TOPIC ASSESSMENT ANSWERS: FINANCIAL REPORTING AND ANALYSIS
LOS 19.a: Calculate the yearly cash flows of expansion and replacement capital projects and evaluate how the choice of depreciation method affects those cash flows
CFA® Program Curriculum, Volume 3, page 27 Generally, we can classify incremental cash flows for capital projects as (1) initial investment outlay, (2) operating cash flow over the project’s life, and (3) terminal-year cash flow.
Initial investment outlay is the up-front costs associated with the project. Components are price, which includes shipping and installation (FCInv) and investment in net working capital (NWCInv).
outlay = FCInv + NWCInv
The investment in NWC must be included in the capital budgeting decision. Whenever a firm undertakes a new operation, product, or service, additional inventories are usually needed to support increased sales, and the increased additional sales lead to increases in accounts receivable. Accounts payable and accruals will probably also increase proportionally.
The investment in net working capital is defined as the difference between the changes in non-cash current assets and changes in non-cash current liabilities (i.e., those other than short-term debt). Cash is excluded because it is generally assumed not to be an operating asset.
NWCInv = Δnon-cash current assets − Δnon-debt current liabilities = ΔNWC If NWCInv is positive, additional financing is required and represents a cash outflow because cash must be used to fund the net investment in current assets. (If negative, the project frees up cash, creating a cash inflow.) Note that at the termination of the
project, the firm will expect to receive an end-of-project cash inflow (or outflow) equal to initial NWC when the need for the additional working capital ends.
After-tax operating cash flows (CF) are the incremental cash inflows over the capital asset’s economic life. Operating cash flows are defined as:
CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + (TD) where:
S = sales
C = cash operating costs D = depreciation expense T = marginal tax rate
Although depreciation is a non-cash operating expense, it is an important part of determining operating cash flow because it reduces the amount of taxes paid by the firm. We can account for depreciation either by adding it back to net income from the project (as in the first cash flow formula) or by adding the tax savings caused by depreciation back to the project’s after-tax gross profit (as in the second formula). In general, a higher depreciation expense will result in greater tax savings and higher cash flows. This means that accelerated depreciation methods will create higher after-tax cash flows for the project earlier in the project’s life as compared to the straight-line method, resulting in a higher net present value (NPV) for the project.
PROFESSOR’S NOTE
Interest is not included in operating cash flows for capital budgeting purposes because it is incorporated into the project’s cost of capital.
Terminal year after-tax non-operating cash flows (TNOCF). At the end of the asset’s life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.
TNOCF = SalT + NWCInv − T (SalT − BT) where:
SalT = pre-tax cash proceeds from sale of fixed capital BT = book value of the fixed capital sold
PROFESSOR’S NOTE
The notation for this formula is somewhat confusing because T is used in two different ways: (1) as the marginal tax rate and (2) as a time subscript indicating year T, the final year of the project. If T shows up in a formula, assume it refers to the marginal tax rate unless it is subscripted.
Expansion Project Analysis
An expansion project is an investment in a new asset to increase both the size and earnings of a business.
EXAMPLE: Expansion project analysis
Mayco, Inc. would like to set up a new plant (expand). Currently, Mayco has an option to buy an existing building at a cost of $24,000. Necessary equipment for the plant will cost $16,000, including installation costs. The equipment falls into a MACRS 5-year class. The building falls into a MACRS 39-year class.
The project would also require an initial investment of $12,000 in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment.
The project’s estimated economic life is four years. At the end of that time, the building is expected to have a market value of $15,000 and a book value of $21,816, whereas the equipment is expected to have a market value of $4,000 and a book value of $2,720.
Annual sales will be $80,000. The production department has estimated that variable manufacturing costs will total 60% of sales and that fixed overhead costs, excluding depreciation, will be $10,000 a year [costs:
(0.60)80,000 + 10,000 = 58,000]. Depreciation expense will be determined for the year in accordance with the MACRS rate.
Mayco’s marginal federal-plus-state tax rate is 40%; its cost of capital is 12%; and, for capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.
Under MACRS, the pre-tax depreciation for the building and equipment is:
Year 1 = $3,512; Year 2 = $5,744; Year 3 = $3,664; Year 4 = $2,544
Compute the initial investment outlay, operating cash flow over the project’s life, and the terminal-year cash flows for Mayco’s expansion project. Then determine whether the project should be accepted using NPV analysis.
