Download Capital Budgeting – Free Cash Flow Estimation

Capital Budgeting II
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Professor:
Burcu Esmer
Cash Flows
Last chapter introduced valuation techniques based on
discounted cash flows.
This chapter develops criteria for properly identifying and
calculating cash flows.
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Capital Budgeting
• Remember:
•
•
•
•
Estimate project cash flows (CFs)
Estimate a discount rate, if needed
Discount the cash flows
Select the projects with positive NPV
• Question: How do we forecast the cash flows?
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Cash Flow vs. Accounting Income
• Discount actual cash flows (not accounting
profits! )
• Using accounting income, rather than cash flow,
could lead to erroneous decisions.
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.
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Cash Flow vs. Accounting Income
Today
Year 1
Year 2
$1,500
$ 500
- 2,000 + 1,500
+ 500
Cash Inflow
Project Cost
Free Cash Flow
- 2,000
Cash NPV = 2,000 
1,500
500

 $223.14
2
(1.10) (1.10)
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Cash Flow vs. Accounting Income
Cash Inflow
Depreciati on
Accounting Income
Year 1
Year 2
$1,500
$ 500
- $1,000 - $1,000
+ 500
- 500
500
 500
Apparent NPV =

 $41.32
2
1.10 (1.10)
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Recognize investment expenditures when they occur!
Incremental Cash Flows
• Discount incremental cash flows
•
•
•
•
•
•
Include All Indirect Effects
Forget Sunk Costs
Include Opportunity Costs
Recognize the Investment in Working Capital
Beware of Allocated Overhead Costs
Remember Shutdown Cash Flows
Incremental
Cash Flow
=
cash flow with
project
-
cash flow without
project
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Include all Indirect Effects
Indirect Effect Rule: You must include all
indirect effects in your analysis.
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Indirect Effect
As CFO of Hidden Valley you are considering building a new salad
dressing factory. The new bottled salad dressing will have sales of $1.25
million, but some of those sales (equivalent to $10,000 in FCFF) will come
from consumers who switch from buying Hidden Valley's existing dry
packet salad dressing. Does this affect our decision to produce bottled
dressing?
0
-10,000
-10,000
-10,000
-10,000
1
2
3
4
-10,000
5
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This type of externality is known as : Product cannibalization
Sunk Costs
Sunk Cost
– A cost that cannot be recovered
Sunk Cost Rule: Always ignore sunk costs.
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Sunk Costs
Hidden Valley plans to use a building that it owns for its
new factory. The building was built at a cost of $250,000
which we did not include in the initial cost of the project.
Should we include it?
NO!
Whether we accept or reject the project this cost is
sunk. I.e. the cost of the building has been incurred and
does not depend on whether we accept or reject the
project. It is not an incremental cash flow!
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Opportunity Costs
Opportunity Cost – Benefit or cash flow foregone as a
result of an action.
Opportunity Cost Rule: Be sure to recognize the opportunity cost
(that which is foregone).
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Opportunity Costs
Hidden Valley plans to use a building it owns for its new factory. It could rent
the building instead for $15,000 per year (FCFF equivalent). Does this affect
our project decision?
Yes! If the project is taken then we lose the opportunity to rent the building.
So,
0
-15,000
-15,000
-15,000
-15,000
1
2
3
4
-15,000
5
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Investments in Working Capital
Working Capital Rule: Investments in working
capital, just like investments in plant and
equipment, result in cash outflows.
Common ways working capital is overlooked:
1. Forgetting about working capital entirely.
2. Forgetting that working capital may change during the life of the project.
3. Forgetting that working capital is recovered at the end of the project.
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Additional Considerations
1) Remember Terminal Cash Flows
2) Beware of Allocated Overhead Costs
3) Separation of Investment &
Financing Decisions
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Separation of Investment &
Financing Decisions
• When valuing a project, ignore how the project is financed.
• Following the logic from incremental analysis ask yourself the
following question:
Is the project existence dependent on the financing? If no, you
must separate financing and investment decisions.
