CAPITAL BUDGETING &

CASH FLOWS PROJECTION

Lecture 6
TOPIC COVER

 Principles of cash flow projection

 Estimating Project “After-Tax Incremental
Operating Cash Flows”
 Baldwin company project example
 The Baldwin Company (Cont.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Initial Investments: -250.00
(1.1) Bowling ball machine –100.00
(1.2) Opportunity cost –150.00
(warehouse)
(1.3)Total Initial investment –250.00

2. Cash flows from operations: 39.80 60.51 75.51 56.62 31.68

3. Change in WC: –10.00 –6.32 –8.65 3.75 21.22

(3.1) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(3.2) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital

4. Selling assets 171.76

(4.1) Warehouse 150.00
(4.2) Bowling ball machine 21.76*

5. CASH FLOWS of the PROJECT = (1)+(2)+(3)+(4)

 PRINCIPLES OF CASH FLOWS ESTIMATION

 No. 1: Cash flows (not accounting

income) – only cash flows relevant

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. Tax rate 0%.
 PRINCIPLES OF CASH FLOWS ESTIMATION

Accounting income: Cash flows:

Year 1 Year 2 Today Year 1 Year 2

Cash Income $1500 $ 500
Cash Income $1500 $ 500
Project Cost - 2000
Depreciation -$1000 -$1000
Free Cash Flow - 2000 +1500 + 500
Accounting Income + 500 - 500

500  500 NPV = -2,000 

1,500

500
 $223.14
NPV =  2
 $41.32 1
(1.10) (1.10) 2
1.10 (1.10)

Calculating NPV based on cash flows gives correct result

 PRINCIPLES OF CASH FLOWS ESTIMATION

 No. 2: Incremental cash flows

Incremental cash flow with cash flow without
Cash Flow
= project - project

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.
 PRINCIPLES OF CASH FLOWS ESTIMATION

 No. 2: Incremental cash flows (Cont.)

 Ignore sunk costs:
Just because “we have come this far” does not mean that we
should continue to throw good money after bad.

 Include all opportunity costs

 Include project-driven changes in working capital

 After-tax flows

 Include Side effects

– If our new product causes existing customers to demand less of
current products, we need to recognize that.
– If, however, synergies result that create increased demand of
existing products, we also need to recognize that.
PRINCIPLES OF CASH FLOWS ESTIMATION

 No.3: Separate financing and investment

decision

Project cash flows must make sense regardless of how

financed

Ignore all financing costs, even if the project is partially financed with
debt

Financing side effects will be considered later.

Interest costs are considered in the discount rate
 PRINCIPLES OF CASH FLOWS ESTIMATION

 No.4: Interest rate and cash flows must be

measured on the same basis

Use nominal interest rates to discount

nominal cash flows.
OR

Use real interest rates to discount real

cash flows.

You will get the same results, whether

you use nominal or real figures
 PRINCIPLES OF CASH FLOWS ESTIMATION

No.4: Interest rate and cash flows must be

measured on the same basis (Cont.)

Example
You own a lease that will cost you $8,000 next year,
increasing at 3% a year (the forecasted inflation rate)
for 3 additional years (4 years total). If discount rates
are 10% what is the present value cost of the lease?

1+ nominal interest rate

1  real interest rate = 1+inflation rate
 PRINCIPLES OF CASH FLOWS ESTIMATION

Nominal cash flows

Year Cash Flow PV @ 10%
0 8000 8,000.00
1 8000x1.03 = 8,240 8240
1.10
 7,490.91
2 8000x1.032 = 8,487.20 8487 .20
1.10 2
 7,014.22
3 8000x1.033 = 8,741.82 8741 .82
1.103
 6,567.86
Real cash flows $29,072.98
Year Cash Flow PV@6.7961%
0 8,000 8,000
1 8,000 8,000
1.068
 7,490.91
2 8,000 8,000
1.068 2
 7,014.22
3 8,000 8,000
1.068 3
 6,567.86
= $ 29,072.98
Major Cash Flow Components

1.Capital Investment
Cost of Buying Fixed Asset Capitalized Expenditures Cash from replacement

2. Cash Flows from Operations

Income Method Tax shield Method

3. Investment in Working Capital

Capital covered within one year Fully recovered at the end of the project

4. The Sale of a Asset Fixed Assets

Capital gain Capital loss
The Baldwin Company

 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 MACRS

5-year)

 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.

 Initial working capital requirement: $10,000. Working capital requirement is

10% of revenue each year.

 After 5 years, market value of proposed factory site is expected to sell

@$150,000, and machine will be sold at $30,000. Tax rate is 34%
1. Capital Investment

1. Cost of “new” assets

2. + Capitalized expenditures
(shipping/installation)
3. - Net proceeds from sale of
“old” asset(s) if replacement Consider when
4. + (-) Taxes (savings) due to the sale replacing current
machine
of “old” asset(s) if replacement

5. + Opportunity cost

= Capital Investment (Investment in Fixed assets)

 1. Capital Investment (Baldwin example)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Initial Investments: -250.00
(1) Bowling ball machine -100.00
(2) Opportunity cost -150.00
(warehouse)

