The initial investment, operating cash flows, and terminal cash flow together represent a project’s relevant cash flows. These cash flows can be viewed as the incremental after-tax cash flows attributable to the proposed project. They repre- sent, in a cash flow sense, how much better or worse off the firm will be if it chooses to implement the proposal.
The relevant cash flows for Powell Corporation’s proposed replacement expendi- ture can be shown graphically, on a time line. Note that because the new asset is assumed to be sold at the end of its 5-year usable life, the year-6 incremental op- erating cash inflow calculated in Table 11.8 has no relevance; the terminal cash flow effectively replaces this value in the analysis.
Example 11.9 ▶
With these cash flow estimates in hand, a financial manager could then cal- culate the investment’s NPV or IRR using the techniques covered in Chapter 10.
Time line for Powell Corpora- tion’s relevant cash flows with the proposed machine
0
–$221,160
End of Year
5
$122,200 Total Cash Flow 73,200 Operating Cash Flow 49,000
$ Terminal Cash Flow
4
$61,200
3
$55,600
2
$57,680
1
$26,480
After receiving a sizable bonus from her employer, Tina Talor is contemplating the purchase of a new car. She believes that by estimating and analyzing the cash flows, she could make a more rational deci- sion about whether to make this large purchase. Tina’s cash flow estimates for the car purchase are as follows:
Negotiated price of new car $23,500
Taxes and fees on new car purchase $ 1,650 Proceeds from sale of old car $ 9,750 Estimated value of new car in 3 years $10,500 Estimated value of old car in 3 years $ 5,700
Estimated annual repair costs on new car 0 (in warranty) Estimated annual repair costs on old car $ 400
Using the cash flow estimates, Tina calculates the initial investment, operating cash flows, terminal cash flow, and a summary of all cash flows for the car purchase.
Initial Investment Total cost of new car
Cost of car $23,500
1 Taxes and fees 1,650 $25,150
– Proceeds from sale of old car 9,750
Initial investment $15,400
Operating Cash Flows Year 1 Year 2 Year 3
Cost of repairs on new car $ 0 $ 0 $ 0 – Cost of repairs on old car 400 400 400 Operating cash flows (savings) $400 $400 $400 Terminal Cash Flow: End of Year 3
Proceeds from sale of new car $10,500 – Proceeds from sale of old car 5,700
Terminal cash flow $ 4,800
Summary of Cash Flows
End of Year Cash Flow
0 2$15,400
1 1 400
2 1 400
3 1 5,200 ($400 1 $4,800)
The cash flows associated with Tina’s car purchase decision reflect her net costs of the new car over the assumed 3-year ownership period, but they ignore the many intangible benefits of owning a car. Whereas the fuel cost and basic transportation service provided are assumed to be the same with the new car as with the old car, Tina will have to decide if the cost of moving up to a new car can be justified in terms of intangibles, such as luxury and prestige.
Personal Finance Example 11.10 ▶
➔REVIEW QuESTION
11–12 Diagram and describe the three components of the relevant cash flows for a capital budgeting project.
Summary
FOCuS ON VALuE
A key responsibility of financial managers is to review and analyze proposed investment decisions to make sure that the firm undertakes only those that contribute positively to the value of the firm. Using a variety of tools and tech- niques, financial managers estimate the cash flows that a proposed investment will generate and then apply decision techniques to assess the investment’s im- pact on the firm’s value. The most difficult and important aspect of this capi- tal budgeting process is developing good estimates of the relevant cash flows.
The relevant cash flows are the incremental after-tax cash flows resulting from a proposed investment. These estimates represent the cash flow benefits that are likely to accrue to the firm as a result of implementing the investment.
By applying to the cash flows decision techniques that capture the time value of money and risk factors, the financial manager can estimate how the investment will affect the firm’s share price. Consistent application of capital budgeting procedures to proposed long-term investments should therefore allow the firm to maximize its stock price.
REVIEW OF LEARNING GOALS
LG 1 Discuss the three major cash flow components. The three major cash flow components of any project can include (1) an initial investment, (2) operat- ing cash flows, and (3) terminal cash flow. The initial investment occurs at time zero, the operating cash flows occur during the project’s life, and the terminal cash flow occurs at the end of the project.
