PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 10 pps

291 10 PLANNING CAPITAL EXPENDITURE Steven P. Feinstein A beer company is considering building a new brewery. An airline is deciding whether to add flights to its schedule. An engineer at a high-tech company has designed a new microchip and hopes to encourage the company to manufac- ture and sell it. A small college contemplates buying a new photocopy machine. A nonprofit museum is toying with the idea of installing an education center for children. Newlyweds dream of buying a house. A retailer considers building a Web site and selling on the Internet. What do these projects have in common? All of them entail a commit- ment of capital and managerial effort that may or may not be justified by later performance. A common set of tools can be applied to assess these seemingly very different propositions. The financial analysis used to assess such projects is known as “capital budgeting.” How should a limited supply of capital and managerial talent be allocated among an unlimited number of possible projects and corporate initiatives? THE OBJECTIVE: MAXIMIZE WEALTH Capital budgeting decisions cut to the heart of the most fundamental ques- tions in business. What is the purpose of the firm? Is it to create wealth for in- vestors? To serve the needs of customers? To provide jobs for employees? To better the community? These questions are fodder for endless debate. Ulti- mately, however, project decisions have to be made, and so we must adopt a 292 Planning and Forecasting de cision rule. The perspective of financial analysis is that capital investment belongs to the investors. The goal of the firm is to maximize investors’ wealth. Other factors are important and should be considered, but this is the primary objective. In the case of nonprofit organizations, wealth and return on invest- ment need not be measured in dollars and cents but rather can be measured in terms of benefits to society. But in the case of for-profit companies, wealth is monetary. A project creates wealth if it generates cash flows over time that are worth more in present-value terms than the initial setup cost. For example, suppose a brewery costs $10 million to build, but once built it generates a stream of cash flows that is worth $11 million. Building the brewery would cre- ate $1 million of new wealth. If there were no other proposed projects that would create more wealth than this, then the beer company would be well ad- vised to build the new brewery. This example illustrates the “net present value” rule. Net present value (NPV) is the difference between the setup cost of a project and the value of the project once it is set up. If that difference is positive, then the NPV is positive and the project creates wealth. If a firm must choose from several proposed projects, the one with the highest NPV will create the most wealth, and so it should be the one adopted. For example, suppose the beer company can either build the new brewery or, alternatively, can introduce a new prod- uct—a light beer, for example. There is not enough managerial talent to over- see more than one new project, or maybe there are not enough funds to start both. Let us assume that both projects create wealth: The NPV of the new brewery is $1 million, and the NPV of the new-product project is $500,000. If it could, the beer company should undertake both projects; but since it has to choose, building the new brewery would be the right option because it has the higher NPV. COMPUTING NPV: PROJECTING CASH FLOWS The first step in calculating a project’s NPV is to forecast the project’s future cash flows. Cash is king. It is cash flow, not profit, that investors really care about. If a company never generates cash flow, there can be no return to in- vestors. Also, profit can be manipulated by discretionary accounting treat- ments such as depreciation method or inventory valuation. Regardless of accounting choices, however, cash flow either materializes or does not. For these reasons, cash flow is the most important variable to investors. A project’s value derives from the cash flow it creates, and NPV is the value of the future cash flows net of the initial cash outflow. We can illustrate the method of forecasting cash flows with an example. Let us continue to explore the brewery project. Suppose project engineers in- form you that the construction costs for the brewery would be $8 million. The Planning Capital Expenditure 293 expected life of the new brewery is 10 years. The brewery will be depreciated to zero over its 10-year life using a straight-line depreciation schedule. Land for the brewery can be purchased for $1 million. Additional inventory to stock the new brewery would cost $1 million. The brewery would be fully opera- tional within a year. If the project is undertaken, increased sales for