The International University, VNU-HCM

School of Business

Fundamental of Financial Management

Lecturer: Dr. Nguyen Thi My Linh
Email: [email protected]
 The International University, VNU-HCM
School of Business

Lecture 8:
Capital Budgeting &
Cash Flows Projection

Slides are prepared based on the lecture slides of Ms. Le Hong Nhung, Lecturer, IU School of Business
Process of capital budgeting decision
3

Make decision of Accept or Reject a project

1. Identify promising/potential projects

2. Estimate cash flows of promising projects and

discounted rate

3. Choose method to evaluate NPV, IRR, PP, etc.

 Capital Budgeting & Cash Flows Projection

Topics covered
 Identifying cash flows (principles of CF estimation)

 Estimating project “after-tax incremental operating

cash flows”

 An example

 Self-study part
 Principles of Cash Flows Estimation

 No. 1: Cash flows (not accounting

income) – only cash flows relevant

Example
A project costs $2,000 and is expected to last 2 years,
producing cash income of $1,500 and $500 respectively. The
cost of the project can be depreciated at $1,000 per year.
Given a 10% required return, compare the NPV using cash flow
to the NPV using accounting income. Tax rate 0%.
 Principles of Cash Flows Estimation

Accounting income: Cash flows:

Year 1 Year 2 Today Year 1 Year 2

Cash Income $1500 $ 500 Cash Income $1500 $ 500
Depreciation - $1000 - $1000 Project Cost - 2000
Accounting Income + 500 - 500 Free Cash Flow - 2000 +1500 + 500

500  500 1,500 500

NPV =  2
 $41.32 NPV = -2,000  1
 2
 $223.14
1.10 (1.10) (1.10) (1.10)

Calculating NPV based on cash flows gives correct result

 Principles of Cash Flows Estimation

 No. 2: Incremental cash flows

Incremental Cash flow Cash flow without
Cash Flow
= with project - project

You should always ask yourself “Will this cash flow occur ONLY
if we accept the project?”

If the answer is “yes,” it should be included in the analysis

because it is incremental
If the answer is “no,” it should not be included in the
analysis because it will occur anyway
If the answer is “part of it,” then we should include the
part that occurs because of the project
 Principles of Cash Flows Estimation

 No. 2: Incremental cash flows (Cont.)

 Sunk costs – costs that have accrued in the past 
irrelevant CF
 Opportunity costs – costs of lost options  Relevant
 Side effects/ Externalities  Relevant
 Positive side effects – benefits to other projects

 Negative side effects – costs to other projects

 Changes in net working capital: change in Cash, AR,

Inventory, AP  Relevant

“Will this cash flow occur ONLY if we accept the project?”

 Principles of Cash Flows Estimation

 No. 2: Incremental cash flows (Cont.)

 Financing costs: cost of capital is already included in the
discount rate  should not be double counted  irrelevant
 Taxes  relevant (after-tax cashflows)
 Depreciation  non-cash expense  irrelevant
 Terminal cashflows: sell plants, machines (cash inflows) or
expenses to shutting down a project (cash outflows)  relevant
 Overhead costs: incremental?  can be relevant or irrelevant

“Will this cash flow occur ONLY if we accept the project?”

 Principles of Cash Flows Estimation

 No.3: Separate financing and investment

decision

Project cash flows must make sense regardless of how financed

Ignore all financing costs (e.g., ignore interest, principal payment), even if
the project is partially financed with debt  assume all-equity financing

Financing side effects will be considered later.

Interest costs are considered in the discount rate
 Principles of Cash Flows Estimation

 No.4: Interest rate and cash flows must be

measured on the same basis

Use nominal interest rates to discount

nominal cash flows.
OR
Use real interest rates to discount real
cash flows.

You will get the same results, whether

you use nominal or real figures
 Principles of Cash Flows Estimation

No.4: Interest rate and cash flows must be measured on

the same basis (Cont.)

