Advanced Corporate Finance

Lecture 2
1

P R O J E C T A P P R A I S A L : A D VA N C E D N P V
T E C H N I Q U E S A N D C A P I TA L R AT I O N I N G

PROJECT APPRAISAL:
ADVANCED NPV
TECHNIQUES AND
CAPITAL RATIONING

BUSF 2454 - Advanced Corporate Finance

 Learning Outcomes
2

 Determine and compute the relevant cash flows for

capital budgeting/investment project;
 Compute depreciation expense for tax purposes into
capital budgeting;
 Appraise projects and apply relevant capital rationing
techniques.
 Evaluate NPV with capital rationing.
 Compute equivalent annual cash flow techniques

Lecture 2
 Chapter Outline
3

1. Incremental Cash Flows

2. The Baldwin Company: An Example
3. Capital Budgeting
4. Alternative Definitions of Operating Cash Flow
5. Capital Rationing and Equivalent Annual Cashflow (EAC)
 Incremental Cash Flows
4

 Cash flows matter—not accounting earnings.

 Sunk costs do not 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 Flows—Not Accounting Income
5

 Consider depreciation expense.

 You never 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
6

 Sunk costs are not relevant

 Justbecause “we have come this far” does not
mean that we should continue to throw good
money after bad.
 Opportunity 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, then we should not proceed.
 Opportunity costs
7

 Should include the opportunity cost of a resource used in a

project even when no cash changes hands

 The opportunity cost of a resource is the cash it could

generate for the company if the project were rejected and it
were sold or put to some other productive use

 Should judge projects on the basis of “with or without”, not

“before versus after”

Lecture 2
 With Versus Without Principle
8

Before After Cash flows

(Before versus After)
Firm owns land Firm still owns land 0

With After Cash flows

Take Project
(With Project)
Firm owns land Firm still owns land 0

Without After Cash flows

(Without Project)
Firm sells land for RM 100,000
Do not take project
RM100,000

Lecture 2
 Incremental Cash Flows
9

 Side effects matter.

 Erosion is a “bad” thing. If our new product causes
existing customers to demand less of our current
products, we need to recognize that.
 If, however, synergies result that create increased
demand of existing products, we also need to
recognize that.
 Estimating Cash Flows
10

 Cash Flow from Operations

 Recall that:
OCF = EBIT – Taxes + Depreciation
 Net Capital Spending
 Do not forget salvage value (after tax, of course).

 Changes in Net Working Capital

 Recall that when the project winds down, we enjoy a
return of net working capital.
 Interest Expense
11

 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, it is enough to assume that the firm’s
level of debt (and, hence, interest expense) is
independent of the project at hand.
 The Baldwin Company (page 180 – item 6.2)
12

❑ Costs of test marketing (already spent): $250,000

❑ Current market value of proposed factory site/warehouse (which we own):
$150,000
❑ Cost of bowling ball machine: $100,000 (depreciated according to Modified
Accelerated Cost Recovery System - MACRS 5-year)
❑ Increase in net working 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)
❑ Selling 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 Capital: initial $10,000 changes with sales (10% of sales)
❑ Market value at the end of investment is $30,000
❑ Tax is 34%.
❑ Cost of capital (WACC) is 10%
 The Baldwin Company – Salvage Value
13
We assume that the ending market value of 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 of the machine is
the purchase price of the machine multiply by depreciation.
The capital gain is $30,000 – $5,760 = $24,240
We will assume the incremental corporate tax for Baldwin on this project is
34%. Capital gains are now taxed at the ordinary income rate, so the
Capital gains tax due is [0.34 * ($30,000 – $5,760)] = $8,242

The after-tax salvage value is $30,000 – 8,242 = $21,758.*

 The Baldwin Company - Total CF of Investment
14

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

Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Depreciation (MACRS) 20.00 32.00 19.20 11.52 11.52
(3) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(4) Opportunity cost –150.00 150.00
(factory/warehouse)
(5) Net working capital * 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 0 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]

*Net working capital changes with sales

 The Baldwin Company – Sales Revenues
15

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

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89

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 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
 The Baldwin Company - Operating Cost
16

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

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

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
17

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

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.52 11.52

Depreciation is calculated using the Modified Year MACRS %

Accelerated Cost Recovery System - MACRS
(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%
 MACRS (Baldwin)
Tax depreciation allowed under the modified accelerated cost recovery system
(MACRS) (Figures in percent of depreciable investment)
Tax Depreciation Schedules by Recovery-Period Class
Year(s) 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 33.33 20 14.29 10 5 3.75
2 44.45 32 24.49 18 9.5 7.22
3 14.81 19.2 17.49 14.4 8.55 6.68
4 7.41 11.52 12.49 11.52 7.7 6.18
5 11.52 8.93 9.22 6.93 5.71
6 5.76 8.92 7.37 6.23 5.28
7 8.93 6.55 5.9 4.89
8 4.45 6.55 5.9 4.52
9 6.56 5.9 4.46
10 6.55 5.9 4.46
11 3.29 5.9 4.46
12 5.9 4.46
13 5.91 4.46
14 5.9 4.46
15 5.91 4.46
16 2.99 4.46
17-20 4.46
21 2.23
 The Baldwin Company
19