the beer company would be $7 million per year. Cost of goods sold for this beer would be $2 million per year; and selling, administrative, and general expenses associ- ated with the new brewery would be $1 million per year. Perhaps advertising would have to increase by $500,000 per year. After 10 years, the land can be sold for $1 million, or it can be used for another project. After 10 years the sal- vage value of the plant is expected to be $1.5 million. The increase in accounts receivable would exactly equal the increase in accounts payable, at $400,000, so these components of net working capital would offset one another and gen- erate no net cash flow. No one expects these forecasts to be perfect. Paraphrasing the famous words of baseball player Yogi Berra, making predictions is very difficult, espe- cially when they are about the future! However, when investors choose among various investments, they too must make predictions. As a financial analyst, you want the quality of your forecasts to be on a par with the quality of the forecasts made by investors. Essentially, the job of the financial analyst is to es- timate how investors will value the project, because the value of the firm will rise if investors decide that the new project creates wealth and will fall if in- vestors conclude that the project destroys wealth. If the investors have reason to believe that sales will be $7 million per year, then that would be the correct forecast to use in the capital budgeting analysis. Investors have to cope with uncertainty in their forecasts. Similarly, the financial analyst conducting a cap- ital budgeting analysis must tolerate the same level of uncertainty. Note that cash flow projections require an integrated team effort across the entire firm. Operations and engineering personnel estimate the cost of building and operating the new plant. The human resources department con- tributes the labor data. Marketing people tell you what advertising budget is needed and forecast revenue. The accounting department estimates taxes, ac- counts payable, and accounts receivable and tabulates the financial data. The job of the financial analyst is to put the pieces together and recommend that the project be adopted or abandoned. Initial Cash Outf low The initial cash outflow required by the project is the sum of the construction cost ($8 million), the land cost ($1 million), and the required new inventory ($1 million). Thus, this project requires an investment of $10 million to launch. If accounts receivable did not equal accounts payable, then the new accounts receivable would add to the initial cash outflow, and the new accounts payable would be subtracted. These cash flows are tabulated in Exhibit 10.1. 294 Planning and Forecasting Cash Flows in Later Years We find cash flow in years 1 through 10 by applying the following formula: Notice that we already have most of the data needed for the cash-flow formula, but we are missing the forecasts for income tax and windfall tax. Before we can finalize the cash flow computation, we have to forecast taxes. Income tax equals earnings before taxes (EBT) times the income tax rate. EBT is computed using the following formula: The formula for EBT is similar to the formula for cash-flow, with a few impor- tant exceptions. The cash-flow calculation does not subtract out depreciation, whereas the EBT calculation does. This is because depreciation is not a cash flow; the firm never has to write a check payable to “depreciation.” Deprecia- tion does reduce taxable income, however, because the government allows this deduction for tax purposes. So depreciation influences cash flow via its impact on income tax, but it is not a cash flow itself. The greater the allowable depre- ciation is in a given year, the lower taxes will be, and the greater the resulting cash flow to the firm. Earnings before Taxes = Sales − Cost of goods sold − Selling, administrative, and general expenses − Advertising − Depreciation Cash Flow = Sales − Cost of goods sold − Selling, administrative, and general expenses − Advertising − Income tax + Decrease in inventory (or − increase) + Decrease in accounts receivable (or − increase) − Decrease in accounts payable (or + increase) + Salvage − Windfall tax on salvage EXHIBIT 10.1 Initial year cash f low for brewery project ($1,000s). Year 0 Construction $ (8,000) Land (1,000) Inventory (1,000) Account receivable (400) Accounts payable 400 Total cash flow $(10,000) Planning Capital Expenditure 295 Treatment of Net Work ing Capital Changes in inventory, accounts receivable, and accounts payable are included in the cash-flow calculation but not in EBT. Changes in the components of working capital directly impact cash flow, but they are not deductible for tax purposes. When a firm buys inventory, it has essentially swapped one asset, (cash) for another asset (inventory). Though this is a negative cash flow, it is not considered a deductible expenditure for tax purposes. Similarly, a rise in accounts receivable means that cash that otherwise would have been in the company coffers is now owed to the company instead. Thus, an increase in accounts receivable effectively sucks cash out of the com- pany and must be treated as a cash outflow. Increasing accounts payable has the opposite effect. One way to gain perspective on the impact of accounts payable and ac- counts receivable on a company’s cash flow is to think of them as adjustments to sales and costs of goods sold. If a company makes a sale but the customer has not yet paid, clearly there is no cash flow generated from the sale. Though the sales variable will increase, the increase in accounts receivable will exactly off- set that increase in the cash flow computation. Similarly, if the company incurs expenses in the manufacture of the goods sold but has not yet paid its suppliers for the raw materials, the costs of goods sold will be offset by the increase in accounts payable. Depreciation According to a straight-line depreciation schedule, depreciation in each year is the initial cost of the plant or equipment divided by the number of years over which the asset will be depreciated. So, the $8 million plant depreciated over 10 years generates depreciation of $800,000 each year. Land is generally not depreciated. Straight-line depreciation is but one acceptable method for deter- mining depreciation of plant and equipment. The tax authorities often sanction other methods and schedules. Windfall Profit and Windfall Tax In order to compute windfall profit and windfall tax, we must be able to track an asset’s book value over its life. Book value is the initial value minus all pre- vious depreciation. For example, the brewery initially has a book value of $8 million, but that value falls $800,000 per year due to depreciation. At the end of the first year, book value falls to $7.2 million. By the end of the second year, following another $800,000 of depreciation, the book value will be $6.4 mil- lion. By the end of the tenth year, when the brewery is fully depreciated, the book value will be zero. Windfall profit is the difference between the salvage value and book value. We are told the beer company will be able to sell the old brewery for 296 Planning and Forecasting $1.5 million at the end of 10 years. By then, however, the book value of the brewery will be zero. Thus, the beer company will realize a windfall profit of $1.5 million. The government will want its share of that windfall profit. Multi- plying the windfall profit by the tax rate determines the windfall tax. In this particular case, with a windfall profit of $1.5 million and a tax rate of 40%, the windfall tax would equal $600 thousand (= $1.5 million × 40%). Taxable Income and Income Tax Exhibit 10.2 shows how taxable income and income tax are computed for the brewery example. Income tax equals EBT times the company’s income tax rate. In each of years 1 through 10, EBT is $2.7 million, so income tax is $1,080,000 (= $2.7 million × 40%). Interest Expense Notice that the calculation of taxable income and income tax in Exhibit 10.2 does not deduct any interest expense. This is not an oversight. Even if the com- pany intends to finance the new project by selling bonds or borrowing from a bank, we should not deduct any anticipated interest expense from our taxable income, and we should not subtract interest payments in the cash flow compu- tation. We will take the tax shield of debt financing into account later when we compute the company’s cost of capital. The reason for omitting interest ex- pense at this stage cuts to the core of the purpose of capital budgeting. We are trying to forecast how much cash is required from investors to start this project and then how much cash this project will generate for the investors once the project is up and running. Interest expense is a distribution of cash to one class of investors—the debt holders. If we want the bottom line of our cash-flow computation to reflect how much cash will be available to all investors, we must not subtract out cash flow going to one class of investors before we get to that bottom line. EXHIBIT 10.2 Income tax forecasts for brewery project (thousands). Years 1–10 Sales $ 7,000 Cost of goods sold (2,000) Selling, administrative, and general expense s (1,000) Advertising (500) Depreciation (800) Earnings before taxes $ 2,700 Income tax (40%) $(1,080) Planning Capital Expenditure 297 Putting the Pieces Together to Forecast Cash Flow We now have all the puzzle pieces to construct our capital budgeting cash-flow projection. These pieces and the resulting cash-flow projection are presented in Exhibit 10.3. Cash flows in years 1 through 9 are forecast to be $2.42 mil- lion, and the cash