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Relevant Cash Flows and Other

Topics in Capital Budgeting
Timothy R. Mayes, Ph.D.
FIN 3300: Chapter 10

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Project Cash Flows
When deciding whether or not to make an
investment, we must first estimate the cash flows that
the investment will provide
Generally, these cash flows can be categorized as
follows:
The initial outlay (IO)
The annual after-tax cash flows (ATCF)
The terminal cash flow (TCF)
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Relevant Cash Flows
Determining the relevant cash flows can sometimes
be difficult, here are some guidelines
Cash flows must be:
Incremental (i.e., in addition to what you already have)
After-tax
Ignore those cash flows that are:
Sunk costs (monies already spent, and not recoverable)
Additional financing costs (e.g., extra interest expense)
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The Initial Outlay
The initial outlay is the total up-front cost of the
investment
The initial outlay can consist of many components,
among these are:
The cost of the investment
Shipping and setup costs
Training costs
Any increase in net working capital
When we are making a replacement decision, we also
need to subtract the after-tax salvage value of the old
machine (or land, building, etc.)
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The Annual After-tax Cash Flows
The annual after-tax cash flows (ATCF) are the
incremental after-tax cash flows that the investment
will provide
Generally, these cash flows fall into four categories:
Incremental savings (positive cash flow) or expenses
(negative cash flow)
Incremental income (positive cash flow)
The tax savings due to depreciation
Lost cash flows (negative cash flow) from the existing
project. This is an opportunity cost.
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The Terminal Cash Flow
The terminal cash flow consists of those cash flows
that are unique to the last year of the life of the
project
There may be a number of components of the TCF,
but three common categories are:
Estimated salvage value
Shut-down costs
Recovery of the increase in net working capital
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Problems in Capital Budgeting
Thus far we have been analyzing relatively simple
capital budgeting problems. The methodolgy that
we have used is fairly robust, but there are some
difficulties. In particular we will now look at
problems with:
Unequal lives
Inflation
Differential risk
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The Unequal Lives Problem
Any time that mutually exclusive projects are being
examined, it is vital that we make apples to apples
comparisons. A perfect example is two projects with
unequal lives.
Suppose, for example, that we are trying to decide
between projects A and B and that they are mutually
exclusive. They have the following cash flows, and
the cost of capital is 10%:
0 1 2 3 4 5
3000 3000 3500 4000 -10,000
-10,000 6000 6000 Project A
Project B
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The Unequal Lives Problem (cont.)
If we calculate the NPVs of both projects, we find:
NPV
A
= $413.22
NPV
B
= $568.27
From these calculations it appears that project B is the
better project. However, we are making a potentially
serious mistake.
Obviously, because we are willing to invest in B we
have a 5-year investment horizon. So, we must ask if
we accepted project A, what would we do with our
money for the remaining 3 years? Only then can a
valid comparison be made.
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The Unequal Lives Problem (cont.)
There are two ways to correctly deal with the
unequal lives problem:
The replacement chain approach
The equivalent annual annuity approach
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The Replacement Chain Approach
The replacement chain approach assumes that a
project will be repeated as many times as necessary
to fit into the investment horizon. In this example,
we need to repeat project A just once so that it has a
4-year life (the same a B). After replication, the cash
flows for A are:
0 1 2 3 4 5
-10,000 6000 6000 Project A
-10,000
6000 6000
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The Rep. Chain Approach (Cont.)
Note that the net cash flow in year 2 is now -$4,000
because we must pay for project A a second time.
Now, recalculating the NPV for project A reveals that
the correct NPV for the entire 4-year horizon is
actually $754.73 which exceeds the NPV of project B.
Therefore, when the problem is correctly analyzed,
we find that it is actually project A which should be
accepted, not B.
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The EAA Approach
The equivalent annual annuity approach is identical
to the replacement chain approach in its results, but it
is much simpler to perform
First, we calculate the NPVs for both projects
assuming that they are NOT replicated. Then, we
convert these NPVs into equivalent annuity
payments that they could provide over the life of the
project.
