1、,Corporate Finance Ross Westerfield Jaffe,Sixth Edition,Chapter Outline,7.1 Incremental Cash Flows7.2 The Baldwin Company:An Example7.3 Inflation and Capital Budgeting7.4 Investments of Unequal Lives:The Equivalent Annual Cost Method7.5 Summary and Conclusions,7.1 Incremental Cash Flows,Cash flows m
2、atternot accounting earnings.Sunk costs dont matter.Incremental cash flows matter.Opportunity costs matter.Side effects like cannibalism and erosion matter.Taxes matter:we want incremental after-tax cash flows.Inflation matters.,Cash FlowsNot Accounting Earnings.,Consider depreciation expense.You ne
3、ver write a check made out to“depreciation”.Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.,Incremental Cash Flows,Sunk costs are not relevantJust because“we have come this far”does not mean that we should continue to throw good money after bad.O
4、pportunity costs do matter.Just because a project has a positive NPV that does not mean that it should also have automatic acceptance.Specifically if another project with a higher NPV would have to be passed up we should not proceed.Side effects matter.Erosion and cannibalism are both bad things.If
5、our new product causes existing customers to demand less of current products,we need to recognize that.,Estimating Cash Flows,Cash Flows from OperationsRecall that:Operating Cash Flow=EBIT Taxes+DepreciationNet Capital SpendingDont forget salvage value(after tax,of course).Changes in Net Working Cap
6、italRecall that when the project winds down,we enjoy a return of net working capital.,Interest Expense,Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value.For now,its enough to assume that the firms level of debt(hence interest
7、expense)is independent of the project at hand.,7.2 The Baldwin Company:An Example,Costs of test marketing(already spent):$250,000.Current market value of proposed factory site(which we own):$150,000.Cost of bowling ball machine:$100,000(depreciated according to ACRS 5-year life).Increase in net work
8、ing capital:$10,000.Production(in units)by year during 5-year life of the machine:5,000,8,000,12,000,10,000,6,000.Price during first year is$20;price increases 2%per year thereafter.Production costs during first year are$10 per unit and increase 10%per year thereafter.Annual inflation rate:5%Working
9、 Capital:initially$10,000 changes with sales.,The Worksheet for Cash Flows of the Baldwin Company,Year 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1)Bowling ball machine100.00 21.76*(2)Accumulated 20.0052.0071.2082.72 94.24 depreciation(3)Adjusted basis of 80.0048.0028.8017.28 5.76 machine after d
10、epreciation(end of year)(4)Opportunity cost150.00 150.00(warehouse)(5)Net working capital 10.00 10.0016.3224.9721.22 0(end of year)(6)Change in net 10.006.32 8.653.75 21.22 working capital(7)Total cash flow of260.00 6.32 8.653.75 192.98 investment(1)+(4)+(6),*We assume that the ending market value o
11、f the capital investment at year 5 is$30,000.Capital gain is the difference between ending market value and adjusted basis of the machine.The adjusted basis is the original purchase price of the machine less depreciation.The capital gain is$24,240(=$30,000$5,760).We will assume the incremental corpo
12、rate tax for Baldwin on this project is 34 percent.Capital gains are now taxed at the ordinary income rate,so the capital gains tax due is$8,240 0.34($30,000$5,760).The after-tax salvage value is$30,000 0.34($30,000$5,760)=21,760.,($thousands)(All cash flows occur at the end of the year.),The Worksh
13、eet for Cash Flows of the Baldwin Company,At the end of the project,the warehouse is unencumbered,so we can sell it if we want to.,($thousands)(All cash flows occur at the end of the year.),Year 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1)Bowling ball machine100.00 21.76*(2)Accumulated 20.0052.0
14、071.2082.72 94.24 depreciation(3)Adjusted basis of 80.0048.0028.8017.28 5.76 machine after depreciation(end of year)(4)Opportunity cost150.00 150.00(warehouse)(5)Net working capital 10.00 10.0016.3224.9721.22 0(end of year)(6)Change in net 10.006.32 8.653.75 21.22 working capital(7)Total cash flow o