flow in year 10 is expected to be $5.32 million. Year 10 has a greater cash flow because of the recovery of the inventory and the assumed sale of the land and plant. GUIDING PRINCIPLES FOR FORECASTING CASH FLOWS The brewery example is one illustration of how cash flows are forecast. Every project is different, however, and the financial analyst must be keen to identify all sources of cash flow. The following three principles can serve as a guide: (1) Focus on cash flow, not on raw accounting data, (2) use expected values, and (3) focus on the incremental. Principle No. 1: Focus on Cash Flow NPV analysis focuses on cash flows—that is, actual cash payments and receipts flowing into or out of the firm. Recall that accounting profit is not the same thing as cash flow. Accounting profit often mixes variables whose timings dif- fer. A sale made today may show up in today’s profits, but since the cash re- ceipt for the sale may be deferred, the corresponding cash flow takes place EXHIBIT 10.3 Cash f low projections for brewery project (thousands). Year: 0 1–9 10 Construction $ (8,000) Land (1,000) $1,000 Inventory (1,000) 1,000 Account receivable (400) 400 Accounts payable 400 (400) Sales $7,000 7,000 Cost of goods sold (2,000) (2,000) Selling, admin., and general (1,000) (1,000) Advertising (500) (500) Income tax (1,080) (1,080) Salvage 1,500 Windfall tax (600) Total cash flow $(10,000) $2,420 $5,320 298 Planning and Forecasting later. Since the cash flow is deferred, the true value of that sale to the firm is somewhat diminished. By focusing on cash flows and when they occur, NPV reflects the true value of increased revenues and costs. Consequently, NPV analysis requires that accounting data be unraveled to reveal the underlying cash flows. That is why changes in net working capital must be accounted for and why deprecia- tion does not show up directly. Principle No. 2: Use Expected Values There is always going to be some uncertainty over future cash flows. Future costs and revenues cannot be known for sure. The analyst must gather as much information as possible and assemble it to construct expected values of the input variables. Although expected values are not perfect, these best guesses have to be good enough. What is the alternative? The uncertainty in forecast- ing the inputs is accounted for in the discount rate that is later used to discount the expected cash flows. Principle No. 3: Focus on the Incremental NPV analysis is done in terms of “incremental” cash flows—that is, the change in cash flow generated by the decision to undertake the project. Incremental cash flow is the difference between what the cash flow would be with the proj- ect and what the firm’s cash flow would be without the project. Any sales or savings that would have happened without the project and are unaffected by doing the project are irrelevant and should be ignored. Similarly, any costs that would have been incurred anyway are irrelevant. It is often difficult yet nonetheless important to focus on the incremental when calculating how cash flows are impacted by opportunity costs, sunk costs, and overhead. These trou- blesome areas will be elaborated on next. Opportunity Costs Opportunity costs are opportunities for cash inflows that must be sacrificed in order to undertake the project. No check is written to pay for opportunity costs, but they represent changes in the firm’s cash flows caused by the project and must, therefore, be treated as actual costs of doing the project. For exam- ple, suppose the firm owns a parking lot, and a proposed project requires use of that land. Is the land free since the firm already owns it? No; if the project were not undertaken then the company could sell or rent out the land. Use of the company’s land is, therefore, not free. There is an opportunity cost. Money that could have been earned if the project were rejected will not be earned if the project is started. In order to reflect fully the incremental impact of the proposed project, the incremental cash flows used in NPV analysis must incor- porate opportunity costs. Planning Capital Expenditure 299 Sunk Costs Sunk costs are expenses that have already been paid or have already been com- mitted to. Past research and development are examples. Since sunk costs are not incremental to the proposed project, NPV analysis must ignore them. NPV analysis is always forward-looking. The past cannot be changed and so should not enter into the choice of a future course of action. If research was under- taken last year, the effects of that research might bear on future cash flows, but the cost of that research is already water under the bridge and so is not rel- evant in the decision to continue the project. The project decision must be made on the basis of whether the project increases or decreases wealth from the present into the future. The