrupt LTV were also in the works. Cleveland Cliffs has been successful in cutting its costs, reducing the tax on the production from these mines, and securing other concessions from the states where they operate in exchange for commitments to keep the mines open.This cost -cutting was an essential element of the financing of these acquisitions. Cleveland Cliffs now considers every iron -ore mine owned by U.S. steelmakers to be for sale, and was aggressively pursuing them during the period of the business downturn and cash flow problems for the nation’s steelmakers.

Other companies have used the weak business climate as an opportunity to acquire strategic resources and bargain prices. For example, Kinder Morgan Energy Partners LP spent about $500 million on acquisitions during 2001. During 2001, American Greetings Corporation paid $35 million to buy its biggest online competitor, BlueMountain. A few years ago, Excite@Home, which entered Chapter 11 bankruptcy proceedings, had paid $780 million to acquire BlueMountain.

Acquisitions such as these offer some important lessons. First, liquidity provides a company with opportunities to acquire assets at very favorable prices during times of weak business conditions. Strong firms set the stage for further growth by making bargain purchases during business downturns. Second, there is usually a price at which the assets in even the weakest industries (such as iron -ore mines) can make good economic sense. Cleveland Cliffs’ strategy of picking up iron -ore mine assets at bargain prices speaks to this. Regardless of the economic conditions, financial managers need to scrutinize all major capital investments to determine whether they are likely to contribute to the creation of shareholder value.

The analysis of capital investments (that is, projects having economic lives extending beyond one year in time) is a key financial management function. Each year, large and small firms spend hundreds of billions of dollars on capital investments. These investments chart the course of a company’s future for many years to come.Therefore, it is imperative that capital investment analysis be performed correctly. This chapter develops the principles of capital investment analysis —with an emphasis on the estimation of cash flows from a project. Chapter considers appropriate decision criteria in the capital budgeting process that will maximize shareholder wealth.


This is the first of several chapters that explicitly deal with the financial management of the assets on a firm’s balance sheet. In this and the following two chapters we consider the management of long -term assets.

Capital budgeting

is the process of planning for purchases of assets whose returns are expected to continue beyond one year.A capital expenditure is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year. It is distinguished from a normal operating expenditure, which is expected to result in cash benefits during the coming 1-year period. (The choice of a 1-year period is arbitrary, but it does serve as a useful guideline.)

Several different types of outlays may be classified as capital expenditures and evaluated using the framework of capital budgeting models, including the following:

  • The purchase of a new piece of equipment, real estate, or a building in order to expand an existing product or service line or enter a new line of business
  • The replacement of an existing capital asset, such as a drill press
  • Expenditures for an advertising campaign
  • Expenditures for a research and development program
  • Investments in permanent increases of target inventory levels or levels of accounts receivable
  • Investments in employee education and training
  • The refunding of an old bond issue with a new, lower-interest issue
  • Lease-versus-buy analysis
  • Merger and acquisition evaluation

Total investments or capital expenditures of all industries in the United States during 2002 exceeded $1.1 trillion. Capital expenditures are important to a firm both because they require sizable cash outlays and because they have a long -range impact on the firm’s performance. The following example illustrates the magnitude and long-term impact of capital expenditures for an individual company.

In June 2002, Ford Motor Company announced plans to invest $5 billion to $6 billion in Volvo, its Swedish luxury -car subsidiary that it had purchased for $6.5 billion in 1999.1 The bulk of the funds invested were to be used to build up to five new or redesigned midsize vehicle models. Also, part of the capital invested was to be used to expand its manufacturing facilities in Sweden and Belgium in order to be able t produce up to 600,000 units per year, compared with the 425,000 units it produced in 2001. These capital expenditures were being made despite a weak economy, a loss of $5.45 billion by Ford in the previous year, and a 15 percent drop in Volvo’s U.S. sales during the first five months of 2002, compared with the previous year. Despite these concerns, Ford had confidence in Volvo’s new products and the long-term health of the economy and the company.

A firm’s capital expenditures affect its future profitability and, when taken together, essentially plot the company’s future direction by determining which products will be produced, which markets will be entered, where production facilities will be located, and what type of technology will be used. Capital expenditure decision making is important for another reason as well.

Specifically, it is often difficult, if not impossible, to reverse a major capital expenditure without incurring considerable additional expense. For example, if a firm acquires highly specialized production facilities and equipment, it must recognize that there may be no ready used -equipment market in which to dispose of them if they do not generate the desired future cash flows.

For these reasons, a firm’s management should establish a number of definite procedures to follow when analyzing capital expenditure projects. Choosing from among such projects is the objective of capital budgeting models.

Key Terms and Concepts in Capital Budgeting

Before proceeding with the discussion of the capital budgeting process, it is necessary to introduce a number of terms and concepts encountered in subsequent chapters.

Cost of Capital

A firm’s cost of capital is defined as the cost of the funds supplied to it. It is also termed the required rate of return because it specifies the minimum necessary rate of return required by the firm’s investors. In this context, the cost of capital provides the firm with a basis for choosing among various capital investment projects. In this and the following two chapters, it is assumed that the cost of capital is a known value.

How Projects Are Classified

A firm usually encounters several different types of projects when making capital expenditure decisions, including independent projects, mutually exclusive projects, and contingent projects. As is demonstrated in previous Chapter , project classification can influence the investment decision process.