Example
You own a lease that will cost you $8,000 this year,
increasing at 3% a year (the forecasted inflation rate)
for 3 additional years (4 years total). If discount rates
are 10% what is the present value cost of the lease?

1+ nominal interest rate

1  real interest rate = 1+inflation rate
 Principles of Cash Flows Estimation

Nominal cash flows

Year Cash Flow PV @ 10%
0 8000 8,000.00
1 8000x1.03 = 8,240 8240
1.10
 7,490.91
2 8000x1.03 2 = 8,487.20 8487.20
1.102
 7,014.22
3 8000x1.03 3 = 8,741.82 8741.82
1.103
 6,567.86
Real cash flows
$29,072.98
Year Cash Flow [email protected]%
0 8,000 8,000
1 8,000 8,000
1.068
 7,490.91
2 8,000 8,000
1.0682
 7,014.22
3 8,000 8,000
1.0683
 6,567.86
= $ 29,072.98
 Estimating Cash Flows

1.CASH FLOWS FROM

CAPITAL
INVESTMENTS

2. OPERATING CASH
FLOWS
TOTAL CASH
FLOW
3. CASH FLOWS FROM
CHANGES IN
WORKING CAPITAL

4. CAPITAL GAIN/LOSS
FROM SALE OF THE
PROJECT/PLANT/MACHINE)
 BALDWIN EXAMPLE

Baldwin Company is considering an investment project:

producing colored bowling balls.

•The estimated life of the project: 5 years.

•The cost of test marketing (already spent): $250,000.
•Would be produced in a vacant building owned by the firm; the property
can be sold for $150,000 after taxes.
•The cost of a new machine: $100,000, (depreciated according to MACRS
5-year)
•The estimated market value of the machine at the end of 5 years:
$30,000.
 BALDWIN EXAMPLE

• Production by year for the 5-year life: 5,000 units, 8,000 units, 12,000
units, 10,000 units, and 6,000 units; The price of bowling balls in the
first year: $20; The price of bowling balls will increase at 2% per year.
• No debt financing; no interest expenses.

• First-year production costs: $10 per unit; Production costs will

increase at 10% per year.
• An initial investment (at year 0) in net working capital: $10,000;
NWC at the end of each year will be equal to 10% of sales for that year;
NWC at the end of the project is zero.

• After 5 years, market value of proposed factory site is expected to sell

@$150,000, and machine will be sold at $30,000.
• Incremental/marginal corporate tax rate: 34%.
 1. Capital Investment

1. - Cost of “new” assets

2. - Capitalized expenditures
(shipping/installation costs)
3. + Net proceeds from sale of
Consider when
“old” asset(s) if replacement replacing current
4. - (+) Taxes (savings) due to the sale machine
of “old” asset(s) if replacement

5. - Opportunity cost

= Capital Investment (Investment in Fixed assets)

 1. Capital Investment (Baldwin example)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Initial Investments:
(1) Bowling ball machine -100.00
(2) Opportunity cost -150.00
(warehouse)
(3) Total Initial investment -250.00

2. Cash flows from operations:

3. Change in working capital:

(5) Net working capital
(6) Change in net
working capital

4. Selling assets
warehouse
Bowling ball machine
 2a. Cash flows from operation – Income method
1. Operating revenues (R)
2. Variable costs (V)
3. Fixed costs (F) (exclude depr. and int. costs)
4. Depreciation cost (D)

5. = (1)-(2)-(3)-(4)
= Earning before interest and tax (EBIT =R-V-F-D)
6. Taxes charge on profit before tax (T=EBIT x Tc)

7. = (5)-(6)
7. = Net income (NI = EBIT x (1-Tc))

8. = (7)+(4)
8. = Cash flows from operations
8. CFO = Net Income + Dep. = EBIT(1-Tc) + D
2a. Cash flows from operation – Baldwin example
 2b. Cash flows from operation – Taxshield method
1. Operating revenues (R)
2. Variable costs (V)
3. Fixed costs (F) (exclude depr. and int. costs)

