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INTRODUCTION TO

CORPORATE FINANCE
SECOND EDITION

Lawrence Booth & W. Sean Cleary


Chapter 11
Cash Flow Estimation and Capital
Budgeting Decisions
Prepared by Ken Hartviksen & Jared Laneus
Edited by Dr. William F. Rentz, Ph.D., LIFA

General Guidelines for


Capital Expenditure Analysis
1. Estimate all cash flows on an after-tax basis and use an
after-tax discount rate.
2. Use appropriate cash flow estimates that represent the
marginal or incremental cash flows arising capital
budgeting decisions. These are the additional cash flows
that result from capital budgeting decisions.
3. Do not include associated interest and dividend payments
in estimated project cash flows; these should be accounted
for in the discount rate.
4. Adjust cash flows to reflect any additional working capital
requirements, particularly the initial outlay and the
terminal cash flow.
5. Treat sunk costs, costs that have already been incurred
and cannot be recovered regardless of the capital
budgeting decision, as irrelevant. We are concerned only
with future cash flows.
Booth/Cleary Introduction to Corporate Finance,
Second Edition

General Guidelines for


Capital Expenditure Analysis
7. Determine the appropriate time horizon for a project.
8. Ignore intangible considerations that cannot be measured
unless their impact on cash flows can be estimated.
Intangibles should not be used to justify poor projects.
9. Ignore externalities, which are consequences that result
from an investment that may benefit or harm unrelated
third parties.
10. Consider the effect of all project interdependencies on cash
flow estimates. Undertaking a negative NPV project could
lose money in the short-term, but give the firm the option
to generate value in the future.
11. Treat inflation consistently: discount nominal cash flows
with nominal discount rates, or real cash flows with real
discount rates.
12. Undertake all social investments required by law. Many
social
and
infrastructure
projects must be undertaken even 3
Booth/Cleary
Introduction
to Corporate
Finance,
Second Edition

Estimating and Discounting Cash Flows


All evaluation approaches (NPV, IRR, discounted payback
and PI) require the same data:

CF0 = the estimate of the initial outlay


CFBT(1 T) = the net incremental after-tax cash flows
k = the cost of capital
n = the estimate of the useful life
ECFn = the ending cash flow
T = the corporate tax rate
d = the Capital Cost Allowance rate

The basic cash flow pattern has an initial investment at t


= 0, an annual stream of after-tax cash flow benefits at
each time period, and, at the end of the useful life,
ending cash flow benefits after-tax. The NPV is given by
Equation 14-5:NPV PV (Annual CFs) PV ( ECF ) CF
n

Booth/Cleary Introduction to Corporate Finance,


Second Edition

Cash Flows
Equation 14-1 shows that the initial investment at t = 0
consists of:
C0 = the initial capital cost of the asset
NWC0 = the change in the net working capital
OC = the opportunity costs associated with the project

CF0 C 0 NWC 0 OC

Equation 14-2 shows that cash flows subsequent to the


initial cash flow form a stream of after-tax cash flows
consisting of:
CFBTt(1 T) = the operating after-tax cash flow benefit at
CFt CFBTt (1 T ) CCAt T
time t
CCAt(T) = tax shield benefits from the CCA at time t
Booth/Cleary Introduction to Corporate Finance,
Second Edition

Cash Flows
Equation 14-2 needs to be modified if a project requires
any build-up of net working capital as the project
progresses.

CFt CFBTt (1 T ) CCAt T NWCt


This equation does NOT appear in the text, but must be
used in periods 1 through (n 1) when appropriate. In the
last period n, the text treats net working capital release
as part of the ending cash flows.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

Cash Flows
Equation 14-4 shows that the ending cash flow in the absence
of tax issues (i.e. SVn = UCCn ) consists of:
SVn = the estimated salvage value of the asset.
NWCn = the net working capital investment released at
the end of the project.

ECFn SVn NWCn

Note that net working capital is placed with the ending


cash flows in period n and that NWC in the last period is
defined as being positive when it DECREASES in value!
Booth/Cleary Introduction to Corporate Finance,
Second Edition

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing

$90,000 Price of bottling machine

$10,000 Shipping & installation

Class 8 asset, 20% CCA rate

Booth/Cleary Introduction to Corporate Finance,


Second Edition

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing

T = 40%, k = 15%, 3-year life

Salvage value at t = 3 is $57,600

Net cash revenues of $40,000 per year

Booth/Cleary Introduction to Corporate Finance,


Second Edition

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing

NWC increases by $2,000 initially

NWC increases by $200 in years 1 & 2

NWC decreases by $2,400 year 3

Booth/Cleary Introduction to Corporate Finance,


Second Edition

10

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing
$ 90,000
$ 10,000
$100,000
$ 2,000
$102,000

