1)Should Reinaldo focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?
Cash flow refers to the flow of cash in or out of our business for a financial year. Cash flow is used for the following purposes
To determine a projects rate of return
Liquidity problems faced by a business
Is an alternative way to measure the profit of the business
It's used to evaluate the quality of the income
Accounting profits means the total profit that the company has earned for a financial year. It also includes the explicit cost of doing business like Depreciation, Interest and Taxes.
Capital budgeting is the planning process used to determine whether a firms long term investments are worth pursuing. It's a budget for major capital or investment expenditures. Methods used for capital budgeting are
Accounting rate of return
Net Present Value
Profitability Index
Internal rate of return
Modified internal rate of return
Equivalent Annuity
Reinaldo should focus on cash flows in making the capital budgeting decisions. Capital budgeting has the following characteristics
The exchange of current funds for future benefits
The funds are invested in long-term assets
The future benefits will occur to the firm over a series of years
Following are the reasons for selection of Capital Budgeting project
It should maximize the shareholders' wealth
It should consider all cash flows to determine the true profitability of the project
It should provide for an objective and unambiguous way of separating good projects from bad projects
It should help ranking of projects according to their true profitability
It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones
It should help to choose among mutually exclusive projects that project which maximizes the shareholders' wealth
It should be a criterion, which is applicable to any conceivable investment project independent of others
Incremental Cash flow is the additional operating cash flow that an organization receives from taking new projects. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project.
Incremental Profits 1 is comparison of estimated incremental (marginal) revenue with the estimated incremental cost of a proposed investment or action, to determine the incremental profit estimated to be generated. Following are the reasons why incremental profits is not the best option
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
Reference 1) http://www.businessdictionary.com/definition/incremental-profit-analysis.html
Total free cash flows are cash flow available for distribution among all the securities holders of an organization which includes Equity holders, Preference share holders, Debt Holders, etc.
Total Free Cash Flows /Net Free Cash Flow = Operation Cash flow - Capital Expenses to keep current level of operation - dividends - Current Portion of long term debt - Depreciation
Profit is positive gain from an investment or business operation after subtracting for all expenses. In a new business environment Total profit would be regarded as
Unrealistic
Difficult
Inappropriate
Immoral
We should be interested in Incremental Cash flows as:-
Maximizes the net present value of a course of action to shareholders.
Accounts for the timing and risk of the expected benefits
Meets the fundamental objective-maximize the market value of the firm's shares
2) How does depreciation affect free cash flows?
Depreciation is the reduction in the value of an asset due to usage, passage of time , wear and tear , Technological outdating or obsolescence , etc. It is a term used to spread the cost of an asset over the spam of several years.
Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are non-cash expenses. Neither depreciation nor amortization will directly affect the cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may neither figure in the cash flow statement, nor be "added back" to net income (along with other items) to derive the operating cash flow. Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not match the depreciation for tax purposes
Element
Data Source
Net Income
Current Income Statement
+ Depreciation /Amortization
Current Income Statement
- Changes in Working Capital
Prior & Current Balance Sheets: Current Assets and Liability accounts
- Capital expenditure
Prior & Current Balance Sheets: Property, Plant and Equipment accounts
= Free Cash Flow
Element
Data Source
Net Income
Current Income Statement
+Depreciation /Amortization
Current Income Statement
- Changes in Working Capital
Prior & Current Balance Sheets: Current Assets and Liability accounts
= Cash Flows from Operations
Depreciation and other amortization expenses is added back to find out the accurate cash flows. These are added back because these are non-cash expense. Hence Depreciation improves the free cash flow as it gives the benefit of tax shield. Hence Depreciation increases the cash flows.
3) How do sunk costs affect the determination of cash flows?
Sunk Cost is a cost which has already been incurred and cannot be reversed. They are not impacted by the future. This is because sunk cost refers to that which has already been incurred and cannot be changed. Sunk costs are sometimes contrasted with prospective cost, which are future cost that may be incurred or changed if an action is taken. In traditional microeconomics theory , only prospective (future) cost are relevant to an investment decisions , because doing so would not be rationally assessing a decision exclusively on its own merits. Sunk cost greatly affects decisions , because humans are inherently loss-averse and thus normally act irrationally when making economic decisions
Sunk costs should not affect the rational decision maker's best choice. However, until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes
When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant.