Independent Projects

An independent project is one whose acceptance or rejection does not directly eliminate other projects from consideration. For example, a firm may want to install a new telephone communications system in its headquarters and replace a drill press during approximately the same time. In the absence of a constraint on the availability of funds, both projects could be adopted if they meet minimum investment criteria.

Mutually Exclusive Projects

A mutually exclusive project is one whose acceptance precludes the acceptance of one or more alternative proposals. Because two mutually exclusive projects have the capacity to perform the same function for a firm, only one should be chosen. For example, BMW was faced with deciding whether it should locate its U.S. manufacturing complex in Spartanburg, South Carolina, or at one of several competing North Carolina sites. It ultimately chose the Spartanburg site; this precluded other alternatives.

Contingent Projects

A contingent project is one whose acceptance is dependent on the adoption of one or more other projects. For example, a decision by Nucor to build a new steel plant in North Carolina is contingent upon Nucor investing in suitable air and water pollution control equipment.When a firm is considering contingent projects, it is best to consider together all projects that are dependent on one another and treat them as a single project for purposes of evaluation.

Availability of Funds

When a firm has adequate funds to invest in all projects that meet some capital budgeting selection criterion, such as has been true for Philip Morris (now part of Altria Group) in recent years, the firm is said to be operating without a funds constraint. Frequently, however, the total initial cost of the acceptable projects in the absence of a funds constraint is greater than the total funds the firm has available to invest in capital projects.This necessitates capital rationing, or setting limits on capital expenditures, and results in some special capital budgeting problems.

Basic Framework for Capital Budgeting

According to economic theory, a firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue derived from the output. Following this rule leads to profit maximization. This principle may also be applied to capital budgeting decisions. In this context, a firm’s marginal revenue is the rates of return earned on succeeding investments, and marginal cost may be defined as the firm’s marginal cost of capital (MCC), that is, the cost of successive increments of capital acquired by the firm. We illustrates a simplified capital budgeting model.

This model assumes that all projects have the same risk. The projects under consideration are indicated by lettered bars on the graph. Project A requires an investment of $2 million and is expected to generate a 24 percent rate of return. Project B will cost $1 million ($3 million minus $2 million on the horizontal axis) and is expected to generate a 22 percent rate of return, and so on. The projects are arranged in descending order according to their expected rates of return, in recognition of the fact that no firm has an inexhaustible supply of projects offering high expected rates of return.

This schedule of projects is often called the firm’s investment opportunity curve (IOC). Typically, a firm will invest in its highest rate of return projects first—such as Project A —before moving on to less attractive alternatives. The MCC schedule represents the marginal cost of capital to the firm. Note that the schedule increases as more funds are sought in the capital markets. The reasons for this include the following:

  • Investors’ expectations about the firm’s ability to successfully undertake a large number of new projects
  • The business risk to which the firm is exposed because of its particular line of business
  • The firm’s financial risk, which is due to its capital structure
  • The supply and demand for investment capital in the capital market
  • The cost of selling new stock, which is greater than the cost of retained earnings

The basic capital budgeting model indicates that, in principle, the firm should invest $9 million and undertake Projects A, B, C, D, and E, because the expected returns from each project exceed the firm’s marginal cost of capital. Unfortunately, however, in practice, financial decision making is not this simple. Some practical problems are encountered in trying to apply this model, including the following:

  • At any point in time, a firm probably will not know all of the capital projects available to it. In most firms, capital expenditures are proposed continually, based on results of research and development programs, changing market conditions, new technologies, corporate planning efforts, and so on. Thus, a schedule of projects similarly We will probably be incomplete at the time the firm makes its capital expenditure decisions.
  • The shape of the MCC schedule itself may be difficult to determine.
  • In most cases, a firm can only make uncertain estimates of a project’s future costs and revenues (and, consequently, its rate of return). Some projects will be more risky than others. The riskier a project is, the greater the rate of return that is required before it will be acceptable. In spite of these and other problems, all firms make capital investment decisions. This chapter and the following two chapters provide tools that may be applied to the capital budgeting decision-making process.

Briefly, that process consists of four important steps:

  1. Generating capital investment project proposals
  2. Estimating cash flows
  3. Evaluating alternatives and selecting projects to be implemented
  4. Reviewing a project’s performance after it has been implemented, and post-auditing its performance after its termination

The remainder of this chapter is devoted to a discussion of the first two steps.

Generating Capital Investment Project Proposals

Ideas for new capital investments can come from many sources, both inside and outside a firm. Proposals may originate at all levels of the organization —from factory workers up to the board of directors. Most large and medium -size firms allocate the responsibility for identifying and analyzing capital expenditures to specific staff groups.

These groups can include cost accounting, industrial engineering, marketing research, research and development, and corporate planning. In most firms, systematic procedures are established to assist in the search and analysis steps. For example, many firms provide detailed forms that the originator of a capital expenditure proposal must complete.

These forms normally request information on the project’s initial cost, the revenues it is expected to generate, and how it will affect the firm’s overall operating expenses. These data are then channeled to a reviewer or group of reviewers at a higher level in the firm for analysis and possible acceptance or rejection.

Where a proposal goes for review often depends on how the particular project is classified.

Classifying Investment Projects

As noted earlier, there are several types of capital expenditures. These can be grouped into projects generated by growth opportunities, projects generated by cost reduction opportunities, and projects generated to meet legal requirements and health and safety standards.

