Analyzing Project Cash Flows

12.1 Identifying Incremental Cash

Flows (pgs. 380–382)

12.2 Forecasting Project Cash

Flows (pgs. 383–389)

12.3 Inflation and Capital

Budgeting (pgs. 389–390)

12.4 Replacement Project Cash

Flows (pgs. 390–394)

Objective 1. Identify incremental cash flows that are relevant to project valuation.

Objective 3. Evaluate the effect of inflation on project cash flows.

Objective 4. Calculate the incremental cash flows for replacement-type investments.

Objective 2. Calculate and forecast project cash flows for expansion-type investments.

Part 1 Introduction to Financial Management (Chapters 1, 2, 3, 4)

Part 2 Valuation of Financial Assets (Chapters 5, 6, 7, 8, 9, 10)

Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)

Part 4 Capital Structure and Dividend Policy (Chapters 15, 16)

Part 5 Liquidity Management and Special Topics in Finance (Chapters 17, 18, 19, 20)

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Forecasting Sales of Hybrid Automobiles In 2001, when Toyota introduced the first-generation model of its gas-electric powered hybrid car, the Prius, it seemed more like a science experiment than real competition for auto industry market share. Toyota’s decision to introduce the Prius and enter the hybrid car market was particularly difficult to eval- uate because the cash flows were so difficult to forecast. Revenues from the Prius would depend largely upon how many buyers the newly designed hybrids drew away from traditionally powered cars—a number that would be strongly influenced by the future price of gasoline. Moreover, some of the hybrid sales would come from customers who would have otherwise bought another Toyota model. These are difficult issues for any firm to face; however, they are issues a financial manager must address to make an informed decision about the introduction of an innovative new product.

379

In this chapter, we calculate investment cash flows and discuss methods that can be used to develop cash flow forecasts. It is not always obvious what constitutes a relevant cash flow, and we of- fer some guidelines that are designed to avoid some of the more

common mistakes in valuing investments. In particular, we will stress that for the purpose of valuation, as we learned from Principle 3: Cash Flows Are the Source of Value.P

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380 PART 3 | Capital Budgeting

Regardless of Your Major…

Cash flow forecasting frequently involves more than just the finance specialists in the firm. In practice, teams of technical, marketing, ac- counting, and other specialists often work to- gether to develop cash flow forecasts for large investments. For example, major airlines are now beginning to provide Internet access on

their flights. The idea is that for a fee of, say, $10 per flight, a customer can buy wireless access to the Internet while in-flight. However, the airline must overcome a number of hurdles to offer this

service. There are technical issues related to both the hardware that must be installed on the aircraft and the infrastructure required to support access to the Internet—and all of this costs money. Then there is the question of how much revenue the airline would receive from this

service. Consequently, for the airline to analyze the decision to include in-flight Internet access, it needs a team that includes technical staff, such as engineers, to address the cost of installing and maintaining the service; marketing personnel to estimate customer acceptance rates and revenues; and a financial analyst to combine the various cost and revenue estimates into a proj- ect evaluation.

Your Turn: See Study Question 12–2.

“The Internet on Airline Flights—

Making It Happen”

12.1 Identifying Incremental Cash Flows When a firm takes on a new investment it does so in the anticipation that it will change the firm’s future cash flows. So when we are evaluating whether to undertake the investment, as we learned from Principle 3: Cash Flows Are the Source of Value, we consider the cash flows that add value to the firm and thus, add value for the shareholders. In particular we con- sider what we will refer to as the incremental cash flow associated with the investment—that is, the additional cash flow a firm receives from taking on a new project.

To understand this concept of incremental cash flows, suppose that you recently opened a small convenience store. The store has been a big success and you are offered the opportu- nity to rent space in a strip mall six blocks away to open a second convenience store. To eval- uate this opportunity, you begin by calculating the costs of the initial investment and the cash flows from the investment in exactly the same way you evaluated the initial site. However, be- fore calculating the NPV of this new opportunity, you start to think about how adding a sec- ond location will affect your sales in the initial location. To what extent will you generate business by simply stealing business from your initial location? Cash flows that are generated by stealing customers from your initial location are clearly worth less to you than cash flows generated by stealing customers from your competitors.

This example serves to emphasize that the proper way to look at the cash flows from the second convenience store involves calculating the incremental cash flows generated by the new store. That is, the cash flows for the second store should be calculated by comparing the total cash flows from two stores less the total cash flows without the second store. More generally, we define incremental project cash flows as follows:

(12–1)

Thus, to find the incremental cash flow for a project, we take the difference between the firm’s cash flows if the new investment is, and is not, undertaken. This may sound simple enough, but there are a number of circumstances in which estimating this incremental cash flow can be very challenging, requiring the analyst to carefully consider each potential source of cash flow.

Incremental Project Cash Flows

� aFirm Cash Flows with the Project b � a Firm Cash Flowswithout the Project b ISBN

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CHAPTER 12 | Analyzing Project Cash Flows 381

Guidelines for Forecasting Incremental Cash Flows In this section we focus on some simple guidelines for proper identification of incremental cash flows for a project. As we will see, this is not always easy to do, so it is helpful to have a set of basic guidelines to help us avoid some common mistakes.

Sunk Costs Are Not Incremental Cash Flows Sunk costs are those costs that have already been incurred or are going to be incurred regard- less of whether or not the investment is undertaken. An example would be the cost of a mar- ket research study or a pilot program. These costs are not incremental cash flows resulting from the acceptance of the investment because they will be incurred in any case. For example, in the convenience store example just discussed, if last year you spent $1,000 getting an appraisal of the prospective site for the second store, this expenditure is not relevant to the decision we have to make today, because you already spent that money. The cost of the appraisal is a sunk cost since the money has already been spent and cannot be recovered whether or not you build the second convenience store.

Overhead Costs Are Generally Not Incremental Cash Flows Overhead expenses such as the cost of heat, light, and rent often occur regardless of whether we accept or reject a particular project. In these instances, overhead expenses are not a rele- vant consideration when evaluating project cash flows.

To illustrate, consider the decision as to whether the university bookstore should open a sub shop in an underutilized portion of the bookstore. The bookstore manager estimates that the sub shop will take up one-tenth of the bookstore’s floor space. If the store’s monthly heat and light bill is $10,000, should the manager allocate $1,000 of this cost to the sub shop pro- posal? Assuming the space will be heated and lighted regardless of whether or not it is con- verted into a sub shop, the answer is no.

Look for Synergistic Effects Oftentimes the acceptance of a new project will have an effect on the cash flows of the firm’s other projects or investments. These effects can be either positive or negative, and if these syn- ergistic effects can be anticipated, their costs and benefits are relevant to the project analysis.

Don’t Overlook Positive Synergies

In 2000, GM’s Pontiac division introduced the Aztek, a boldly designed sport-utility vehicle aimed at young buyers. The idea was to sell Azteks, of course, but also to help lure younger customers back into Pontiac’s showrooms. Thus, in evaluating the Aztek, if Pontiac’s analysts were to have focused only on the expected revenues from new Aztek sales, they would have missed the incremental cash flow from new customers who came in to see the Aztek but in- stead purchased another Pontiac automobile.

Another example of a synergistic effect is that of Harley-Davidson’s introduction of the Buell Blast and the Lightning Low XB95—two smaller, lighter motorcycles targeted at younger riders and female riders not yet ready for heavier and more expensive Harley-Davidson bikes. The company had two goals in mind when it introduced the Buell Blast and Lightning Low bikes. First, it was trying to expand its customer base into a new market made up of Genera- tion Xers. Second, it wanted to expand the market for existing products by introducing more people to motorcycling. That is, the Buell Blast and Lightning Low models were offered not only to produce their own sales, but also to ultimately increase the sales of Harley’s heavier cruiser and touring bikes.

Beware of Cash Flows Diverted from Existing Products

An important type of negative synergistic effect comes in the form of revenue cannibalization. This occurs when the offering of a new product draws sales away from an existing product. This is a very real concern, for example, when a firm such as Frito-Lay considers offering a new flavor of Dorito® chips. A supermarket allocates limited shelf space to Frito-Lay’s snack products. So, if a new flavor is offered, it must take space away from existing products. If the new flavor is expected to produce $10 million per year in cash flows, perhaps as much as

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382 PART 3 | Capital Budgeting

$6 million of this cash flow may be at the expense of existing flavors of Doritos®. Conse- quently, we take the resulting $4 million dollars, our incremental cash flow, as the relevant cash flow in evaluating whether or not to introduce the new flavor.

Account for Opportunity Costs In calculating the cash flows of an investment it is important to account for what economists refer to as opportunity costs, the cost of passing up the next best choice when making a deci- sion. To illustrate, consider the convenience store example we introduced earlier. Remember that we were considering whether to open a second location just a few blocks from our first very successful store. Let’s now assume that you have purchased the building in which the sec- ond store is to be located and it has space for two businesses. One of the spaces is occupied by a tanning salon and you are considering opening a second convenience store in the unoccupied space. Since you already own the building and the space needed for the convenience store is currently unused, should you charge the second convenience store business for use of the open space? The answer is no if you have no other foreseeable use for the space. However, what if a local restaurant owner approaches you with a proposal to rent the space for $2,000 a month? If you open the second convenience store, you will then forego the $2,000 per month in rent, and this becomes a very relevant incremental expense since it represents an opportunity cost of putting in the convenience store.

Work in Working Capital Requirements Many times a new project involves an additional investment in working capital. Additional working capital arises out of the fact that cash inflows and outflows from the operations of an investment are often mismatched. That is, inventory is purchased and paid for before it is sold. For example, this may take the form of new inventory to stock a sales outlet or an additional investment in accounts receivable resulting from additional credit sales. Some of the funds needed to finance the increase in inventory and accounts receivable may come from an increase in accounts payable that arises when the firm buys goods on credit. As a result, the actual amount of new investment required by the project is determined by the difference in the sum of the increase in accounts receivables plus inventories less the increase in accounts payable. We will refer to this quantity as net operating working capital. You may recall that in Chapter 3 we defined net working capital as the difference in current assets and current liabil- ities. Net operating working capital is very similar but it focuses on the firm’s accounts receiv- able and inventories compared to accounts payable.

Ignore Interest Payments and Other Financing Costs Although interest payments are incremental to the investments that are partly financed by bor- rowing, we do not include the interest payments in the computation of project cash flows. The reason, as we will discuss more fully in Chapter 14, is that the cost of capital for the project takes into account how the project is financed, including the after-tax cost of any debt that is used in financing the investment. Consequently, when we discount the incremental cash flows back to the present using the cost of capital, we are implicitly accounting for the cost of rais- ing funds to finance the new project (including the after-tax interest expense). Including inter- est expense in both the computation of the project’s cash flows and in the discount rate would amount to counting interest twice.

Before you move on to 12.2

Concept Check | 12.1 1. What makes an investment cash flow relevant to the evaluation of an investment proposal?

2. What are sunk costs?

3. What are some examples of synergistic effects that affect a project’s cash flows?

4. When borrowing the money needed to make an investment, is the interest expense incurred relevant to the analysis of the project? Explain.

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CHAPTER 12 | Analyzing Project Cash Flows 383

12.2 Forecasting Project Cash Flows To analyze an investment and determine whether it adds value to the firm, following Principle 3: Cash Flows Are the Source of Value, we use the project’s free cash flow. Recall from Chapter 3 that a free cash flow is the total amount of cash available for distribution to the creditors who have loaned money to finance the project and to the owners who have invested in the equity of the proj- ect. In practice this cash flow information is compiled from pro forma financial statements. Pro forma financial statements are forecasts of future financial statements. We can calculate free cash flow using Equation (12–2) as follows:

Operating Cash Flow

(12–2)

Net Operating Profit after Taxes or NOPAT

�

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working

Capital (NOWC)

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense

Figure 12.1 contains a quick reference guide to the free cash flow calculation, including fur- ther elaborations concerning the specific calculations.

Dealing with Depreciation Expense, Taxes, and Cash Flow When accountants calculate a firm’s taxable income, one of the expenses they subtract out is depreciation. In fact, depreciation has already been deducted from revenues before we calcu- late net operating income. However, depreciation is a non–cash flow expense. If you think about it, depreciation occurs because you bought a fixed asset (for example, you built a plant) in an earlier period, and now, by depreciating the asset, you’re effectively allocating the ex- pense of acquiring the asset over time. However, depreciation is not a cash expense since the

Figure 12.1

A Quick Reference Guide for Calculating an Investment’s Free Cash Flow The annual free cash flow for an investment project is calculated using Equation (12–2):

(12–2)

Net Operating Profit after Taxes or NOPAT

Important Definitions and Concepts:

• Net Operating Income is the profit after deducting the cost of goods sold and all operating expenses (including depreciation expense). Net operating income or net operating profit is also equal to earnings before interest and taxes (EBIT) for capital in- vestment projects since projects do not have other (non-operating) sources of income or expense. For firms that have both op- erating and non-operating income and expenses, EBIT differs from net operating income by the amount of these non-operating sources of income and expense.