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Incremental Cash Flows
IMPORTANT
Ask yourself this question
Would the cash flow still exist if the project does not exist?
If yes, do not include it in your analysis.
If no, include it.
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Question
• A firm is considering an investment in a new manufacturing
plant. The site already is owned by the company, but existing
buildings would need to be demolished. Which of the
following should be treated as incremental cash flows?
a. The market value of the site.
b. The market value of the existing buildings.
c. Demolition costs and site clearance.
d. The cost of a new access road put in last year.
e. Lost cash flows on other projects due to executive time
spent on the new facility.
f. Future depreciation of the new plant.
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Inflation
INFLATION RULE
• Be consistent in how you handle inflation!!
• Use nominal interest rates to discount nominal cash flows.
• Use real interest rates to discount real cash flows.
• You will get the same results, whether you use nominal or real
figures
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Inflation
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% (nominal) what is
the present value cost of the lease?
1+nominal interest rate
1  real interest rate =
1+inflation rate
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Inflation
Example - nominal figures
Year
0
1
2
3
Cash Flow
PV @ 10%
8000
8,000.00
8000x1.03 = 8,240 18240

7
,
491
.10
8000x1.03 2 = 8,487 18487
 7,014
.10 2
3
8000x1.03 = 8,742 18742
 6,568
.10 3
$29,073
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Inflation
Example - real figures
Year
0
Cash Flow
8,000
1
8,000
2
8,000
3
8,000
[email protected]%
8,000
8,000
1.068
8,000
1.068 2
8,000
1.068 3
 7,491
 7,014
 6,568
= $ 29,073
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Calculating Cash Flows
• Think of cash flows as coming from three elements
Total cash flow =
+ cash flows from capital investments
+ cash flows from changes in working capital
+ operating cash flows
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Calculating Cash Flows
• 1) Cash Flow from Capital Investments
• Almost every project requires some sort of initial investment. This
is often capitalized from an accounting perspective. In finance,
the investment represents a negative cash flow.
• 2) Cash Flow from Working Capital (WC)
• Remember: NWC= CA-CL
• e.g. Slick makes an initial investment of $10 m in inventories of
plastic and steel for its blade plant. In year 1, it accumulates an
additional $20m of raw materials. In year 5, it decides to reduce
its inventory from $20 m to $15 m. Show the cash flows from
changes in working capital.
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• Cash Flow from Working Capital (cont)
Slick makes an initial investment of $10 m in inventories of
plastic and steel for its blade plant. In year 1, it accumulates an
additional $20 m of raw materials. In year 5, it decides to
reduce its inventory from $20 m to $15 m. Show the cash flows
from changes in working capital.
Year
0
1
2
3
4
5
Total WC
10
30
30
30
30
25
Change
in WC
10
20
0
0
0
-5
-20
0
0
0
5
CF from
-10
change in
WC
• Summary: An increase in WC is an investment a negative cash flow
An decrease in WC  a positive cash flow
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Calculating Cash Flows (cont.)
• 3) Operating Cash Flow
• Operating cash flow =
+ Revenue
- Costs
- Taxes
• Methods of Handling Depreciation
• Method l: Dollars in Minus Dollars Out (use income statement entries)
• OCF= revenues – cash expenses - taxes
• Method 2: Adjusted Accounting Profits
• OCF= after-tax profit + depreciation
• Method 3: Add Back Depreciation Tax Shield
• OCF= (revenues – cash expenses ) x (1- tax rate) + (tax rate x depreciation)
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Net profit
Depreciation tax shield
e.g. Methods of Handling
Depreciation
• A project generates revenues of $1000, cash expenses of $600
and depreciation charges of $200 in a year. The firm’s tax
bracket is 35%. What is Net Income ? Calculate the OCF using
all three aproaches.