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

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
(11) Income before taxes (EBIT) 30.00 43.20 85.30 67.62 30.53
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 22.99 10.38
(13) Net Income (after tax) 19.80 28.51 56.30 44.63 20.15
 Incremental After Tax Cash Flows
20

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

(1) Sales $100.00 $163.20 $249.70 $212.24 $129.89

Revenues
(2) Operating -50.00 -88.00 -145.20 -133.10 -87.85
costs
(3) Taxes 34% -10.20 -14.69 -29.00 -22.99 -10.38

(4) OCF 39.80 60.51 75.50 56.15 31.67

(1) – (2) – (3)
(5) Total CF –260. –6.32 –8.65 3.75 192.98
of Investment
(6) IATCF –260. 39.80 54.19 66.85 59.90 224.65
[(4) + (5)]
$39.80 $54.19 $66.85 $59.90 $224.65
NPV = −$260 + + + + +
(1.10 ) (1.10 ) 2 (1.10 ) 3 (1.10 ) 4 (1.10 ) 5

NPV = $51.59
 NPV of Baldwin Company
21

–260 1
CF0 F3
59.90 10
CF1 39.80 CF4 I
1 1 NPV 51.59
F1 F4
54.19
CF2 224.65
CF5
1
F2
1
F5
66.85
CF3
 Capital Rationing
23
 Soft capital rationing – Internally imposed limits on investment
expenditure despite the availability of positive NPV projects.
 Hard capital rationing – Externally imposed limits on investment
expenditure in the presence of positive NPV projects.
 For divisible one-period capital rationing problems, focus on the
returns per $ of outlay:
Gross Present Value
 Profitability index = Initial Outlay

Net present value

 Benefit-cost ratio = Initial outlay

Lecture 2
 Capital Rationing Techniques
Bigtasks Plc (Arnold, 2013, pp. 156-159)
24
 Four positive NPV projects.
 Capital at time 0 limited to £4.5 Million – no further borrowing in
the current year.
 Acceptance of one project does not exclude the possibility of
accepting another one.

Lecture 2
 Profitability Index and Benefit-Cost Ratio
25

Lecture 2
 Ranking – Profitability Index
26

Lecture 2
 If the projects were indivisible……..
27

Assume capital rationed at £ 3 Million

 Equivalent Annual Cashflow/Annuity
28
 Sometimes in project analysis it is helpful to reverse the
calculation of NPV, i.e. transforming an investment today into an
equivalent stream of future cash flows

 How much extra annual revenue for the next 25 years would be
needed to recover the cost of a $400M investment to upgrade
an oil refinery? The cost of capital is 7%.

Lecture 2
 Equivalent annual cashflow continued
29

 The answer is to find the 25-year annuity with a present value

equal to $400M
PV = annuity payment * 25-year annuity factor
$400M = annuity payment * [(1 - 1.07-25)/0.07]
annuity payment = $34.324M

 This annuity is called an equivalent annual cash flow (EAC);

EAC is the annual cash flow sufficient to recover a capital
investment, including the cost of capital for that investment, over
the investment’s life

Lecture 2
 Choosing between mutually exclusive projects with
unequal lives 30

 Suppose a firm is forced to choose between two machines.

A and B, which do exactly the same job and have the
following lives and costs:

Machine Co C1 C2 C3 PV at 6%
A 15 5 5 5 28.37
B 10 6 6 - 21.00

Lecture 2
Mutually exclusive projects with unequal lives cont’d
31

 Machine B has a lower present value of costs but will have to be

replaced a year earlier than A; the choice between them affects
future investment decisions

 When A and B will be replaced at different future dates, the rule

is to select the asset with the lowest equivalent annual cost (or
alternatively the asset with the highest equivalent annual cash
inflow)

Lecture 2
Mutually exclusive projects cont’d
32

PVA = EACA * 3-year annuity factor

EACA = PVA / [(1 – 1.06-3)/0.06]
EACA = 28.37 / 2.673 = 10.61

Co C1 C2 C3 PV at 6%
Machine A 15 5 5 5 28.37
EAC 10.61 10.61 10.61 28.37

Note : EAC starts in Year 1 NOT Year 0

Lecture 2
Mutually exclusive projects cont’d
33

EACB = PVB / 2-year annuity factor

EACB = 21.00 / [(1 - 1.06-2)/0.06] = 11.45

Co C1 C2 PV at 6%
Machine B 10 6 6 21.00
EAC 11.45 11.45 21.00

EACA< EACB => Select Machine A

Lecture 2
 QUIZ 2
35

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BUSF 2454 - Advanced Corporate Finance