• Net Operating Profit after Taxes (NOPAT) is equal to the firm’s net operating profit minus taxes on net operating profit. Note that we do not deduct interest expense before computing the corporate income taxes owed because the tax deductibility of interest is accounted for in the computation of the discount rate or the weighted average cost of capital, which is discussed in detail in Chapter 14.

• Depreciation Expense is allocation of the cost of fixed assets to the period when the assets are used.

• Capital Expenditures (CAPEX) is the periodic expenditure of money for new capital equipment that generally occurs at the time the investment is undertaken (i.e., in year 0). However, many investments require periodic expenditures over the life of the investment to repair or replace worn out capital equipment. Finally, if the equipment has a salvage value then this becomes a cash inflow in the final year of the project’s life.

• Change in Net Operating Working Capital (NOWC) represents changes in the balance of accounts receivable plus inven- tories less accounts payable. Any changes in this quantity represent either the need to invest more cash or an opportunity to extract cash from the project.

>> END FIGURE 12.1

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense �

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working Capital (NOWC)

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384 PART 3 | Capital Budgeting

actual cash expense occurred when the asset was acquired. As a result, the firm’s net operat- ing income understates cash flows by the amount of depreciation expense that is deducted for the period. Therefore, we’ll want to compensate for this by adding depreciation back into net operating income when calculating cash flows.

For our purposes in this chapter, depreciation is calculated using a simplified version of the straight-line method. Specifically, we calculate annual depreciation for a piece of plant or equipment by taking its initial cost (including the cost of any equipment plus shipping costs and other costs incurred when installing the equipment) and dividing this total by the depre- ciable life of the equipment. If the equipment has an expected salvage value at the end of its useful life this is deducted from the initial cost before determining the annual depreciation ex- pense. For example, if a firm were to purchase a piece of equipment for $100,000 and paid an additional $20,000 in shipping and installation expenses, then the initial outlay for the equip- ment and its depreciable cost would be $120,000. If the equipment is expected to last 5 years at which time it will have a salvage value of $40,000 then the annual depreciation expense would be $16,000 � ($100,000 � 20,000 � 40,000) � 5 years.

In the Appendix to this chapter we discuss the modified accelerated cost recovery system (MACRS), which is used for most tangible depreciable property. This method is typically used by firms to compute their tax liability but straight-line is used for financial reporting to the public.

Four-Step Procedure for Calculating Project Cash Flows Our objective is to identify incremental cash flows for the project, or changes to the firm’s cash flows as a result of taking the project. To do this, we forecast cash flows for future periods and then estimate the value of the project using the investment criteria discussed in the previous chapter. As we introduce these calculations, keep in mind the guidelines introduced in the pre- vious section dealing with sunk costs, synergistic effects, and opportunity costs. In order to es- timate project cash flows for future periods, we use the following four-step procedure:

Step 1. Estimating a Project’s Operating Cash Flows

Step 2. Calculating a Project’s Working Capital Requirements

Step 3. Calculating a Project’s Capital Expenditure Requirements

Step 4. Calculating a Project’s Free Cash Flow

In the pages that follow we will discuss each of these steps in detail.

Step 1: Estimating a Project’s Operating Cash Flows Operating cash flow is simply the sum of the first three terms found in Equation 12–2. Specif- ically, operating cash flow for year t is defined in Equation 12–3:

(12–3)

NOPATt

There are two observations we should make regarding the computation of operating cash flow:

• First, our estimate of cash flows from operations begins with an estimate of net op- erating income. However, when calculating net operating income we subtract out depre- ciation expense since it is a tax deductible expense. Thus to estimate the cash flow the firm has earned from its operations we first calculate the firm’s tax liability based on net oper- ating income and then add back depreciation expense.

• Second, when we calculate the increase in taxes, we ignore interest expenses. Even if the project is financed with debt, we do not subtract out the increased interest payments. Cer- tainly there is a cost to money, but we are accounting for this cost when we discount the free cash flows back to present. If we were to subtract out any increase in interest expenses and then discount those cash flows back to the present, we would be double counting the inter- est expense—once when we subtracted it out, and once again when we discounted the cash flows back to the present. In addition, when we calculate the increased taxes from taking on the new project, we calculate those taxes from the change in net operating income so as not to allow any increase in interest expense to impact our tax calculations. The important point

Operating Cash Flowt

� Net Operating

Income (or Profit)t � Taxest �

Depreciation Expenset

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CHAPTER 12 | Analyzing Project Cash Flows 385

Checkpoint 12.1

Forecasting a Project’s Operating Cash Flow The Crockett Clothing Company, located in El Paso, TX, owns and operates a clothing factory across the Mexican border in Juarez. The Juarez factory imports materials into Mexico for assembly and then exports the assembled products back to the United States without having to pay duties or tariffs. This type of factory is commonly referred to as a maquiladora.

Crockett is considering the purchase of an automated sewing machine that will cost $200,000 and is expected to operate for five years, after which time it is not expected to have any value. The investment is expected to generate $360,000 in additional revenues for the firm during each of the five years of the project’s life. Due to the expanded sales, Crockett expects to have to expand its investment in accounts receivable by $60,000 and inventories by $36,000. These investments in working capital will be partially offset by an increase in the firm’s accounts payable of $18,000, which makes the increase in net operating working capital equal to $78,000 in year zero. Note that this investment will be returned at the end of year five as inventories are sold, receivables are collected, and payables are repaid.

The project will also result in cost of goods sold equal to 60% of revenues while incurring other annual cash operat- ing expenses of $5,000 per year. In addition, the depreciation expense for the machine is $40,000 per year. This depre- ciation expense is one-fifth of the initial investment of $200,000 where the estimated salvage value is zero at the end of its five-year life. Profits from the investment will be taxed at a 30% tax rate and the firm uses a 20% required rate of return. Cal- culate the operating cash flow.

STEP 1: Picture the problem

Operating cash flows only encompass the revenues and operating expenses (after-taxes) corresponding to the operation of the asset. Therefore, they only begin with the end of the first year of operations (year 1). The oper- ating cash flow then is determined by the revenues less operating expenses for years 1 through 5.

OCF1 OCF2 OCF3 OCF4 OCF5

0 1 2 3 4 5Time Period

Operating Cash Flow

Years

Operating cash flow (OCF) for years 1 through 5 equals the sum of additional revenues less operating expenses (cash expenses and depreciation) less taxes plus depreciation expense.

The following list summarizes what we know about the investment opportunity:

Equipment cost or CAPEX (today) $(200,000) Project life 5 years Salvage Value 0 Depreciation expense $ 40,000 per year Cash operating expenses $ (5,000) per year Revenues (Year 1) $ 360,000 per year Growth rate for revenues 0% per year Cost of Goods Sold/Revenues 60% Investment in Net Operating Working Capital (Year 0) $ (78,000) Required rate of return 20% Tax rate 30%

STEP 2: Decide on a solution strategy

Using Equation (12–3), we calculate operating cash flow as the sum of NOPAT and depreciation expense as follows:

(12–3)

NOPAT

STEP 3: Solve

The project produces $360,000 in revenues annually and cost of goods sold equals 60% of revenues or $(216,000) leaving gross profits of $144,000. Subtracting cash operating expenses of $5,000 per year and de- preciation expenses of $40,000 per year we get net operating income of $99,000. Subtracting taxes of $29,700

Operating Cash Flow

� Net Operating

Income (or Profit) � Taxes �

Depreciation Expense

(12.1 CONTINUED >> ON NEXT PAGE)

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386 PART 3 | Capital Budgeting

Operating Cash Flow Calculation Income Statement Calculation

Revenues Revenues

Less: Cost of Goods Sold Less: Cost of Goods Sold

Equals: Gross Profit Equals: Gross Profit

Less: Operating Expenses (including depreciation) Less: Operating Expenses (including depreciation)

Equals: Net Operating Income (Profit) Equals: Net Operating Income (Profit)

Less: Taxes based on Net Operating Income Less: Interest Expense

Equals: Net Operating Profit after Taxes (NOPAT) Earnings before Taxes (EBT)

Plus: Depreciation Expense Less: Taxes based on EBT

Operating Cash Flow Net Income

leaves net operating profit of $69,300. Finally adding back depreciation expense this gives us operating cash flow of $109,300 per year for years 1 through 5:

D iff

er en

ce s d

STEP 4: Analyze

The project contributes $99,000 to the firm’s net operating income (before taxes), and if the project operates ex- actly as forecast here, this will be the observed impact of the project on the net operating income on the firm’s income statement. Of course, in a world where the future is uncertain, this will not be the outcome. As such, we might want to analyze the consequences of lower revenues and higher costs. For example, if project revenues were to drop to $300,000, the operating cash flow would drop to only $92,500. We will have more to say about how analysts typically address project risk analysis in Chapter 13.

STEP 5: Check yourself

Crockett Clothing Company is reconsidering its sewing machine investment in light of a change in its expecta- tions regarding project revenues. The firm’s management wants to know the impact of a decrease in expected revenues from $360,000 to $240,000 per year. What would be the project’s operating cash flows under the re- vised revenue estimate?

ANSWER: Operating cash flow � $75,700.

to remember here is that no interest or other costs of financing are deducted in determining the project’s free cash flow.

The format we use in calculating a project’s operating cash flow looks a lot like a typical income statement. The left-hand column below depicts the calculation of operating cash flow whereas the right hand column depicts the calculation of net income using a traditional income statement:

Year 1 Year 2 Year 3 Year 4 Year 5

Project Revenues (growing at 0% per year) $360,000 $360,000 $360,000 $360,000 $360,000 � Cost of Goods Sold (60% of revenues) (216,000) (216,000) (216,000) (216,000) (216,000) � Gross Profit $144,000 $144,000 $144,000 $144,000 $144,000 � Cash Operating Expenses (fixed at $5,000 per year) (5,000) (5,000) (5,000) (5,000) (5,000) � Depreciation ($200,000/5 years) (40,000) (40,000) (40,000) (40,000) (40,000) � Net Operating Income $ 99,000 $ 99,000 $ 99,000 $ 99,000 $ 99,000 � Taxes (30%) (29,700) (29,700) (29,700) (29,700) (29,700) � Net Operating Profit after Taxes (NOPAT) $ 69,300 $ 69,300 $ 69,300 $ 69,300 $ 69,300 � Depreciation 40,000 40,000 40,000 40,000 40,000 � Operating Cash Flow $109,300 $109,300 $109,300 $109,300 $109,300

Your Turn: For more practice, do related Study Problems 12–3 through 12–18 at the end of this chapter. >> END Checkpoint 12.1

Note: Operating Expenses include both cash expenses and depreciation expense.

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CHAPTER 12 | Analyzing Project Cash Flows 387

Without the Project (A)

With the Project (B)

Difference (B � A)

Accounts receivable $600,000 $660,000 $60,000 Inventory 390,000 426,000 36,000 Accounts payable 180,000 198,000 18,000

To compute operating cash flow in the left-hand column above we begin with Revenues (just like the income statement). Next, we subtract Cost of Goods Sold and Operating Ex- penses to calculate Net Operating Income (Profit). To this point the calculation of operating cash flow looks just like the income statement in the right-hand column. From this point for- ward the calculation of operating cash flow deviates from the standard form of the income statement. Specifically, to calculate operating cash flow we estimate taxes based on the firm’s net operating profit. Deducting taxes from net operating profit gives us an estimate of Net Op- erating Profit after Taxes, or NOPAT. Finally, since depreciation expense is a non-cash operat- ing expense and was subtracted before the tax calculation, we add back the annual depreciation expense to NOPAT to estimate Operating Cash Flow.

Step 2: Calculating a Project’s Working Capital Requirements When a firm invests in a new project, it often leads to an increase in sales that require the firm to extend credit, which means that the firm’s accounts receivable balance will grow. In addi- tion, new projects often lead to a need to increase the firm’s investment in inventories. Both the increase in accounts receivable and the increase in inventories mean that the firm must in- vest more cash in the business. This is a cash outflow. However, if the firm is able to finance some or all of its inventories using trade credit, this offsets the effects of the increased invest- ment in receivables and inventories. The difference in the increased accounts receivable plus inventories, less the increase in accounts payable (trade credit), indicates just how much cash the firm must come up with to cover the project’s additional working capital requirements.