Projects Generated by Growth Opportunities

Assume that a firm produces a particular product that is expected to experience increased demand during the upcoming years. If the firm’s existing facilities are inadequate to handle the demand, proposals should be developed for expanding the firm’s capacity such as Ford’s decision to expand Volvo’s manufacturing facilities, discussed in the first section of the chapter. These proposals may come from the corporate planning staff group, from a divisional staff group, or from some other source.

Because most existing products eventually become obsolete, a firm’s growth is also dependent on the development and marketing of new products. This involves the generation of research and development investment proposals, marketing research investments, test marketing investments, and perhaps even investments in new plants, property, and equipment. For example, in order for the mineral extraction industries to keep growing, they must continually make investments in exploration and development. In 2002, ExxonMobil’s capital and exploration expenditures were $14.0 billion.

Similarly, firms in high-technology industries —such as electronics and pharmaceuticals—must undertake continuing programs of research and development to compete successfully. For example, Merck spent over $2.4 billion on research and development in 2002.

Projects Generated by Cost Reduction Opportunities

Just as products become obsolete over time, so do plants, property, equipment, and production processes. Normal use makes older plants more expensive to operate because of the higher cost of maintenance and downtime (idle time). In addition, new technological developments may render existing equipment economically obsolete. These factors create opportunities for cost reduction investments, which include replacing old, obsolete capital equipment with newer, more efficient equipment.

Projects Generated to Meet Legal Requirements and Health and Safety Standards

These projects include investment proposals for such things as pollution control, ventilation, and fire protection equipment. In terms of analysis, this group of projects is best considered as contingent upon other projects.

To illustrate, suppose USX wishes to build a new steel plant in Cleveland, Ohio. The decision will be contingent upon the investment in the amount of pollution abatement equipment required by state and local laws. Thus, the decision to invest in the new plant must be based upon the total cost of the plant, including the pollution abatement equipment, and not just the operating equipment alone. In the case of existing facilities, this type of decision making is sometimes more complex.

For example, suppose a firm is told it must install new pollution abatement equipment in a plant that has been in operation for some time. The firm first needs to determine the lowest cost alternative that will meet these legal requirements. “Lowest cost” is normally measured by the smallest present value of net cash outflows from the project. Then management must decide whether the remaining stream of cash flows from the plant is sufficient to justify the expenditure. If it appears as though it will not be, the firm may consider building a new facility, or it may decide simply to close down the original plant.

Project Size and the Decision-Making Process

The classification of a proposed project influences the capital investment decision-making process. However, there are other factors to consider —in particular, the size of the expenditure required to carry out the project. Most firms decentralize the decision-making function. For example, whereas the approval of the president and the board of directors may be needed for especially large outlays, such as Ford’s $5 to $6 billion investment in Volvo discussed earlier in the chapter, a divisional vice president may be the final decision maker in the case of medium -size outlays.

A plant manager may have responsibility for deciding on smaller outlays, and a department head in a particular plant may be authorized to approve small outlays. For example, at Hershey Foods, a corporate -level review is required for all projects of more than $500,000. Projects below this amount are evaluated at the operating division level only. Hershey is moving toward a system that will require a corporate-level review for all projects of $50,000 or more. This chain of command varies with individual companies. In large firms, however, it is impossible for any one person to make every decision regarding proposed capital expenditures, and a decentralized system is usually employed.

Principles of Estimating Cash Flows

The capital budgeting process is concerned primarily with the estimation of the cash flows associated with a project, not just the project’s contribution to accounting profits. Typically, a capital expenditure requires an initial cash outflow, termed the net investment. Thus it is important to measure a project’s performance in terms of the net (operating) cash flows it is expected to generate over a number of future years.

Figure shows the estimated cash flows for a particular project. After an initial net investment of $100,000, the project is expected to generate a stream of net cash inflows over its anticipated 5-year life of $50,000 in year 1; $40,000 in year 2; $30,000 in year 3; $25,000 in year 4; and $5,000 in year 5. This type of project is called a conventional or normal project.

Illustration of Estimated Cash Flows for a Normal Capital Investment Project

Nonnormal or nonconventional projects have cash flow patterns with either more than one or no sign change. Table illustrates the cash flow patterns for three sample projects. Projects X and Y can cause some analytical problems, as we shall see in the discussion of the internal rate of return criterion in the following chapter. Project X might require that certain equipment be shut down and rebuilt in year 3, and Project Y could be an investment in a mining property, with the negative cash flow in year 5 representing abandonment costs associated with closing down the mine after its mineral wealth has been depleted.

Finally, Project Z, which generates negative cash flows over the entire life of the investment, such as an investment in pollution control equipment, can be difficult to evaluate using the decision- making criteria developed in the next chapter.

Regardless of whether a project’s cash flows are expected to be normal or nonnormal, certain basic principles should be applied during their estimation, including the following:

  • Cash flows should be measured on an incremental basis. In other words, the cash flow stream for a particular project should be estimated from the perspective of how the entire cash flow stream of the firm will be affected if the project is adopted as compared with how the stream will be affected if the project is not adopted. Therefore, all changes in the firm’s revenue stream, cost stream, and tax stream that would result from the acceptance of the project should be included in the analysis. In contrast, cash flows that would not be changed by the investment should be disregarded.
  • Cash flows should be measured on an after -tax basis. Because the initial investment made on a project requires the outlay of after -tax cash dollars, the returns from the project should be measured in the same units, namely, after-tax cash flows.
  • All the indirect effects of a project should be included in the cash flow calculations. For example, if a proposed plant expansion requires that working capital be increased for the firm as a whole —perhaps in the form of larger cash balances, inventories, or accounts receivable —the increase in working capital should be included in the net investment required for the project.