Answer:
Initial outlay:
initial outlay = price of building + price of equipment + NWCInv = $24,000 + $16,000 + $12,000 =
$52,000 Operating cash flows:
CF = (S − C)(1 − T) + DT
CF1 = [($80,000 − 58,000)(0.6)] + (3,512)(0.4) = $14,605 CF2 = 13,200 + (5,744)(0.4) = $15,498
CF3 = 13,200 + (3,664)(0.4) = $14,666
CF4 = 13,200 + (2,544)(0.4) = $14,218 Terminal year after-tax non-operating cash flows:
There are two elements to the terminal year cash flow (TNOCF): (1) return of net working capital and (2) salvage value of both the building and the equipment.
First calculate the after-tax terminal cash flows associated with the building and the equipment separately:
CF for building = $15,000 − 0.4($15,000 − $21,816) = $17,726 CF for equipment = $4,000 − 0.4($4,000 − $2,720) = $3,488 Then include the return of NWCInv:
TNOCF = $17,726 + $3,488 + $12,000 = $33,214
Note in this example the investment in NWC was positive (a use of cash resulting in a cash outflow), so the terminal value effect will be a cash inflow. Had the project freed up working capital, the initial investment in NWC would be negative (a cash inflow) and the terminal value effect would be a cash outflow. Also notice that the building was sold for less than book value. The loss on the building reduces taxes and results in a positive incremental cash flow equal to the tax savings.
Using the expansion project’s relevant after-tax cash flows and given that Mayco has a cost of capital of 12%, the NPV for the project can be computed as:
NPV = –52,000 + + + + + = $13,978
IRR (from financial calculator) = 21.9%
Decision: Since NPV > 0 and the IRR > 12%, Mayco should accept the expansion project.
PROFESSOR’S NOTE
Remember that you can use the time value functions of your calculator to quickly calculate NPV and IRR.
The TI BA II Plus keystrokes to calculate the 21.9% IRR for Mayco’s new plant project are: [CF]
[2nd] [CLR WORK] 52000 [+/–] [ENTER] [↓] 14605 [ENTER] [↓][↓] 15498 [ENTER] [↓][↓]
14666 [ENTER] [↓][↓] 47432 [ENTER] [↓] [IRR] [CPT]
Other Presentation Formats
There are two other formats for presenting the analysis of a capital budgeting project with which you should be familiar: (1) table format with cash flows collected by year, and (2) table format with cash flows collected by type. Be prepared to analyze a project when the cash flows are presented in either of these formats on the exam.
Figure 19.2 presents the analysis of the Mayco capital budgeting project with cash flows collected by year.
Figure 19.2: Mayco Project: Cash Flows Collected by Year
Year 0 1 2 3 4
Initial outlay:
FCInv −$40,000
WCInv −$12,000
−$52,000 After-tax operating CFs:
Sales $80,000 $80,000 $80,000 $80,000
Cash operating expenses 58,000 58,000 58,000 58,000
Depreciation 3,512 5,744 3,664 2,544
$14,605 1.121
$15,498 1.122
$14,666 1.123
$14,218 1.124
$33,214 1.124
Oper. income before taxes 18,488 16,256 18,336 19,456
Taxes on oper. income 7,395 6,502 7,334 7,782
Oper. income after taxes 11,093 9,754 11,002 11,674
Add back: depreciation 3,512 5,744 3,664 2,544
After tax oper. CF 14,605 15,498 14,666 14,218
Terminal year after-tax non-oper. CF (TNOCF)
After-tax salvage value 21,214
Return of NWC 12,000
TNOCF 33,214
Total after-tax CF −$52,000 $14,605 $15,498 $14,666 $47,432
NPV(12%) $13,978
IRR 21.9%
Figure 19.3 presents the analysis of the Mayco capital budgeting project with cash flows collected by type.
Figure 19.3: Mayco Project: Cash Flows Collected by Type
Time Type of CF Before-Tax CF After-Tax CF PV at 12%
0 FCInv –$40,000 –$40,000 –$40,000
0 NWCInv –12,000 –12,000 –12,000
1 – 4 Sales − cash expenses 22,000 22,000 (1 − 0.4) = 13,200 40,093
1 Depreciation tax savings* None 3,512 (0.4) = 1,405 1,255
2 Depreciation tax savings* None 5,744(0.4) = 2,298 1,832
3 Depreciation tax savings* None 3,664(0.4) = 1,466 1,043
4 Depreciation tax savings* None 2,544(0.4) = 1,018 647
4 After-tax salvage value 19,000 = 15,000 + 4,000 21,214 (from Figure 19.2) 13,482
4 Return of NWCInv 12,000 12,000 7,626
NPV = $13,978
*Note that if straight-line depreciation is used, the depreciation tax savings is an annuity and you can calculate the present value of that annuity directly, rather than summing the present values of the individual depreciation tax savings for each year.