past is irrelevant. Overhead The treatment of overhead often gives project managers a headache. Overhead comprises expenditures made by the firm for resources that are shared by many projects or departments. Heat and maintenance for common facilities are examples. Management resources and shared support staff are other examples. Overhead represents resources required for the firm to provide an environ- ment in which projects can be undertaken. Different firms use different for- mulas for charging overhead expenses to various projects and departments. If overhead charges accurately reflect the shared resources used by a project, then they should be treated as incremental costs of operating the project. If the project were not undertaken, those shared resources would benefit another moneymaking project, or perhaps the firm could possibly cut some of the shared overhead expenditures. Thus, to the extent that overhead does repre- sent resources used by the project, it should be included in calculating incre- mental cash flows. If, on the other hand, overhead expense is unaffected by the decision to undertake the new project, and no other proposed project could use those shared resources, then overhead should be ignored in the NPV analysis. Sometimes the formulas used to calculate overhead for budgeting purposes are unrealistic and overcharge projects for their use of shared resources. If the fi- nancial analyst does not correct this unrepresentative allocation of costs, some worthwhile projects might incorrectly appear undesirable. COMPUTING NPV: THE TIME VALUE OF MONEY In deciding whether a project is worthwhile, one needs to know more than whether it will make money. One must also know when it will make money. Time is money! Project decisions involve cash flows spread out over several pe- riods. As we shall see, cash flows in different periods are distinct products in the financial marketplace—as different as apples and oranges. To make deci- sions affecting many future periods, we must know how to convert the differ- ent periods’ cash flows into a common currency. 300 Planning and Forecasting The concept that future cash flows have a lower present value and the set of tools used to discount future cash flows to their present values are collec- tively known as “time value of money” (TVOM) analysis. I have always thought this to be a misnomer; the name should be the “money value of time.” But there is no use bucking the trend, so we will adopt the standard nomenclature. You probably already have an intuitive grasp of the fundamentals of TVOM analysis, as your likely answer to the following question illustrates: Would you rather have $100 today or $100 next year? Why? The answer to this question is the essence of TVOM. You no doubt an- swered that you would rather have the money today. Money today is worth more than money to be delivered in the future. Even if there were perfect cer- tainty that the future money would be received, we prefer to have money in hand today. There are many reasons for this. Having money in hand allows greater flexibility for planning. You might choose to spend it before the future money would be delivered. If you choose not to spend the money during the course of the year, you can earn interest on it by investing it. Understanding TVOM allows you to quantify exactly how much more early cash flows are worth than deferred cash flows. An example will illuminate the concept. Suppose you and a friend have dinner together in a restaurant. You order an inexpensive sandwich. Your friend orders a large steak, a bottle of wine, and several desserts. The bill arrives and your friend’s share is $100. Unfortu- nately, your friend forgot his wallet and asks to borrow the $100 from you. You agree and pay. A year passes before your friend remembers to pay you back the money. “Here is the $100,” he finally says one day. Such events test a friend- ship, especially if you had to carry a $100 balance on your credit card over the course of the year on which interest accrued at a rate of 18%. Is the $100 that your friend is offering you now worth the same as the $100 that he borrowed a year earlier? Actually, no; a $100 cash flow today is not worth $100 next year. The same nominal amount has different values depending on when it is paid. If the interest rate is 18%, a $100 cash flow today is worth $118 next year and is worth $139.24 the year after because of compound interest. The present value of $118 to be received next year is exactly $100 today. Your friend should pay you $118 if he borrowed $100 from you a year earlier. The formula for converting a future value to a present value is: where PV stands for present value, FV is future value, n is the number of peri- ods in the future that the future cash flow is paid, and r is the appropriate in- terest rate or discount rate. Discounting Cash Flows Suppose in the brewery example that the appropriate discount rate for translat- ing future values to present values was 20%. Recall that the brewery project PV FV r n = + () 1 [...]