4. = (1)-(2)-(3)
= Cash flows before tax (CF =R-V-F)
5. Taxes charge on cash flows before tax (T=CF x Tc)

6. = (4)-(5)
7. = Cash flows after tax (CF –T= CFx (1-Tc))
7. Depreciation Tax shield (D x Tc)

8. = (6)+(7)
8. = Cash flows from operations
8. CFO = CF(1-Tc) +TcxD
2b. Cash flows from operation – Baldwin example
 Depreciation

 Depreciation represents the systematic allocation of the cost

of a capital asset over a period of time for financial reporting
purposes, tax purposes, or both.
 Generally, profitable firms prefer to use an accelerated
method for tax reporting purposes (e.g. MACRS).

 Depreciation Methods
 Straight Line
 Accelerated
 Modified accelerated cost recovery system (MARCRS)
 Depreciable Basis

Cost of Capitalized
Depreciable
Expendi-
Asset tures
Basis

In tax accounting, depreciable basis is the fully installed cost

of an asset.
Examples: Cost of assets + shipping and installation cost
 MACRS Sample Schedule

Recovery Property Class

Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
Suppose a machine that has cost of buying is $100 mil is depreciated by 5-
year MACRS schedule.
Year 1 Year 2 Year 3 year 4 Year 5 Year 6
Depreciation ($ mil.) : 20.00 32.00 19.20 11.52 11.52 5.76
 Depreciation

Because depreciation is a noncash expense.

Cash out
the lower
Everything flows
the taxes
inform of
else equal paid by the
taxes
firm
smaller

profitable
the greater firms prefer
The lower
the
depreciation
reported to use an
profit accelerated
charges
method
 3. Change in Working Capital
Working capital
requirements
increase when
volume increase.

Working capital will

be recovered at the Consider
end of each year.
change in
working
For the last year of capital rather
the project, there is than working
no working capital capital.
requirement.

Working capital is
fully recovered at the
end of the project
3. Change in Working Capital (Baldwin example)
 4. The sale of an asset

The sale of a “capital asset”

generates a:

Capital gain Capital loss

(asset sells for more than (asset sells for less than
book value) book value)
 4. The sale of an asset

Calculate capital gain/loss from selling asset

Selling price of the assets

- Book value of the assets

= Capital gain/loss

Calculate tax paid on selling asset

Taxes (tax savings) due to capital gain/loss = Capital gain/loss * Tax rate

Calculate cash flow from selling asset

c) Selling price of the assets

d) - (+) Taxes (tax savings) due to capital gain/loss

= Cash flows from selling assets

 4. The sale of an asset (Baldwin example)

(3) Depreciation 20.00 32.00 19.20 11.52 11.52

(4) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
The Baldwin Company (Cont.)
Baldwin example
 Baldwin example

DETAILED CALCULATION OF CASH

FLOWS FROM OPERATION (INCOME
METHOD)
The Baldwin Company
Baldwin(Cont.)
example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Sales Revenues 100.00 163.20 249.72 212.20 129.90

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.
The Baldwin Company
Baldwin(Cont.)
example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84

Again, production (in units) by year during 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
The Baldwin Company
Baldwin(Cont.)
example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52

Depreciation is calculated using the Accelerated Cost Year ACRS %

Recovery System (shown at right). 1 20.00%
Our cost basis is $100,000. 2 32.00%
Depreciation charge in year 4 3 19.20%
4 11.52%
= $100,000×(.1152) = $11,520. 5 11.52%
6 5.76%
Total 100.00%
The Baldwin Company
Baldwin(Cont.)
example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4)Income before taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
 Baldwin example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4)Income before taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
(5) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(6) Net Income 19.80 28.51 56.31 44.60 20.16
 Baldwin example

Cash flows from operations

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90

(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4)Income before taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
(5) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(6) Net Income 19.80 28.51 56.31 44.60 20.16
(7) Cash flows from operations 39.80 60.51 75.51 56.62 31.68
[(6) + (3)]
 Example 1: Bottoms Up Diaper Service

Bottoms Up Diaper Service is considering the purchase of a new industrial washer. It can
purchase
the washer for $6,000 and sell its old washer for $2,000. The new washer will last for 6
years and
save $1,500 a year in expenses. The opportunity cost of capital is 16%, and the firm’s tax rate
is 40%.

