PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 10 pps

But in the case of for-profit companies, wealth ismonetary.A project creates wealth if it generates cash f lows over time that areworth more in present-value terms than the initial setup

A nonprofit museum is toying with the idea of installing an education center forchildren Newlyweds dream of buying a house A retailer considers building aWeb site and selling on the Internet.

What do these projects have in common? All of them entail a ment of capital and managerial effort that may or may not be justified by laterperformance A common set of tools can be applied to assess these seeminglyvery different propositions The financial analysis used to assess such projects

commit-is known as “capital budgeting.” How should a limited supply of capital andmanagerial talent be allocated among an unlimited number of possible projectsand corporate initiatives?

THE OBJECTIVE: MAXIMIZE WEALTH

Capital budgeting decisions cut to the heart of the most fundamental tions in business What is the purpose of the firm? Is it to create wealth for in-vestors? To serve the needs of customers? To provide jobs for employees? Tobetter the community? These questions are fodder for endless debate Ulti-mately, however, project decisions have to be made, and so we must adopt a

ques-decision rule The perspective of financial analysis is that capital investmentbelongs to the investors The goal of the firm is to maximize investors’ wealth.Other factors are important and should be considered, but this is the primaryobjective In the case of nonprofit organizations, wealth and return on invest-ment need not be measured in dollars and cents but rather can be measured interms of benefits to society But in the case of for-profit companies, wealth ismonetary.

A project creates wealth if it generates cash f lows over time that areworth more in present-value terms than the initial setup cost For example,suppose a brewery costs $10 million to build, but once built it generates astream of cash f lows that is worth $11 million Building the brewery would cre-ate $1 million of new wealth If there were no other proposed projects thatwould create more wealth than this, then the beer company would be well ad-vised to build the new brewery

This example illustrates the “net present value” rule Net present value(NPV) is the difference between the setup cost of a project and the value ofthe project once it is set up If that difference is positive, then the NPV ispositive and the project creates wealth If a firm must choose from severalproposed projects, the one with the highest NPV will create the most wealth,and so it should be the one adopted For example, suppose the beer companycan either build the new brewery or, alternatively, can introduce a new prod-uct—a light beer, for example There is not enough managerial talent to over-see more than one new project, or maybe there are not enough funds to startboth Let us assume that both projects create wealth: The NPV of the newbrewery is $1 million, and the NPV of the new-product project is $500,000 If

it could, the beer company should undertake both projects; but since it has tochoose, building the new brewery would be the right option because it hasthe higher NPV

COMPUTING NPV: PROJECTING CASH FLOWS

The first step in calculating a project’s NPV is to forecast the project’s futurecash f lows Cash is king It is cash f low, not profit, that investors really careabout If a company never generates cash f low, there can be no return to in-vestors Also, profit can be manipulated by discretionary accounting treat-ments such as depreciation method or inventory valuation Regardless ofaccounting choices, however, cash f low either materializes or does not Forthese reasons, cash f low is the most important variable to investors A project’svalue derives from the cash f low it creates, and NPV is the value of the futurecash f lows net of the initial cash outf low

We can illustrate the method of forecasting cash f lows with an example.Let us continue to explore the brewery project Suppose project engineers in-form you that the construction costs for the brewery would be $8 million The

expected life of the new brewery is 10 years The brewery will be depreciated

to zero over its 10-year life using a straight-line depreciation schedule Landfor the brewery can be purchased for $1 million Additional inventory to stockthe new brewery would cost $1 million The brewery would be fully opera-tional within a year If the project is undertaken, increased sales for the beercompany would be $7 million per year Cost of goods sold for this beer would

be $2 million per year; and selling, administrative, and general expenses ated with the new brewery would be $1 million per year Perhaps advertisingwould have to increase by $500,000 per year After 10 years, the land can besold for $1 million, or it can be used for another project After 10 years the sal-vage value of the plant is expected to be $1.5 million The increase in accountsreceivable would exactly equal the increase in accounts payable, at $400,000,