    A firm may also have to provide for further working capital increases as sales increase over the life of the project. These additional working capital requirements should be included in the yearly net cash flows as outflows.However, as the project winds down, net working capital balances decline; these should be included as inflows when determining yearly cash flows. Other indirect effects may occur when one division of a firm introduces a new product that competes directly with a product produced by another division. The first division may consider this product desirable, but when the impact on the second division’s sales is considered, the project may be much less attractive.

    For example, in the Ford capital expenditure decision discussed earlier in the chapter, the company should consider the impact of the increased output of Volvos on the demand for Ford’s other luxury -car brands —namely, Lincoln and Jaguar.

    Sample Cash Flow Patterns for Nonnormal Projects

  • Sunk costs should not be considered when evaluating a project. A sunk cost is an outlay that has already been made (or committed to be made).

    Because sunk costs cannot be recovered, they should not be considered in the decision to accept or reject a project. For example, in 2004, the Chemtron Corporation was considering constructing a new chemical disposal facility. Two years earlier, the firm had hired the R.O.E. Consulting Group to do an environmental impact analysis of the proposed site at a cost of $500,000.

    Because this $500,000 cost cannot be recovered whether the project is undertaken or not, it should not be considered in the accept –reject analysis taking place in 2004. The only relevant costs are the incremental outlays that will be made from this point forward if the project is undertaken.

  • The value of resources used in a project should be measured in terms of their opportunity

    costs. Opportunity costs of resources (assets) are the cash flows those resources could generate if they are not used in the project under consideration. For example, suppose that the site Chemtron is considering to use for its disposal facility has been owned by the firm for some time. The property originally cost $50,000, but a recent appraisal indicates that the property could be sold for $1 million.

    Because Chemtron must forgo the receipt of $1 million from the sale of the site if the disposal facility is constructed, the appropriate opportunity cost of this piece of land is $1 million, not the original cost of $50,000. These five principles of cash flow estimation may be applied to the specific problem of defining and calculating a project’s net investment and net cash flows.

Net Investment (NINV)

The net investment (NINV) in a project is defined as the project’s initial net cash outlay, that is, the outlay at time (period) 0. It is calculated using the following steps:

  1. The new project cost plus any installation and shipping costs associated with acquiring the asset and putting it into service
  2. Any increases in net working capital initially required as a result of the new investment
  3. The net proceeds from the sale of existing assets when the investment is a replacement decision
  4. The taxes associated with the sale of the existing assets and/or the purchase of the new assets
The net investment (NINV).

The calculation of the net investment for two example projects is illustrated in later sections of the chapter dealing with asset expansion and asset replacement projects. Also discussed are some of the tax consequences that can influence the net investment of a project. These tax effects are the treatment of gains and losses from asset sales in the case of replacement decisions.

If a project generates additional revenues and the company extends credit to its customers, an additional initial investment in accounts receivable is required.Moreover, if additional inventories are necessary to generate the increased revenues, then an additional initial investment in inventory is required, too. This increase in initial working capital—that is, cash, accounts receivable, and inventories —should be calculated net of any automatic increases in current liabilities, such as accounts payable or wages and taxes payable, that occur because of the project.

As a general rule, replacement projects require little or no net working capital increase. Expansion projects, on the other hand, normally require investments in additional net working capital.

Some projects require outlays over more than one year before positive cash inflows are generated. It may take several years to design and construct a new production facility, such as an automobile assembly plant. In these cases, the NINV for that project will be equal to the present value (at time 0) of this series of outlays, discounted at the firm’s cost of capital. For example, consider a project requiring outlays of $100,000 in year 0, $30,000 in year 1, and $20,000 in year 2, with a cost of capital equal to 10 percent. The NINV or present value of the cash outlays is calculated as follows:

Figure illustrates this concept.

Timeline of NINV for a Project with Multiple Period Outlays

Net (Operating) Cash Flows

Capital investment projects are expected to generate after -tax cash flow streams after the initial net investment has been made. The process of estimating incremental cash flows associated with a specific project is an important part of the capital budgeting process.

Capital budgeting is concerned primarily with the after -tax net (operating) cash flows (NCF) of a particular project, or change in cash inflows minus change in cash outflows. For any year during the life of a project, these may be defined as the change in operating earnings after taxes, _OEAT, plus the change in depreciation, _Dep, minus the change in the net working capital investment required by the firm to support the project, _NWC:


The term change (Δ) refers to the difference in cash (and noncash) flows with and without adoption of the investment project.

Depreciation is the systematic allocation of the cost of an asset with an economic life in excess of one year. Although depreciation is not a cash flow, it does affect a firm’s after -tax cash flows by reducing reported earnings and there by reducing taxes paid by a firm. If a firm’s depreciation increases in a particular year as a result of adopting a project, after -tax net cash flow in that year will increase, all other things being equal.