LG 2 Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity costs, and international capital budgeting. The relevant cash flows for capital budgeting decisions are the initial investment, the operating cash flows, and the terminal cash flow. For replacement decisions, these flows are the difference between the cash flows of the new asset and the old asset. Expan- sion decisions are viewed as replacement decisions in which all cash flows from the old asset are zero. When estimating relevant cash flows, ignore sunk costs and include opportunity costs as cash outflows. In international capital budget- ing, currency risks and political risks can be minimized through careful planning.
LG 3 Calculate the initial investment associated with a proposed capital expen- diture. The initial investment is the initial outflow required, taking into account the installed cost of the new asset, the after-tax proceeds from the sale of the old asset, and any change in net working capital. The initial investment is reduced by finding the after-tax proceeds from sale of the old asset. The book value of an
asset is used to determine the taxes owed as a result of its sale. Either of two forms of taxable income—a gain or a loss—can result from sale of an asset, depending on whether the asset is sold for (1) more than book value, (2) book value, or (3) less than book value. The change in net working capital is the dif- ference between the change in current assets and the change in current liabilities expected to accompany a given capital expenditure.
LG 4 Discuss the tax implications associated with the sale of an old asset.
There is typically a tax implication from the sale of an old asset. The tax impli- cation depends on the relationship between its sale price and book value and on existing government tax rules. Generally, if the old asset is sold for an amount greater than its book value, the difference is subject to a capital gains tax, and if the old asset is sold for an amount less than its book value, the company is enti- tled to a tax deduction equal to the difference.
LG 5 Find the relevant operating cash flows associated with a proposed capital expenditure. The operating cash flows are the incremental after-tax cash flows expected to result from a project. The income statement format involves adding depreciation back to net operating profit after taxes and gives the operating cash inflows, which are the same as operating cash flows (OCF), associated with the proposed and present projects. The relevant (incremental) cash flows for a re- placement project are the difference between the operating cash flows of the proposed project and those of the present project.
LG 6 Determine the terminal cash flow associated with a proposed capital ex- penditure. The terminal cash flow represents the after-tax cash flow (exclusive of operating cash inflows) that is expected from liquidation of a project. It is calculated for replacement projects by finding the difference between the after- tax proceeds from sale of the new and the old asset at termination and then ad- justing this difference for any change in net working capital. Sale price and de- preciation data are used to find the taxes and the after-tax sale proceeds on the new and old assets. The change in net working capital typically represents the reversion of any initial net working capital investment.
Opener-in-Review
The chapter opener talked about Diamond Comic Distributor’s attempt to re- duce the cost of opening a retail comic book store. Suppose that the current cost of opening such a store is $400,000 and that $250,000 of that initial investment is the cost of stocking the shelves with new inventory. Suppose also that the an- nual operating cash inflow from running an average comic book store is about
$62,000 before taxes and that the tax rate is 35%.
a. Assuming that the average comic book store has a life of about 10 years, what is the NPV of opening a new store if the required rate of return in this business is 10%? You may assume that the $250,000 in initial inventory will be recovered at the end of the tenth year (in addition to the annual operating cash flow for that year). What is the IRR that one can earn by opening up a new store?
b. Assume that by offering merchandise discounts to customers who are opening new stores Diamond can reduce the required initial inventory investment from
$250,000 to $150,000. Maintaining all other assumptions as previously stated, how will that affect the NPV and IRR earned on a new comic book store?
Self-Test Problems (Solutions in Appendix)
ST11–1 Book value, taxes, and initial investment Irvin Enterprises is considering the pur- chase of a new piece of equipment to replace the current equipment. The new equip- ment costs $75,000 and requires $5,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. The old piece of equipment was pur- chased 4 years ago for an installed cost of $50,000; it was being depreciated under MACRS using a 5-year recovery period. The old equipment can be sold today for
$55,000 net of any removal or cleanup costs. As a result of the proposed replace- ment, the firm’s investment in net working capital is expected to increase by
$15,000. The firm pays taxes at a rate of 40%. (Table 4.2 on page 166 contains the applicable MACRS depreciation percentages.)
a. Calculate the book value of the old piece of equipment.
b. Determine the taxes, if any, attributable to the sale of the old equipment.
c. Find the initial investment associated with the proposed equipment replacement.
