FINS5514: Capital Budgeting and Financial
Capital Budgeting and Financial
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FINS5514: Capital Budgeting and Financial
Decisions
Lecture 4: The Investment Decision III
Project Cash Flows II and Estimating Risk in
Capital Budgeting
1
• Pro-forma financial statements
• Depreciation
‒ Straight-line deprecation
‒ Modified accelerated cost recovery system
• Examples of capital budgeting decisions in
practice
• Break-even analysis
• Operating leverage
Outline
• So far, it has been assumed that project cash
flows are known with certainty.
• What if this is not true?
– In reality it is often difficult to know what cash flows a
project will produce.
– So the cash flows must be estimated.
• Pro-forma statements are projected financial
statements
– They are used to produce projected cash flows from
the project which are then used for capital budgeting
decisions.
Pro-forma Financial Statements
• Pro-forma statements require information on:
– Net capital spending
– Net working capital
– Variable costs per unit
– Fixed costs
– Unit sales
– Selling price per unit
Pro-forma Financial Statements
• Thus we can estimate project income:
ITEM DEFINITION
Sales Units sold x price per unit
Variable costs Units sold x variable costs per unit
Gross Profit Sales – Variable costs
Fixed costs Given information
Depreciation Given information
EBIT Gross Profit – (Fixed costs + Depreciation)
Taxes EBIT x tax rate
Net income EBIT – Taxes
Pro-forma Financial Statements
• Using this information, we can also estimate
project capital requirements:
ITEM DEFINITION
Change in net working
capital
ΔNet working capital
Net capital spending ΔNet fixed assets + Depreciation
Total investment Change in NWC+ Net capital spending
Pro-forma Financial Statements
• Why do we have to consider changes in NWC
separately?
₋ Sales may not translate immediately into cash inflows,
if customers buy on credit
₋ Expenses may not translate immediately into cash
outflows, if suppliers provide credit
₋ Finally, we have to increase inventory to support
sales; inventory will eventually turn into cash
• Changes in NWC adjust for the discrepancy
between the accounting of sales and costs, and
their actual cash receipts and payments
Net working capital
• Project cash flow is calculated as:
Project Cash Flow = Project Operating Cash Flow
– Project Change in Net Working Capital
– Project Net Capital Spending
• Where
Operating Cash Flow = EBIT + Depreciation −Taxes
• In addition, recall that net working capital will be
repaid at the end of the project, altering the final
year cash inflows
Project Cash Flows
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
Pro-forma Income Statement
Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000
NFA 90,000 60,000 30,000 0
Total $110,000 $80,000 $50,000 $20,000
Projected Capital Requirements
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in
NWC
-$20,000 20,000
NCS -$90,000
Project CF -$110,00 $51,780 $51,780 $71,780
Year 0 CF = cost of machinery and working capital investment
Year 1 OCF = EBIT + dep – tax = $33000 + 30000-11220 = $51780
Year 3 – recoup working capital investment
Projected Total Cash Flows
$ -110,000
1 2 3
CF1 =
51,780
CF2 =
51,780
CF3 =
71,780
R = 20%
NPV=-110,000+51,780/(1+0.2)+51,780/(1+ 0.2)2+ 71,780/(1+ 0.2)3
=10,647.69
IRR = ?
25.8%
Making The Decision
• Depreciation is a non-cash item
– Non-cash items track things such as changes to the value
of investments that have not been sold, and wear and tear
on valuable items
– Depreciation appears in as an income statement item
• Depreciation impacts the firm’s tax bill and, as
a result, has an impact on cash flows
– It must be considered in capital budgeting decisions
– The tax shield on depreciation is
Depreciation tax shield = T × Depreciation
Depreciation
• Straight line depreciation works by multiplying
the original asset cost by the depreciation rate
every year in which it is owned.
– This is the depreciation that can be claimed that year.
Depreciation = (Initial cost − Salvage)/ number of years
– Salvage here is book value of an asset at the end of useful
life
• Depreciation can be claimed each year, to the
end of its useful life, assuming the asset is owned
until it is fully depreciated
– A fully depreciated asset is one whose accumulated
depreciation equals its original cost.
Straight Line Depreciation
• Consider an asset worth $25,000 that has
5-year economic life.
– Depreciation is at 20% per annum, straight line
– The asset has $0 salvage value
• At the end of the first year, the depreciation is:
Depreciation = Cost ×Depreciation rate
Depreciation = 25,000×20% = $5000
Straight Line Depreciation Example
• If the asset were purchased part way through
the year so there were only 9 months until the
end of the fiscal year, the deprecation would
be:
Depreciation = (Cost ×Depreciation rate)× Months owned
12
Depreciation = ($25,000×20%)× 9 = $3750
12
Straight Line Depreciation Example
• An alternative method of calculating
depreciation, MACRS allocates every asset to a
particular depreciation class for tax purposes
• Each class specifies a sequence of percentages
which alter each year.
– To calculate depreciation, the initial cost of the asset is
multiplied by the relevant percentage for that year
– The asset is depreciated to zero
Modified Accelerated Cost Recovery System (MACRS)
• MACRS depreciation allowances :
Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.44 32.00 24.49
3 14.82 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.93
7 8.93
8 4.45
Modified Accelerated Cost Recovery System (MACRS)
• Consider a $12,000 asset in the 5-year class
Year 5-Year
(%)
Depreciation Starting Book
Value
Ending Book
Value
1 20.00 0.20 x $12,000= $2,400.00 $12,000 $9,600.00
2 32.00 0.32 x $12,000 = $3,840 $9,600.00 $5,760.00
3 19.20 0.1920 x $12,000 = $2,304.00 $5,760.00 $3,456.00
4 11.52 0.1152 x $12,000 = $1,382.40 $3,456.00 $2,073.60
5 11.52 0.1152 x $12,000 = $1,382.40 $2,073.60 $691.20
6 5.76 0.0576 x $12,000 = $691.20 $691.20 0
100.00 $12,000.00
Modified Accelerated Cost Recovery System Example
• If the salvage value of an asset is different
from the book value, then there is a tax effect
Book value = Initial cost - accumulated depreciation
After - tax salvage = salvage value - T(salvage value - book
value)
• Salvage value here is the market price that the
asset is sold.
After-tax Salvage
• Some equipment is purchased for $100,000 and it
costs $10,000 to have it delivered and installed.
• Based on past information, you believe that you
can sell the equipment for $17,000 when you
are done with it in 6 years
• The marginal tax rate is 40%.
• What is the depreciation expense each year and
the after-tax salvage in year 6 for each of the
following situations?
– Straight line depreciation
– 3-years MACRS
After-tax Salvage and Depreciation Example
• With Straight-line depreciation
Depreciation = (Initial cost − Salvage)/ number of years
Depreciation = (110,000 −17,000)/ 6 = 15,500 eachyear
Book value in year 6 = 110,000 − (6×15,500)= 17,000
After - tax salvage = salvage value - T(salvage - book value)
After - tax salvage = 17,000 - 0.40(17,000 - 17,000)= 17,000
After-tax Salvage and Depreciation Example