To calculate the increase in net operating working capital we examine the levels of ac- counts receivable, inventory, and accounts payable with and without the project. For the Crockett Clothing Company, let’s assume that the purchase of an automated sewing machine described in Checkpoint 12.1 would cause the following changes:

We can now use Equation (12–4) to calculate Crockett’s additional investment in working capital as follows:

(12–4)

So to meet the needs of the firm for working capital in year 1 Crockett must invest $78,000. Although this investment will be made throughout the year, to be conservative we assume that the full $78,000 is invested immediately in year 0. In this particular example, sales do not grow or decline over the five-year life of the investment, so there are no additional investments in working capital in years 1 through 5. However, at the end of year 5, Crockett will collect out- standing receivables, sell down its remaining inventory, and pay off the outstanding balance of its accounts payable, thereby realizing a $78,000 cash inflow at the end of year 5 from its ini- tial investment of $78,000 in net operating working capital made in year 0. In summary, Crock- ett expects to have a cash outflow of $78,000 for working capital in year 0 and receive a cash inflow of $78,000 in year 5 when the project is shut down.

Step 3: Calculating a Project’s Capital Expenditure Requirements Capital expenditures, or CAPEX, is the term we use to refer to the cash the firm spends to purchase fixed assets. As we discussed earlier, for accounting purposes, the cost of a firm’s purchases of long-term assets is not recognized immediately, but is allocated or expensed over the life of the asset by depreciating the investment. Specifically, the difference between the purchase price and the expected salvage value of the investment is calculated as a depre- ciation expense over the life of the asset.

� $60,000 � 36,000 � 18,000 � $78,000

Investment in Net Operating

Working Capital � a Increase in

Accounts Receivable b � a Increase in

Inventories b � a Increase in

Accounts Payable b

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388 PART 3 | Capital Budgeting

We incorporate depreciation into our computation of project cash flow by deducting it from taxable income and then adding it back after taxes have been computed. In this way, the effect of depreciation is simply to reduce the tax liability created by the investment. When the project life is over, the book value of the asset is expected to equal the salvage value. Since the book value and salvage value are equal, there is no taxable gain or loss on the sale, and we simply add the salvage value to the final year’s free cash flow along with the recovery of any net operating working capital.

Step 4: Calculating a Project’s Free Cash Flow Using Equation (12–3), we calculate Crockett Clothing Company’s free cash flows for the five-year life of its investment opportunity in the new automated sewing machine. These cash flows are found below:

Note that in year 0, the free cash flow is simply the sum of the capital expenditure of $200,000 and the investment in net operating working capital of $78,000. The operating cash flows for years one through five are $109,300 and in year 5 we add back the $78,000 invest- ment in net operating working capital, which produces a total free cash flow in this year of $187,300. Finally, note that since the equipment is not expected to have a salvage value, none is added back in year 5.

Computing Project NPV We can now apply the tools we learned in Chapter 11 to evaluate the investment opportunity. If Crockett applies a 20% discount rate or required rate of return to evaluate the sewing ma- chine investment, we can calculate the net present value (NPV) of the investment using Equa- tion (11–1) as follows:

(11–1)

CF0 is the �$278,000 initial cash outlay, k is the required rate of return (20%) used to discount the project’s future cash flows, and CF1 through CF5 are the investment’s free cash flows for years 1 through 5. Substituting for each of these terms in the NPV equation above we get the following:

Based on our estimates of the investment’s cash flows, it appears that Crockett should go ahead and purchase the new automated machine since it offers an expected NPV of $80,220.

NPV � $80,220

$109,300

(1 � .20)4 �

$187,300

(1 � .20)5 NPV � �$278,000 �

$109,300

(1 � .20)1 �

$109,300

(1 � .20)2 �

$109,300

(1 � .20)3 �

NPV � CF0 � CF1

(1 � k)1 �

CF2 (1 � k)2

� CF3

(1 � k)3 �

CF4 (1 � k)4

� CF5

(1 � k)5

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

Project Revenues (growing at 0% per year) $ 360,000 $ 360,000 $ 360,000 $ 360,000 $ 360,000

� Cost of Goods Sold (60% of revenues) (216,000) (216,000) (216,000) (216,000) (216,000)

� Gross Profit $ 144,000 $ 144,000 $ 144,000 $ 144,000 $ 144,000

� Cash Operating Expenses (fixed at $5,000 per year) (5,000) (5,000) (5,000) (5,000) (5,000)

� Depreciation ($200,000 / 5 years) (40,000) (40,000) (40,000) (40,000) (40,000)

� Net Operating Income $ 99,000 $ 99,000 $ 99,000 $ 99,000 $ 99,000

� Taxes (30%) (29,700) (29,700) (29,700) (29,700) (29,700)

� Net Operating Profit after Taxes (NOPAT) $ 69,300 $ 69,300 $ 69,300 $ 69,300 $ 69,300

� Depreciation 40,000 40,000 40,000 40,000 40,000

� Operating Cash Flow $ 109,300 $ 109,300 $ 109,300 $ 109,300 $ 109,300

less: Increase in CAPEX $(200,000) — — — — —

less: Increase in net operating working capital (78,000) — — — — 78,000

Free Cash Flow (278,000) $ 109,300 $ 109,300 $ 109,300 $ 109,300 $ 187,300

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CHAPTER 12 | Analyzing Project Cash Flows 389

Before you move on to 12.3

Concept Check | 12.2 1. What does the term free cash flow mean?

2. What are the four steps used to forecast a project’s future cash flows?

3. What is net operating working capital, and how does it affect a project’s cash flows?

4. What is CAPEX, and how does it affect a project’s cash flows?

1While the numbers listed for price and cost per unit have been rounded to four decimal places in this table, the cal- culations for revenue and cost of goods sold have been made without rounding.

1 2 3

Units Sold 5,000,000 5,000,000 5,000,000

Price per unit (inflation rate � 3%) $0.2060 $0.2122 $0.2185

Cost per unit (inflation rate � 8%) $0.1080 $0.1166 $0.1260

Revenues $1,030,000.00 $1,060,900.00 $1,092,727.00

Cost of Goods Sold (540,000.00) (583,200.00) (629,856.00)

Gross Profit $490,000.00 $477,700.00 $462,871.00

.2060 � .20(1.03)

.2185 � .2122(1.03)

.1260 � .1166(1.08)

.1080 � .10(1.08)

12.3 Inflation and Capital Budgeting Since investments are expected to provide cash flows over many years, we cannot overlook the issue of price inflation. Fortunately, we can adjust project revenues and expenses for the antic- ipated effects of inflation. Cash flows that account for future inflation are generally referred to as nominal cash flows. Sometimes analysts calculate what is referred to as real cash flows, which are the cash flows that would occur in the absence of inflation.

When nominal cash flows are used, they should be discounted at the nominal interest rate, which you can recall from Chapter 9 as the rate that we observe in the financial markets. In most cases, firms do use nominal rates of return for the discount rates that are used to evaluate a project, so it is appropriate to also calculate nominal cash flows. However, when firms cal- culate the real cash flows that are generated by a project, the cash flows should be discounted at the real rate of interest, which is the nominal rate of interest adjusted for inflation.

Typically, firms calculate project values by discounting nominal cash flows at nominal rates of interest. Let’s see how nominal cash flows are estimated.

Estimating Nominal Cash Flows Although not stated formally, the cash flows that we have looked at up to now have been nomi- nal cash flows. To illustrate how we can directly incorporate the affects of inflation into our cash flow forecasts, consider the situation faced by the Plantation Chemical Company. The firm pur- chases HDPE (High Density Polyethylene) pellets manufactured by oil refineries and uses them to manufacture the plastic containers used to package milk, fruit juice, and soft drinks. The firm is considering an expansion of one of its plants that makes milk bottles. The new plant will pro- duce 5 million plastic bottles a year. The bottles currently sell for $0.20 each and cost $0.10 each to produce. The price of the bottles is expected to rise at a rate of 3% a year while the HDPE is expected to increase by 8% per year due to restrictions on world crude oil production. We can forecast the gross profit for the proposed investment for each of the next three years as follows:1

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390 PART 3 | Capital Budgeting

Before you move on to 12.4

Concept Check | 12.3 1. What is the distinction between nominal and real interest rates?

2. If you forecast nominal cash flows, should you use the nominal or the real discount rate? Why?

12.4 Replacement Project Cash Flows To this point, we have been evaluating project cash flows for an expansion project. An expansion project increases the scope of the firm’s operations, but does not replace any existing assets or operations. In this section, we consider a replacement investment, an acquisition of a new pro- ductive asset that replaces an older, less productive asset. A distinctive feature of many replace- ment investments is that the principal source of investment cash flows comes from cost savings, not new revenues, since the firm already operates an existing asset to generate revenues.

The objective of our analysis of investment cash flows is the same for a replacement project as it was for the expansion projects considered earlier. Specifically, project or investment free cash flow is still defined by Equation (12–3). However, with a replacement project, we must ex- plicitly compare what the firm’s cash flows would be without making a change to the firm’s cash flows with the replacement assets. To perform this analysis, it is helpful to categorize investment cash flows as an initial outlay of CF0 and future cash flows as CF1, CF2, CF3, and so forth.

Category 1: Initial Outlay, CF0 For an expansion project, the initial cash outlay typically includes the immediate cash outflow (CAPEX) necessary to purchase fixed assets and put them in operating order, plus the cost of any increased investment in net operating working capital (NOWC) required by the project. However, when the investment proposal involves the replacement of an existing asset, the com- putation of the initial cash outlay is a bit more complicated because disposing of the existing asset can involve immediate expenses. If the old asset is sold for more than the book value of the asset, this gives rise to a taxable gain on the sale. On the other hand, if the old asset is sold for less than its book value, then a tax deductible loss occurs.

When an existing asset is sold, there are three possible tax scenarios:

• The old asset is sold for a price above the depreciated value. Here the difference be- tween the selling price of the old machine and its depreciated book value is a taxable gain, taxed at the marginal corporate tax rate and subtracted from the CAPEX. For example, as- sume the old machine was originally purchased for $350,000, had a depreciated book value of $100,000 today, and could be sold for $150,000, and assume that the firm’s mar- ginal corporate tax rate is 30 percent. The taxes due from the gain would then be ($150,000 � $100,000) � (.30), or $15,000.

• The old asset is sold for its depreciated value. In this case, no taxes result, as there is neither a gain nor a loss from the asset’s sale.

• The old asset is sold for less than its depreciated value. In this case, the difference be- tween the depreciated book value and the salvage value of the asset is a taxable loss and may be used to offset capital gains. Thus, it results in tax savings and we add it to the CAPEX. For example, if the depreciated book value of the asset is $100,000 and it is sold for $70,000, we have a $30,000 loss. Assuming the firm’s marginal corporate tax rate is 30 percent, the cash inflow from tax savings is ($100,000 � $70,000) � (.30), or $9,000.

Category 2: Annual Cash Flows Annual cash flows for a replacement decision differ from a simple asset acquisition because we must now consider the differential operating cash flow of the new versus the old (replaced) asset.

Note that Gross Profit actually declines over time as the cost of raw materials is inflating more rapidly than the price of the end product.

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CHAPTER 12 | Analyzing Project Cash Flows 391

Changes in Depreciation and Taxes. Once again, we are only interested in any change in taxes that the change in depreciation might bring about—after all, depreciation is not a cash flow expense, but since it is tax deductible it impacts taxes, which are a cash flow item. We want to look at the incremental change in taxes—that is, what the taxes would be if the asset were replaced versus what they would be if the asset were not replaced.

For a replacement project, the firm’s depreciation expense increases by the amount of de- preciation on the new asset but decreases by the amount of the depreciation on the replaced as- set. Since our concern is with incremental changes, we take the new depreciation less the lost depreciation, and that difference would be our incremental change in depreciation. That is what we would use in our cash flow calculations to determine the change in taxes.

Changes in Working Capital. Many replacement projects require an increased investment in working capital. For example, if the new asset has greater capacity than the one it replaces and generates more sales, these new sales, if they are credit sales, will result in an increased investment in accounts receivable. Also, in order to produce and sell the product, the firm may have to increase its investment in inventory, which also requires additional financing. On the other hand, some of this increased investment in inventory is financed by an increase in ac- counts payable, which offsets the outlay for new investment in inventories.

Changes in Capital Spending. The replacement asset will require an outlay at the time of its acquisition but may also require additional capital over its life. We must be careful, how- ever, to net out any additional capital spending requirements of the older, replaced asset when computing project free cash flows. Finally, at the end of the project’s life, there will be a cash inflow equal to the after-tax salvage value of the new asset, if it is expected to have one. Once again, we need to be careful to net out any salvage value that the older asset might have had to get the net cash effect of salvage value.