ST11–2 Determining relevant cash flows A machine currently in use was originally pur- chased 2 years ago for $40,000. The machine is being depreciated under MACRS using a 5-year recovery period; it has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs. A new machine, using a 3-year MACRS recovery period, can be purchased at a price of
$140,000. It requires $10,000 to install and has a 3-year usable life. If the new ma- chine is acquired, the investment in accounts receivable will be expected to rise by
$10,000, the inventory investment will increase by $25,000, and accounts payable will increase by $15,000. Earnings before depreciation, interest, and taxes are ex- pected to be $70,000 for each of the next 3 years with the old machine and to be
$120,000 in the first year and $130,000 in the second and third years with the new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new machine could be sold to net $35,000 before taxes. The firm is subject to a 40% tax rate. (Table 4.2 on page 166 contains the applicable MACRS deprecia- tion percentages.)
a. Determine the initial investment associated with the proposed replacement decision.
b. Calculate the incremental operating cash flows for years 1 to 4 associated with the proposed replacement. (Note: Only depreciation cash flows must be consid- ered in year 4.)
c. Calculate the terminal cash flow associated with the proposed replacement deci- sion. (Note: This decision is made at the end of year 3.)
d. Depict on a time line the relevant cash flows found in parts a, b, and c that are associated with the proposed replacement decision, assuming that it is terminated at the end of year 3.
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Warm-up Exercises
All problems are available in MyFinancelab.
E11–1 If Halley Industries reimburses employees who earn master’s degrees and who agree to remain with the firm for an additional 3 years, should the expense of the tuition reimbursement be categorized as a capital expenditure or an operating expenditure?
E11–2 Iridium Corp. has spent $3.5 billion over the past decade developing a satellite- based telecommunication system. It is currently trying to decide whether to spend an additional $350 million on the project. The firm expects that this outlay will finish the project and will generate cash flow of $15 million per year over the next 5 years.
A competitor has offered $450 million for the satellites already in orbit. Classify the firm’s outlays as sunk costs or opportunity costs, and specify the relevant cash flows.
E11–3 Canvas Reproductions, Inc., has spent $4,500 dollars researching a new project. The project requires $20,000 worth of new machinery, which would cost $3,000 to in- stall. The company would realize $4,500 in after-tax proceeds from the sale of old machinery. If Canvas’s working capital is unaffected by this project, what is the ini- tial investment amount for this project?
E11–4 A few years ago, Tasty Food Company purchased an automatic production line at an installed cost of $325,000. The company has recognized depreciation expenses totaling $215,250 since its installation. What is the production line’s current book value? If Tasty Food sells the production line for $236,000, how much recaptured depreciation would result?
E11–5 Bryson Sciences is planning to purchase a high-powered microscopy machine for
$55,000 and incur an additional $7,500 in installation expenses. It is replacing simi- lar microscopy equipment that can be sold to net $35,000, resulting in taxes from a gain on the sale of $11,250. Because of this transaction, current assets will increase by $6,000, and current liabilities will increase by $4,000. Calculate the initial invest- ment in the high-powered microscopy machine.
Problems
All problems are available in MyFinancelab.
P11–1 Classification of expenditures Given the following list of expenditures, indicate whether each is normally considered an operating expenditure or a capital expendi- ture. Explain your answers.
a. An initial lease payment of $7,500 for renting the office building
b. An outlay of $150,000 to purchase a trademark for manufacturing a new product line c. Repair and maintenance expenses of $4,500 paid for the delivery truck
d. A total of $2,300 paid for fuel for the company vehicles e. A cash outlay of $980,000 to acquire a new office building
f. A cash outflow of $249,000 for a significant research and development program g. Amount of $32,000 had been written off as bad debts and cannot be collected h. A $108,000 payment for major structural improvements to the office building P11–2 Relevant cash flow and timeline depiction For each of the following projects, deter-
mine the relevant cash flows, and depict the cash flows on a time line.
a. A project that requires an initial investment of $120,000 and will generate an- nual operating cash inflows of $25,000 for the next 18 years. In each of the 18 years, maintenance of the project will require a $5,000 cash outflow.