After -tax net cash flow also considers changes in a firm’s investment in net working capital. If a firm increases its accounts receivable, for example, in a particular year without increasing its current liabilities as a result of adopting a specific project, after -tax net cash flow in that year will decrease, all other things being equal. On the other hand, a reduction in a firm’s investment in net working capital during a given year results in an increase in the firm’s NCF for that year.

From basic accounting definitions, the change in operating earnings after taxes (ΔOEAT) in Equation is equal to the change in operating earnings before taxes (ΔOEBT) times (1 – T) where T is the marginal corporate income tax rate. Furthermore, _OEBT is equal to the change in revenues (ΔR) minus the change in operating costs (ΔO) minus the change in depreciation (ΔDep). Substituting these terms in Equation yields the following definition of net cash flow:

NCF = (ΔR – ΔO – ΔDep)(1 – T) + ΔDep – ΔNWC

Equation can be further extended into an operational definition of NCF by defining ΔR as Rw – Rwo, ΔO as Ow – Owo, andΔDep as Depw – Depwo where

Rwo = Revenues of the firm without the project
Rw = Revenues of the firm with the project
Owo = Operating costs exclusive of depreciation for the firm without the project
Ow = Operating costs exclusive of depreciation for the firm with the project
Depwo = Depreciation charges for the firm without the project
Depw = Depreciation charges for the firm with the project

The definition given in Equation can be rewritten as follows:

NCF = [(Rw – Rwo) – (Ow – Owo) – 
(Depw – Depwo)] (1 – T) + (Depw – Depwo) – ΔNWC

These calculations and equations are summarized in Table In the final year of a project’s economic life, Equation must be modified to reflect recovery of the incremental after-tax salvage value of the asset(s).

The following two sections illustrate the calculation of net cash flows using these equations.

Recovery of After-Tax Salvage Value

Whenever an asset that has been depreciated is sold, there are potential tax consequences that may affect the after-tax net proceeds received from the asset sale. These tax consequences are important when estimating the after-tax salvage value to be received at the end of the economic life of any project. As discussed earlier, the tax consequences of asset sales are also important when calculating the net investment required in a replacement investment project. There are four cases that need to be considered.

Case 1: Sale of an Asset for Its Book Value If a company disposes of an asset for an amount exactly equal to the asset’s tax book value, there is neither a gain nor a loss on the sale and thus there are no tax consequences. For example, if Burlington Textile sells for $50,000 an asset with a book value for tax purposes of $50,000, no taxes are associated with this disposal.(In general, the tax book value of an asset equals the installed cost of the asset less accumulated tax depreciation.)

Case 2: Sale of an Asset for Less Than Its Book Value If Burlington Textile sells for $20,000 an asset having a tax book value of $50,000, Burlington Textile incurs a $30,000 pretax loss. Assuming that this asset is used in business or trade (an essential criterion for this tax treatment), this loss may be treated as an operating loss or an offset to operating income. This operating loss effectively reduces the company’s taxes by an amount equal to the loss times the company’s marginal tax rate.

Summary of Net Cash Flow Calculations and Equations

Assume that the company’s earnings before taxes is $100,000 (before consideration of the operating loss from the disposal of the asset). Taxes on these earnings are $100,000 times the company’s marginal (40 percent) tax rate, or $40,000. (We use a 40 percent marginal tax rate throughout the book for ease of calculation. Actual current corporate marginal tax rates are discussed in Appendix 2A.) Because of the operating loss incurred by selling the asset for $20,000, the company’s taxable income is reduced to $70,000 and the taxes decline to $28,000 (40 percent of $70,000). The $12,000 difference in taxes is equal to the tax loss on the sale of the old asset times the company’s marginal tax rate ($30,000 *40%).

Case 3: Sale of an Asset for More Than Its Book Value but Less Than Its Original Cost

If Burlington Textile sells the asset for $60,000—$10,000 more than the current tax book value —$50,000 of this amount constitutes a tax -free cash inflow, and the remaining $10,000 is taxed as operating income. As a result, the firm’s taxes increase by $4,000, or the amount of the gain times the firm’s marginal tax rate ($10,000 _40%). (The IRS treats this gain as a recapture of depreciation.)

Case 4: Sale of an Asset for More Than Its Original Cost If Burlington Textile sells the asset for $120,000 (assuming an original asset cost of $110,000), part of the gain from the sale is treated as ordinary income and part is treated as a long-term capital gain. The gain receiving ordinary income treatment is equal to the difference between the original asset cost and the current tax book value, or $60,000 ($110,000*$50,000). The capital gain portion is the amount in excess of the original asset cost, or $10,000. Under the Revenue Reconciliation Act of 1993, both ordinary income and capital gains are taxed at the same corporate rate (35 percent).

Recovery of Net Working Capital

In the last year of a project that, over its economic life, has required incremental net working capital investments, this net working capital is assumed to be liquidated and returned to the firm as cash. At the end of a project’s life, all net working capital additions required over the project’s life are recovered —not just the initial net working capital outlay occurring at time 0. Hence, the total accumulated net working capital is normally recovered in the last year of the project. This decrease in net working capital in the last year of the project increases the net cash flow for that year, all other things being equal. Of course, no tax consequences are associated with the recovery of NWC.

Interest Charges and Net Cash Flows

Often the purchase of a particular asset is tied closely to the creation of some debt obligation, such as the sale of mortgage bonds or a bank loan. Nevertheless, it is generally considered incorrect to deduct the interest charges associated with a particular project from the estimated cash flows. This is true for two reasons.

