Chapter 11

Cash Flows
and Other Topics
in Capital Budgeting
 Learning Objectives

• Identify guidelines by which we measure

cash flows.
• Explain how a project’s benefits and costs—
that is, its free cash flows—are calculated.
• Explain the importance of options, or
flexibility, in capital budgeting.
• Understand, measure, and adjust for project
risk.

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 GUIDELINES FOR
CAPITAL BUDGETING

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 Guidelines for
Capital Budgeting

• To evaluate investment proposals, we must

first set guidelines by which we measure the
value of each proposal.
• We must know what is and what isn’t
relevant cash flow.

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 Use Free Cash Flows Rather than
Accounting Profits

• Free cash flow accurately reflects the timing

of benefits and costs—when money is
received, when it can be reinvested, and
when it must be paid out.
• Accounting profits do not reflect actual
money in hand.

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 Think Incrementally

• After-tax free cash flows must be measured

incrementally.
• Determining incremental free cash flow
involves determining the cash flows with
and without the project. Incremental is the
“additional cash flows” (inflows or outflows)
that occur due to the project.

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 Beware of Cash Flows
Diverted From Existing Products

• Not all incremental free cash flow is

relevant.
• Thus new product sales achieved at the cost
of losing sales from existing product line are
not considered a benefit.
• However, if the new product captures sales
from competitors or prevents loss of sales to
new competing products, it would be a
relevant incremental free cash flows.

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 Look for Incidental or
Synergistic Effects

• Although some projects may take sales

away from a firm’s existing projects (such
as a new flavor of ice cream), in other cases
new projects may add sales to the existing
line (such as adding a coffee store to an
existing retail store). This is called
synergistic effect and is a relevant cash
flow.

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 Work in Working-Capital
Requirements

• New projects require infusion of working

capital (such as inventory to stock the
shelves), which would be an outflow.
• Generally, when the project terminates,
working capital is recovered and there is an
inflow of working capital.

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 Consider Incremental Expenses

• Similar to cash inflows, cash outflows must

also be considered on an incremental basis.
• For example, replacing an existing
equipment may require training expense (an
incidental expense) for current employees
on the new equipment.

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 Sunk Costs Are Not
Incremental Cash Flows
• Sunk costs are cash flows that have already
occurred (such as marketing research) and cannot
be undone. Any cash flows that are not affected by
the accept/reject criterion should not be included in
the analysis.
• Managers need to ask two basic questions:
1. Will this cash flow occur if the project is
accepted?
2. Will this cash flow occur if the project is
rejected?
• If the answer is“Yes”to #1 and“No to #2, it will
be an incremental cash flow.

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 Account for Opportunity Costs

• Opportunity cost refers to cash flows that

are lost because of accepting the current
project.
• For example, using the building space for
the project will mean loss of potential rental
revenue.

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 Decide If Overhead Costs Are
Truly Incremental Cash Flows

• Must include incremental overhead costs or

costs that were incurred as a result of the
project and relevant to capital budgeting
• Note, not all overhead costs may be
relevant (for example, utilities bill may have
been the same with or without the project).

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 Ignore Interest Payments and
Financing Flows

• Interest payments and other financing cash

flows that might result from raising funds to
finance a project are not relevant cash
flows.
• Reason: Required rate of return implicitly
accounts for the cost of raising funds to
finance a new project.

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 CALCULATING A
PROJECT’S FREE CASH
FLOWS

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 Free Cash Flow Calculations

• Three components of free cash flows:

– The initial outlay,
– The annual free cash flows over the project’s life,
and
– The terminal free cash flow

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 Initial Cash Outlay

• The initial cash outlay is the immediate cash

outflow necessary to purchase the asset and
put it in operating order.
• This includes: (1) purchase cost, set-up
cost, installation, shipping/freight, training
cost (2) increased working-capital
requirements (3) sale of existing asset and
tax implications (if the project replaces an
existing project/asset)

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 Sale of Asset and Taxes

• If Sale = Book Value (BV) ==> No tax

effect
• If sale > BV (but less than cost)
==> recaptured depreciation, taxed as
ordinary income
• If sale > BV (greater than cost)
==> anything above cost, taxed as capital
gain, rest taxed as recaptured depreciation
• If sale < BV ==> capital loss
==> tax savings

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 Annual Free Cash Flows

• Annual free cash flows is the incremental

after-tax cash flows resulting form the
project being considered.
• Free cash flow considers the following:
– Cash flow from operations
– Cash flows from working capital requirements
– Cash flows from capital spending

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 Calculating
Operating Cash Flows
Step 1: Measure the project’s change in
after-tax operating cash flows

Operating cash flows

= Changes in EBIT
– Changes in taxes
+ Change in depreciation

Note, depreciation is a non-cash expense but

influences the cash flows through impact on
taxes (see next two slides).

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 Depreciation and Cash Flow

• Earnings before tax and dep. $40,000

• Depreciation $25,000
• Earnings before tax (EBT) $15,000

• If the corporation is taxed at 35%,

taxes = 0.35*$15,000 = $5,250

• If the depreciation was $0,

EBT = $40,000 and
taxes = 0.35*$40,000 = $14,000

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 Depreciation and Cash Flow

• Depreciation is a“non-cash expense”BUT

affects cash flow through its impact on
“taxes.”
• Depreciation ==> in expense
==> in taxes
=> cash flows

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 Calculating
Operating Cash Flows

Step 2: Calculate the cash flows from the

change in net working capital.

This refers to additional investment in current

assets minus any additional short-term
liabilities that were generated.

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 Calculating
Operating Cash Flows
Step 3: Determine the cash flows from the
changes in capital spending.