If the firm uses straight-line depreciation to an assumed salvage value of zero over a 6-
a. year life,
what are the cash flows of the project in years 0 to 6? The new washer will in fact have
zero
salvage value after 6 years, and the old washer is fully depreciated.

b. What is project NPV?

What is NPV if the firm uses MACRS depreciation with a 5-year tax
c. life?
PLEASE SEE THE EXCEL FILE
 Example 2: Rapid Corp.
41
 Rapid Corp is evaluating the installation of a new machine
that costs of $150,000 plus installation costs of $25,000.

 It generates revenues of $150,000 and expenses of

$100,000 annually.

 If the machine can be depreciated on a straight-line basis to

its estimated salvage value of $25,000 over its 5-year life.
The machine will be sold at $25,000 at the end of year 5.

 The firm’s tax rate is 30%

 What is the relevant cash flows?

Example 2: Rapid Corp.
42
 Example 3: ABC’s Optimal Replacement
43

 Should ABC replace its photocopy equipment every year,

every second years, or every third year
 Cost of machine is $15,000, using straight-line depreciation
 The discount rate is 12% p.a.
 Salvage value is:
 $6,000 at the end of year 1
 $3,000 at the end of year 2
 $0 at the end of year 3
 Maintenance costs are:
 $1,000 in first year,
 $2,000 in second year.
 $3,000 in third year
 Corporate tax rate 34%
 Assume that company revenues are unaffected by the replacement
policy
Example 3: ABC’s Optimal Replacement (cont)
44
Cash Flows if replaced every year
Year 0 1
Depreciation (9,000)
Maintenance cost (1,000)
Effect on tax payable (10,000)
Effect on tax paid (3,400)
Year 0 1
Cost of machine (15,000)
Salvage 6,000
Maintenance cost (1,000)
Tax benefit (tax shield) 3,400
Net cash flows (15,000) 8,400
NPV (7,500)
Equivalent annual cost (8,400)
Example 3: ABC’s Optimal Replacement (cont)

Cash Flows if replaced every second year

Year 0 1 2
Depreciation (6,000) (6,000)
Maintenance cost (1,000) (2,000)
Effect on tax payable (7,000) (8,000)
Effect on tax paid (2,380) (2,720)

Year 0 1 2
Cost of machine (15,000)
Salvage 3,000
Maintenance cost (1,000) (2,000)
Tax benefit (tax shield) 2,380 2,720
Net cash flows (15,000) 1,380 3,720
NPV (10,802)
Equivalent annual cost (6,392)

45
Example 3: ABC’s Optimal Replacement (cont)
Cash Flows if replaced every third year

Year 0 1 2 3
Depreciation (5,000) (5,000) (5,000)
Maintenance cost (1,000) (2,000) (3,000)
Effect on tax payable (6,000) (7,000) (8,000)
Effect on tax paid (2,040) (2,380) (2,720)
Year 0 1 2 3
Cost of machine (15,000)
Salvage 0
Maintenance cost (1,000) (2,000) (3,000)
Tax benefit (tax shield) 2,040 2,380 2,720
Net cash flows (15,000) 1,040 380 (280)
NPV (13,968)
Equivalent annual cost (5,815)

46
Example 2: ABC’s Optimal Replacement (cont)

Year 1 2 3
NPV (7,500) (10,802) (13,968)
Equivalent
annual cost (8,400) (6,392) (5,815)

 Recommendation: Replace every third year

47
 48

Homework: please see the

tutorial set