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1、McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-0Chapter Outline7.1 Incremental Cash Flows7.2 The Baldwin Company: An Example7.3 Inflation and Capital Budgeting7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method7.5 Summary and ConclusionsMcGra
2、w-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-17.1 Incremental Cash Flows Cash flows matternot accounting earnings. Sunk costs dont matter. Incremental cash flows matter. Opportunity costs matter. Side effects like cannibalism and erosion matter. Taxes matter: w
3、e want incremental after-tax cash flows. Inflation matters.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-2Cash FlowsNot Accounting Earnings. Consider depreciation expense. You never write a check made out to “depreciation”. Much of the work in evaluating a
4、project lies in taking accounting numbers and generating cash flows.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-3Incremental Cash Flows Sunk costs are not relevant Just because “we have come this far” does not mean that we should continue to throw good mo
5、ney after bad. Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed. Side effects matter. Erosion and cannibalism are
6、 both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-4Estimating Cash Flows Cash Flows from Operations Recall that:Operating Cash Flow = EB
7、IT Taxes + Depreciation Net Capital Spending Dont forget salvage value (after tax, of course). Changes in Net Working Capital Recall that when the project winds down, we enjoy a return of net working capital.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-5In
8、terest Expense Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value. For now, its enough to assume that the firms level of debt (hence interest expense) is independent of the project at hand.McGraw-Hill/IrwinCopyright 2002 by The
9、 McGraw-Hill Companies, Inc. All rights reserved.7-67.2 The Baldwin Company: An ExampleCosts of test marketing (already spent): $250,000.Current market value of proposed factory site (which we own): $150,000.Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life).Increase
10、in net working capital: $10,000.Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000.Price during first year is $20; price increases 2% per year thereafter.Production costs during first year are $10 per unit and increase 10% per year thereafter.Annual
11、inflation rate: 5%Working Capital: initially $10,000 changes with sales.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-7The Worksheet for Cash Flows of the Baldwin CompanyYear 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1) Bowling ball machine100.00 21.76*
12、(2) Accumulated 20.0052.0071.2082.72 94.24 depreciation(3) Adjusted basis of 80.0048.0028.8017.28 5.76 machine after depreciation (end of year)(4) Opportunity cost150.00 150.00(warehouse)(5) Net working capital 10.00 10.0016.3224.9721.22 0 (end of year)(6) Change in net 10.006.32 8.653.75 21.22 work
13、ing capital(7) Total cash flow of260.00 6.32 8.653.75 192.98 investment(1) + (4) + (6)* We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the origi
14、nal purchase price of the machine less depreciation. The capital gain is $24,240 (= $30,000 $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 0.34 ($30,000 $
15、5,760). The after-tax salvage value is $30,000 0.34 ($30,000 $5,760) = 21,760.($ thousands) (All cash flows occur at the end of the year.)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-8The Worksheet for Cash Flows of the Baldwin CompanyAt the end of the pro
16、ject, the warehouse is unencumbered, so we can sell it if we want to.($ thousands) (All cash flows occur at the end of the year.)Year 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1) Bowling ball machine100.00 21.76*(2) Accumulated 20.0052.0071.2082.72 94.24 depreciation(3) Adjusted basis of 80.0048
17、.0028.8017.28 5.76 machine after depreciation (end of year)(4) Opportunity cost150.00 150.00(warehouse)(5) Net working capital 10.00 10.0016.3224.9721.22 0 (end of year)(6) Change in net 10.006.32 8.653.75 21.22 working capital(7) Total cash flow of260.00 6.32 8.653.75 192.98 investment(1) + (4) + (
18、6)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-9The Worksheet for Cash Flows of the Baldwin Company (continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.00249.72212.20 129.90 ($ thousands) (All cash flows occur at the end of