Purchase price
Shipping & installation
Initial capital cost
Increase in NWC
Initial outlay

Booth/Cleary Introduction to Corporate Finance,


Second Edition

11

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing
CCA
UCC
t=0
$100,000
t=1
$10,000*
$90,000
t=2
$18,000 $72,000
t=3
$14,400 $57,600
*1/2 Year Convention
Booth/Cleary Introduction to Corporate Finance,
Second Edition

12

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing

Note that the UCC at the end of the


economic life equals S.

This greatly simplifies the tax


calculations.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

13

ESTIMATION OF CASH FLOWS


Canadian Example: Beaver Brewing
t=1
t=2
t=3
$24,000$24,000 $24,000 (R-O)(1-T)
$ 4,000$ 7,200 $ 5,760 TCCA
$ -200 $ -200 $ 2,400 -NWC
$
0$
0 $57,600 S
$27,800$31,000 $89,760 NCF

Booth/Cleary Introduction to Corporate Finance,


Second Edition

14

NPV FOR BEAVER BREWING


Calculate the NPV using the project cost
of capital of 15%.
$27, 800 $31, 000 $89, 760
NPV

$102, 000
2
3
1.15
1.15
1.15
NPV $24,174 $23, 440 $59, 019 $102, 000
NPV $4, 633

Booth/Cleary Introduction to Corporate Finance,


Second Edition

15

NPV FOR BEAVER BREWING

NPV of bottling machine is POSITIVE

Beaver should invest in this project

Booth/Cleary Introduction to Corporate Finance,


Second Edition

16

Cash Flows
ASSUMPTIONS:
(1) Asset class is closed. Highly unlikely!
(2) Asset is sold before the end of year n. Would only be done
if UCCn > Sn.

If there are tax issues, the ECF must be modified, as in


Equation 14-3, to adjust for any taxes payable on the
salvage
due
Casevalue
: SVn
C0 to capital gains or recapture of
depreciation:

ECFn SVn NWCn 0.5T (SVn C0 ) T (C0 UCCn )


Case : C0 SVn
ECFn SVn NWCn T (SVn UCCn )

Booth/Cleary Introduction to Corporate Finance,


Second Edition

17

Cash Flows
ASSUMPTIONS ALWAYS USED IN THIS COURSE:
(1) Asset class remains open.
(2) Asset is sold on the first day of year n + 1.
(3) No new asset purchased for this class in year n + 1.
(4) C0 > SVn.

Td UCCn SVn
ECFn SVn NWCn

kd

Booth/Cleary Introduction to Corporate Finance,


Second Edition

18

Putting It All Together


Once you have estimated the cash flows:
Determine their after-tax values
Determine their present value
Sum the present values to determine the NPV
Equation 14-5, again:

NPV PV (Annual CFs) PV ( ECFn ) CF0

Booth/Cleary Introduction to Corporate Finance,


Second Edition

19

BEAVER BREWING REVISTED


Suppose the bottling machine will only
have a salvage value of $10,000 in
three years
Assume that Beaver has many assets
in class 8
Should Beaver still do the project?

Booth/Cleary Introduction to Corporate Finance,


Second Edition

20

BEAVER BREWING REVISTED

Reducing the salvage value will reduce


the NPV

However, this is partially offset by the


fact that the difference between the
UCC and the S will generate CCA tax
shields in years 4 through infinity.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

21

BEAVER BREWING REVISTED

Lets look at the ending cash flow

Td UCCn SVn
ECFn SVn NWCn

kd

0.4 0.2 $57,600 $10,000


$10,000 $2, 400

0.15 0.20

$10,000 $2, 400 $10,880 $23,280


Booth/Cleary Introduction to Corporate Finance,
Second Edition

22

BEAVER BREWING REVISTED

Note that the $10,880 is the PV at the


end of the economic life of the asset
due to the CCA tax shields generated
after the economic life.