Revenues
1000
- Cash expense
600
- Depreciation
200
Profit before tax
200
- Tax at 35%
70
Net profit
130
• Method 1: OCF = revenues – cash expenses – tax = 1000- 600 – 70= 330
• Method 2: OCF = after-tax profit + depreciation = 130 + 200 = 330
• Method 3 : OCF = = (revenues – cash expenses ) x (1- tax rate) + (tax rate x
depreciation) = (1000-600) x (0.65) x (0.35 x 200) = 330
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Recall, Operating Cash Flows
Firm Approach: FCFF
Need measure of
the actual cash flow
created by the
project available to
pay the debt,
preferred, and
common stock their
required rates of
return.
Note: Many different
books use different
acronyms but the
process for
estimating free cash
flow is the same
Revenues
- Costs
- Dep
EBIT
- Tax
EBIT(1-t)
+ DEP
OPCF
- CapExp
- DWC
FCFF
Free Cash
Flow to Firm
DO FCFF in 3-Steps:
a - operating cash flow
b - additional cap. exp.
c - change in noncash
working capital
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FCFF
FCFF
 (Re v  Cost  Dep)(1  t )  Dep  CapExp  DWC
 (Re v  Cost )(1  t )  (1  t ) Dep  Dep  CapExp  DWC
 (Re v  Cost )(1  t )  ( t ) Dep  CapExp  DWC
After tax cash flow
Depreciation tax shield
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Note: from previous slide OPCF=After tax cash flow + Dep. tax shield
Example – Blooper Industries
(BI)
• BI is analyzing a proposal for mining and seeling a small deposit of high-grade
magnoosium ore. A consulting study which cost $800 million has been completed to
assess the costs and benefits of the project. The data have been simplified in the
following terms:
• The global unified tax rate is 35%. The inflation rate is 5%.
• The global unified after-tax cost of capital is 12% for projects with this level of risk.
The project life is 5 years.
• The project would require the purchase of a $10 million mining equipment . This
equipment would be depreciated (straight-line) over 5 years to a zero salvage
value. However, experts argue that the equipment could be sold for as much as
$2 million after 5 years.
• Annual maintenance expenses will be $10 million in year 1.
• The working capital requirements will be $1.5 million starting immediately) , then
$ 4.075 m, $ 4.279 m , $4.493 m, $4.717 m , $3.039 m.
• The consultants estimate that BI will be able to sell 750,000 pounds of
magnoosium a year at a price of $20 a pound in year 1.
• (For all practical purposes, you can assume that the venture has sufficient profits
to immediately take advantage of potential tax shields)
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Blooper Industries
Cash Flow From Operations (,000s) in year 1
Revenues
15,000
- Expenses
10,000
 Depreciation
2,000
= Profit before tax
3,000
.-Tax @ 35 %
1,050
= Net profit
1,950
+ Depreciation
2,000
= CF from operations
3,950
or $3,950,000
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Blooper Industries
Year 0
Cap Invest
1
2
3
4
5
6
10 ,000
WC
1,500
4,075
4,279
4,493
4,717
3,039
0
Change in WC
1,500
2,575
204
214
225
 1,679
 3,039
Revenues
15,000
15,750
16,538
17,364
18,233
Expenses
10,000
10,500
11,025
11,576
12,155
Depreciati on
2,000
2,000
2,000
2,000
2,000
Pretax Profit
3,000
3,250
3,513
3,788
4,078
.Tax (35%)
1,050
1,137
1,230
1,326
1,427
Profit
1,950
2,113
2,283
2,462
2,650
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(,000s)
Blooper Industries
Net Cash Flow (entire project) (,000s)
Cap Invest
Salvage value
Change in WC
Year 0
- 10,000
- 1,500
CF from Op
Net Cash Flow
- 11,500
1
2
3
4
5
6
1,300
3,039
- 2,575
- 204
- 214
- 225
1,679
3,950
4,113
4,283
4,462
4,651
1,375
3,909
4,069
4,238
6,329
NPV @ 12% = $4,222,350
4,339
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