Replacement Example Checkpoint 12.2 describes an asset replacement problem faced by the Leggett Scrap Metal Company. The company operates a large scrap metal yard that buys junk automobiles, strips them of their valuable parts, and then crushes them in a large press. Leggett is considering the replacement of its largest press with a newer and more efficient model.

Checkpoint 12.2

Calculating Free Cash Flows for a Replacement Investment Leggett Scrap Metal, Inc. operates an auto salvage business in Salem, Oregon. The firm is considering the replacement of one of the presses it uses to crush scrapped automobiles. The following information summarizes the new versus old machine costs:

Machine

New Old

Annual cost of defects $ 20,000 $ 70,000 Net operating income $580,000 $580,000 Book value of equipment 350,000 100,000 Salvage value (today) NA 150,000 Salvage value (Year 5) 50,000 — Shipping cost $ 20,000 NA Installation cost 30,000 NA Remaining project life (years) 5 5 Net operating working capital $ 60,000 $ 60,000 Salaries 100,000 200,000 Fringe benefits 10,000 20,000 Maintenance 60,000 20,000

(12.2 CONTINUED >> ON NEXT PAGE)

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392 PART 3 | Capital Budgeting

Leggett faces a 30% marginal tax rate and uses a 15% discount rate to evaluate equipment purchases for its automobile scrap operation.

The appeal of the new press is that it is more automated (requires two fewer employees to operate the machine). The older machine requires four employees with salaries totaling $200,000 and fringe benefits costing $20,000. The new ma- chine cuts this total in half. In addition, the new machine is able to separate out the glass and rubber components of the crushed automobiles, which reduces the annual cost of defects which are $20,000 with the new machine compared to $70,000 for the older model. However, the added automation feature comes at the cost of higher annual maintenance fees of $60,000 compared to only $20,000 for the older press.

Should Leggett replace the older machine with the newer one?

STEP 1: Picture the problem

The automated scrap press machine requires an initial investment to purchase the equipment, which is partially offset by the after-tax proceeds realized from the sale of the older press. In addition, the newer press provides net cash savings to Leggett in years 1 through 5 based on the predicted difference in the costs of operating the two machines. Finally, in year 5 the new press can be sold for an amount equal to its book value of $50,000. The relevant cash flow for analyzing the replacement decision equals the difference in cash flow between the new and old machine as we illustrate below:

CF(New)0 CF(New)1 CF(New)2

Minus

Equals

CF(New)3 CF(New)4 CF(New)5

0 1 2 3 4 5Time Period

Cash Flow (New)

CF(Old)0 CF(Old)1 CF(Old)2 CF(Old)3 CF(Old)4 CF(Old)5Cash Flow (Old)

�CF0 �CF1 �CF2 �CF3 �CF4 �CF5Difference (New − Old)

Years

k = 15%

Where the cash flows to be used in analyzing the replacement decision equal the difference in cash flows of the new and old asset, i.e.,

(12–5)

STEP 2: Decide on a solution strategy

The cash flows of the replacement decision are still calculated using Equation (12–3), which requires that we identify operating cash flows after taxes, capital expenditure (CAPEX) requirements, and required investments in net operating working capital, i.e.,

(12–3)

However, for a replacement decision we focus on the difference in costs and benefits with the new machine ver- sus the old. For this type of problem it is helpful to focus on the initial cash outflow (CF0) and then the annual cash flows including any terminal cash flow resulting from the difference in the salvage values of the two machines in year 5—in this case $50,000 for the new machine compared to $0 for the older machine.

STEP 3: Solve

The initial cash outlay for year 0 reflects the difference in the cost of acquiring the new machine (including ship- ping and installation costs) and the after-tax proceeds Leggett realizes from the sale of the old press, i.e.,

Free Cash Flow

� ° Net OperatingProfit after Taxes (NOPAT)

¢ � °Depreciation Expense

¢ � ° Increase in CapitalExpenditures (CAPEX)

¢ � ° Increase in NetOperating Working Capital (NOWC)

¢

Replacement Cash Flows (¢CF)Year t

� ° Cash Flow forthe New Asset CF (New)Year t

¢ � °Cash Flow forthe Old Asset CF (Old)Year t

¢

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CHAPTER 12 | Analyzing Project Cash Flows 393

The new press costs $400,000 to purchase and install. This cost is partially offset by the after-tax proceeds from the sale of the older press, which equal $135,000, such that the initial cash outlay is $265,000 � $400,000 � $135,000.

Next we estimate the annual cash flows for years 1 through 5 assuming that the new press is purchased and the older one is sold.

The new press will reduce costs (totaling $160,000 per year) compared to the older press; however, the new press requires an additional $40,000 in maintenance expenses and has $50,000 more depreciation expense. For years 1 through 4, this results in increased after-tax free cash flow of $99,000 per year. In year 5 the new press is salvaged for an estimated $50,000 (recall that this is also the book value of the machine, so there is no gain on the sale and, consequently, there is no tax to be paid).

STEP 4: Analyze

Free cash flows for replacement projects require us to explicitly consider the changes that occur when one as- set is used to replace an existing asset. The replacement decision in this example resulted only in cost savings since it did not add to the firm’s capacity to generate revenues. However, this will not always be the case. The new or replacement asset might have greater capacity, in which case additional revenues might be generated in addition to cost savings. Note, too, that where new revenues are produced, there will likely be an increase in the firm’s investment in net operating working capital.

(12.2 CONTINUED >> ON NEXT PAGE)

Analysis of the Initial Outlay Year 0

New Machine Purchase price $(350,000) Shipping cost (20,000) Installation cost (30,000) Total installed cost of purchasing the new press $(400,000)

Old Machine Sale price $150,000 less: Tax on gain � [($150,000 � 100,000) � .30] (15,000) After-tax proceeds from the sale of the old press $135,000

Operating Working Capital $ 0 Initial Cash Flow (265,000)

Analysis of the Annual Cash Flows Year 1-4 Year 5

Cash inflows Increase in operating income $ 0 Reduced salaries $100,000 Reduced defects 50,000 Reduced fringe benefits 10,000

$ 160,000 $160,000 Cash outflows

Increased maintenance $ (40,000) Increased depreciation (50,000)

(90,000) $ (90,000) Net Operating Income $ 70,000 $ 70,000 less: Taxes (21,000) (21,000) Net operating profit after taxes (NOPAT) $ 49,000 $ 49,000 plus: Depreciation 50,000 50,000 Operating cash flow $ 99,000 $ 99,000 less: Increase in net operating working capital 0 0 less: Increase in CAPEX 0 50,000 Free Cash Flows $ 99,000 $149,000

Note: Capital expenditures (CAPEX) are generally outflows, hence subtracted out. However, when a project has a salvage value at the end of it useful life, the CAPEX takes on a positive value and is added to the free cash flows in the project’s final year.

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394 PART 3 | Capital Budgeting

Cash flows for the replacement decision are forecast in Checkpoint 12.2 and indicate that Leggett will have to invest an additional $265,000 to purchase the new press. This figure cap- tures the deduction of the $150,000 the firm will receive from the sale of the older model. In addition, Leggett expects to generate additional free cash flows in years 1 through 5 equal to $99,000 from the savings in personnel costs and reduced defects. Finally, in year 5 the sale of the replacement press is expected to generate an additional $50,000 in after-tax cash flows for a total free cash flow of $149,000 � $99,000 � 50,000.

We are now prepared to estimate the NPV of the replacement proposal as follows:

Thus, we estimate that the NPV of the replacement opportunity is $91,722, which suggests that the added cost savings from the newer press more than offset the cost of making the replacement.

� $91,722

NPV � �$265,000 � $99,000

(1 � .15)1 �

$99,000

(1 � .15)2 �

$99,000

(1 � .15)3 �

$99,000

(1 � .15)4 �

$149,00011 � .15 2 5

Machine

New Old

Annual cost of defects $ 20,000 $ 70,000 Net operating income $600,000 $580,000 Book value of equipment 350,000 100,000 Salvage value (today) NA 150,000 Salvage value (Year 5) 50,000 — Shipping cost $ 20,000 NA Installation cost 30,000 NA Remaining project life (years) 5 5 Net operating working capital $ 80,000 $ 60,000 Salaries 100,000 200,000 Fringe benefits 10,000 20,000 Maintenance 60,000 20,000

STEP 5: Check yourself

Forecast the project cash flows for the replacement press for Leggett where the new press results in net oper- ating income per year of $600,000 compared to $580,000 for the old machine. This increase in revenues also means that the firm will also have to increase its net operating working capital by $20,000. The information for the replacement opportunity is summarized below:

Estimate the initial cash outlay required to replace the old machine with the new one and estimate the annual cash flows for years 1 through 5.

ANSWER: Initial cash outflow � �$285,000; cash flows for years 1–4 � $113,000; and cash flow for year 5 � $183,000.

Your Turn: For more practice, do related Study Problems 12–25 through 12–27 at the end of this chapter. >> END Checkpoint 12.2

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CHAPTER 12 | Analyzing Project Cash Flows 395

Before you begin end of chapter material

Concept Check | 12.4 1. What is a replacement investment?

2. What is the relevant depreciation expense when you are analyzing a replacement decision?

Australia

USA

Mexico

Brazil

Argentina

North Africa Morocco

Spain

Norway England Sweden

Finland

Denmark Germany

Russia

South Africa

Malaysia

Turkey China

Thailand

France Italy

Sweden Denmark

Italy

Philippines

Japan South Korea

Your Turn: See Study Question 12–12.

Finance in a Flat World Entering New Markets

When measuring free cash flow, it is important to think glob- ally. We should consider threats from foreign competition as well as opportunities to sell internationally. To illustrate the threat from foreign competition, we need only look at how the U.S. auto indus- try has evolved over the past 30 years. When foreign car makers first started making inroads into the U.S. market during the 1970s, no one would have thought that firms like Toyota, Honda, and Nissan could challenge the likes of Ford and GM. On the other hand, the opportunities that come from foreign markets can also be huge. For example, more than half of the revenues from Hollywood movies now come from abroad.

There are also other intangible benefits from investing in countries like Germany and Japan, where cutting-edge technol-

ogy is making its way into the marketplace. Here, investment abroad provides a chance to observe the introduction of new in- novations on a first-hand basis. This allows firms like IBM, GE, and 3Com to react more quickly to any technological advances and product innovations that might come out of countries like Germany or Japan.

Finally, if a product is well received at home, international mar- kets can be viewed as an opportunity to expand. For example, McDonald’s was much more of a hit at home than anyone ever ex- pected 40 years ago. Once it conquered the United States, it moved abroad—but it hasn’t always been a smooth move. There is much uncertainty every time McDonald’s opens a new store in an- other country; it is unlikely that any new store will be without prob- lems stemming from cultural differences. What McDonald’s learns in the first store that it opens in a new country can be used to modify the firm’s plans for opening subsequent stores in that country. McDonald’s also learns what works in different countries, and main- tains the flexibility to adapt to different tastes. As a result, you’ll find McLaks, a sandwich made of grilled salmon and dill sauce in Norway, Koroke Burgers (mashed potato, cabbage and katsu sauce, all in a sandwich), as well as green tea-flavored milkshakes in Japan, and McHuevos (which are regular hamburgers topped with a poached egg) in Uruguay. In effect, taking abroad a product that has been successful in the U.S. requires flexibility to adapt to the new culture and to quickly modify products. As a result, fore- casting cash flows from international markets is quite challenging.

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Chapter Summary

Principle 3: Cash Flows Are the Source of Value The process of deciding whether or not to accept an investment proposal begins with an estimation of the amount and timing of the relevant future free cash flows. These cash flows are discounted back to present at the project’s required rate of return to determine the present value of the investment proposal.

P

Applying the Principles of Finance to Chapter 12 C

H A

P T

E R

1 2

396

12.1 Identify incremental cash flows that are relevant to project valuation. (pgs. 380–382) SUMMARY: The cash flows that are relevant to the valuation of an investment project are those that are incremental to the firm. Although this seems straightforward, identifying incremental cash flows can be very challenging; therefore, we offered the following guidelines and words of caution:

• Sunk costs are not incremental cash flows—sunk costs are one particular category of ex- penditures that frequently give rise to difficulty when evaluating an investment opportunity; they are expenditures that have already been made and cannot be undone if the project is not undertaken. By definition, such costs are not incremental to the decision to undertake a new investment.

• Overhead costs are generally not incremental cash flows—overhead costs include such things as the utilities required to heat and cool a business. If the utility bills of the firm will not change whether the investment is undertaken or not, then the allocated costs of utilities are ir- relevant to the analysis of the investment proposal.