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b. A new machine with an installed cost of $85,000. Sale of the old machine will yield $30,000 after taxes. Operating cash inflows generated by the replacement will exceed the operating cash inflows of the old machine by $20,000 in each year of a 6-year period. At the end of year 6, liquidation of the new machine will yield
$20,000 after taxes, which is $10,000 greater than the after-tax proceeds expected from the old machine had it been retained and liquidated at the end of year 6.
c. An asset that requires an initial investment of $2 million and will yield annual operating cash inflows of $300,000 for each of the next 10 years. Operating cash outlays will be $20,000 for each year except year 6, when an overhaul requiring an additional cash outlay of $500,000 will be required. The asset’s liquidation value at the end of year 10 is expected to be zero.
P11–3 Expansion versus replacement cash flows Stable Nuclear Plant Corporation has esti- mated the cash flows over the 5-year lives for two projects, A and B. These cash flows are summarized in the table below.
Project A Project B
Initial investment $60,000 $38,000* Year Operating cash inflows
1 $20,000 $ 14,000
2 18,000 12,000
3 16,000 13,000
4 12,000 8,000
5 10,000 6,000
*After-tax cash inflow expected from liquidation.
a. If project A were actually a replacement for project B and the $38,000 initial investment shown for project B were the after-tax cash inflow expected from liquidating it, what would be the relevant cash flows for this replacement decision?
b. How can an expansion decision such as project A be viewed as a special form of a replacement decision? Explain.
P11–4 Sunk costs and opportunity costs Masters Golf Products, Inc., spent 3 years and
$1,000,000 to develop its new line of club heads to replace a line that is becoming ob- solete. To begin manufacturing them, the company will have to invest $1,800,000 in new equipment. The new clubs are expected to generate an increase in operating cash inflows of $750,000 per year for the next 10 years. The company has determined that the existing line could be sold to a competitor for $250,000.
a. How should the $1,000,000 in development costs be classified?
b. How should the $250,000 sale price for the existing line be classified?
c. Depict all the known relevant cash flows on a time line.
P11–5 Sunk costs and opportunity costs Covol Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, tech- nologically advanced one. Given the following costs related to the proposed project, ex- plain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision.
a. Covol would be able to use the same tooling, which had a book value of
$40,000, on the new machine tool as it had used on the old one.
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b. Covol would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these pro- grams. Although the firm’s computer has excess capacity available, the capacity could be leased to another firm for an annual fee of $17,000.
c. Covol would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to an- other company for $10,000 per year.
d. Covol would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Covol 3 years earlier at a cost of
$120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm.
e. Covol would retain an existing overhead crane, which it had planned to sell for its $180,000 market value. Although the crane was not needed with the old ma- chine tool, it would be used to position raw materials on the new machine tool.
Personal Finance Problem
P11–6 Sunk and opportunity cash flows Dave and Ann Stone have been living at their present home for the past 6 years. During that time, they have replaced the water heater for $375, have replaced the dishwasher for $599, and have had to make mis- cellaneous repair and maintenance expenditures of approximately $1,500. They have decided to move out and rent the house for $975 per month. Newspaper adver- tising will cost $75. Dave and Ann intend to paint the interior of the home and power-wash the exterior. They estimate that that will run about $900.
The house should be ready to rent after that. In reviewing the financial situa- tion, Dave views all the expenditures as being relevant, so he plans to net out the estimated expenditures discussed above from the rental income.
a. Do Dave and Ann understand the difference between sunk costs and opportunity costs? Explain the two concepts to them.
b. Which of the expenditures should be classified as sunk cash flows, and which should be viewed as opportunity cash flows?
P11–7 Book value Find the book value for each of the assets shown in the following table, assuming that MACRS depreciation is being used. See Table 4.2 on page 166 for the applicable depreciation percentages.
Asset Installed cost
Recovery period (years)
Elapsed time since purchase (years)
A $ 890,000 5 2
B 67,000 7 4
C 34,000 3 1
D 4,280,000 10 5
E 753,000 5 3
P11–8 Book value and taxes on sale of assets Research Clinic purchased a blood-testing machine 4 years ago for $96,000. It is being depreciated under MACRS with a 7-year recovery period using the percentages given in Table 4.2 on page 166. Assume a 30% tax rate.
a. What is the book value of the blood-testing machine?
b. Calculate the clinic’s tax liability if it sold the blood-testing machine for each of the following amounts: $120,000; $26,000; $231,200; and $21,000.
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