associ-so these components of net working capital would offset one another and erate no net cash f low

gen-No one expects these forecasts to be perfect Paraphrasing the famouswords of baseball player Yogi Berra, making predictions is very difficult, espe-cially when they are about the future! However, when investors choose amongvarious investments, they too must make predictions As a financial analyst,you want the quality of your forecasts to be on a par with the quality of theforecasts made by investors Essentially, the job of the financial analyst is to es-timate how investors will value the project, because the value of the firm willrise if investors decide that the new project creates wealth and will fall if in-vestors conclude that the project destroys wealth If the investors have reason

to believe that sales will be $7 million per year, then that would be the correctforecast to use in the capital budgeting analysis Investors have to cope withuncertainty in their forecasts Similarly, the financial analyst conducting a cap-ital budgeting analysis must tolerate the same level of uncertainty

Note that cash f low projections require an integrated team effort acrossthe entire firm Operations and engineering personnel estimate the cost ofbuilding and operating the new plant The human resources department con-tributes the labor data Marketing people tell you what advertising budget isneeded and forecast revenue The accounting department estimates taxes, ac-counts payable, and accounts receivable and tabulates the financial data Thejob of the financial analyst is to put the pieces together and recommend thatthe project be adopted or abandoned

Initial Cash Outf low

The initial cash outf low required by the project is the sum of the constructioncost ($8 million), the land cost ($1 million), and the required new inventory ($1 million) Thus, this project requires an investment of $10 million to launch

If accounts receivable did not equal accounts payable, then the new accountsreceivable would add to the initial cash outf low, and the new accounts payablewould be subtracted These cash f lows are tabulated in Exhibit 10.1

Cash Flows in Later Years

We find cash f low in years 1 through 10 by applying the following formula:

Notice that we already have most of the data needed for the cash-f low formula,but we are missing the forecasts for income tax and windfall tax Before we canfinalize the cash f low computation, we have to forecast taxes

Income tax equals earnings before taxes (EBT) times the income tax rate.EBT is computed using the following formula:

The formula for EBT is similar to the formula for cash-f low, with a few tant exceptions The cash-f low calculation does not subtract out depreciation,whereas the EBT calculation does This is because depreciation is not a cash

impor-f low; the impor-firm never has to write a check payable to “depreciation.” tion does reduce taxable income, however, because the government allows thisdeduction for tax purposes So depreciation inf luences cash f low via its impact

Deprecia-on income tax, but it is not a cash f low itself The greater the allowable ciation is in a given year, the lower taxes will be, and the greater the resultingcash f low to the firm

depre-Earnings before Taxes= Sales − Cost of goods sold

− Selling, administrative, and general expenses

− Advertising

− Depreciation

Cash Flow= Sales − Cost of goods sold

− Selling, administrative, and general expenses

− Advertising

− Income tax+ Decrease in inventory (or − increase)+ Decrease in accounts receivable (or − increase)

− Decrease in accounts payable (or + increase)+ Salvage

− Windfall tax on salvage

EXHIBIT 10.1 Initial year cash f low for

Treatment of Net Work ing Capital

Changes in inventory, accounts receivable, and accounts payable are included

in the cash-f low calculation but not in EBT Changes in the components ofworking capital directly impact cash f low, but they are not deductible for taxpurposes When a firm buys inventory, it has essentially swapped one asset,(cash) for another asset (inventory) Though this is a negative cash f low, it is notconsidered a deductible expenditure for tax purposes

Similarly, a rise in accounts receivable means that cash that otherwisewould have been in the company coffers is now owed to the company instead.Thus, an increase in accounts receivable effectively sucks cash out of the com-pany and must be treated as a cash outf low Increasing accounts payable hasthe opposite effect

One way to gain perspective on the impact of accounts payable and counts receivable on a company’s cash f low is to think of them as adjustments

ac-to sales and costs of goods sold If a company makes a sale but the cusac-tomer hasnot yet paid, clearly there is no cash f low generated from the sale Though thesales variable will increase, the increase in accounts receivable will exactly off-set that increase in the cash f low computation Similarly, if the company incursexpenses in the manufacture of the goods sold but has not yet paid its suppliersfor the raw materials, the costs of goods sold will be offset by the increase inaccounts payable