15、f260.00 6.32 8.653.75 192.98 investment(1)+(4)+(6),The Worksheet for Cash Flows of the Baldwin Company(continued),Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)Sales Revenues100.00163.00249.72212.20 129.90,($thousands)(All cash flows occur at the end of the year.),Recall that production(in units)by
16、 year during 5-year life of the machine is given by:(5,000,8,000,12,000,10,000,6,000).Price during 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=$249,720.,The Worksheet for Cash Flows of the Baldwin Company(continued),Year 0Year 1Year 2Yea
17、r 3Year 4 Year 5Income:(8)Sales Revenues100.00163.00249.72212.20 129.90(9)Operating costs 50.00 88.00145.20 133.10 87.84,($thousands)(All cash flows occur at the end of the year.),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).Produc
18、tion costs during first year(per unit)are$10 and(increase 10%per year thereafter).Production costs in year 2=8,000$10(1.10)1=$88,000,The Worksheet for Cash Flows of the Baldwin Company(continued),Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)Sales Revenues100.00163.00249.72212.20 129.90(9)Operating
19、 costs 50.00 88.00145.20 133.10 87.84(10)Depreciation 20.00 32.00 19.20 11.52 11.52,($thousands)(All cash flows occur at the end of the year.),Depreciation is calculated using the Accelerated Cost Recovery System(shown at right)Our cost basis is$100,000Depreciation charge in year 4=$100,000(.1152)=$
20、11,520.,The Worksheet for Cash Flows of the Baldwin Company(continued),Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)Sales Revenues100.00163.00249.72212.20 129.90(9)Operating costs 50.00 88.00145.20 133.10 87.84(10)Depreciation 20.00 32.00 19.20 11.52 11.52(11)Income before taxes 30.00 43.20 85.32
21、67.58 30.54(8)(9)-(10)(12)Tax at 34 percent 10.20 14.69 29.01 22.98 10.38(13)Net Income 19.80 28.51 56.31 44.60 20.16,($thousands)(All cash flows occur at the end of the year.),Incremental After Tax Cash Flows of the Baldwin Company,7.3 Inflation and Capital Budgeting,Inflation is an important fact
22、of economic life and must be considered in capital budgeting.Consider the relationship between interest rates and inflation,often referred to as the Fisher relationship:(1+Nominal Rate)=(1+Real Rate)(1+Inflation Rate)For low rates of inflation,this is often approximated as Real Rate Nominal Rate Inf
23、lation RateWhile the nominal rate in the U.S.has fluctuated with inflation,most of the time the real rate has exhibited far less variance than the nominal rate.When accounting for inflation in capital budgeting,one must compare real cash flows discounted at real rates or nominal cash flows discounte
24、d at nominal rates.,Example of Capital Budgeting under Inflation,Sony International has an investment opportunity to produce a new stereo color TV.The required investment on January 1 of this year is$32 million.The firm will depreciate the investment to zero using the straight-line method.The firm i
25、s in the 34%tax bracket.The price of the product on January 1 will be$400 per unit.The price will stay constant in real terms.Labor costs will be$15 per hour on January 1.The will increase at 2%per year in real terms.Energy costs will be$5 per TV;they will increase 3%per year in real terms.The infla
26、tion rate is 5%Revenues are received and costs are paid at year-end.,Example of Capital Budgeting under Inflation,The riskless nominal discount rate is 4%.The real discount rate for costs and revenues is 8%.Calculate the NPV.,Example of Capital Budgeting under Inflation,The depreciation tax shield i
27、s a risk-free nominal cash flow,and is therefore discounted at the nominal riskless rate.Cost of investment today=$32,000,000Project life=4 yearsAnnual depreciation expense:,Depreciation tax shield=$8,000,000.34=$2,720,000,Example of Capital Budgeting under Inflation,Risky Real Cash FlowsPrice:$400
28、per unit with zero real price increaseLabor:$15 per hour with 2%real wage increaseEnergy:$5 per unit with 3%real energy cost increaseYear 1 After-tax Real Risky Cash Flows:After-tax revenues=$400 100,000(1-.34)=$26,400,000After-tax labor costs=$15 2,000,000 1.02(1-.34)=$20,196,000After-tax energy co