This refers to any capital spending

requirements during the life of the project.

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 Putting It All Together

Step 4: Project free cash flows

= change in EBIT
– changes in taxes
+ change in depreciation
– change in net working capital
– changes in capital spending

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 Terminal Cash Flow

• Terminal cash flows are flows associated

with the project at termination.
• It may include:
– Salvage value of the project
– Any taxable gains or losses associated with the
sale of any asset

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 Refer to Example 11.2

• Initial outlay = $200,000 + $30,000 = $230,000

• ∆ Operating cash flow
= Net Income + Depreciation
= $154,000
(see Tables 11-1, 11-2)
• Terminal free cash flows
= ∆ Operating cash flow
+ ∆ Net working capital
= $184,000
(See Table 11-3)

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 Putting It All Together

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 OPTIONS IN CAPITAL
BUDGETING

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 Options in
Capital Budgeting

• Options add value to capital budgeting

project by being able to modify the project
based on future developments (that are
currently unknown). Some common options
are:
– Option to delay a project
– Option to expand a project
– Option to abandon a project

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 The Option to Delay a Project

• Almost every project has a mutually

exclusive alternative—waiting and pursuing
at a later time.
• It is conceivable that a project with a
negative NPV now may have a positive NPV
if undertaken later on. This could be due to
various reasons such as favorable changes
in fashion, technology, economy, or
borrowing costs.

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 The Option to Expand

• Even if a project is currently unprofitable, it

may be useful to determine whether the
profitability of the project will change if the
company is able to expand in the future.
• For example, a firm may choose to invest in
a negative NPV projects to gain access to
new market.

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 The Option to Abandon

• It may be necessary to abandon the project before

its estimated life due to inaccurate project analysis
models or cash flow forecasts or due to changes in
market conditions.
• When comparing two projects with similar NPVs, a
project that is easier to abandon may be more
desirable (for example, hiring temporary versus
permanent workers, leasing versus buying a car).
The option to abandon infuses flexibility, which is
desirable.

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 RISK AND THE
INVESTMENT DECISION

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 Risk and the
Investment Decisions
Two main issues:
• What is risk in capital-budgeting decisions,
and how should it be measured?
• How should risk be incorporated into a
capital-budgeting analysis?

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 Three Perspectives on Risk

• Project standing alone risk

• Project’s contribution-to-firm risk
• Systematic risk

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 Project Standing Alone Risk

• This is a project’s risk ignoring the fact that

much of the risk will be diversified away as
the project is combined with other projects
and assets.
• This is an inappropriate measure of risk for
capital-budgeting projects.

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 Contribution-to-Firm Risk

• This is the amount of risk that the project

contributes to the firm as a whole.
• This measure considers the fact that some
of the project’s risk will be diversified away
as the project is combined with the firm’s
other projects and assets but ignores the
effects of the diversification of the firm’s
shareholders.

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 Systematic Risk

• Risk of the project from the viewpoint of a

well-diversified shareholder.
• This measure takes into account that some
of the risk will be diversified away as the
project is combined with the firm’s other
projects and in addition, some of the
remaining risk will be diversified away by
the shareholders as they combine this stock
with other stocks in their portfolios.

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 Relevant Risk

• Theoretically, the only risk of concern to

shareholders is systematic risk.
• Since the project’s contribution-to-firm risk
affects the probability of bankruptcy for the
firm, it is a relevant risk measure.
• Thus we need to consider both the project’s
contribution-to-firm risk and the project’s
systematic risk.

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 Incorporating Risk into
Capital Budgeting
• We know that investors demand higher
returns for more risky projects.
• As the risk of a project increases, the
required rate of return is adjusted upward
to compensate for the added risk.
• This risk-adjusted discount rate is then
used for discounting free cash flows (in NPV
model) or as the benchmark required rate of
return (in IRR model).

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 Measuring a Project’s
Systematic Risk

• Estimating risk of a project can be difficult.

Historical stock return data relates to an
entire firm, rather than a specific project or
division. Risk must be estimated. Options to
estimate risk include:
– Accounting Beta
– Pure Play Method
– Simulation
– Scenario Analysis
– Sensitivity Analysis

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 Accounting Beta

– Accounting beta can be estimated via time-series

regression on a division’s return on assets on the
market index.
– How good is this measure? The correlation
between accounting beta and the beta calculated
on historical stock return data is only about 0.6.

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 Pure Play Method

– Pure play method identifies publicly traded firms

engaged solely in the same business as the
project or division.
– The systematic risk of the proxy firm or pure
play firm is used as a proxy for the project or
division’s level of systematic risk.

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 Simulation

• Simulation involves the process of imitating

the performance of the project under
evaluation (see Figure 11-6).
– Done by randomly selecting observations from
each of the distributions that affect the outcome
of the project and continuing with this process
until a representative record of the project’s
probable outcome is assembled.

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 Sensitivity Analysis

• Sensitivity analysis involves determining

how the distribution of possible net present
values or internal rate of return for a
particular project is affected by a change in
one particular input variable while holding
all other input variables constant (also
known as what-if analysis).

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 Key Terms

• Contribution-to-firm risk
• Incremental after-tax free cash flows
• Initial outlay
• Project-standing-alone risk
• Pure play method
• Risk-adjusted discount rate
• Scenario analysis
• Sensitivity analysis
• Simulation
• Systematic risk

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 A Comprehensive Example:
Calculating Free Cash Flows

• Raymobile is considering a scooter line

• Tax bracket: 34% (no state income tax)
• Required rate of return: 15%

1. Estimate cash flows

2. Calculate NPV
3. Calculate profitability ratio
4. Calculate IRR
5. Make a decision

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