First, the decision about how a firm should be financed can —and should—be made independently of the decision to accept or reject one or more projects. Instead, the firm should seek some combination of debt, equity (common stock), and preferred stock capital that is consistent with management’s wishes concerning the trade-off between financial risk and the cost of capital. In many cases, this will result in a capital structure with the cost of capital at or near its minimum. Because investment and financing decisions should normally be made independently of one another, each new project can be viewed as being financed with the same proportions of the various sources of capital funds used to finance the firm as a whole.

Second, when a discounting framework is used for project evaluation, the discount rate, or cost of capital, already incorporates the cost of funds used to finance a project. Thus, including interest charges in cash flow calculations essentially would result in a double counting of costs.

Depreciation was defined earlier as the systematic allocation of the cost of an asset over more than one year. It allows a firm to spread the costs of fixed assets over a period of years to better match costs and revenues in each accounting period. The annual depreciation expense recorded for a particular asset is simply an allocation of historic costs and does not necessarily indicate a declining market value. For example, a company that is depreciating an office building may find the building’s market value appreciating each year.

There are a number of alternative methods of recording the depreciation of an asset for financial reporting purposes. These include straight-line depreciation and various accelerated depreciation methods. Under the straight-line depreciation method, the annual amount of an asset’s depreciation is calculated as follows:

                 Annual Installed Cost
  Depreciation = —————————————
                 Amount Number of years over which the asset is depreciated

The installed cost includes the purchase price of the asset plus shipping and installation charges, that is, Step 1 of the NINV calculation described earlier.

For tax purposes, the depreciation rate a firm uses has a significant impact on the cash flows of the firm. This is so because depreciation represents a noncash expense that is deductible for tax purposes.Hence, the greater the amount of depreciation charged in a period, the lower the firm’s taxable income will be.With a lower reported taxable income, the firm’s tax obligation (a cash outflow) is reduced and the cash inflows for the firm are increased. For example, suppose that the Badger Company in a given year has revenues of $1,000,000, operating expenses exclusive of depreciation of $500,000, straight-line depreciation of $100,000, and a marginal tax rate of 40 percent.

Its operating cash flow is calculated in part (a) of Table to be $340,000. Now suppose Badger opts to use an accelerated depreciation method for tax purposes, rather than the straight-line method. As a result, its depreciation expense is recorded as $150,000 instead of $100,000. Its operating cash flow is now $360,000, as shown in part (b) of Table

Comparison of Straight-Line and Accelerated Depreciation Methods:

A comparison of the two cash flow statements shows that the use of accelerated depreciation reduces operating earnings after taxes from $240,000 to $210,000 and reduces taxes from $160,000 to $140,000 but increases operating cash flow from $340,000 to $360,000. Hence, the use of accelerated depreciation for tax purposes is desirable for the firm because it reduces tax outlays and thereby increases cash flow. In general, a profitable firm will depreciate its assets as quickly as the tax law allows, and it should use whatever allowable method permits the highest percentage depreciation in the early years of an asset’s life.

The tax method currently used in the United States is the Modified Accelerated Cost Recovery System (MACRS) method.

The cash flow examples discussed in this chapter use straight -line depreciation to keep the calculations simple. In actual practice, companies today should use the MACRS method when computing the NCFs from a project. The relevant depreciation number that should be used when computing the after -tax net cash flows expected from a capital expenditure project is the tax depreciation amount.

Asset Expansion Projects

A project that requires a firm to invest funds in additional assets in order to increase sales (or reduce costs) is called an asset expansion project. For example, suppose the TLC Yogurt Company has decided to capitalize on the exercise fad and plans to open an exercise facility in conjunction with its main yogurt and health foods store. To get the project under way, the company will rent additional space adjacent to its current store. The equipment required for the facility will cost $50,000.

Shipping and installation charges for the equipment are expected to total $5,000. This equipment will be depreciated on a straight-line basis over its 5-year economic life to an estimated salvage value of $0. In order to open the exercise facility, TLC estimates that it will have to add about $7,000 initially to its net working capital in the form of additional inventories of exercise supplies, cash, and accounts receivable for its exercise customers (less accounts payable).

During the first year of operations, TLC expects its total revenues (from yogurt sales and exercise services) to increase by $50,000 above the level that would have prevailed without the exercise facility addition. These incremental revenues are expected to grow to $60,000 in year 2, $75,000 in year 3, decline to $60,000 in year 4, and decline again to $45,000 during the fifth and final year of the project’s life. The company’s incremental operating costs associated with the exercise facility, including the rental of the facility, are expected to total $25,000 during the first year and increase at a rate of 6 percent per year over the 5-year project life.

Depreciation will be $11,000 per year ($55,000 installed cost, assuming no salvage value, divided by the 5-year economic life). TLC has a marginal tax rate of 40 percent. In addition, TLC expects that it will have to add about $5,000 per year to its net working capital in years 1, 2, and 3 and nothing in years 4 and 5. At the end of the project, the total accumulated net working capital required by the project will be recovered.

Calculating the Net Investment

First, we determine the net investment required for the exercise facility expansion. TLC must make a cash outlay of $50,000 to pay for the facility equipment. In addition, it must pay $5,000 in cash to cover the costs of shipping and installation of the equipment. Finally, TLC must invest $7,000 in initial net working capital to get the project under way. The 4-step procedure discussed earlier for calculating the net investment yields the NINV required at time 0:

Note that steps 3 and 4 are not required in this problem since this is an asset expansion decision and no existing assets are being sold.