19、the year.)Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000).Price during first year is $20 and increases 2% per year thereafter.Sales revenue in year 3 = 12,000$20(1.02)2 = 12,000$20.81 = $249,720.McGraw-Hill/IrwinCopyright
20、 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-10The Worksheet for Cash Flows of the Baldwin Company (continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.00249.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.84($ thousands) (All cash flo
21、ws occur at the end of the year.)Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000).Production costs during first year (per unit) are $10 and (increase 10% per year thereafter).Production costs in year 2 = 8,000$10(1.10)1 = $88,0
22、00McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-11The Worksheet for Cash Flows of the Baldwin Company (continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.00249.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.8
23、4(10) Depreciation 20.00 32.00 19.20 11.52 11.52($ thousands) (All cash flows occur at the end of the year.)Depreciation is calculated using the Accelerated Cost Recovery System (shown at right)Our cost basis is $100,000Depreciation charge in year 4 = $100,000(.1152) = $11,520.YearACRS % 120.00% 232
24、.00%319.20%411.52%511.52%65.76%Total 100.00%McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-12The Worksheet for Cash Flows of the Baldwin Company (continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.00249.72212.20 129.90 (9) Ope
25、rating costs 50.00 88.00145.20 133.10 87.84(10) Depreciation 20.00 32.00 19.20 11.52 11.52(11) Income before taxes 30.00 43.20 85.32 67.58 30.54 (8) (9) - (10)(12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38(13) Net Income 19.80 28.51 56.31 44.60 20.16($ thousands) (All cash flows occur at the e
26、nd of the year.)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-13Incremental After Tax Cash Flows of the Baldwin CompanyYear 0Year 1Year 2Year 3Year 4Year 5(1)SalesRevenues$100.00$163.00$249.72$212.20$129.90(2)Operatingcosts-50.00-88.00-145.20133.10-87.84(3)
27、Taxes-10.20-14.69-29.01-22.98-10.38(4)OCF(1)(2)-(3)39.8060.5175.5156.1231.68(5)TotalCFofInvestment260.6.328.653.75192.98(6)IATCF(4)+(5)260. 39.8054.1966.8659.87224.6605.588,51$)10. 1 (66.224$)10. 1 (87.59$)10. 1 (86.66$)10. 1 (19.54$)10. 1 (80.39$260$5432NPVNPVMcGraw-Hill/IrwinCopyright 2002 by The
28、McGraw-Hill Companies, Inc. All rights reserved.7-147.3 Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship:(1 + Nomin
29、al Rate) = (1 + Real Rate) (1 + Inflation Rate) For low rates of inflation, this is often approximated as Real Rate Nominal Rate Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, most of the time the real rate has exhibited far less variance than the nominal rate. When
30、 accounting for inflation in capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-15Example of Capital Budgeting under Inflation Sony Int
31、ernational has an investment opportunity to produce a new stereo color TV. The required investment on January 1 of this year is $32 million. The firm will depreciate the investment to zero using the straight-line method. The firm is in the 34% tax bracket. The price of the product on January 1 will
32、be $400 per unit. The price will stay constant in real terms. Labor costs will be $15 per hour on January 1. The will increase at 2% per year in real terms. Energy costs will be $5 per TV; they will increase 3% per year in real terms.The inflation rate is 5% Revenues are received and costs are paid
33、at year-end.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-16Example of Capital Budgeting under InflationThe riskless nominal discount rate is 4%. The real discount rate for costs and revenues is 8%. Calculate the NPV. Year 1Year 2Year 3Year 4Physical Produc
34、tion (units)100,000200,000200,000150,000Labor Input (hours)2,000,0002,000,0002,000,0002,000,000Energy input, physical units200,000200,000200,000200,000McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-17Example of Capital Budgeting under InflationThe depreciati