• Beware of cash flows diverted from existing products—oftentimes a new product will get some portion of its revenues from reduced demand for another product produced by the same firm. For example, you might purchase lime-flavored Dorito chips rather than Nacho Cheese Doritos. When this happens, the analyst must be careful not to count the cannibalized sales taken away from an existing product as incremental sales.

• Account for opportunity costs—sometimes there are important cash flow consequences of undertaking an investment that do not actually happen but which are foregone as a result of the investment. For example, if you rent out a part of your floor space, you obviously cannot use it in your business. Similarly, if you decide to use the space yourself you forego the rent that would otherwise be received. The latter is an opportunity cost of using the space.

• Work in working capital requirements—if an investment requires that the firm increase its investment in working capital (e.g., accounts receivable and inventories net of any correspond- ing increase in funding provided in the form of accounts payable), this investment is no differ- ent than capital expenditures and results in a cash outflow.

• Ignore interest payments and other financing costs—interest expense associated with new debt financing used to finance an investment is not included as part of incremental cash flows. The interest expenses are considered part of the firm’s cost of capital, which we will discuss in Chapter 14.

KEY TERMS Incremental cash flow, page 380 The change in a firm’s cash flows that is a direct consequence of its having undertaken a particular project.

Sunk costs, page 381 Costs that have already been incurred.

KEY EQUATIONS

(12–1) Incremental Project

Cash Flows � aFirm Cash Flows

with the Project b � a Firm Cash Flows

without the Project b

Concept Check | 12.1

1. What makes an investment cash flow relevant to the evaluation of an investment proposal?

2. What are sunk costs?

3. What are some examples of synergistic effects that affect a project’s cash flows?

4. When borrowing the money needed to make an investment, is the interest expense incurred relevant to the analysis of the project? Explain.

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CHAPTER 12 | Analyzing Project Cash Flows 397

12.2 Calculate and forecast project cash flows for expansion-type investments. (pgs. 383–389) SUMMARY: An expansion project expands or increases the scope of the firm’s operations, in- cluding the addition of both revenues and costs, but does not replace any existing assets or opera- tions. Project cash flow is equal to the sum of operating cash flow less capital expenditures and any change needed in the firm’s investment in working capital, i.e.,

Operating Cash Flow

(12–2)

Net Operating Profit after Taxes or NOPAT

Estimating a project’s free cash flow involves a four-step process:

Step 1: Measure the effect of the proposed investment on the firm’s operating cash flows, or cash flows from operations. This includes the estimated incremental revenues and oper- ating expenses resulting from the project’s acceptance.

Step 2: Calculate the project’s requirements for working capital and the resulting cash flows. Here we consider the incremental investment that the project may require in ac- counts receivable plus inventories less any increase in accounts payable or trade credit.

Step 3: Calculate the project’s cash requirements for capital expenditures. Capital expendi- tures, as we learned in Chapter 11, include expenditures for property, plant and equipment that are expected to last for longer than one year. The biggest capital expenditure for most investments occurs when the investment is made. However, additional capital expendi- tures may have to be made periodically over the life of the project as older equipment wears out or new capacity needs to be added to meet the needs of growth over time.

Step 4: Combine the project’s operating cash flow with any investments made in net operat- ing working capital and capital expenditures to calculate the project’s free cash flow. In the initial year the free cash flow will generally include only the required investment out- lays for capital equipment and working capital. In subsequent years both operating revenues and expenses determine the project’s cash flows, and in the final year of the project addi- tional cash inflows from salvage value and the return of working capital may be present.

KEY TERM

Pro forma financial statements, page 383 A forecast of financial statements for a future period.

KEY EQUATIONS

Operating Cash Flow

(12–2)

Net Operating Profit after Taxes or NOPAT

(12–3)

NOPAT

(12–4) Investment in Net Operating

Working Capital � a Increase in

Accounts Receivable b � a Increase in

Inventories b � a Increase in

Accounts Payable b

Operating Cash Flowt

� Net Operating

Income (or Profit)t � Taxes t �

Depreciation Expenset

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense �

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working

Capital (NOWC)

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working

Capital (NOWC)

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense �

Concept Check | 12.2

1. What does the term free cash flow mean?

2. What are the four steps used to forecast a project’s future cash flows?

3. What is net operating working capital, and how does it affect a project’s cash flows?

4. What is CAPEX, and how does it affect a project’s cash flows?

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398 PART 3 | Capital Budgeting

SUMMARY: Inflation can have a very significant effect on project cash flows and consequently the value of an investment opportunity. The consequences of inflation can be felt in both revenues and costs and the effect is often quite different, so project cash flows may increase as a result of in- flation (revenues rise faster than costs) or fall (costs rise faster than revenues). The important thing is that the analysts carefully consider the potential effects of inflationary expectations and incorpo- rate them into the cash flow forecast. These inflation-adjusted cash flows are referred to as nomi- nal cash flows (as contrasted with real cash flows, which do not incorporate the effects of inflation). Since we forecast nominal cash flows we should use nominal rates of interest as the basis for de- termining the discount rate for the project (discussed in detail in Chapter 14).

KEY TERMS Nominal cash flows, page 389 Cash flows that account for the effects of inflation.

Nominal rate of interest, page 389 The rate of interest that is observed in financial markets and which incorporates consideration for inflation.

Real cash flows, page 389 Cash flows that would occur in the absence of any inflation.

Real rate of interest, page 389 The rate of interest that would occur in the absence of any inflation.

Concept Check | 12.3

1. What is the distinction between nominal and real interest rates?

2. If you forecast nominal cash flows, should you use the nominal or the real discount rate? Why?

SUMMARY: A replacement project is one in which an existing asset is taken out of service and an- other is added in its place. Thus, a distinctive feature of many replacement investments is that the prin- cipal source of investment cash flows comes from cost savings, not new revenues. Since the firm already operates an existing asset to generate revenues, the primary benefit of acquiring the new asset comes from the cost savings it offers.

The cash flows for a replacement project are calculated using Equation (12–1) just like those for an expansion project. The only difference is that with a replacement project we are continually asking how cash flows with the new asset differ from those generated by the older asset. For this reason, computing project cash flows for replacement asset investments is a bit more complicated. However, the principles are exactly the same.

KEY TERMS Expansion project, page 390 An investment proposal that increases the scope of the firm’s operations, including the addition of both revenues and costs, but does not replace any existing assets or operations.

Replacement investment, page 390 An investment proposal that is a substitute for an existing investment.

Concept Check | 12.4

1. What is a replacement investment?

2. What is the relevant depreciation expense when you are analyzing a replacement decision?

Study Questions 12–1. As you saw in the introduction, the Toyota Prius took some of its sales away from other

Toyota products. Toyota has also licensed its hybrid technology to Ford Motor Company, which has allowed Ford to introduce a Ford Fusion Hybrid in 2010 with 39 mpg, almost doubling the city efficiency of the non-hybrid Fusion. Obviously this new Ford product will compete directly with Toyota’s hybrids. Why do you think Toyota licensed its technology to Ford?

12–2. (Related to Regardless of Your Major: The Internet on Airline Flights—Making It Happen on page 380) In the feature titled Regardless of Your Major, we describe an investment proposal involving the sale of Internet services on airlines. How would you approach the problem of calculating the cash flows for such a venture? What costs would you include in the initial cash outlay, the annual operating cash flows, capital expenditures, and working capital?

12–3. Corporate overhead expenses related to utilities and other corporate expenses are generally not relevant to the analysis of new investment opportunities. Why?

12–4. New investments often require that the firm invest additional money in working capital. Give some examples of what this means.

12–5. When a firm finances a new investment, it often borrows part of the money, so the interest and principal payments this creates are incremental to the project’s acceptance. Why are these expenditures not included in the project’s cash flow computation?

12.3 Evaluate the effect of inflation on project cash flows. (pgs. 389–390)

12.4 Calculate the incremental cash flows for replacement-type investments. (pgs. 390–394)

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CHAPTER 12 | Analyzing Project Cash Flows 399

12–6. Discuss how to compute a project’s free cash flow. How does free cash flow differ from operating cash flow?

12–7. If depreciation is not a cash flow item, why does it affect the level of cash flows from a project?

12–8. Describe net operating working capital, and explain how changes in this quantity affect an investment proposal’s cash flows.

12–9. What are sunk costs and how should they be considered when evaluating an investment’s cash flows?

12–10. Should overhead expense ever be considered when evaluating investment cash flows?

12–11. What are opportunity costs, and how should they affect an investment’s cash flows? Give an example.

12–12. Should anticipated inflation be incorporated into project cash flow forecasts? If so, how?

12–13. When McDonald’s (MCD) moved into India, it faced a particularly difficult task. The major religion in India is the Hindu religion, and Hindus don’t eat beef—in fact, most of the one billion people living in India are vegetarians. Still, McDonald’s ventured into India and has been enormously successful. Why do you think they have been so successful and what kind of products do you think they sell in their stores?

12–14. (Related to Finance in a Flat World: Entering New Markets on page 395) In the feature titled Finance in a Flat World: Entering New Markets, we described the importance of thinking globally when making investments. Pick a new product that you have just learned about that is being sold domestically and describe how the product might benefit from international markets.

12–15. For years GM treated each car brand as if it were a separate company, considering all new car sales as incremental sales. Critically evaluate this position.

12–16. Throughout the examples in this chapter we have assumed that the initial investment in working capital is later recaptured when the project ends. Is this a realistic assumption? Do firms always recover 100% of their investment in accounts receivable and inventories?

Self-Test Problems Problem ST.1 (Calculating Free Cash Flow) Clarion Enterprises is considering an investment in a new digital reader for use in its inventory man- agement system. The reader will cost $50,000 to purchase and install, will be depreciated over a five- year life using straight-line depreciation toward a $10,000 salvage value in five years. The firm’s analyst estimates that the new reader will reduce the firm’s inventory costs by $30,000 per year, which means that the firm’s net operating profits will increase by $22,000 per year after depreciation expense. If the firm purchases the reader there will be no need to increase the firm’s working capital, nor will there be any added capital expenditures over the five-year investment life. If Clarion faces a 30% marginal tax rate, what will be the free cash flow to the firm from the new reader in years 0 through 5?

Solution ST.1

STEP 1: Picture the problem

Clarion Enterprises is considering investing in a new digital reader and needs to determine the cash flows asso- ciated with this new investment.

CF0 CF1 CF2 CF3 CF4 CF5

0 1 2 3 4 5Time Period

Cash Flow

Years

(SOLUTION ST.1 CONTINUED >> ON NEXT PAGE)

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400 PART 3 | Capital Budgeting

Problem ST.2 (Calculating Free Cash Flow) Easterwood Corporation is currently considering an investment of $400,000 in a lab tester that it ex- pects will generate an additional $500,000 per year in revenues (all on credit) to the firm’s laboratory division over the next five years. The firm realizes a 30% gross profit margin (i.e., cost of services pro- vided are 70% of revenues) and collects on credit sales in approximately 90 days (all sales involve credit since they are billed to the patient’s insurance provider). Thus, the firm expects accounts receiv- able to increase by $125,000. In addition to the cost of services, if Easterwood invests in the lab tester, it will incur a fixed cash operating expense of $10,000 per year, and the new lab tester will be depre- ciated using straight-line depreciation over a period of 5 years, at which time it is expected to have a zero salvage value. The new investment will not require any new investment in inventories and ac- counts payable will not increase if the investment is made.

a. Calculate the operating cash flow for the lab tester investment for years 1 through 5. b. Assuming the only investment made in fixed assets is for the cost of the lab tester, what is CAPEX

for the investment over the five-year life of the equipment investment? c. What additional investment(s) is (are) required if the new tester is purchased?

STEP 2: Decide on a solution strategy

We can calculate the project’s free cash flows using Equation (12–2):

(12–2)

STEP 3: Solve

The free cash flows for years 0 through 5 are computed using Equation (12–2) in the table below:

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense �

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working

Capital (NOWC)

STEP 4: Analyze

The digital reader requires a $50,000 initial investment and the $30,000 annual savings result in additional oper- ating cash flow of $23,400 after taxes. In year five the firm expects to sell the used piece of equipment for $10,000, which is the book value of the equipment, such that this cash flow represents no gain or loss and does not result in the firm having to pay additional taxes. Consequently, the free cash flow for year five equals $33,400, which is the sum of the $23,400 in operating cash flow plus the $10,000 salvage value.