4. What is the project's initial outlay?
Projects initial outlay is the money required to start the project. A measure of a company's investment in capital, found by subtracting non-cash depreciation from capital expenditures. This measure helps to give a sense of how much money a company is spending on capital items (such as property, plants and equipment), which are used for operations.
Following is the way to calculate the same
STEP 1 - Calculate Explicit Initial Outlays
+ Cost
+ Shipping & Insurance
+ Installation related costs
+ Any required training fees or books and manuals for new equipment
+ Any taxes and fees
+ Any other required outlays
STEP 2 - Calculate Changes in Working Capital
(Note: working capital is an investment. A rise in the average amount invested in a working capital account requires an outlay of cash.)
+ Increases in accounts receivables
- Decreases in accounts receivables
+ Increases in inventory
- Decreases in inventory
+ Increases in cash balances
- Decreases in cash balances
STEP 3 - Salvage Value (Market Value of old equipment if a replacement decision)
- subtract positive salvage value
+ add additional removal costs (negative salvage value)
STEP 4 - Tax Implications if replacement decision
- LOSS * (TAX RATE)
Tax benefit inflows
+ GAIN * (TAX RATE)
Tax expense outlays
Note: If BV = MV no tax adjustment
STEP 5 - Calculate any available tax credits associate with the investment
(Note: in some tax environments there exists tax credits that lower the cost of investments)
- Investment tax credits (often calculated as a % of the net investment)
Subtract from Net Investment
- Solar Energy and other Energy Related Tax Credits
Subtract from Net Investment
STEP 6 - Final Number Equals Net Investment (Initial Outlay) for use in DCF decision models.
The projects initial outlay with this case study would be as follows
Project's Initial Outlay
Investment in Fixed Assets
$7,900,000
Shipping and Installation costs
$100,000
Investment in Working capital
$100,000
Project's Initial Outlay
$8,100,000
5) What are the differential cash flows over the project's life?
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II)
Year
0
1
2
3
5
5
Units Sold
70,000
120,000
140,000
80,000
60,000
Sale Price
$300
$300
$300
$300
$260
Sales Revenue
$21,000,000
$36,000,000
$42,000,000
$24,000,000
$15,600,000
Less: Variable Costs
12,600,000
21,600,000
25,200,000
14,400,000
10,800,000
Less: Fixed Costs
$200,000
$200,000
$200,000
$200,000
$200,000
Equals: EBDIT
$8,200,000
$14,200,000
$16,600,000
$9,400,000
$4,600,000
Less: Depreciation
$1,600,000
$1,600,000
$1,600,000
$1,600,000
$1,600,000
Equals: EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Taxes (@34%)
$2,244,000
$4,284,000
$5,100,000
$2,652,000
$1,020,000
Calculations:-
Depreciation is calculated on S7,900,000 +100,000= 8,000,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
Year 1
Year 2
Year 3
Year 4
Year 5
EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Minus: Taxes
$2,244,000
$4,284,000
$5,100,000
$2,652,000
$1,020,000
Plus: Depreciation
$1,600,000
$1,600,000
$1,600,000
$1,600,000
$1,600,000
Equals: Operating Cash Flow
$5,956,000
$9,916,000
$11,500,000
$6,748,000
$3,580,000
Section III. Calculate the Net Working Capital (This becomes an input in the calculation of Free Cash Flows in Section IV).
Change In Net Working Capital:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue:
$21,000,000
$36,000,000
$42,000,000
$24,000,000
$15,600,000
Initial Working Capital Requirement
$100,000
Net Working Capital Needs:
$2,100,000
$3,600,000
$4,200,000
$2,400,000
$1,560,000
Liquidation of Working Capital
$1,560,000
Change in Working Capital:
$100,000
$2,000,000
$1,500,000
$600,000
($1,800,000)
($2,400,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending)
Free Cash Flow:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Operating Cash Flow
$5,956,000
$9,916,000
$11,500,000
$6,748,000
$3,580,000
Minus: Change in Net Working Capital
$100,000
$2,000,000
$1,500,000
$600,000
($1,800,000)
($2,400,000)
Minus: Change in Capital Spending
$8,000,000
0
$0
0
0
0
Free Cash Flow:
($8,100,000)
$3,956,000
$8,416,000
$10,900,000
$8,548,000
$5,980,000
NPV =
$16,731,095.66
IRR =
77%
6) What is the terminal cash flow?