Depreciation

According to a straight-line depreciation schedule, depreciation in each year isthe initial cost of the plant or equipment divided by the number of years overwhich the asset will be depreciated So, the $8 million plant depreciated over

10 years generates depreciation of $800,000 each year Land is generally notdepreciated Straight-line depreciation is but one acceptable method for deter-mining depreciation of plant and equipment The tax authorities often sanctionother methods and schedules

Windfall Prof it and Windfall Tax

In order to compute windfall profit and windfall tax, we must be able to track

an asset’s book value over its life Book value is the initial value minus all vious depreciation For example, the brewery initially has a book value of $8million, but that value falls $800,000 per year due to depreciation At the end

pre-of the first year, book value falls to $7.2 million By the end pre-of the second year,following another $800,000 of depreciation, the book value will be $6.4 mil-lion By the end of the tenth year, when the brewery is fully depreciated, thebook value will be zero

Windfall profit is the difference between the salvage value and bookvalue We are told the beer company will be able to sell the old brewery for

$1.5 million at the end of 10 years By then, however, the book value of thebrewery will be zero Thus, the beer company will realize a windfall profit of

$1.5 million The government will want its share of that windfall profit plying the windfall profit by the tax rate determines the windfall tax In thisparticular case, with a windfall profit of $1.5 million and a tax rate of 40%, thewindfall tax would equal $600 thousand (= $1.5 million × 40%)

Multi-Taxable Income and Income Tax

Exhibit 10.2 shows how taxable income and income tax are computed for thebrewery example Income tax equals EBT times the company’s income tax rate

In each of years 1 through 10, EBT is $2.7 million, so income tax is $1,080,000(= $2.7 million × 40%)

Interest Expense

Notice that the calculation of taxable income and income tax in Exhibit 10.2does not deduct any interest expense This is not an oversight Even if the com-pany intends to finance the new project by selling bonds or borrowing from abank, we should not deduct any anticipated interest expense from our taxableincome, and we should not subtract interest payments in the cash f low compu-tation We will take the tax shield of debt financing into account later when wecompute the company’s cost of capital The reason for omitting interest ex-pense at this stage cuts to the core of the purpose of capital budgeting We aretrying to forecast how much cash is required from investors to start this projectand then how much cash this project will generate for the investors once theproject is up and running Interest expense is a distribution of cash to one class

of investors—the debt holders If we want the bottom line of our cash-f lowcomputation to ref lect how much cash will be available to all investors, wemust not subtract out cash f low going to one class of investors before we get tothat bottom line

EXHIBIT 10.2 Income tax forecasts for brewer y

project (thousands).

Years 1–10

Cost of goods sold (2,000)

Selling, administrative, and general expenses (1,000)

Earnings before taxes $ 2,700

Income tax (40%) $(1,080)

Putting the Pieces Together to

Forecast Cash Flow

We now have all the puzzle pieces to construct our capital budgeting cash-f lowprojection These pieces and the resulting cash-f low projection are presented

in Exhibit 10.3 Cash f lows in years 1 through 9 are forecast to be $2.42 lion, and the cash f low in year 10 is expected to be $5.32 million Year 10 has agreater cash f low because of the recovery of the inventory and the assumedsale of the land and plant

mil-GUIDING PR INCIPLES FOR

FOR ECASTING CASH FLOWS

The brewery example is one illustration of how cash f lows are forecast Everyproject is different, however, and the financial analyst must be keen to identifyall sources of cash f low The following three principles can serve as a guide: (1) Focus on cash f low, not on raw accounting data, (2) use expected values,and (3) focus on the incremental

Principle No 1: Focus on Cash Flow

NPV analysis focuses on cash f lows—that is, actual cash payments and receipts

f lowing into or out of the firm Recall that accounting profit is not the samething as cash f low Accounting profit often mixes variables whose timings dif-fer A sale made today may show up in today’s profits, but since the cash re-ceipt for the sale may be deferred, the corresponding cash f low takes place

EXHIBIT 10.3 Cash f low projections for brewer y project

later Since the cash f low is deferred, the true value of that sale to the firm issomewhat diminished.