Replacement Project Analysis
Replacement project analysis occurs when a firm must decide whether to replace an existing asset with a newer or better asset. There are two key differences in the analysis of a
replacement project versus an expansion project. In a replacement project analysis we have to:
1. Reflect the sale of the old asset in the calculation of the initial outlay:
outlay = FCInv + NWCInv − Sal0 + T (Sal0 − B0)
2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset:
ΔCF = (ΔS − ΔC)(1 − T) + ΔDT
3. Compute the terminal year non-operating cash flow:
TNOCF = (SalTNew − SalTOld) + NWCInv − T[(SalTNew − BTNew) − (SalTOld − BTOld)]
EXAMPLE: Replacement project analysis
Suppose Mayco wants to replace an existing printer with a new high-speed copier. The existing printer was purchased ten years ago at a cost of $15,000. The printer is being depreciated using straight line basis assuming a useful life of 15 years and no salvage value (i.e., its annual depreciation is $1,000). If the existing printer is not replaced, it will have zero market value at the end of its useful life.
The new high-speed copier can be purchased for $24,000 (including freight and installation). Over its 5- year life, it will reduce labor and raw materials usage sufficiently to cut annual operating costs from
$14,000 to $8,000.
It is estimated that the new copier can be sold for $4,000 at the end of five years; this is its estimated salvage value. The old printer’s current market value is $2,000, which is below its $5,000 book value. If the new copier is acquired, the old printer will be sold to another company.
The company’s marginal federal-plus-state tax rate is 40%, and the replacement copier is of slightly below- average risk. Net working capital requirements will also increase by $3,000 at the time of replacement. By an IRS ruling, the new copier falls into the 3-year MACRS class. The project’s cost of capital is set at 11.5%.
Under the MACRS system, the pre-tax depreciation for the equipment is:
Year 1 = $7,920; Year 2 = $10,800; Year 3 = $3,600; Year 4 = $1,680; Year 5 = $0
Compute the initial investment outlay, operating cash flow over the project’s life, and the terminal-year cash flows for Mayco’s replacement project. Then determine whether the project should be accepted using NPV analysis.
Answer:
Initial investment outlay:
initial outlay = $24,000 + $3,000 − $2,000 + 0.4($2,000 − $5,000) = $23,800
Operating cash flows:
CFt = [(ΔS − ΔC) (1 − T)] + ΔDT ΔS = 0
ΔC = –6,000
ΔDT = (MACRSD − 1,000)(0.4)
CF1 = [0 − (–6,000)](1 − 0.4) + (7,920 − 1,000)(0.4) = $6,368 CF2 = [0 − (–6,000)](1 − 0.4) + (10,800 − 1,000)(0.4) = $7,520 CF3 = [0 − (–6,000)](1 − 0.4) + (3,600 − 1,000)(0.4) = $4,640 CF4 = [0 − (–6,000)](1 − 0.4) + (1,680 − 1,000)(0.4) = $3,872 CF5 = [0 − (–6,000)](1 − 0.4) + (0 − 1,000)(0.4) = $3,200
PROFESSOR’S NOTE:
When calculating depreciation, we need to decrease the new printer depreciation expense by the depreciation that would have occurred with the old printer, which was $1,000 per year.
Terminal year flow:
Sal (new machine) = $4,000
Sal (old) = 0 (after five more years)—this is given in the first paragraph.
NWCInv (given) = $3,000
profit on salvage of new = 4,000 − 0 (book value) = 4,000 profit on salvage of old = 0
Tax on (4,000 − 0) at 40% = 1,600
TNOCF = (SalNew − SalOld) + NWCInv − T[(SalTNew − BTNew) − (SalTOld − BTOld)]
TNOCF = (4,000 − 0) + 3,000 − 0.4[(4,000 − 0) − (0)] = $5,400
Given Mayco’s incremental cash flows and a cost of capital of 11.5%, net present value (NPV) for the project can be computed as:
6,368 7,520 4,640 3,872 3,200+ 5,400
NPV = –23,800 + + + + + = −$1,197.28 IRR = 9.46%
Decision: Since the NPV is negative and the IRR is less than the cost of capital, Mayco should not replace the printer with the new copier.