>> END Solution ST.1

0 1 2 3 4 5

Inventory Savings � Added Operating Earnings $30,000 $30,000 $30,000 $30,000 $30,000 less: Depreciation Expense (8,000) (8,000) (8,000) (8,000) (8,000) Net Operating Income $22,000 $22,000 $22,000 $22,000 $22,000 less: Taxes (30%) (6,600) (6,600) (6,600) (6,600) (6,600) Net Operating Profit after tax (NOPAT) $15,400 $15,400 $15,400 $15,400 $15,400 plus: Depreciation Expense 8,000 8,000 8,000 8,000 8,000 Operating Cash Flow $23,400 $23,400 $23,400 $23,400 $23,400 less: Increase in net operating working capital — — — — — — less: Increase in CAPEX $(50,000) — — — — 10,000 Free Cash Flow $(50,000) $23,400 $23,400 $23,400 $23,400 $33,400

Note: Salvage value is added back.

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CHAPTER 12 | Analyzing Project Cash Flows 401

Solution ST.2

STEP 1: Picture the problem

In addition to the cash flows from operations, the lab tester requires an initial investment in net operating working capital in year 0 based on the change in accounts receivable resulting from increased sales. This increase in ac- counts receivable will occur initially and, since project revenues are constant, there will be no additional invest- ments in accounts receivable after the initial investment in year 0. Finally, in year 5 the project will realize the money invested in net operating working capital.

CF0 CF1 CF2 CF3 CF4 CF5

0 1 2 3 4 5Time Period

Cash Flow

Years

CF0: The CAPEX plus the added investment equal to the change in accounts receivable

CF5: The operating cash flow for year 5 plus recovery of the added investment in accounts receivable

STEP 2: Decide on a solution strategy

We can calculate the project’s free cash flows using Equation (12–2):

(12–2)

In this instance there will be an increased investment in net operating working capital due to the increase in the level of accounts receivable. There is no increase expected in inventories or accounts payable.

STEP 3: Solve

a. Operating flows are calculated in line 12 of the spreadsheet found below:

Free Cash Flow

� Net Operating Income (Profit)

� Taxes � Depreciation

Expense �

Increase in Capital Expenditures

(CAPEX) �

Increase in Net Operating Working

Capital (NOWC)

b. Only one capital expenditure is made and it equals $400,000 in year 0. Since there is no expected salvage value none is added back in year 5.

c. An additional $125,000 investment in net operating working capital must be made in year 0 and this invest- ment is recovered in year 5 when the project is shut down.

(SOLUTION ST.2 CONTINUED >> ON NEXT PAGE)

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

Project Revenues $500,000 $500,000 $500,000 $500,000 $500,000 � Cost of Goods Sold (70% of revenues) (350,000) (350,000) (350,000) (350,000) (350,000) � Gross Profit $150,000 $150,000 $150,000 $150,000 $150,000 � Cash Operating Expenses ($10,000 per year) (10,000) (10,000) (10,000) (10,000) (10,000) � Depreciation ($400,000 / 5 years ) (80,000) (80,000) (80,000) (80,000) (80,000) � Net Operating Income $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ 60,000 � Taxes (Tax rate is 30%) (18,000) (18,000) (18,000) (18,000) (18,000) � Net Operating Profit after Taxes (NOPAT) $ 42,000 $ 42,000 $ 42,000 $ 42,000 $42,000 � Depreciation 80,000 80,000 80,000 80,000 80,000 � Operating Cash Flow $122,000 $122,000 $122,000 $122,000 $122,000

less: Increase in Capital Expenditure (CAPEX) $(400,000) — — — — — less: Increase in operating working capital (125,000) — — — — 125,000

Free Cash Flow (525,000) $122,000 $122,000 $122,000 $122,000 $247,000

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402 PART 3 | Capital Budgeting

Problem ST.3 (Replacement Project Cash Flows) The Marlin Tribune Herald purchased a used printing press five years ago that it hoped would serve its printing needs for 10 years. Although the press had performed as expected for the last five years, newer and more highly automated color printers have now become available. The existing press has a book value of $100,000 and is being depreciated at $20,000 per year toward a zero salvage value in 5 years. However, today the press can be sold for only $50,000; the $50,000 loss would be used to off- set taxes. The new press being considered costs $300,000 to purchase, plus an additional $10,000 in shipping and installation costs. Moreover, the new press has an expected salvage value of $100,000 in 5 years.

The appeal of the new press is that it is completely automated (requires two fewer employees whose combined salaries and fringe benefits total $110,000 per year) and also does color printing. The ability to sell color ads is expected to increase the paper’s ad revenues from $150,000 per year to $200,000. However, the added color printing feature comes at the cost of higher maintenance and ink costs of $100,000 compared to only $80,000 for the older press.

The Tribune Herald faces a 30% marginal tax rate and uses a 15% discount rate to evaluate equip- ment purchases for the newspaper.

a. What would be the initial cash outflow associated with replacing the older printer with the new one? b. What would be the annual free cash flows for years 1 through 5 if the new printer were purchased? c. Should the newspaper replace the older printer?

STEP 4: Analyze

The new tester will cost the firm $400,000 to purchase and an additional investment of $125,000 in accounts receivable. In return for making this investment the project is expected to earn operating cash flow of $122,000 per year for each of the next five years plus the return of the investment in accounts receivable in year five for a total free cash flow in that year of $247,000.

>> END Solution ST.2

Solution ST.3

STEP 1: Picture the problem

An older printing press with 5 years more of life is being replaced with a new printing press with an expected life of 5 years. To calculate the change in cash flows we will take the cash flows from the new printing press and subtract out the cash flows from the old printing press:

CF(New)0 CF(New)1 CF(New)2

Minus

Equals: Difference (New – Old)

Where the cash flows to be used in analyzing the replacement decision ( �CFt ) equal the difference in cash flows of the new and old asset

CF(New)3 CF(New)4 CF(New)5

0 1 2 3 4 5Time Period

Cash Flow

CF(Old)0 CF(Old)1 CF(Old)2 CF(Old)3 CF(Old)4 CF(Old)5

�CF0 �CF1 �CF2 �CF3 �CF4 �CF5

Years

k = 15%

STEP 2: Decide on a solution strategy

This investment involves the replacement of an existing printer with a newer model. Consequently, what we are interested in doing is analyzing the incremental cash flows from the new printer net of those with the older printer. As we know from Equation (12–5), this means that all the cash flows will represent the difference between those realized with and without the new printer,

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CHAPTER 12 | Analyzing Project Cash Flows 403

(12–5)

STEP 3: Solve

a. The incremental cash flows from purchasing the new printer in year 0 are the following:

Replacement Cash Flows (¢CF)Year t

� ° Cash Flow forthe New Asset CF(New)Year t

¢ � °Cash Flow forthe Old Asset CF(Old)Year t

¢

b. The annual free cash flows for years 1 through 5 are calculated as follows:

c. The NPV for the project is calculated as follows:

or

STEP 4: Analyze

Thus, the replacement of the older printer with the new one appears to be a good idea. The present value of the additional cash inflows exceeds the cost of making the exchange by over $155,000.

>> END Solution ST.3

NPV = ($245,000) + $400,353 = $155,353

NPV = ($245,000) + $104,600

(1 + .15)1 +

$104,600

(1 + .15)2 +

$104,600

(1 + .15)3 +

$104,600

(1 + .15)4 +

$204,600

(1 + .15)5

Analysis of the Annual Cash Flows Years 1–4 Year 5

Cash inflows Increase in operating income $ 50,000 Reduced salaries $100,000 Reduced fringe benefits 10,000

$160,000 $160,000 Cash outflows

Increased maintenance $ (20,000) Increased depreciation (22,000)

(42,000) $(42,000) Net Operating Income $118,000 $118,000 less: Taxes (35,400) (35,400) Net operating profit after taxes (NOPAT) $ 82,600 $ 82,600 plus: Depreciation 22,000 22,000 Operating cash flow $104,600 $104,600 less: Increase in net operating working capital — — less: Increase in CAPEX — 100,000 Free Cash Flows $104,600 $204,600

Analysis of the Initial Outlay Year 0

New Printer Purchase price $(300,000) Shipping cost (5,000) Installation cost (5,000) Total installed cost of purchasing the new press $(310,000)

Old Printer Sale price $ 50,000 less: Tax savings � [($ 100,000 � 50,000) � .30] 15,000 After-tax proceeds from the sale of the old press $ 65,000

Operating Working Capital — Initial Cash Flow (245,000)

Note: Tax Savings are added back.

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404 PART 3 | Capital Budgeting

Without the Project With the Project

Accounts receivable $ 55,000 $ 89,000 Inventory 100,000 180,000 Accounts payable 70,000 120,000

Without the Project With the Project

Accounts receivable $33,000 $23,000 Inventory 25,000 40,000 Accounts payable 50,000 86,000

Without the Project With the Project

Accounts receivable $45,000 $63,000 Inventory 65,000 80,000 Accounts payable 70,000 94,000

Study Problems Forecasting Project Cash Flows 12–1. (Determining relevant cash flows) Captain’s Cereal is considering introducing a

variation of its current breakfast cereal, Crunch Stuff. This new cereal will be similar to the old, with the exception that it will contain sugar-coated marshmallows shaped in the form of stars. The new cereal will be called Crunch Stuff n’ Stars. It is estimated that the sales for the new cereal will be $25 million; however, 20% of those sales will draw from former Crunch Stuff customers who have switched to Crunch Stuff n’ Stars and who would not have switched if the new product had not been introduced. What is the relevant sales level to consider when deciding whether or not to introduce Crunch Stuff n’ Stars?

12–2. (Determining relevant cash flows) Fruity Stones is considering introducing a variation of its current breakfast cereal, Jolt ’n Stones. This new cereal will be similar to the old with the exception that it will contain more sugar in the form of small pebbles. The new cereal will be called Stones ’n Stuff. It is estimated that the sales for the new cereal will be $100 million; however, 40% of those sales will be from former Fruity Stones customers who have switched to Stones ’n Stuff. These former customers will be lost regardless of whether the new product is offered since this is the amount of sales the firm expects to lose to a competitor product that is going to be introduced at about the same time. What is the relevant sales level to consider when deciding whether or not to introduce Stones ’n Stuff?

12–3. (Related to Checkpoint 12.1 on page 385) (Calculating changes in net operating working capital) Tetious Dimensions is introducing a new product and has an expected change in net operating income of $775,000. Tetious Dimensions has a 34% marginal tax rate. This project will also produce $200,000 of depreciation per year. In addition, this project will cause the following changes:

What is the project’s free cash flow?

12–4. (Calculating changes in net operating working capital) Duncan Motors is introducing a new product and has an expected change in net operating income of $300,000. Duncan Motors has a 34% marginal tax rate. This project will also produce $50,000 of depreciation per year. In addition, this project will cause the following changes:

What is the project’s free cash flow?

12–5. (Calculating changes in net operating working capital) Racin’ Scooters is introducing a new product and has an expected change in net operating income of $475,000. Racin’ Scooters has a 34% marginal tax rate. This project will also produce $100,000 of depreciation per year. In addition, this project will cause the following changes:

What is the project’s free cash flow?

Go to www.myfinancelab.com to complete these exercises online and

get instant feedback.

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CHAPTER 12 | Analyzing Project Cash Flows 405

Without the Project With the Project

Accounts receivable $55,000 $ 63,000 Inventory 55,000 70,000 Accounts payable 90,000 106,000

12–6. (Calculating changes in net operating working capital) Visible Fences is introducing a new product and has an expected change in net operating income of $900,000. Visible Fences has a 34% marginal tax rate. This project will also produce $300,000 of depreciation per year. In addition, this project will cause the following changes:

What is the project’s free cash flow?

12–7. (Related to Checkpoint 12.1 on page 385) (Calculating operating cash flows) Assume that a new project will annually generate revenues of $2,000,000 and cash expenses (including both fixed and variable costs) of $800,000, while increasing depreciation by $200,000 per year. In addition, the firm’s tax rate is 34%. Calculate the operating cash flows for the new project.

12–8. (Calculating operating cash flows) The Heritage Farm Implement Company is considering an investment that is expected to generate revenues of $3 million per year. The project will also involve annual cash expenses (including both fixed and variable costs) of $900,000, while increasing depreciation by $400,000 per year. If the firm’s tax rate is 34% what is the project’s estimated net operating profit after taxes? What is the project’s annual operating cash flows?

12–9. (Related to Checkpoint 12.1 on page 385) (Calculating project cash flows and NPV) You are considering expanding your product line that currently consists of skateboards to include gas-powered skateboards, and you feel you can sell 10,000 of these per year for 10 years (after which time this project is expected to shut down with solar-powered skateboards taking over). The gas skateboards would sell for $100 each with variable costs of $40 for each one produced, while annual fixed costs associated with production would be $160,000. In addition, there would be a $1,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over 10 years. The project will also require a one-time initial investment of $50,000 in net working capital associated with inventory, and this working capital investment will be recovered when the project is shut down. Finally, assume that the firm’s marginal tax rate is 34%.

a. What is the initial cash outlay associated with this project? b. What are the annual net cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. What is the project’s NPV given a 10% required rate of return?

