Advanced Corporate Finance

Lecture 2
1

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
•Capital Budgeting
1.Alternative Definitions of Operating Cash Flow
2.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

Just because “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 0
land

With After Cash flows

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

Without After Cash flows

(Without Project)

Do not take
Firm sells land for RM 100,000
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 20.00 32.00 19.20 11.52 21.76*
(2) Depreciation (MACRS) 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 * 10.00 10.00 16.32 24.97 21.22 0
capital
(end of year) –10.00 0 –6.32 –8.65 3.75 21.22
(4)Change
working in net
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

Accelerated Cost Recovery System - MACRS Year MACRS %
(shown at right).
Our cost basis is $100,000. Depreciation 1 20.00%
2 32.00%
charge in year 4
3 19.20%
= $100,000×(.1152) = $11,520. 4 11.52%
5 11.52%
6
5.76%
Total
 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
(1) Sales Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$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 of –260. –6.32 –8.65 3.75 192.98
Investment
(6) IATCF [(4) –260. 39.80 54.19 66.85 59.90 224.65
+ (5)]
$39.80
NPV  $260   $54.19  $66.85  $59.90  $224.65
(1.10)
(1.10) 2 (1.10)3 (1.10) 4 (1.10)5
NPV $51.59
 NPV of Baldwin Company
21

CF0 –260 F3 1

39.80 CF4 59.90 10

CF1 I

F1 1 1 NPV 51.59
F4

CF2 54.19
CF5 224.65

F2 1
F5 1
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 =
Co C1 C2 PV at 6%
21.00 / [(1 -
Machine B 10 6 -2 6 21.00
1.06 )/0.06] =
EAC 11.45
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