That is, since the asset class remains


open, the amount (UCC S) must be
depreciated for tax purposes after the
economic life of the asset.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

23

BEAVER BREWING REVISTED


t=1 t
$24,000
T)
$ 4,000
$ -200
$
0
$
0
shields
$27,800

=2 t=3
$24,000 $24,000

(R-O)(1-

$ 7,200 $ 5,760 TCCA


$ -200 $ 2,400 -NWC
$
0 $10,000 S
$
0 $10,880 PV tax
$31,000

Booth/Cleary Introduction to Corporate Finance,


Second Edition

$53,040

NCF

24

BEAVER BREWING REVISTED

$27, 800 $31, 000 $53, 040


NPV

$102, 000
2
3
1.15
1.15
1.15
NPV $24,174 $23, 440 $34, 875 $102, 000
NPV $19, 511

Booth/Cleary Introduction to Corporate Finance,


Second Edition

25

BEAVER BREWING REVISTED


NPV of bottling machine is now
NEGATIVE
Beaver should NOT invest in this
project

Booth/Cleary Introduction to Corporate Finance,


Second Edition

26

CAPITAL BUDGETING TEMPLATE


One can confirm these results
using the Excel template Capital
Budgeting.xls available on docdepot in the Excel templates
subfolder of the Course Materials
folder

Booth/Cleary Introduction to Corporate Finance,


Second Edition

27

CCA FORMULA METHOD


The approach that we have used
so far to find the NPV is called the
Cash Flow Analysis Method
Now let us examine the CCA
Formula Method

Booth/Cleary Introduction to Corporate Finance,


Second Edition

28

Formula for NPV: Asset Class Remains Open


STEP 1: PV of operating after-tax net cash flow benefits
n

CFBTt 1 T

t 1

1 k

STEP 2: PV of all tax shields

C0 dT
dk

1 0.5k SVn dT

1 k
dk

Booth/Cleary Introduction to Corporate Finance,


Second Edition

1
(1 k)n

29

Formula for NPV: Asset Class Remains Open

STEP 3: PV of salvage value

SVn

1 k n

STEP 4: less PV of build-up of net working capital in years 1


through n - 1 plus the release of net working capital at end of
project
n 1
NWCt
NWCn

t
n
1

k
1

t 1

STEP 5:

CF0

Booth/Cleary Introduction to Corporate Finance,


Second Edition

30

NPV for Beaver: CCA Formula Method


Solution: Steps 1 & 2
C0 = $100,000
CF0 = C0 + NWC0 + OC = $100,000 + $2,000 + $0 =
$102,000
SVn = $10,000
CFBT (1 T )
1
PV (OperatingCFs)
1

k
(1 k)n

$40, 000(1 0.40)


1
PV (OperatingCFs)
1
$54, 797
3

0.15
1.15

$100, 000(0.2)(0.4) 1 0.5(0.15) $10, 000(0.2)(0.4) 1

1.15 3
0.20 0.15
1.15
0.2 0.15

PV (CCATaxShield) $21, 366 $1, 503 $19, 863


PV (CCATaxShield)

Booth/Cleary Introduction to Corporate Finance,


Second Edition

31

NPV for Beaver: CCA Formula Method


Solution (contd): Steps 3 & 4
Salvage Value = $10,000

$10, 000
PV
$6, 575
3
1.15
Net working capital effects in years 1 through n
PV

$200 $200 $2, 400

$174 $151 $1, 578 $1, 253


2
3
1.15 1.15
1.15

Booth/Cleary Introduction to Corporate Finance,


Second Edition

32

NPV for Beaver: CCA Formula Method


Now sum up first 4 Steps and subtract the initial outlay
(Step 5).

NPV $54,797 $19,863 $6,575 $1,253 $102,000


NPV $19,512

Conclusion: Since the proposals NPV < 0, we should not


implement it.
Note that the answer is the same as the Cash Flow
Analysis Method except for a $1 difference due to
rounding intermediate results in both methods to the
nearest dollar.
Booth/Cleary Introduction to Corporate Finance,
Second Edition

33

Sensitivity to Inputs
Stress testing NPV models to determine the sensitivity
of the decision to input variables is an important part
of risk assessment
There are two common approaches:
Sensitivity analysis is an examination of how an
investments NPV changes as the value of one input
at a time is changed
Scenario analysis is an examination of how an
investments NPV changes in response to varying
scenarios in terms of one or more estimates, such
as sales or costs
Booth/Cleary Introduction to Corporate Finance,
Second Edition

34

Sensitivity to Inputs
In scenario analysis, input variables are often given
discrete forecast ranges: best case, most likely case,
worst case, etc.
Analysts are interested in what the NPV might be in the
worst combination of cases, for example: worst-case
operating cash flows (low), worst-case initial cost
(high), and worst-case net working capital investment
(high)

Booth/Cleary Introduction to Corporate Finance,


Second Edition

35

Real Option Valuation (ROV)


Real Option Value (ROV) and decision tree analysis have
dramatically increased the understanding of corporate
decision making and the value of flexibility and strategic
considerations.
Decision trees are a schematic way to represent
alternative decisions and the possible outcomes.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

36

Real Option Valuation (ROV)


Table 14-2 gives a real options example of three alternative
ore-price scenarios for a mine, and illustrates that the
highest expected cash flows occur when ore prices are the
most volatile because of the shutdown option.