12–10. (Calculating project cash flows and NPV) You are considering new elliptical trainers and you feel you can sell 5,000 of these per year for 5 years (after which time this project is expected to shut down when it is learned that being fit is unhealthy). The elliptical trainers would sell for $1,000 each with variable costs of $500 for each one produced, while annual fixed costs associated with production would be $1,000,000. In addition, there would be a $5,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over 5 years. This project will also require a one-time initial investment of $1,000,000 in net working capital associated with inventory, and it is assumed that this working capital investment will be recovered when the project is shut down. Finally, assume that the firm’s tax rate is 34%.

a. What is the initial outlay associated with this project? b. What are the annual net cash flows associated with this project for years 1 through 4? c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 5

plus any additional cash flows associated with termination of the project)? d. What is the project’s NPV given a 10% required rate of return?

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406 PART 3 | Capital Budgeting

12–11. (Calculating project cash flows and NPV) The Guo Chemical Corporation is considering the purchase of a chemical analysis machine. The purchase of this machine will result in an increase in earnings before interest and taxes of $70,000 per year. The machine has a purchase price of $250,000, and it would cost an additional $10,000 after tax to install this machine correctly. In addition, to operate this machine properly, inventory must be increased by $15,000. This machine has an expected life of 10 years, after which time it will have no salvage value. Also, assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34% marginal tax rate, and a required rate of return of 15%.

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flow associated with termination of the project)? d. Should this machine be purchased?

12–12. (Calculating project cash flows and NPV) El Gato’s Motors is considering the purchase of a new production machine for $1 million. The purchase of this machine will result in an increase in earnings before interest and taxes of $400,000 per year. It would cost $50,000 after tax to install this machine; in addition, to operate this machine properly, workers would have to go through a brief training session that would cost $100,000 after tax. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $150,000. This machine has an expected life of 10 years, after which time it will have no salvage value. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34% marginal tax rate, and a required rate of return of 12%.

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased?

12–13. (Calculating project cash flows and NPV) Weir’s Trucking, Inc. is considering the purchase of a new production machine for $100,000. The purchase of this new machine will result in an increase in earnings before interest and taxes of $25,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5,000 after tax. In addition, it would cost $5,000 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $25,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $80,000 at 10 percent interest from its local bank, resulting in additional interest payments of $8,000 per year. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34% marginal tax rate, and a required rate of return of 12%.

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased?

12–14. (Calculating project cash flows and NPV) The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although the machine being considered will result in an increase in earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and it would cost an additional $5,000 after tax to correctly install this machine. In addition, to properly operate this machine, inventory must be increased by $5,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34% marginal tax rate, and a required rate of return of 15%.

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CHAPTER 12 | Analyzing Project Cash Flows 407

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased?

12–15. (Calculating project cash flows and NPV) Raymobile Motors is considering the purchase of a new production machine for $500,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $150,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $25,000 after tax. In addition, it would cost $5,000 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $30,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight- line depreciation, that this machine is being depreciated down to zero, a 34% marginal tax rate, and a required rate of return of 15%.

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased?

12–16. (Calculating project cash flows and NPV) Garcia’s Truckin’, Inc. is considering the purchase of a new production machine for $200,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $50,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5,000 after tax. In addition, it would cost $5,000 after tax to install this machine correctly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $20,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $100,000 at 8 percent interest from its local bank, resulting in additional interest payments of $8,000 per year. Assume simplified straight-line depreciation, that this machine is being depreciated down to zero, a 34% tax rate, and a required rate of return of 10%.

a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1

through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in

year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased?

12–17. (Related to Checkpoint 12.1 on page 385) (Comprehensive problem—calculating project cash flows, NPV, PI, and IRR) Traid Winds Corporation, a firm in the 34% marginal tax bracket with a 15% required rate of return or discount rate, is considering a new project. This project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad project, it will be terminated. Given the following information, determine the net cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.

Cost of new plant and equipment: $14,800,000

Shipping and installation costs: $200,000

Unit sales:

Year Units Sold

1 70,000 2 120,000 3 120,000 4 80,000 5 70,000

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408 PART 3 | Capital Budgeting

Year Units Sold

1 70,000 2 100,000 3 140,000 4 70,000 5 60,000

Year Units Sold

1 80,000 2 100,000 3 120,000 4 70,000 5 70,000

Sales price per unit: $300/unit in years 1–4, $250/unit in year 5

Variable cost per unit: $140/unit

Annual fixed costs: $700,000

Working capital requirements: There will be an initial working capital requirement of $200,000 to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method: Use the simplified straight-line method over 5 years. It is assumed that the plant and equipment will have no salvage value after 5 years.

12–18. (Calculating cash flows—comprehensive problem) The Kumar Corporation, a firm in the 34% marginal tax bracket with a 15% required rate of return or discount rate, is considering a new project. This project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad product, it will be terminated. Given the following information, determine the net cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.

Cost of new plant and equipment: $ 9,900,000

Shipping and installation costs: $ 100,000

Unit sales:

Sales price per unit: $280/unit in years 1–4, $180/unit in year 5

Variable cost per unit: $140/unit

Annual fixed costs: $300,000

Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will equal 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method: Use the simplified straight-line method over 5 years. It is assumed that the plant and equipment will have no salvage value after 5 years.

12–19. (Calculating cash flows—comprehensive problem) The Shome Corporation, a firm in the 34% marginal tax bracket with a 15 percent required rate of return or discount rate, is considering a new project. This project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad project, it will be terminated. Given the following information, determine the net cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.

Cost of new plant and equipment: $6,900,000

Shipping and installation costs: $100,000

Unit sales:

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CHAPTER 12 | Analyzing Project Cash Flows 409

Year Units Sold

1 1,000,000 2 1,800,000 3 1,800,000 4 1,200,000 5 700,000

Sales price per unit: $250/unit in years 1–4, $200/unit in year 5

Variable cost per unit: $130/unit

Annual fixed costs: $300,000

Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method: Use the simplified straight-line method over 5 years. It is assumed that the plant and equipment will have no salvage value after 5 years.

12–20. (Calculating cash flows—comprehensive problem) The C Corporation, a firm in the 34% marginal tax bracket with a 15% required rate of return or discount rate, is considering a new project. This project involves the introduction of a new product. This project is expected to last 5 years and then, because this is somewhat of a fad product, it will be terminated. Given the following information, determine the net cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria.

Cost of new plant and equipment: $198,000,000

Shipping and installation costs: $2,000,000

Unit sales:

Sales price per unit: $800/unit in years 1–4, $600/unit in year 5

Variable cost per unit: $400/unit

Annual fixed costs: $10,000,000

Working capital requirements: There will be an initial working capital requirement of $2,000,000 just to get production started. For each year, the total investment in net working capital will equal 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method: Use the simplified straight-line method over 5 years. It is assumed that the plant and equipment will have no salvage value after 5 years.

Inflation and Capital Budgeting 12–21. (Inflation and project cash flows) If the price of a gallon of regular gasoline is $2.49

and the anticipated rate of inflation in energy prices is such that this cost of gasoline is expected to rise by 5% per year, what is the expected price per gallon in 10 years?

12–22. (Inflation and project cash flows) On June 1, 2003 the average price of a gallon of gasoline in San Francisco, CA was $1.80. Just three years later the price of that same gallon of gas was $3.20. What was the rate of inflation in the price of a gallon of gas over the period?

12–23. (Inflation and project cash flows) Carlyle Chemicals is evaluating a new chemical compound used in the manufacture of a wide range of consumer products. The firm is concerned that inflation in the cost of raw materials will have an adverse effect on the project cash flows. Specifically, the firm expects the cost per unit (which is currently $0.80) will rise at a 10% rate over the next three years. The per unit selling price is currently $1.00 and this price is expected to rise at a meager 2% rate over the next three

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410 PART 3 | Capital Budgeting

years. If Carlyle expects to sell 5, 7, and 9 million units for the next three years, respectively, what is your estimate of the gross profits to the firm? Based on these estimates what recommendation would you offer to the firm’s management with regard to this product?

12–24. (Inflation and project cash flows) After reporting your findings to the company management (problem 12–23), the company CFO suggested that they could purchase raw materials in advance for future delivery. This would involve paying for the raw materials today and taking delivery as the materials are needed. Through the advance purchase plan the cost of raw materials would cost $0.90 per unit. How does this new plan affect your cash flow estimates? How should the advance payment for the raw materials enter into your analysis of project cash flows?

Replacement Project Cash Flows 12–25. (Related to Checkpoint 12.2 on page 391) (Replacement project cash flows) Madrano’s

Wholesale Fruit Company located in McAllen, TX is considering the purchase of a new fleet of tractors to be used in the delivery of fruits and vegetables grown in the Rio Grand Valley of Texas. If it goes through with the purchase, it will spend $400,000 on eight rigs. The new trucks will be kept for 5 years, during which time they will be depreciated toward a $40,000 salvage value using straight-line depreciation. The rigs are expected to have a market value in 5 years equal to their salvage value. The new tractors will be used to replace the company’s older fleet of eight trucks which are fully depreciated but can be sold for an estimated $20,000 (since the tractors have a current book value of zero, the selling price is fully taxable at the firm’s 30% tax rate). The existing tractor fleet is expected to be useable for 5 more years after which time they will have no salvage value at all. The existing fleet of tractors uses $200,000 per year in diesel fuel, whereas the new, more efficient fleet will use only $150,000. In addition, the new fleet will be covered under warranty, so the maintenance costs per year are expected to be only $12,000 compared to $35,000 for the existing fleet.

a. What are the differential operating cash flow savings per year during years 1 through 5 for the new fleet?

b. What is the initial cash outlay required to replace the existing fleet with the newer tractors?

c. Sketch a timeline for the replacement project cash flows for years 0 through 5. d. If Madrano requires a 15% discount rate for new investments, should the fleet be

replaced?

12–26. (Replacement project cash flows) The Minot Kit Aircraft Company of Minot, ND uses a plasma cutter to fabricate metal aircraft parts for its plane kits. The company currently is using a cutter that it purchased used 4 years ago which has an $80,000 book value and is being depreciated $20,000 per year over the next 4 years. If the old cutter were to be sold today, the company estimates that it would bring in an amount equal to the book value of the equipment.

The company is considering the purchase of a new automated plasma cutter that would cost $400,000 to install and which would be depreciated over the next 4 years toward a $40,000 salvage value using straight-line depreciation. The primary advantage of the new cutter is the fact that it is fully automated and can be run by one operator rather than the three employees that are currently required. The labor savings would be $100,000 per year. The firm faces a marginal tax rate of 30%.

a. What are the differential operating cash flow savings per year during years 1 through 4 for the new plasma cutter?

b. What is the initial cash outlay required to replace the existing plasma cutter with the newer model?

c. Sketch a timeline for the replacement project cash flows for years 0 through 5. d. If the company requires a 15% discount rate for new investments, should the fleet be

replaced?

12–27. (Replacement project cash flows) The Louisiana Land and Cattle Company (LL&CC) is one of the largest cattle buyers in the country. They have buyers at all the major cattle auctions throughout the southeastern part of the U.S. who buy on the company’s behalf and then have the cattle shipped to Sulpher Springs, Louisiana, where they are sorted by

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CHAPTER 12 | Analyzing Project Cash Flows 411

weight and type before shipping off to feed lots in the Midwest. The company has been considering the replacement of their tractor-trailer rigs with a newer, more fuel- efficient fleet for some time, and a local Peterbilt dealer has approached the company with a proposal. The proposal would call for the purchase of 10 new rigs at a cost of $100,000 each. The rigs would be depreciated toward a salvage value of $40,000 over a period of 5 years. If LL&CC purchases the rigs, it will sell its existing fleet of 10 rigs to the Peterbilt dealer for their current book value of $25,000 per unit. The existing fleet will be fully depreciated in 1 more year but is expected to be serviceable for 5 more years, at which time they would be worth only $5,000 per unit as scrap.

The new fleet of trucks is much more fuel-efficient and will require only $200,000 in fuel costs compared to $300,000 for the existing fleet. In addition, the new fleet of trucks will require minimal maintenance over the next 5 years, equal to an estimated $150,000 compared to almost $400,000 per year that is currently being spent to keep the older fleet running. The marginal tax rate is 30%.

a. What are the differential operating cash flow savings per year during years 1 through 5 for the new fleet? The firm pays taxes at a 30% marginal tax rate.

b. What is the initial cash outlay required to replace the existing fleet with new rigs? c. Sketch a timeline for the replacement project cash flows for years 0 through 5. d. If LL&CC requires a 15% discount rate for new investments, should the fleet be

replaced?