Calculating Annual Net Cash Flows

Next, we need to calculate the annual net cash flows associated with the project. The first year net cash flows can be computed by substituting _R = $50,000, _O = $25,000, _Dep = $11,000, T = 0.40, and _NWC = $5,000 into Equation :

Year 1:

NCF1 = ($50,000 – $25,000 – $11,000) (1 – 0.40)
        + $11,000 –  $5,000
     = $14,400

A similar calculation for the second year, where _R = $60,000, _O = $25,000 (1 + 0.06)1 = $26,500, _Dep = $11,000, T = 0.40, and _NWC = $5,000, yields:

Year 2:

NCF2 = ($60,000 – $26,500 – $11,000) (1 – 0.40)
       + $11,000 –  $5,000
     = $19,500

Finally, in the fifth year, TLC will recover its working capital investment of $22,000, i.e., $7,000 (Year 0) and $5,000 (Years 1, 2, and 3). Substituting _NWC = –$22,000, along with _R = $45,000 and _O = $25,000 (1 + 0.06)4 = $31,562, _Dep = $11,000, and T = 0.40 into Equation yields:

Year 5

NCF5 = ($45,000 – $31,562 – $11,000) (1 – 0.40)
        + $11,000 –  (–$22,000)
     = $34,463

The calculations of annual cash flows for these years as well as for years 3 and 4 are summarized in Table Note that since the equipment was fully depreciated and had no salvage value at the end of the fifth year, the after-tax salvage value was $0. The cash flows associated with the exercise facility project are illustrated with the time line in Figure

Asset Replacement Projects

The previous example of an asset expansion project illustrated the key elements of the calculation of a project’s net investment and its annual net cash flows. In this section, we consider an asset replacement project. Asset replacements involve retiring one asset and replacing it with a more efficient asset.

Suppose Briggs & Stratton purchased an automated drill press 10 years ago that had an estimated economic life of 20 years. The drill press originally cost $150,000 and has been fully depreciated, leaving a current book value of $0. The actual market value of this drill press is $40,000. The company is considering replacing the drill press with a new one costing $190,000.

Shipping and installation charges will add an additional $10,000 to the cost. The new machine would be depreciated to zero on a straight-line basis. The new machine is expected to have a 10 -year economic life, and its actual salvage value at the end of the 10 -year period is estimated to be $25,000. Briggs & Stratton’s current marginal tax rate is 40 percent.

Calculation of Annual Net Cash Flows for TLC Exercise Facility

Estimated Cash Flows for TLC Investment Project

Calculating the Net Investment

Steps 1 and 2 of the net investment calculation are easy; the new project cost($190,000) plus shipping and installation ($10,000) is $200,000. In this case, no initial incremental net working capital is required. In steps 3 and 4, the net proceeds received from the sale of the old drill press have to be adjusted for taxes.

Because the old drill press is sold for $40,000, the gain from this sale is treated as a recapture of depreciation and thus taxed as ordinary income. Table summarizes the NINV calculation for Briggs & Stratton. As can be seen in this table, the NINV is equal to $176,000.

Calculating Annual Net Cash Flows

Suppose Briggs & Stratton expects annual revenues during the project’s first year to increase from $70,000 to $85,000 if the new drill press is purchased. (This might occur because the new press is faster than the old one and can meet the increasing demands for more work.) After the first year, revenues from the new project are expected to increase at a rate of $2,000 a year for the remainder of the project life.

Assume further that while the old drill press required two operators, the new drill press is more automated and needs only one, thereby reducing annual operating costs from $40,000 to $20,000 during the project’s first year. After the first year, annual operating costs of the new drill press are expected to increase by $1,000 a year over the remaining life of the project. The old machine is fully depreciated, whereas the new machine will be depreciated on a straight -line basis.

The marginal tax rate of 40 percent applies. Assume also that the company’s net working capital does not change as a result of replacing the drill press. The first -year net cash flow resulting from the purchase of the new drill press can be computed by substituting Rw = $85,000, Rwo = $70,000,Ow = $20,000,Owo = $40,000, Depw = $20,000 ( = $200,000/10), Depwo = $0, T = 0.40, and _NWC = $0 into Equation 9.3 as follows:

NCF1 = [($85,000 – $70,000) – ($20,000 – $40,000)– ($20,000  – $0)](1 – 0.4) + ($20,000 – $0) – $0
     = $29,000

Using the different expected values for new revenues Rw = $87,000 and new operating costs Ow = $21,000 in the second year, the second-year net cash flows can be computed as follows:

Net Investment Calculation for Briggs & Stratton

Year 2:

NCF2 = [($87,000 – $70,000) – ($21,000 – $40,000)– ($20,000  – $0)](1 – 0.4) + ($20,000 - $0) – $0
     = $29,600

Similar calculations are used to obtain the net cash flows in years 3 through 9.

Finally, in year 10, the $25,000 estimated salvage from the new drill press must be added along with its associated tax effects. This $25,000 salvage is treated as ordinary income because it represents a recapture of depreciation for tax purposes.

