Incremental Cash Flow: Example

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1 Note 8. Making Capital Investment Decisions To include or not to include? that is the question. General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation the company had paid a consulting firm $100,000 to perform a test-marketing analysis. The expenditure was made last year. Should you include this $100,000 as part of the relevant costs for the capital budgeting decision now confronting the management of General Milk Company? 1 2 I. Fundamental Principles of Project Evaluation A project evaluation is an application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision. Then, what is relevant cash flow? Relevent cash flows are the incremental cash flows associated with the decision to invest in a project. The incremental cash flows for project evaluation consist of any and all changes in the firm s future cash flows that are a direct consequence of taking the project. Incremental Cash Flow: Example PharMed Co. is the producer of the best-seller toothpaste EVERSHINE. The company is now considering the introduction of a new formula toothpaste ultra-evershine. EVERSHINE ultra-evershine 3 4 1

2 EVERSHINE Before (Base Case) Revenues: $800M Expenses: $400M Net Cash Flow: $400M ultra-evershine New Product Revenues: $500M Expenses: $250M Net Cash Flow: $250M <Incremental Cash Flows> Every capital budgeting problem compares an investment alternative to a base case. Incremental cash flows in the investment alternative are those which differ from the base case (that is, the difference between the cash flows with a project and the cash flows without the project). Incremental = Cash flow Cash Flow Cash Flow with Project without Project In estimating relevant cash flows from a project, you should include only extra (that is, incremental ) cash flows that would result from the project! In the process, you need to apply the following general rules (in the next slide). 5 6 Sunk Costs: an Example 1 st Stage 2 nd Stage 3 rd Stage Initial test Test drilling Mass Production NPV drilling NPV NPV analysis analysis analysis -$30 million -$200 million -$2 billion 7 8 2

3 Example: Incremental Cash Flow Concept Suppose the Beta Trading Company has an empty warehouse that can be used to store a new line of products. Should the cost of warehouse and land be included in the costs associated with introducing the new line? Example: Incremental Cash Flow Concept General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation the company had paid a consulting firm $100,000 to perform a testmarketing analysis. The expenditure was made last year. Is this cost relevant for the capital budgeting decision now confronting the management of General Milk Company? 9 10 Example: Incremental Cash Flow In 1971, Lockheed sought a federal guarantee for a bank loan to continue development of the TriStar aero-plane. Lockheed and its supporters argued it would be foolish to abandon a project on which nearly $1 billion has already been spent. Some of Lockheed s critics countered that it would be equally foolish to continue with the project that offered no prospect of a satisfactory return on that $1 billion. Whose argument is correct? 11 Is Uber's Service Doomed To Get Worse? A car owner faces two sources of cost: variable use costs and fixed costs. Variable use costs happen with every mile of use, and include gas prices, maintenance, and labor, whereas fixed costs happen no matter what you do, like cost of capital and time depreciation. For someone deciding whether or not to become an Uber driver, the fixed costs are a sunk cost. In the future, when car purchase decisions are made entirely on the net present value of buying the asset and using it as an Uber vehicle, fixed costs won't be sunk costs, but will be part of the NPV consideration. 12 Oct. 31, 201 3

4 II. Cash Flow Revisited Now, once you have determined the incremental cash flows from undertaking a project, you can view the project as a "mini-firm" with its own future revenues and costs, its own assets, and its own cash flows and just focus on the cash flows. Recall how we calculated cash flows from assets. Cash Flow From Assets Cash Flow To Creditors Cash Flow To Equityholders

5 III. Example Cash Flow Analysis Using NPV: Nittany Mining As the financial manager of Nittany Mining, you are about to analyze a proposal for developing a new dollarmond mine in the Nittany Mountain area. The following is the summary of the information about the project. 1. Capital Spending: $12 million in mining machinery. After 6 years, the machinery has no further value on the book but can be sold at $5 million. 2. Working Capital: Increases in the initial years, but will be recovered (disinvestment) at the end of the project's life. The schedule for the working capital is as follows: Year Working Capital Sales Revenues: The company expects to sell 7,500 pounds of dollarmond a year at a price of $2,000 a pound in Year 1. That points to initial revenues of 7,500 $2,000 = $15,000,000. Inflation is expected at 5% a year Expenses (or costs): Initially $10 million (Year 1). Then, increases in line with inflation at 5% a year. 5. Depreciation: Straight-line over 6 years for the mining machinery. 6. Tax: 35% of pre-tax profits. 7. The company s capital consists of all equity (no debt). The company s beta is estimated at 0.9. The going risk-free rate is 3%. The market risk premium is estimated at 10%. We will apply NPV, IRR, and PI. We will go through the following steps. Step 1. Forecast the project cash flows based on a pro forma income statement. Step 2. Use the required return to discount the future cash flows. Step 3. Go ahead with the project if the present value of the payoff is greater than the investment (i.e., if NPV > 0)