At t = 0, the firm must invest $150 to open the mine. This


investment must be made before the prevailing ore price is
known.

The unit variable cost is $6 and the firm can produce 100 units.

The fixed cost of operating the mine is $200 and occurs at t =


1.

As long as ore prices are above $6, the firm can operate the
mine for a profit.

Below $6, the mine shuts down and variable costs at t = 1 are
Booth/Cleary
Introduction to Corporate Finance,
avoided.
37
Second Edition

Real Option Valuation (ROV)

Note the shutdown option is what makes the


expected cash flow at t = 1 be $300 for Scenario 3.
Otherwise, if the firm produced when the price is only
$4, then the cash flow would be
100 x ($4 - $6) -$200 = -$400
and the expected cash flow for Scenario 3 would be

Booth/Cleary Introduction to Corporate Finance,


Second Edition

38

Real Option Valuation (ROV)


ROV is more difficult to apply than conventional capital
budgeting
The binomial or Black-Scholes option pricing models can
be used only in highly restrictive circumstances
The following real options almost always exist in a capital
expenditure decision:
1. Delay undertake the investment now, or in the future?
2. Contingent decisions will accepting a project generate
other projects that are linked or interdependent?
3. Redeployment can resources be put to alternative uses if
the project does not proceed as expected?
4. Abandonment can the project be terminated if expected
cash flows do not materialize?
5. Improvement can expected cash costs be lowered
through learning as the project is implemented?
Booth/Cleary Introduction to Corporate Finance,
Second Edition

39

NPV Break Even Analysis


The NPV break-even point is the level of annual operating
cash flow required for a project to produce an NPV of zero
The break-even discount rate is the projects IRR.
Example: A project has an initial outlay of $100,000, and the
present value of the CCA tax shield and ending cash flow
are $20,453 and $12,834, respectively. The project will last
for 12 years and has a 12% discount rate.
Solution: Set the NPV equal to zero and solve for the required
present value of the operating cash flows.
NPV PV (Operating Cash Flows ) PV (CCA Tax Shield ) PV ( ECFn ) CF0
$0 PV (Operating Cash Flows ) $20,453 $12,834 $100,000
PV (Operating Cash Flows ) $66,713
Booth/Cleary Introduction to Corporate Finance,
Second Edition

40

NPV Break Even Analysis


Next, find the annual after-tax cash flow over 12 years:
PV (Operating Cash Flows ) Break Even Operating Cash Flow
$66,713 Break Even Operating Cash Flow

1
1
1

0.12
1.1212

1
1
1

0.12
1.1212

Break Even Operating Cash Flow $10,770

Booth/Cleary Introduction to Corporate Finance,


Second Edition

41

Replacement Decisions
Expansion projects add something extra to the firm in
terms of sales or cost savings; their new cash flows are
incremental cash flows
Replacement projects involve the replacement of an
existing asset (or assets) with a new one and, in such cases,
we must clearly identify the incremental cash flows paying
particular attention to:
The effect on the incremental capital cost (C0), which is the
difference between the purchase price of the new
equipment and the salvage price of the equipment
The effect on the CCA tax shield. The equipment to be
replaced is normally sold early. Normally, there are no tax
consequences on disposal, except when assets are sold at a
price greater than their original cost, which triggers capital
on the difference.
Booth/Cleary gains
Introduction taxes
to Corporate Finance,
42
Second Edition

Replacement Decisions:
The Effect on the CCA Tax Shield
When an asset is removed from a CCA class:
There is no CCA in the year of disposal
The UCC of the pool or class is reduced by the disposal
value

When an asset is added to a CCA class:


There is of the normal CCA on the net additions to the
pool in that year
The UCC of the pool is increased by half of the net addition
in the first year, and half of the net additions in the second
year

In replacement decisions we must modify the present


change
Cformula
0.5account
k SVfor
1
0 dT 1 to
n dT
value
of
the
tax
shield
the
PV (CCATax Shield )

d salvage
k 1 values:
k
d k (1 k ) n
in the initial outlay and
Booth/Cleary Introduction to Corporate Finance,
Second Edition