By focusing on cash f lows and when they occur, NPV ref lects the truevalue of increased revenues and costs Consequently, NPV analysis requiresthat accounting data be unraveled to reveal the underlying cash f lows That iswhy changes in net working capital must be accounted for and why deprecia-tion does not show up directly

Principle No 2: Use Expected Values

There is always going to be some uncertainty over future cash f lows Futurecosts and revenues cannot be known for sure The analyst must gather as muchinformation as possible and assemble it to construct expected values of theinput variables Although expected values are not perfect, these best guesseshave to be good enough What is the alternative? The uncertainty in forecast-ing the inputs is accounted for in the discount rate that is later used to discountthe expected cash f lows

Principle No 3: Focus on the Incremental

NPV analysis is done in terms of “incremental” cash f lows—that is, the change

in cash f low generated by the decision to undertake the project Incrementalcash f low is the difference between what the cash f low would be with the proj-ect and what the firm’s cash f low would be without the project Any sales orsavings that would have happened without the project and are unaffected

by doing the project are irrelevant and should be ignored Similarly, any coststhat would have been incurred anyway are irrelevant It is often difficult yetnonetheless important to focus on the incremental when calculating how cash

f lows are impacted by opportunity costs, sunk costs, and overhead These blesome areas will be elaborated on next

trou-Opportunity Costs

Opportunity costs are opportunities for cash inf lows that must be sacrificed inorder to undertake the project No check is written to pay for opportunitycosts, but they represent changes in the firm’s cash f lows caused by the projectand must, therefore, be treated as actual costs of doing the project For exam-ple, suppose the firm owns a parking lot, and a proposed project requires use ofthat land Is the land free since the firm already owns it? No; if the projectwere not undertaken then the company could sell or rent out the land Use ofthe company’s land is, therefore, not free There is an opportunity cost Moneythat could have been earned if the project were rejected will not be earned ifthe project is started In order to ref lect fully the incremental impact of theproposed project, the incremental cash f lows used in NPV analysis must incor-porate opportunity costs

Sunk Costs

Sunk costs are expenses that have already been paid or have already been mitted to Past research and development are examples Since sunk costs arenot incremental to the proposed project, NPV analysis must ignore them NPVanalysis is always forward-looking The past cannot be changed and so shouldnot enter into the choice of a future course of action If research was under-taken last year, the effects of that research might bear on future cash f lows,but the cost of that research is already water under the bridge and so is not rel-evant in the decision to continue the project The project decision must bemade on the basis of whether the project increases or decreases wealth fromthe present into the future The past is irrelevant

com-Overhead

The treatment of overhead often gives project managers a headache Overheadcomprises expenditures made by the firm for resources that are shared bymany projects or departments Heat and maintenance for common facilities areexamples Management resources and shared support staff are other examples.Overhead represents resources required for the firm to provide an environ-ment in which projects can be undertaken Different firms use different for-mulas for charging overhead expenses to various projects and departments Ifoverhead charges accurately ref lect the shared resources used by a project,then they should be treated as incremental costs of operating the project Ifthe project were not undertaken, those shared resources would benefit anothermoneymaking project, or perhaps the firm could possibly cut some of theshared overhead expenditures Thus, to the extent that overhead does repre-sent resources used by the project, it should be included in calculating incre-mental cash f lows If, on the other hand, overhead expense is unaffected by thedecision to undertake the new project, and no other proposed project could usethose shared resources, then overhead should be ignored in the NPV analysis.Sometimes the formulas used to calculate overhead for budgeting purposes areunrealistic and overcharge projects for their use of shared resources If the fi-nancial analyst does not correct this unrepresentative allocation of costs, someworthwhile projects might incorrectly appear undesirable

COMPUTING NPV: THE TIME VALUE OF MONEY

In deciding whether a project is worthwhile, one needs to know more than

whether it will make money One must also know when it will make money.