6 Step 1. Cash Flow Projections We need to fill out the following table in three steps First Component - Capital Spending: First, we have to figure out the amount of capital spending. We know that the capital investment for the mining machine is $12 million at time 0. The machine will bear no book value but can be sold at $5 million in year 6. Taxes on capital gains from sales of fixed assets at project termination Any capital gains from selling fixed assets (i.e., market value less book value) are subject to taxes. Capital gain (from the sale of a fixed asset) = market value book value Tax = capital gain tax rate In our example, Tax = ($5M - $0)(0.35) = $1.75M Hence, after-tax salvage cash flow = $5M - $1.75 = $3.25M

7 Taxes on capital losses from sales of fixed assets at project termination When the market value of a fixed asset is below the asset s book value, the gap is subject to a tax credit. Tax credit = (book value market value) tax rate For example, if you sold an asset worth $10M in the book at $5M, you are eligible for a tax credit of ($10M - $5M)*0.35 = $1.75M First Component - Capital Spending: In our case, the after-tax cash flow from the sale of the machine at project termination is $3.25M. (in $1,000) Second Component - Investment in Net Working Capital: Third Component - Operating Cash Flows: We first prepare a pro-forma income statement. Then, we calculate the projected cash flow based on the information provided by the income statement. In the process, we have to pay attention to non-cash items. We can use either the top-down or bottom-up approaches

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9 Step 2. Use the required return to discount the projected annual cash flows. The company s capital consists of all equity (no debt). The compa ny s beta is estimated at 0.9. The going risk-free rate is 3%. The m arket risk premium is estimated at 10%. According to the CAPM, E(r) = Based on the above calculation, you decide to apply a 12% discount rate to discount your estimated project cash flows Step 3. Calculate the NPV. NPV = PV(CF 0 ) + PV(CF 1 ) + +PV(CF 6 ) = $5,666 (in 000) We accept the investment since its NPV is positive. Other Rules IRR = 22.29% (Using Excel) > 12% (Accept) Profitability Index = $19,166/$13,500 = 1.42 > 1 (Accept)

10 IV. Special Case: Evaluating Investment Options with Different Lives When two different equipment setups, systems, or procedures have different economic lives and when we will need whatever we buy more or less indefinitely, the typical NPV rule, which typically assumes one investment horizon, does not help. In this case, we have to use one of the following: 1.Replacement Chains 2.Equivalent Annual Cost (EAC) 1.Replacement Chains We assume for each of the alternative equipment setups that we purchase it as soon as its life is over until we find a matching cycle. Then, we calculate the present value for each equipment for this matching cycle. The project with the lower PV is chosen. Option A Option B 2 yrs. 2 yrs. 2 yrs. 3 yrs. 3 yrs Example: Replacement Chains You have to choose between two alternatives Life: 5 years Price: $140,000 Annual Maintenance Cost: $8,000 No salvage value after 5 years 5 yrs. 5 yrs. Solution: NPV = $140,000 + $140,000/(1.08) 5 + $8,000 x Annuity PVF( 10 yrs 8%) = $288,962 Life: 10 years Price: $245,000 Annual Maintenance Cost: $7,000 No salvage value after 10 years 10 yrs. Solution: NPV = $245,000 + $7,000 x Annuity PVF( 10 years 8%) = $291,

11 If we apply EAC to the truck example. Solution: PV of Costs = $140,000 + $8,000 x Annuity PVF( 5 yrs 8%) =$171, EAC = $171,941.68/Annuity PVF( 5 yrs 8%) = $43, Solution: NPV = $245,000 + $7,000 x Annuity PVF( 10 yrs 8%) = $291, EAC = $291,970.57/Annuity PVF( 10 yrs 8%) = $43,