35、on tax shield is a risk-free nominal cash flow, and is therefore discounted at the nominal riskless rate.Cost of investment today = $32,000,000Project life = 4 yearsAnnual depreciation expense:years 4000,000,32$000,000, 8$315,873, 9$)04. 1 (000,720, 2$)04. 1 (000,720, 2$)04. 1 (000,720, 2$)04. 1 (00
36、0,720, 2$DTS432DTSPVPVDepreciation tax shield = $8,000,000 .34 = $2,720,000McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-18Example of Capital Budgeting under Inflation Risky Real Cash Flows Price: $400 per unit with zero real price increase Labor: $15 per h
37、our with 2% real wage increase Energy: $5 per unit with 3% real energy cost increase Year 1 After-tax Real Risky Cash Flows:After-tax revenues = $400 100,000 (1-.34) = $26,400,000After-tax labor costs = $15 2,000,000 1.02 (1-.34) = $20,196,000After-tax energy costs = $5 2,00,000 1.03 (1-.34) = $679,
38、800After-tax net operating CF = $26,400,000 - $20,196,000 - $679,800 =$5,524,200McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-19Example of Capital Budgeting under Inflation$5,524,200 $31,499,886 $31,066,882 $17,425,007-$32,000,0000 1 2 34868,590,69$)08. 1 (
39、007,425,17$)08. 1 (882,066,31$)08. 1 (886,499,31$)08. 1 (200,524, 5$32$CFsrisky 432CFsrisky PVmPVYear One After-tax revenues = $400 100,000 (1-.34) = $26,400,000Year One After-tax labor costs = $15 2,000,000 1.02 (1-.34) = $20,196,000Year One After-tax energy costs = $5 2,00,000 1.03 (1-.34) = $679,
40、800Year One After-tax net operating CF =$5,524,200McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-20Example of Capital Budgeting under Inflation The project NPV can now be computed as the sum of the PV of the cost, the PV of the risky cash flows discounted at
41、 the risky rate and the PV of the risk-free cash flows discounted at the risk-free discount rate.NPV = -$32,000,000 + $69,590,868 + $9,873,315 = $47,464,183McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-21Investments of Unequal Lives The Equivalent Annual Co
42、st Method Replacement Chain Repeat the projects forever, find the PV of that perpetuity. Assumption: Both projects can and will be repeated. Matching Cycle Repeat projects until they begin and end at the same timelike we just did with the air cleaners. Compute NPV for the “repeated projects”.McGraw-
43、Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-227.4 Investments of Unequal Lives: The Equivalent Annual Cost Method There are times when application of the NPV rule can lead to the wrong decision. Consider a factory which must have an air cleaner. The equipment is
44、 mandated by law, so there is no “doing without”. There are two choices: The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years. The “cheaper cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years. Which one should we choos
45、e?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-237.4 Investments of Unequal Lives: The Equivalent Annual Cost MethodAt first glance, the cheap cleaner has the lower NPV (r = 10%):46.614, 4)10. 1 (100$000, 4$101CadillacttNPV39.895, 2)10. 1 (500$000, 1$51che
46、apttNPVThis overlooks the fact that the Cadillac cleaner lasts twice as long.When we incorporate that, the Cadillac cleaner is actually cheaper.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-247.4 Investments of Unequal Lives: The Equivalent Annual Cost Meth
47、odThe Cadillac cleaner time line of cash flows:-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -1000 1 2 3 4 5 6 7 8 9 10-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -5000 1 2 3 4 5 6 7 8 9 10The “cheaper cleaner” time line of cash flows over ten years:20.693, 4$)10. 1 (500$)10. 1 (000,
48、 1$)10. 1 (500$000, 1$106551cheapttttNPV46.614, 4)10. 1 (100$000, 4$101CadillacttNPVMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-25Investments of Unequal Lives: EAC The Equivalent Annual Cost Method Applicable to a much more robust set of circumstances tha
49、n replacement chain or matching cycle. The Equivalent Annual Cost is the value of the level payment annuity that has the same PV as our original set of cash flows. NPV = EAC ArT For example, the EAC for the Cadillac air cleaner is $750.98101101)10. 1 (98.750$46.614, 4)10. 1 (100$000, 4$tttt The EAC
50、for the cheaper air cleaner is $763.80 which confirms our earlier decision to reject it.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-26Example of Replacement Projects Consider a Belgian Dentists office; he needs an autoclave to sterilize his instruments. H