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CORPORATE FINANCE

SECOND EDITION

Chapter 11

Cash Flow Estimation and Capital

Budgeting Decisions

Prepared by Ken Hartviksen & Jared Laneus

Edited by Dr. William F. Rentz, Ph.D., LIFA

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

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

All evaluation approaches (NPV, IRR, discounted payback

and PI) require the same data:

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

= 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

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

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.

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.

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.

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

Canadian Example: Beaver Brewing

Second Edition

Canadian Example: Beaver Brewing

Second Edition

Canadian Example: Beaver Brewing

Second Edition

10

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

Second Edition

11

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

Canadian Example: Beaver Brewing

economic life equals S.

calculations.

Second Edition

13

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

Second Edition

14

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

Second Edition

15

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.

Equation 14-3, to adjust for any taxes payable on the

salvage

due

Casevalue

: SVn

C0 to capital gains or recapture of

depreciation:

Case : C0 SVn

ECFn SVn NWCn T (SVn UCCn )

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

Second Edition

18

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:

Second Edition

19

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?

Second Edition

20

the NPV

fact that the difference between the

UCC and the S will generate CCA tax

shields in years 4 through infinity.

Second Edition

21

Td UCCn SVn

ECFn SVn NWCn

kd

$10,000 $2, 400

0.15 0.20

Booth/Cleary Introduction to Corporate Finance,

Second Edition

22

end of the economic life of the asset

due to the CCA tax shields generated

after the economic life.

open, the amount (UCC S) must be

depreciated for tax purposes after the

economic life of the asset.

Second Edition

23

t=1 t

$24,000

T)

$ 4,000

$ -200

$

0

$

0

shields

$27,800

=2 t=3

$24,000 $24,000

(R-O)(1-

$ -200 $ 2,400 -NWC

$

0 $10,000 S

$

0 $10,880 PV tax

$31,000

Second Edition

$53,040

NCF

24

NPV

$102, 000

2

3

1.15

1.15

1.15

NPV $24,174 $23, 440 $34, 875 $102, 000

NPV $19, 511

Second Edition

25

NPV of bottling machine is now

NEGATIVE

Beaver should NOT invest in this

project

Second Edition

26

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

Second Edition

27

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

Second Edition

28

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

n

CFBTt 1 T

t 1

1 k

C0 dT

dk

1 0.5k SVn dT

1 k

dk

Second Edition

1

(1 k)n

29

SVn

1 k n

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

Second Edition

30

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

1

PV (OperatingCFs)

1

$54, 797

3

0.15

1.15

1.15 3

0.20 0.15

1.15

0.2 0.15

PV (CCATaxShield)

Second Edition

31

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

2

3

1.15 1.15

1.15

Second Edition

32

Now sum up first 4 Steps and subtract the initial outlay

(Step 5).

NPV $19,512

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)

Second Edition

35

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.

Second Edition

36

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.

investment must be made before the prevailing ore price is

known.

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

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

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

Second Edition

38

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

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

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

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

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

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

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

1.158

0.3 0.15

1.15

0.3 0.15

PV (CCATax Shield )

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

replace.

Booth/Cleary Introduction to Corporate Finance,

Second Edition

46

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

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

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

Decisions

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.

Second Edition

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