Mini-Cases Danforth & Donnalley Laundry Products Company Determining Relevant Cash Flows

At 3:00 p.m. on April 14, 2010, James Danforth, president of Danforth & Donnalley (D&D) Laundry Products Company, called to order a meeting of the financial directors. The purpose of the meeting was to make a capital-budgeting decision with re- spect to the introduction and production of a new product, a liq- uid detergent called Blast.

D&D was formed in 1993 with the merger of Danforth Chemical Company (producer of Lift-Off detergent, the leading laundry detergent on the West Coast) and Donnalley Home Prod- ucts Company (maker of Wave detergent, a major Midwestern laundry product). As a result of the merger, D&D was producing and marketing two major product lines. Although these products were in direct competition, they were not without product differ- entiation: Lift-Off was a low-suds, concentrated powder, and Wave was a more traditional powder detergent. Each line brought with it considerable brand loyalty; and, by 2010, sales from the two detergent lines had increased ten-fold from 1993 levels, with both products now being sold nationally.

In the face of increased competition and technological inno- vation, D&D spent large amounts of time and money over the past 4 years researching and developing a new, highly concen- trated liquid laundry detergent. D&D’s new detergent, which they call Blast, had many obvious advantages over the conventional powdered products. The company felt that Blast offered the con- sumer benefits in three major areas. Blast was so highly concen- trated that only 2 ounces were needed to do an average load of laundry, as compared with 8 to 12 ounces of powdered detergent. Moreover, being a liquid, it was possible to pour Blast directly on stains and hard-to-wash spots, eliminating the need for a pre-soak and giving it cleaning abilities that powders could not possibly

match. And, finally, it would be packaged in a lightweight, un- breakable plastic bottle with a sure-grip handle, making it much easier to use and more convenient to store than the bulky boxes of powdered detergents with which it would compete.

The meeting participants included James Danforth, presi- dent of D&D; Jim Donnalley, director of the board; Guy Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve Gasper, a newcomer to the D&D financial staff who was invited by McDonald to sit in on the meeting. Dan- forth called the meeting to order, gave a brief statement of its purpose, and immediately gave the floor to Guy Rainey.

Rainey opened with a presentation of the cost and cash flow analysis for the new product. To keep things clear, he passed out copies of the projected cash flows to those present (see Exhibits 1 and 2). In support of this information, he provided some insights

Exhibit 1: D&D Laundry Products Company Forecast of An- nual Cash Flows from the Blast Product (Including cash flows resulting from sales diverted from the existing product lines.)

Year Cash flows Year Cash flows

1 $280,000 9 $350,000 2 280,000 10 350,000 3 280,000 11 250,000 4 280,000 12 250,000 5 280,000 13 250,000 6 350,000 14 250,000 7 350,000 15 250,000 8 350,000I

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412 PART 3 | Capital Budgeting

Exhibit 2 D&D Laundry Products Company Forecast of Annual Cash Flows from the Blast Product (Excluding cash flows result- ing from sales diverted from the existing product lines.)

Year Cash flows Year Cash flows

1 $250,000 9 $315,000 2 250,000 10 315,000 3 250,000 11 225,000 4 250,000 12 225,000 5 250,000 13 225,000 6 315,000 14 225,000 7 315,000 15 225,000 8 315,000

as to how these calculations were determined. Rainey proposed that the initial cost for Blast include $500,000 for the test market- ing, which was conducted in the Detroit area and completed in June of the previous year, and $2 million for new specialized equipment and packaging facilities. The estimated life for the fa- cilities was 15 years, after which they would have no salvage value. This 15-year estimated life assumption coincides with company policy set by Donnalley not to consider cash flows oc- curring more than 15 years into the future, as estimates that far ahead “tend to become little more than blind guesses.”

Rainey cautioned against taking the annual cash flows (as shown in Exhibit 1) at face value because portions of these cash flows actually would be a result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the estimated annual cash flows that had been adjusted to include only those cash flows incremental to the company as a whole (as shown in Exhibit 2).

At this point, discussion opened between Donnalley and McDonald, and it was concluded that the opportunity cost on funds was 10%. Gasper then questioned the fact that no costs were included in the proposed cash budget for plant facilities that would be needed to produce the new product.

Rainey replied that, at the present time, Lift-Off’s produc- tion facilities were being used at only 55% of capacity, and be- cause these facilities were suitable for use in the production of Blast, no new plant facilities would need to be acquired for the production of the new product line. It was estimated that full pro- duction of Blast would only require 10% of the plant capacity.

McDonald then asked if there had been any consideration of increased working capital needs to operate the investment proj- ect. Rainey answered that there had, and that this project would require $200,000 of additional working capital; however, as this money would never leave the firm and would always be in liquid form, it was not considered an outflow and hence not included in the calculations.

Donnalley argued that this project should be charged some- thing for its use of current excess plant facilities. His reasoning was that if another firm had space like this and was willing to rent it out, it could charge somewhere in the neighborhood of $2 mil- lion. However, he went on to acknowledge that D&D had a strict policy that prohibits renting or leasing any of its production facil- ities to any party from outside the firm. If they didn’t charge for facilities, he concluded, the firm might end up accepting projects that under normal circumstances would be rejected.

From here the discussion continued, centering on the ques- tion of what to do about the lost contribution from other projects, the test marketing costs, and the working capital.

Questions

1. If you were put in the place of Steve Gasper, would you ar- gue for the cost from market testing to be included in a cash outflow?

2. What would your opinion be as to how to deal with the ques- tion of working capital?

3. Would you suggest that the product be charged for the use of excess production facilities and building space?

4. Would you suggest that the cash flows resulting from ero- sion of sales from current laundry detergent products be in- cluded as a cash inflow? If there was a chance of competitors introducing a similar product if you did not in- troduce Blast, would this affect your answer?

5. If debt were used to finance this project, should the inter- est payments associated with this new debt be considered cash flows?

6. What are the NPV, IRR, and PI of this project, both including cash flows resulting from sales diverted from the existing product lines (Exhibit 1) and excluding cash flows resulting from sales diverted from the existing product lines (Exhibit 2)? Under the assumption that there is a good chance that compe- tition will introduce a similar product if you don’t, would you accept or reject this project?

Caledonia Products Calculating Free Cash Flow and Project Valuation

It’s been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about

unleashing you without supervision. Your next assignment in- volves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of sev-

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CHAPTER 12 | Analyzing Project Cash Flows 413

Year Units Sold

1 70,000 2 120,000 3 140,000 4 80,000 5 60,000

Questions

1. Why should Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?

2. What are the incremental cash flows for the project in years 1 through 5 and how do these cash flows differ from ac- counting profits or earnings?

3. What is the project’s initial outlay?

4. Sketch out a cash flow diagram for this project.

5. What is the project’s net present value?

6. What is its internal rate of return?

7. Should the project be accepted? Why or why not?

eral mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recom- mendation, but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your as- signment follows:

To: The Assistant Financial Analyst

From: Mr. V. Morrison, CEO, Caledonia Products

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of a new product. Currently we are in the 34% tax bracket with a 15% discount rate. This project is expected to last five years and then, because this is somewhat of a fad project, it will be terminated. The following information describes the new project:

Cost of new plant and equipment: $ 7,900,000

Shipping and installation costs: $ 100,000

Unit sales:

Sales price per unit: $300/unit in years 1–4 and $260/unit in year 5.

Variable cost per unit: $180/unit

Annual fixed costs: $200,000 per year

Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

Depreciation method: Straight-line over 5 years assuming the plant and equipment have no salvage value after 5 years.

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414 PART 3 | Capital Budgeting

Table 12A.1 Percentages for Property Classes

Recovery Year 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year

1 33.3% 20.0% 14.3% 10.0% 5.0% 3.8%

2 44.5 32.0 24.5 18.0 9.5 7.2

3 14.8 19.2 17.5 14.4 8.6 6.7

4 7.4 11.5 12.5 11.5 7.7 6.2

5 11.5 8.9 9.2 6.9 5.7

6 5.8 8.9 7.4 6.2 5.3

7 8.9 6.6 5.9 4.9

8 4.5 6.6 5.9 4.5

9 6.5 5.9 4.5

10 6.5 5.9 4.5

11 3.3 5.9 4.5

12 5.9 4.5

13 5.9 4.5

14 5.9 4.5

15 5.9 4.5

16 3.0 4.5

17 4.5

18 4.5

19 4.5

20 4.5

21 1.7

Total 100.0 100.0 100.0 100.0 100.0 100.0

Appendix: The Modified Accelerated Cost Recovery System

To simplify our computations we have used straight-line depreciation throughout this chapter. However, firms use accelerated depreciation for calculating their taxable income. In fact, since 1987 the modified accelerated cost recovery system (MACRS) has been used. Under the MACRS the depreciation period is based on the asset depreciation range (ADR) system, which groups assets into classes by asset type and industry, and then determines the actual number of years to be used in depreciating the asset. In addition, the MACRS restricts the amount of depre- ciation that may be taken in the year an asset is acquired or sold. These limitations have been called averaging conventions. The two primary conventions, or limitations, may be stated as follows:

1. Half-Year Convention: Personal property, such as machinery, is treated as having been placed in service or disposed of at the midpoint of the taxable year. Thus, a half-year of de- preciation generally is allowed for the taxable year in which property is placed in service and in the final taxable year. As a result, a 3-year property class asset has a depreciation calcula-

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Financial Management: Principles and Applications, Eleventh Edition, by Sheridan Titman, John D. Martin, and Arthur J. Keown. Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

CHAPTER 12 | Analyzing Project Cash Flows 415

Table 12A.2 MACRS Demonstrated

Year Depreciation Percentage

Annual Depreciation

1 20.0% $ 2,400

2 32.0% 3,840

3 19.2% 2,304

4 11.5% 1,380

5 11.5% 1,380

6 5.8% 696

100.0% $12,000

tion that spans 4 years, with only a half a year’s depreciation in the first and fourth years. In effect, it is assumed that the asset is in service for 6 months during both the first and last year.

2. Mid-Month Convention: Real property, such as buildings, is treated as being placed in ser- vice or disposed of in the middle of the month. Accordingly, a half-month of depreciation is allowed for the month the property is placed in service and also for the final month of service.

Using the MACRS results in a different percentage of the asset being depreciated each year; these percentages are shown in Table 12A.1.

To demonstrate the use of the MACRS, assume that a piece of equipment costs $12,000 and has been assigned to a 5-year class. Using the percentages in Table 12A.1 for a 5-year class as- set, the depreciation deductions would be calculated as shown in Table 12A.2.

Note that the averaging convention that allows for the half-year of depreciation in the first year results and a half-year of depreciation beyond the fifth year, or in year 6.

WHAT DOES ALL THIS MEAN?

Depreciation, while an expense, is not a cash flow item. However, depreciation expense lowers the firm’s taxable income which in turn reduces the firm’s tax liability and increases its cash flow. Throughout our calculations in Chapter 12 we used a simplified straight-line depreciation method to keep the calculations simple, but in reality you would use the MACRS method. The advantage of accelerated depreciation is that you end up with more depreciation expense (a non-cash item) in the earlier years and less depreciation expense in the latter years. As a result, you have less tax- able profits in the early years and more taxable profits in the latter years. This reduces taxes in the earlier years when the present values are greatest, while increasing taxes in the latter years when present value are smaller. In effect, the MACRS allows you to postpone paying taxes. Regardless of whether you use straight-line or accelerated depreciation (MACRS), the total depreciation is the same, it is just the timing of when the deprecation is expensed that changes.

Most corporations prepare two sets of books, one for calculating taxes for the IRS in which they use the MACRS, and one for their stockholders in which they use straight-line depreciation. For capital-budgeting purposes, only the set of books used to calculate taxes are relevant.

12A–1.(Depreciation) Compute the annual depreciation for an asset that costs $250,000 and is in the 5-year property class. Use the MACRS in your calculation.

12A–2.(Depreciation) The Mason Falls Mfg. Company just acquired a depreciable asset this year, costing $500,000. Furthermore, the asset falls into the 7-year property class using the MACRS.

a. Using the MACRS, compute the annual depreciation. b. What assumption is being made about when you bought the asset within the year?

Study Problems

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Financial Management: Principles and Applications, Eleventh Edition, by Sheridan Titman, John D. Martin, and Arthur J. Keown. Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.