Time is money! Project decisions involve cash f lows spread out over several riods As we shall see, cash f lows in different periods are distinct products inthe financial marketplace—as different as apples and oranges To make deci-sions affecting many future periods, we must know how to convert the differ-ent periods’ cash f lows into a common currency

pe-The concept that future cash f lows have a lower present value and the set

of tools used to discount future cash f lows to their present values are tively known as “time value of money” (TVOM) analysis I have always thoughtthis to be a misnomer; the name should be the “money value of time.” Butthere is no use bucking the trend, so we will adopt the standard nomenclature.You probably already have an intuitive grasp of the fundamentals ofTVOM analysis, as your likely answer to the following question illustrates:Would you rather have $100 today or $100 next year? Why?

collec-The answer to this question is the essence of TVOM You no doubt swered that you would rather have the money today Money today is worthmore than money to be delivered in the future Even if there were perfect cer-tainty that the future money would be received, we prefer to have money inhand today There are many reasons for this Having money in hand allowsgreater f lexibility for planning You might choose to spend it before the futuremoney would be delivered If you choose not to spend the money during thecourse of the year, you can earn interest on it by investing it UnderstandingTVOM allows you to quantify exactly how much more early cash f lows areworth than deferred cash f lows An example will illuminate the concept.Suppose you and a friend have dinner together in a restaurant You order

an-an inexpensive san-andwich Your friend orders a large steak, a bottle of wine, an-andseveral desserts The bill arrives and your friend’s share is $100 Unfortu-nately, your friend forgot his wallet and asks to borrow the $100 from you Youagree and pay A year passes before your friend remembers to pay you back themoney “Here is the $100,” he finally says one day Such events test a friend-ship, especially if you had to carry a $100 balance on your credit card over thecourse of the year on which interest accrued at a rate of 18% Is the $100 thatyour friend is offering you now worth the same as the $100 that he borrowed ayear earlier? Actually, no; a $100 cash f low today is not worth $100 next year.The same nominal amount has different values depending on when it is paid Ifthe interest rate is 18%, a $100 cash f low today is worth $118 next year and isworth $139.24 the year after because of compound interest The present value

of $118 to be received next year is exactly $100 today Your friend should payyou $118 if he borrowed $100 from you a year earlier

The formula for converting a future value to a present value is:

where PV stands for present value, FV is future value, n is the number of ods in the future that the future cash f low is paid, and r is the appropriate in-

peri-terest rate or discount rate

Discounting Cash Flows

Suppose in the brewery example that the appropriate discount rate for ing future values to present values was 20% Recall that the brewery project

r n

=+

( )1

was forecast to generate $2.42 million of cash in year 1 The present value ofthat cash f low, as of year 0, is $2,016,670, computed as follows:

Similarly, the year-2 cash f low was forecast to be $2.42 million also The ent value of that second-year cash f low is only $1,680,560:

The longer the time over which a cash f low is discounted, the lower is its ent value Exhibit 10.4 presents the forecasted cash f lows and their discountedpresent values for the brewery project

pres-Summing the Discounted Cash Flows

to Arrive at NPV

Finally, we can calculate the NPV The NPV is the sum of all discounted cash

f lows, which in the brewery example equals $614,000 To understand preciselywhat this means, observe that the sum of the discounted cash f lows from years

1 through 10 is $10,614,000 This means that the project generates future cash

f lows that are worth $10,614,000 today The initial cost of the project is

$10,000,000 today Thus, the project is worth $10,614,000 but costs only

$10,000,000 and therefore creates $614,000 of new wealth The managers ofthe beer company would be well advised to adopt this project, because it has apositive NPV and therefore creates wealth

PV=

$ , ,

EXHIBIT 10.4 Discounted cash f lows for

brewer y project (thousands).

Year Cash Flow Discounted Cash Flow