29、sts=$5 2,00,000 1.03(1-.34)=$679,800After-tax net operating CF=$26,400,000-$20,196,000-$679,800=$5,524,200,Example of Capital Budgeting under Inflation,$5,524,200$31,499,886$31,066,882$17,425,007,-$32,000,000,0 1 2 34,Year One After-tax revenues=$400 100,000(1-.34)=$26,400,000Year One After-tax labo
30、r costs=$15 2,000,000 1.02(1-.34)=$20,196,000Year One After-tax energy costs=$5 2,00,000 1.03(1-.34)=$679,800Year One After-tax net operating CF=$5,524,200,Example of Capital Budgeting under Inflation,The project NPV can now be computed as the sum of the PV of the cost,the PV of the risky cash flows
31、 discounted at the risky rate and the PV of the risk-free cash flows discounted at the risk-free discount rate.NPV=-$32,000,000+$69,590,868+$9,873,315=$47,464,183,7.4 Investments of Unequal Lives:The Equivalent Annual Cost Method,There are times when application of the NPV rule can lead to the wrong
32、 decision.Consider a factory which must have an air cleaner.The equipment is mandated by law,so there is no“doing without”.There are two choices:The“Cadillac cleaner”costs$4,000 today,has annual operating costs of$100 and lasts for 10 years.The“cheaper cleaner”costs$1,000 today,has annual operating
33、costs of$500 and lasts for 5 years.Which one should we choose?,7.4 Investments of Unequal Lives:The Equivalent Annual Cost Method,At first glance,the cheap cleaner has the lower NPV(r=10%):,This overlooks the fact that the Cadillac cleaner lasts twice as long.When we incorporate that,the Cadillac cl
34、eaner is actually cheaper.,7.4 Investments of Unequal Lives:The Equivalent Annual Cost Method,The Cadillac cleaner time line of cash flows:,The“cheaper cleaner”time line of cash flows over ten years:,Investments of Unequal Lives,Replacement ChainRepeat the projects forever,find the PV of that perpet
35、uity.Assumption:Both projects can and will be repeated.Matching CycleRepeat projects until they begin and end at the same timelike we just did with the air cleaners.Compute NPV for the“repeated projects”.The Equivalent Annual Cost Method,Investments of Unequal Lives:EAC,The Equivalent Annual Cost Me
36、thodApplicable to a much more robust set of circumstances than replacement chain or matching cycle.The Equivalent Annual Cost is the value of the level payment annuity that has the same PV as our original set of cash flows.NPV=EAC ArTFor example,the EAC for the Cadillac air cleaner is$750.98,The EAC
37、 for the cheaper air cleaner is$763.80 which confirms our earlier decision to reject it.,Example of Replacement Projects,Consider a Belgian Dentists office;he needs an autoclave to sterilize his instruments.He has an old one that is in use,but the maintenance costs are rising and so is considering r
38、eplacing this indispensable piece of equipment.New AutoclaveCost=$3,000 today,Maintenance cost=$20 per yearResale value after 6 years=$1,200NPV of new autoclave(at r=10%):,EAC of new autoclave=-$553.29,Example of Replacement Projects,Existing AutoclaveYear012345Maintenance 0200275325450500Resale9008
39、50775700600500Total Annual Cost,Note that the total cost of keeping an autoclave for the first year includes the$200 maintenance cost as well as the opportunity cost of the foregone future value of the$900 we didnt get from selling it in year 0 less the$850 we have if we still own it at year 1.,Exam
40、ple of Replacement Projects,340,435,478,620,660,New AutoclaveEAC of new autoclave=-$553.29Existing AutoclaveYear012345Maintenance 0200275325450500Resale900850775700600500Total Annual Cost,We should keep the old autoclave until its cheaper to buy a new one.Replace the autoclave after year 3:at that p
41、oint the new one will cost$553.29 for the next years autoclaving and the old one will cost$620 for one more year.,7.5 Summary and Conclusions,Capital budgeting must be placed on an incremental basis.Sunk costs are ignoredOpportunity costs and side effects matterInflation must be handled consistentlyDiscount real flows at real ratesDiscount nominal flows at nominal rates.When a firm must choose between two machines of unequal lives:the firm can apply either the matching cycle approach or the equivalent annual cost approach.,