43

Replacement Decisions

The deconstructed NPV model can be used in replacement


decisions
The focus is on the net change in operating cash flows, CCA
tax shield, ending and initial cash flows:
NPV PV (Operating CFs) PV ( CCA Tax Shield ) PV ( ECFn ) CF0
Example: A firm is considering the purchase of a new machine
priced at $350,000 to replace an existing machine. The
present market value of the existing machine is $50,000 and it
is expected to have a salvage value of $15,000 at the end of
eight years. Management estimates that the company will
benefit from the new machine by reducing annual operating
expenses by $50,000 over the life of the project, which is
expected to be eight years. This new machine is expected to
have a salvage value of $100,000 at the end of eight years.
The firms marginal tax rate is 40% and its marginal cost of
capital
is to15%.
Both machines belong to CCA class 10 which 44
Booth/Cleary
Introduction
Corporate Finance,
Second Edition

Replacement Decisions
Solution: Steps 1 and 2
C0 = 350,000 50,000 = $300,000
CF0 = C0 + NWC0 + OC = $300,000 + $0 + $0 =
$300,000
SVn = 100,000 15,000 = $85,000
CFBT (1 T )
1
PV (Operating CFs)
1

n
k
(
1

k
)

$50,000(1 0.4)
1
PV (Operating CFs)
1

$134,620
8

0.15
1.15

$300,000(0.3)(0.4) 1 0.5(0.15) $85,000(0.3)(0.4) 1

1.158
0.3 0.15
1.15
0.3 0.15

PV (CCATax Shield ) $67,373


PV (CCATax Shield )

Booth/Cleary Introduction to Corporate Finance,


Second Edition

45

Replacement Decisions
Solution (contd): Step 3
Salvage Value = ($100,000 - $15,000) = $85,000

$85,000
PV ( SVn )
$27, 787
8
1.15
Since there are no net working capital effects in this problem,
Step 4 is zero. Now sum up first 4 Steps and subtract the
incremental initial outlay (Step 5).
NPV $134,620 $67,373 $27,787 $0 $300,000 $70,220

Conclusion: Since the proposals NPV < 0, we should not


replace.
Booth/Cleary Introduction to Corporate Finance,
Second Edition

46

Inflation and Capital Budgeting Decisions


Even small rates of inflation over time can have
considerable effects on the economic viability of a project
Although inflation is often measured by aggregate
changes in prices at the retail (CPI, consumer price index)
or wholesale level, these measures often do not reflect
price changes specific to one company to project
Inflation must be treated consistently in project
evaluation models, either by:
1. Using the market-determined nominal discount rate with
its expected inflation component and estimating nominal
(i.e. actual) cash flows
2. Using a real discount rate that removes the inflation
premium from the market-determined nominal discount
rate and using real (i.e. constant dollar) cash flow
forecasts
Booth/Cleary Introduction to Corporate Finance,
Second Edition

47

Inflation and Capital Budgeting Decisions

Common Mistake: Using Real Cash Flows


and the Projects Cost of Capital Based
on Market Rates
If we forecast real (i.e. constant dollar) cash
flows by forgetting to forecast how cash flows
are affected by inflation and then discount
using a nominal discount rate, we will overdiscount because we are using a higher
market-determined rate that includes an
inflation premium but not nominal (i.e.
actual) cash flow forecasts
Booth/Cleary Introduction to Corporate Finance,
Second Edition

48

Inflation and Capital Budgeting


Decisions
Avoiding the Mistake: Two Approaches
If you use a market-determined WACC as
the discount rate, then you must use
nominal cash flow estimates for operating
cash flows (CCA shields are nominal)
If you remove inflation from the discount
rate, then you can use real cash flow
estimates for operating cash flows this is
NOT easily done because CCA tax shields are
nominal
Booth/Cleary Introduction to Corporate Finance,
Second Edition

49

Inflation and Capital Budgeting


Decisions

If you wish to use the real cash flow approach,


first use the Fisher equation to estimate the
embedded inflationary expectations, and then
reduce the nominal discount rate by that
amount
Risk-adjusted discount rate (RADR) = RF +
Risk Premium
RF = Real Return + Expected Inflation Rate
Real rather than actual tax shields must be
used
Booth/Cleary Introduction to Corporate Finance,
Second Edition

50

Copyright
Copyright 2010 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
Copyright 2011 Dr. William F. Rentz & Associates. Unless
permission is given, additions, deletions, and corrections prepared
by Dr. William F. Rentz are solely for use at the University of Ottawa.

Booth/Cleary Introduction to Corporate Finance,


Second Edition

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