... financing that is equity, WD is the proportion of the financing that is debt, RE is the cost of equity financing, RD is the pretax cost of debt financing, and τ is the tax rate For example, suppose a firm acquires 70% of the funds needed for a project by selling stock The remaining 30% of financing comes from borrowing The cost of equity financing is 20%, the pretax cost of debt financing is 10% , and. .. identical In good times both companies make $1 million in sales In bad times sales fall to $200,000 Cost of goods sold is always 50% of sales Selling, administrative, and general expenses are a constant $50,000 For simplicity we assume there is no depreciation 306 Planning and Forecasting EXHIBIT 10. 6 Performance of NoDebt Inc and SomeDebt Inc NoDebt Inc (thousands) Net Earnings SomeDebt Inc (thousands)... Exhibit 10. 4, the IRR is 21.7% Most TOVM problems involve specifying an interest rate and some of the cash f lows and then instructing the calculator to find the missing cash f low variable—either present value, future value, or annual payment IRR calculations involve specifying all of the cash f lows and instructing the calculator to find the missing interest rate The IRR also happens to be the discount... secures financing for the project by borrowing from a bank, the after-tax interest rate should be used to discount cash f lows If the firm obtains funds by selling stock, then an equity financing rate should be applied If the financing combines debt and equity, then the appropriate discount rate would be an average of the debt rate and the equity rate Cost of Debt Financing The after-tax interest rate... and Nalin Kulatilaka, Real Options: Managing Strategic Investment in an Uncertain World (Boston: Harvard Business School Press, 1999) Bodie, Zvi, and Robert C Merton, Finance (Upper Saddle River, NJ: Prentice-Hall, 2000) Brealey, Richard A., and Stewart C Myers, Principles of Corporate Finance (New York: Irwin/McGraw-Hill, 2000) Brigham, Eugene F., Michael C Ehrhardt, and Louis C Gapenski, Financial... could invest money in a bank paying a rate of interest equal to the project’s IRR and receive the same cash f lows One can think of the IRR as an interest rate that a project pays to its investors For example, a project that costs $100 ,000 to set up but then returns $10, 000 every year forever has an IRR of 10% If a project costs $100 ,000 to set up and then ends the following year when it pays back $105 ,000,... financing.” Issuing stock to raise funds is known as “equity financing.” Equity financing is an alternative to debt financing, but it is not free When a firm sells equity, it sells ownership in the firm The return earned by the new shareholders is a cost to the old shareholders The rate of return earned by equity investors is found by adding dividends to the change in the stock price and then dividing... paid for in lost opportunities for creating wealth and occasional misallocation of resources into wasteful projects Internal Rate of Return A project’s internal rate of return (IRR) is the interest rate that the project essentially pays out It is the interest rate that a bank would have to pay so that the project’s cash outf lows would exactly finance its cash inf lows Instead of investing money in the... is the interest rate paid on a firm’s debt less the impact of the tax break they get from issuing debt For example, suppose that a firm pays 10% interest on its debt and the firm’s income tax rate is 40% If the firm issues $100 ,000 of debt, then the annual interest expense will be $10, 000 (10% × $100 ,000) But this $10, 000 of interest expense is tax deductible, so the firm would save $4,000 in taxes... beginning of the year and $112 at the end of the year, and the dividend is $8 per share The stockholders would have earned a return of 20%, and this 20% is also the cost of equity financing: RE = $8 + $112 − $100 = 20% $100 The capital asset pricing model (CAPM) is often used to estimate a firm’s cost of equity financing The idea behind the CAPM is that the rate of return demanded by equity investors . needed for a proj- ect by selling stock. The remaining 30% of financing comes from borrowing. The cost of equity financing is 20%, the pretax cost of debt financing is 10% , and the tax rate is 40% volatile: 48% in good times and 0% in bad times. This is the third EXHIBIT 10. 6 Performance of NoDebt Inc. and SomeDebt Inc. NoDebt Inc. (thousands) SomeDebt Inc. (thousands) Net Earnings Good Times. Advertising − Depreciation Cash Flow = Sales − Cost of goods sold − Selling, administrative, and general expenses − Advertising − Income tax + Decrease in inventory (or − increase) + Decrease in accounts