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Cash Flows in Capital Budgeting Rules: Included: Incremental revenues Incremental costs Initial working capital and any subsequent change in net working capital Opportunity costs Associated costs (revenue enhancements, product cannibalisation) Tax Initial outlay on equipment plus any installation costs Project fixed costs Project overhead costs Excluded: Interest charges (only concerned with investment flows, not financing flows) Feasibility, marketing studies if started before the start of t he project General fixed costs General overhead costs Depreciation (but use in tax calculation to get tax cash flow) Sunk costs (but these may give rise to opportunity costs) Capital budgeting questions would usually involve a project where the company evaluates whether to go ahead or reject a proposed project. Project capital budgeting analyais can be applied to a vast range of situations. Companies will use capital budgeting to evaluate general expenditure; refurbishing the retail estate, a redundancy program, a major acquisition, an overseas expansion, choosing a new fleet of vans, etc. The sums involved can be quite modest through to billions of dollars or pounds in the case of acquisitions. There are probably five stages in the capital budgeting exercise; 1. Determine the initial outlay. Involved here would be; - the capital expenditure on the new equipment, - the installation costs, capitalised installation costs would be added to the cost of the equipment and depreciated, expensed installation costs would be taken down to the tax calculation straight away. - Initial working capital, made up of accounts payable (a cash inflow because you are not spending the money), accounts receivable (a cash outflow because you don’t have the money yet), and inventory (a cash outflow because it is a use of
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funds). Initial working capital will usually be shown net, and is usually a cash outflow at the start of the project. - Any sale of old machinery and whether this is at a profit or a loss. If it is sold at a profit, you will get the cash flow value of the sale, but the gain over book value will be taxed). If the machinery is sold at a loss compared to book value you will get a tax credit (the assumption here is that the firm is tax paying, and the loss will result in a lower tax bill to the company that year). - The tax cash flow. Any items for taxation at the start of the process would be, expensed installation costs, and any gain or loss on the sale of old equipment. 2. The tax calculation The tax calculation will run along underneath the cash flow schedule. The aim of this is to isolate the tax cash flow, keeping depreciation out of the cash flow. Any taxable items are taken down to th e tax calculation as the cash flows are rolled out by year. In year zero the tax calculation might involve expensed installation charges and any gain or loss on old equipment. Subsequent years will have the operating profits (revenues minus all taxable costs) then subtract depreciation. Tax the resulting amount to get your tax cash flow, which is then carried up into the cash flow schedule. If there is the sale of old machinery, there may be lost depreciation tax shields that need to be counted as an opportunity cost in the tax calculation. Because the old machine has been sold, you cannot claim the old depreciation. The old depreciation was valuable, creating a tax shield, which has now been lost with the sale of the equipment, The tax calculation is built up each for each year. Items that do not go in the tax calculation are capital expenditure and working capital. Both these items are balance sheet items, they are not taxed. 3. Regular cash flows. Most capital budgeting case questions will involve a narrative where you have to extract the relevant cash flows and enter them in the cash flow. You would follow the rules laid out at the top of this file to identify the relevant cash flows. In your cash flow schedule you will already have entries for your initial outlays. Any other cash flows will come after that. These may be; revenues, costs, different types of opportunity costs, any on e off cash flows; marketing expenditures, maintenance spend, and specific project fixed costs or project overhead costs and the tax cash flow that is calculated from the above cash flows. There may also be changes to working capital during the project. 4. Final year cash flows.