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The EAA Approach (Cont.)
Using the formula for the present value of an
ordinary annuity, we simply solve for the annuity
payment:
41322
1
1
110
10
2
.
( . )
.

PMT
Solving for the payment for project A, we find that its
EAA is $238.09.
Using the same methodology for project B we find
that its EAA is $179.27.
Since the EAA for A is higher than the EAA for B, we
should accept project A.
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Dealing with Inflation
Inflation must be accounted for in capital budgeting
if we are to make correct decisions.
Generally, we should inflate the cash flow estimates
by the expected rate of inflation since the discount
rate that we are using already incorporates expected
inflation. If we do not do this, then the estimated
NPV will be lower than the correct NPV. This could
cause us to reject a project that (because it appears to
have a negative NPV) when, in fact, we should accept
it.
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Incorporating Risk Estimates
Recall from our discussions in Chapters 1 and 5 that
we assume that investors are risk averse. This means
that they will require higher rates of return on higher
risk investments.
This means that the WACC is not the appropriate
discount rate for projects that are riskier or less risky
than the average for the firm. Instead, we need to
increase the discount rate for riskier projects and
decrease it for less risky projects. This is known as
the risk-adjusted discount rate (RADR).
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Incorporating Risk Estimates
There are, of course, several other techniques for
incorporating risk into our decision making.
However, they are beyond the scope of this course.
Just for completeness, here are a few:
Certainty equivalents
Scenario analysis
Sensitivity analysis
Monte-Carlo Simulation
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Cash Flow Forecasts
P.V. Viswanath
Valuation of the Firm
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Cash Flows:
The Accountants Approach
The objective of the Statement of Cash Flows, prepared by
accountants, is to explain changes in the cash balance
rather than to measure the health or value of the firm
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The Statement of Cash Flows
Cash Flows From Operations
+ Cash Flows From Investing
+ Cash Flows from Financing
Net cash flow from operations,
after taxes and interest expenses
Includes divestiture and acquisition
of real assets (capital expenditures)
and disposal and purchase of
financial assets. Also includes
acquisitions of other firms.
Net cash flow from the issue and
repurchase of equity, from the
issue and repayment of debt and after
dividend payments
= Net Change in Cash Balance
Figure 4.3: Statement of Cash Flows
This is a historical approach. We will modify this to create a
model of cashflows for valuation
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Cash Flows:
The Financial Analysts Approach
In financial analysis, we are concerned about
Cash flows to Equity: These are the cash flows generated
by assets after all expenses and taxes, after all necessary
reinvestment expenditures, and also after payments due
on the debt. Cash flows to equity, which are after cash
flows to debt but prior to cash flows to equity
Cash flow to Firm: This cash flow is before debt
payments but after operating expenses, reinvestment
expenditures and taxes. This looks at not just the equity
investor in the asset, but at the total cash flows generated
by the asset for both the equity investor and the lender.
These cash flow measures can be used to value
assets, the firms equity and the entire firm itself.
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Free Cashflows to the Firm
Free Cashflows to the firm (FCFF) are defined as cashflows
available for distribution to (all) the stakeholders of the firm
without impairing the long-run profitability of the firm.
Free Cash Flow to Firm = EBIT (1-t) Net Reinvestment where
Net Reinvestment = Incr in Non-cash Working Cap +
Cap Exp Depreciation
We do not take into account the tax benefit of interest in
computing FCFF because the tax benefit of interest is
accounted for in the discount rate.
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Free Cashflows to the Firm
We can compute historical, i.e. ex-post FCFF by using
information in the Statement of Cashflows:
FCFF = Cashflow from Operations + Interest (1-t) Capital
Expenditures
Note that Cashflows from Operations already include changes in
working capital so we do not need to subtract this out again.