Terminal cash flow is the last stage of a project i.e. the cash flow that will occur only at the projects termination.
Terminal Cash Flow = Salvage Value + Working Capital
= 0 + 1,560,000
= $ 1,560,000
7) Draw a cash flow diagram for this project?
Cash flow diagram is used to represent the transactions which will take place over the course of a given project. Transactions include investments, maintenance cost, projected earnings or savings resulting from the project, as well as salvage and resale value of equipment at the end of the project.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
-8,100,000
3,956,000
8,416,000
10,900,000
8,548,000
5,980,000
8) What is the net present value?
Net Present Value is defined as the total present value of a time series of a cash flow. The difference between the present value of cash inflows and the present value of cash outflows. It is a standard method for using the time value of money to appraise long term projects.
NPV compares the value of a dollar today to the value of that same dollar in the future.
What NPV Means
NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations.
If...
It means...
Then...
NPV > 0
the investment would add value to the firm
the project may be accepted
NPV < 0
the investment would subtract value from the firm
the project should be rejected
NPV = 0
the investment would neither gain nor lose value for the firm
We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.
Net Present Value
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Free Cash Flow
-8,100,000
3,956,000
8,416,000
10,900,000
8,548,000
5,980,000
PVIF @ 15%
0.86965
0.75635
0.65785
0.5722
0.49775
NPV
3,440,335
6,365,442
7,170,565
4,891,166
2,976,545
Total NPV
$16,731,095.66
The NPV for this project is positive and favourable; we should go ahead with the project.
9) What is the internal rate of return?
Internal Rate of Return is a financial valuation metric used by financial analysts to calculate and assess the financial attractiveness and/or viability of capital intensive projects or investment. The internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment.
An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return.
= - 8,100,000 + 3,956,000 + 8,416,000 + 10,900,000 + 8,548,000 + 5,980,000
(1 + r) 1 (1 + r) 2 (1 + r) 3 (1 + r )4 (1 + r )5
= 77 %
In the above formula Cn is the cash flow generated in the specific period. IRR is denoted by r which is 15%. A simple decision-making criterion can be stated to accept a project if it's Internal Rate of Return exceeds the cost of capital and rejected if this IRR is less than the cost of capital. However, it should be kept in mind that the use of IRR may result in a number of complexities such as a project with multiple IRRs or no IRR. Moreover, IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate.
10) Should the project be accepted? Why or Why not?
The project should be accepted. The company is able to get good returns from the amount of money invested. The rate used to discount future cash flows to their present values is a key variable of this process. A firm's weighted average cost of capital (after tax) is used. Also, the NPV is positive and is favourable for the organisation to launch the new product. Right from the first year the company is able to generate a profit which is a good indicator for the launch of the new product.
Also, the IRR is extremely favourable at 77 %. The internal rate of return is a rate quantity; it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is profitable).In this case it is 15% and we are able to achieve 77%.
Bothe NPV and IRR are favourable for this project; therefore we should go ahead with the project.
11. a. NPVA = $240,000 - $ 195,000
(1 + 0.10) 1
= $218,182 - $195,000
= $23,182
NPVB = $1,650,000 - 1,200,000
(1 + 0.10) 1
= $1,500,000 - $1,200,000
= $300,000
b. PIA = $218,182
$195,000
= 1.1189
PIB = $1,500,000
$1,200,000
= 1.25
c. $195,000 = $240,000 [PVIFIRRA%,1 yr]
0.8125 = PVIFIRRA%,1 yr
Thus, IRRA = 23%
$1,200,000 = $1,650,000 [PVIFIRRB%,1 yr]
0.7273 = [PVIFIRRB%,1 yr]
Thus, IRRB = 37.5%
d. If there is no capital rationing, project B should be accepted because it has a larger net present value. If there is a capital constraint, the problem then focuses on what can be done with the additional $1,005,000 freed up if project A is chosen. If Caledonia can earn more on project A, plus the project financed with the additional $1,005,000, than it can on project B, then project A and the marginal project should be accepted.