2. Cash flows from operations:

3. Change in working capital:

(5) Net working capital requirement
(6) Change in net
working capital

4. Selling assets
warehouse
Bowling ball machine
 2. Cash Flows from Operations – Income Method

1. Revenues
2. Variable costs
3. Fixed costs (exclude dep. and int. costs)
Interest expense

4. Depreciation cost

5. EBIT (Earning before interest and tax) = (1)-(2)-(3)-(4)

6. T (Taxes charge on profit before tax) = EBIT x Tc

7. NI = EBIT – T (5)-(6)
CFO = NI + Dep.
(CFO=Cash flows from operations)
2. Cash Flows from Operations – Baldwin example

Cash flows from operations

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

(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90

(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4) Earning before int. & taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
(5) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(6) Net Income 19.80 28.51 56.31 44.60 20.16

(7) Cash flows from operations 39.80 60.51 75.51 56.62 31.68
[(6) + (3)]
Depreciations

 Depreciation represents the systematic allocation of the cost

of a capital asset over a period of time for financial reporting
purposes, tax purposes, or both.

 Depreciation Methods
 Straight Line
 MARCRS
Depreciable Basis

Cost of Capitalized
Depreciable
Expendi- Basis
Asset tures

In tax accounting, depreciable basis is the fully installed cost

of an asset.
Examples: Cost of assets + shipping and installation cost
MACRS Sample Schedule
Recovery Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
Suppose a machine that has cost of buying is $100 mil is depreciated by 5-
year MACRS schedule.
Year 1 Year 2 Year 3 year 4 Year 5 Year 6
Depreciation ($ mil.) : 20.00 32.00 19.20 11.52 11.52 5.76
3. Change in working capital

Working capital
requirements increase
when volume increase.

Working capital will be

recovered at the end of Consider
each year.
change in
working
For the last year of the capital rather
project, there is no than working
working capital capital.
requirement.

Working capital is fully

recovered at the end of
the project
3. Change in working capital (Baldwin example)

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

1. Initial Investments:

2. Cash flows from operations:

3. Change in working capital:

(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital

4. Selling assets
warehouse
Bowling ball machine
4. The sale of an asset

The sale of a “capital asset”

generates a:

Capital gain Capital loss

(asset sells for more than (asset sells for less than
book value) book value)
4. The sale of an asset (Cont.)

Calculate capital gain/loss from selling asset

Selling price of the assets

- Book value of the assets

= Capital gain/loss

Calculate tax paid on selling asset

Taxes (tax savings) due to capital gain (loss) = Capital gain (loss) * Tax
rate

Calculate cash flow from selling asset

c) Selling price of the assets

d) - (+) Taxes (tax savings) due to capital gain/loss

= Cash flows from selling assets

 4. The sale of an asset _ Baldwin example

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

Selling assets
(1) Selling asset 30.00
(2) BV of machine 100.00 80.00 48.00 28.80 17.28 5.76

(3) = (1) – (2) Capital gain 24.24

(4) Tax paid on selling asset (34%) 8.24

(5)= (1)-(4): Cash flows from selling asset 21.76*

Book value in year t = BV of asset at the beginning – accumulated dep. At year t

= 100.00 – 94.24

(3) Depreciation 20.00 32.00 19.20 11.52 11.52

(4) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
 The Baldwin Company (Cont.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Initial Investments: -250.00
(1.1) Bowling ball machine –100.00
(1.2) Opportunity cost –150.00
(warehouse)
(1.3)Total Initial investment –250.00

2. Cash flows from operations: 39.80 60.51 75.51 56.62 31.68

3. Change in WC: –10.00 –6.32 –8.65 3.75 21.22

(3.1) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(3.2) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital

4. Selling assets 171.76

(4.1) Warehouse 150.00
(4.2) Bowling ball machine 21.76*

5. CASH FLOWS of the PROJECT = (1)+(2)+(3)+(4)

The Baldwin Company (Cont.)

Cash flows from operations

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

Sales Revenues 100.00 163.20 249.72 212.20 129.90

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 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.
The Baldwin Company (Cont.)
Cash flows from operations

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

Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84

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 (Cont.)
Cash flows from operations

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

Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52

Depreciation is calculated using the Accelerated Cost Year ACRS %

Recovery System (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%
The Baldwin Company (Cont.)
Cash flows from operations

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

Income:
(1) Sales Revenues
(2) Operating costs
(3) Depreciation
(4)Income before taxes
[(1) – (2) - (3)]
100.00 163.20 249.72 212.20 129.90
50.00 88.00 145.20 133.10 87.84
20.00 32.00 19.20 11.52 11.52
30.00 43.20 85.32 67.58 30.54
The Baldwin Company (Cont.)
Cash flows from operations

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

Income:
(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4)Income before taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
(5) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(6) Net Income 19.80 28.51 56.31 44.60 20.16
The Baldwin Company (Cont.)
Cash flows from operations

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

(1) Sales Revenues 100.00 163.20 249.72 212.20 129.90

(2) Operating costs 50.00 88.00 145.20 133.10 87.84
(3) Depreciation 20.00 32.00 19.20 11.52 11.52
(4)Income before taxes 30.00 43.20 85.32 67.58 30.54
[(1) – (2) - (3)]
(5) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38
(6) Net Income 19.80 28.51 56.31 44.60 20.16
(7) Cash flows from operations 39.80 60.51 75.51 56.62 31.68
[(6) + (3)]
End-of-chapter problems:

Chapter 9: 1, 2, 3, 5, 6, 7, 9, 11, 12, 13, 16, 19, 21, 23, 29,

34