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These will generally be a repeat of the regular cash flows, but there will be additional final year cash flows. Working capital will be returned, there may be the sale of equipment used in the project – there will be tax effects if the asset is sold above or below book value. There may be clear-up costs, which would be after tax. These extra cash flows are additional to the regular cash flows. Some will be taxed, others will not be taxed, notably working capital. 5. Calculate the NPV. Once you have finished the tax calculation and taken the tax cash flow up into the cash flow schedule, you can net the cash flows off and calculate the NPV. Apply the WACC (see WACC handout for notes on how to calculate) to the cash flows. Positive NPV will mean you go ahead with the project. Free Cash Flows* The cash flows that are required to be discounted are the ungeared free cash flows (FCF*). These are the cash flows as if the company was financed entirely by equity. So the tax cash flow will have to be shown without the interest tax shield effect. The taxes paid will be as if the company only had equity financing, so no tax shield included in the tax cash flow. The FCF* will be the same whether the analysis is a WACC/NPV question or an APV question. The FCF* are used in both cases. With WACC/NPV the capital structure is assumed to be held constant throughout the project period. With APV the capital structure can be varied across the time period of the project. So with the APV, you can alter the amount of debt, increasing or decreasing. With the WACC/NPV you discount the FCF* with the WACC, which reflects the tax deductibility of interest. With APV the FCF* are discounted with the ungeared cost of equity ((ru). The ungeared cost of equity is the cost of equity as if there was no debt in the capital structure. The ru will be higher than the WACC discount rate, so the NPV initially calculated in the APV will be lower than that calculated in the WACC/NPV. The ru will be lower than the re used in the WACC. The re in the WACC/NPV will be higher because there is increased risk to the equity because the company has debt in the capital structure. With the APV, the NPV of the project is worked out as if it was financed entirely by equity. This may well result in a negative NPV. This means that if the project is financed purely with equity, it is a poor project. The benefit of the APV technique is that you can see the value of partially financing with debt. The next part of the APV technique is to work out the present value of the tax shield. The tax shield is the amount of debt times the debt interest rate (giving the interest paid by the company), this is then multiplied by the tax rate. This is the interest tax shield. This has to be worked out for each year. The tax shield is then present valued by discounting with the debt rate (the before tax debt rate). The individual present value tax shields are summed to give the total present value of the tax shield.
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The two elements are added together to give the APV (the NPV of the all equity financing plus the present value of the tax shield). The APV is very useful as it gives valuable information about the benefits of debt financing. The WACC/NPV gives the NPV in the form of one figure, it is not broken down. This is the advantage of APV, you can see exactly the benefit of debt, this is the present value of the tax shield part. Other capital budgeting cases: Leasing The cash flows required for leasing are the - Cost of the machine – a cash inflow because you are not buying the equipment - Depreciation tax shield – a cash outflow because you do not get the tax shield as you have not bought the machine. - Lease payment – a cash outflow, this is the payment to the lessor to use the machine. - Lease tax shield – a cash inflow, this is the lease payment times the tax rate. These cash flows are netted off and discounted by the after tax cost of debt (that is the cost of capital for the lease). If the result is negative it means it is more expensive to lease and you should purchase the equipment. A positive result means you are better off leasing. Sometimes there will be a residual value for the equipment. This is a cash outflow as far as the lease evaluation is concerned. But this cash flow will not be discounted at the after tax cost of capital. It will be discounted by the company WACC as it is a risky cash flow. If this cash flow is present it can turn a positive lease NPV into a negative NPV, so there is no advantage to leasing. Machine replacement This is the equivalent annual cost method. You will be comparing the attractiveness of two or more machines for use by the company. These machines may have different useful lives. The way to analyse this is to work out the present value of an operating cycle of each machine (equipment cost + present value of operating costs after tax) and then annualise the cost of the operating cycle. This is done by dividing the present value of the operating cycle by the annuity factor (number of years in the operating cycle and the company WACC). What you then have is the annualised cost of each machine. If you are working out the equivalent annual cost you want to select the machine with the lowest cost. Foreign Projects
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The best method for evaluating foreign projects is to forecast the cash flows in the foreign currency over the time period of the project and discount them with a cost of capital that has been adjusted for the difference in risk of the two countries (based on interest rate differentials – see WACC handout for more on this). You will have an NPV in the foreign currency which you then convert into your home currency at the spot exchange rate. So what you are doing if you are a company from Country X and you wish to do a project in Country Y, is to firstly forecast the project cash flows in terms of currency Y for the term of the project. Work out the WACC for the project in terms of Country X and then adjust for the difference in risk between the two countries. Discount the cash flows, and work out the NPV in terms of Currency Y, using a WACC that has been adjusted for the risk of doing business in Country Y. You have an NPV in Currency Y. Convert this to Currency X using the spot exchange rate. This method means that you do not have to forecast exchange rates into the future, you are just forecasting cash flows to the project and discounting using a WACC that is risk adjusted for that country.
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