NCF10 = [($103,000 – $70,000) – ($29,000 – $40,000)–  ($20,000 – $0)](1 – 0.4) + ($20,000 – $0) – $0
         + $25,000 salvage – tax on salvage (0.4*$25,000)
      = $34,400 + $25,000 – $10,000
      = $49,400

Table We shown here is a summary worksheet for computing the net cash flows for Briggs & Stratton during the 10-year estimated economic life of the new drill press.

Table We shown summarizes the net cash flows for the entire project. This schedule of net cash flows plus the NINV computed in the preceding section form the basis for further analysis. several different capital budgeting decision models are applied to similar cash flow streams from other projects to determine the investment desirability of these projects. The cash flows developed in this chapter are an essential input in the capital budgeting decision process.

Problems in Cash Flow Estimation

Because project cash flows occur in the future, there are varying degrees of uncertainty about the value of these flows. Therefore, it is difficult to predict the actual cash flows of a project. The capital budgeting process assumes that the decision maker is able to estimate cash flows accurately enough that these estimates can be used in project evaluation and selection. For this assumption to be realistic, a project proposal should be based on inputs from marketing managers regarding revenue estimates and inputs from the production and engineering staffs regarding costs and achievable levels of performance.

Objective inputs from these sources can help reduce the uncertainty associated with cash flow estimation. In addition, cash flow estimates for different projects may have varying degrees of uncertainty. For example, the returns from asset replacement projects are generally easier to forecast than the returns from new product introductio projects.

The Practice of Cash Flow Estimation for Capital Budgeting

The analysis presented in this chapter and throughout the book suggests that generating accurate estimates of the cash flows from investment projects is extremely important to the success of the firm. A survey supports this conclusion and provides considerable insight regarding the cash flow estimation procedures used by larger firms (Fortune 500).

The majority of the firms responding to the survey had annual capital budgets of more than $100 million. Nearly 67 percent of the firms prepared formal cash flow estimates for over 60 percent of their annual capital outlays, and a majority produced detailed cash flow projections for capital investments requiring an initial outlay of $40,000 or more.

Firms with high capital intensity and high leverage were more likely to have one or more persons, such as a financial analyst, treasurer, controller, or department manager, designated to oversee the process of cash flow estimation. This reflects the larger number of projects associated with capital-intensive firms and the need to effectively manage the risk associated with high leverage.

When asked about the type of cash flow estimates that were generated, 56 percent indicated that they used single-dollar estimates, 8 percent used a range of estimates, and 36 percent used both single -dollar estimates and a range of estimates. There was a significant positive correlation between firms that use both types of estimates and measures of operating and financial risk, suggesting that the use of a range of estimates is one procedure for managing high risk. Forecasting methods employed by the respondent firms included subjective estimates from management, sensitivity analysis, consensus analysis of expert opinions, and computer simulation.

Many firms used multiple cash flow forecasting techniques. The longer the forecasting horizon —that is, the longer the economic life of the project —the more likely a firm is to use multiple methods for forecasting future cash flows.

Financial factors considered to be important in generating cash flow estimates include working capital requirements, project risk, tax considerations, the project’s impact on the firm’s liquidity, the anticipated rate of inflation, and expected salvage value. Important marketing factors considered include sales forecasts, the competitive advantages and disadvantages of the product, and product life. Important production factors include operating expenses, material and supply costs, overhead and expenses for manufacturing, capacity utilization, and start-up costs.

Three-fourths of the companies surveyed make comparisons between actual and projected cash flows, with nearly all the firms comparing actual versus projected initial outlays and operating cash flows over the project life; about two -thirds of these firms make comparisons of actual versus projected salvage values. The most accurate cash flow estimates are reported to be the initial outlay estimates, and the least accurate element of cash flow estimates is the annual operating cash flows.

Cash flow forecasts were more accurate for equipment replacement investments than for expansion and modernization investments or for acquisitions of ongoing businesses. Firms with the information system in place to generate cash flow forecasts tend to produce more accurate forecasts than firms with less sophisticated capital project evaluation procedures.

Summary Project Cash Flows for Briggs & Stratton


Cash Flow Estimation Biases

The estimation of the cash flows associated with an investment project is the most important step in the capital expenditure evaluation process. If the cash flow estimates associated with a project are intentionally or unintentionally biased, a firm’s resources are unlikely to be allocated to the set of investment projects that will maximize shareholder wealth. There are several reasons why managers might produce biased cash flow estimates when preparing capital expenditure project proposals.

First, a manager might be tempted to overestimate the revenues or underestimate the costs associated with a project if the manager is attempting to expand the resource base over which he or she has control. By biasing the estimates of a project’s cash flows upward, a manager is likely to receive a larger share of the investment resources of the firm. Because managerial compensation is sometimes tied to the span of job responsibilities, managers may be tempted to expand this span of control at the expense of other areas in the firm.

Second, some firms tie employee compensation to performance relative to stated objectives —a compensation scheme often called management by objective. If a manager is confident that the best estimate of the cash flows from a proposed project is sufficiently large to guarantee project acceptance, the manager may be tempted to reduce these cash flow estimates to a level below the “most likely outcome” level, confident that the project will continue to be viewed as an acceptable investment and that it will be funded.

However, once the project is under way, the project manager will feel less pressure to meet projected performance standards. The downward bias in the cash flow estimates provides a cushion that permits suboptimal management of the project while achieving the objectives enunciated when the project was first proposed.

What impact does intentionally biasing cash flow estimates for investment projects have on achieving the goal of shareholder wealth maximization?

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