However,
They also include interest as a negative flow, so we add it back
CFO does not consider changes in cash, so we dont have to make any
adjustment to CFO for changes in cash.
For valuation purposes, we need forecasts of these quantities
and the disaggregated model is more useful.
The value of the firm is the discounted present value of
cashflows to the firm + any cash position that the firm might
have. Cash is considered separately because it is usually
interest bearing and its present value is simply its current
value.

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Cashflows to Equity
Free Cash Flow to Equity (FCFE) is another cashflow
measure that focuses on cash flows to equityholders
alone.
FCFE = Net Income + Depreciation (Change in noncash
Working Capital) Capital Expenditures Net Debt Paid.
FCFE can also be computed (as an historical quantity)
from the statement of cashflows as
FCFE = Cashflow from Operations Capital
Expenditures Net Debt paid (short-term and long-term)
If there are other non-common stock securities, cashflows
associated with them, such as preferred dividends are
also subtracted.
The value of common equity is the discounted present
value of free cashflows to equity plus current cash.
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Basic FCFE model
Free Cashflow to Equity =
Net Income
Plus Depreciation
Less Capital Expenditures
Less Change in Non-Cash Working Capital
Plus Net Cash Inflow from Borrowings
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Computation of Historical FCFE
Compute these quantities for the historical time
period for which data is available.
Do it for the firm and do it for competitors
(competitors or comparable firms might be
important, if theres not enough data for the firm)
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How to deal with Cash
Assumption: Forecasts derived from these
estimates will generate the value of the firms
equity (other than cash). Hence we need to
add back the value of cash.
A better approach is to figure out the value of
cash required as part of working capital; this
is often computed as 2% of revenues the
remainder is excess cash. In this approach,
cash needs would be budgeted as part of
working capital. Then, only excess cash
would be added back.
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Net Inc or Revenues and Costs?
Each of the components now need to be
forecast.
We could forecast Net Income directly;
however, it often makes sense to look at a
more comprehensive model for Net Income
Net Income = (Revenues less Costs) less
Interest less Taxes
The drivers for Revenues and Costs could be
different, so it would be necessary to model
these differently.
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CapEx & Depreciation
We see that Capex can be related better to Revenues,
rather than to Net Income; hence it might make sense to
forecast Revenues and Costs separately.
Depreciation can be related to Capital Expenditures
(looking at the model, we see that depreciation is about
half of capital expenditures).
If we were simply replenishing capital stock, then wed
have depreciation equal to capital expenditures. Hence
this assumption implies that assets will be growing; this
is appropriate, as long as we have a growing firm.
Once the firm stops growing, this may not be
appropriate.
Keep in mind that our analysis is in nominal dollars.
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Change in Non-Cash Working Capital
What are the drivers for non-cash working capital?
What are the components of non-cash working
capital?
Accounts Payable
Accounts Receivable
Cash in hand
Short-term borrowings
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It may make more sense to look at the drivers
for the different components separately
on the other hand, an outside analyst may not
have enough information to make the
analysis at this level.
If so, it may be sufficient to analyze changes
in non-cash working capital as a function of
change in Net Income or change in Revenues.
Change in Non-Cash Working Capital
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Working Capital or Debt
Should short-term borrowings be considered debt or
should they be included in Working Capital?
If the borrowing has an explicit interest cost, then put
it in debt, if not leave it in Working Capital.
If there is an explicit interest cost, it can be factored
into the cost of capital more easily
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Cashflow from Creditors
In order to compute this, we need to look at the
firms capital structure and figure out whether it
has enough debt, right now, or too much debt.
Look at the capital structure of other firms in the
industry
How will its capital structure change, going
forward?
If its current leverage is too low relative to
target, it would, want to gradually step up debt
issuance until it reaches target leverage.
We need to look at issuance costs: it may make
sense to wait and then issue a lot of debt at a
time to save on the fixed issuance costs.