Chapter 11

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11.1 Project Cash Flows 1. LG1 Discuss incremental cash flows and describe the three major types of project cash flows. 2. LG2 Discuss expansion versus replacement decisions, sunk costs, opportunity costs, and financing costs. 11.1 Project Cash Flows 3. LG1 Discuss incremental cash flows and describe the three major types of project cash flows. LG2 Discuss expansion versus replacem 11.1 Project Cash Flows 1. LG1 Discuss incremental cash flows and describe the three major types of project cash flows. 2. LG2 Discuss expansion versus replacement decisions, sunk costs, opportunity costs, and financing costs. Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investment projects. To evaluate these opportunities, financial managers must identify the project cash flows, which are the free cash flows associated with an investment opportunity. Recall from Chapter 4 that free cash flow (FCF) is the cash available to investors after meeting all operating needs and net investments in fixed assets and working capital. Project cash flows are the incremental free cash flows (after taxes) that a firm expects a project to generate over its life. A general equation for project cash flow is: (11.1) Operating cash flow ( OCF ) refers to the periodic incremental cash flows that most projects generate by enabling the firm to produce and sell goods or services. A project’s operating cash flow equals its after-tax operating profit plus depreciation: (11.2) The net fixed asset investment ( NFAI ) is the investment made in fixed assets each period, or, equivalently, the change in gross fixed assets from one period to the next. It captures purchases and sales of fixed assets as Equation 11.3 shows: (11.3) For most investment projects, net fixed assets increase at first as the firm incurs a significant 4. ent decisions, sunk costs, opportunity costs, and financing costs. 5. Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investment projects. To evaluate

these opportunities, financial managers must identify the project cash flows, which are the free cash flows associated with an investment opportunity. Recall from Chapter 4 that free cash flow (FCF) is the cash available to investors after meeting all operating needs and net investments in fixed assets and working capital. Project cash flows are the incremental free cash flows (after taxes) that a firm expects a project to generate over its life. A general equation for project cash flow is: 6. (11.1) 7. Operating cash flow ( OCF ) refers to the periodic incremental cash flows that most projects generate by enabling the firm to produce and sell goods or services. A project’s operating cash flow equals its after-tax operating profit plus depreciation: 8. (11.2) 9. The net fixed asset investment ( NFAI ) is the investment made in fixed assets each period, or, equivalently, the change in gross fixed assets from one period to the next. It captures purchases and sales of fixed assets as Equation 11.3 shows: 10. (11.3) 11. For most investment projects, net fixed assets increase at first as the firm incurs a significant 12. Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investment projects. To evaluate these opportunities, financial managers must ident11.1 Project Cash Flows LG1 Discuss incremental cash flows and describe the three major types of project cash flows. LG2 Discuss expansion versus replacement decisions, sunk costs, opportunity costs, and financing costs. Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investment projects. To evaluate these opportunities, financial managers must identify the project cash flows, which are the free cash flows associated with an investment opportunity. Recall from Chapter 4 that free cash flow (FCF) is the cash available to investors after meeting all operating needs and net investments in fixed assets and working capital. Project cash flows are the incremental free cash flows (after taxes) that a firm expects a project to generate over its life. A general equation for project cash flow is: (11.1)

Operating cash flow (OCF) refers to the periodic incremental cash flows that most projects generate by enabling the firm to produce and sell goods or services. A project’s operating cash flow equals its after-tax operating profit plus depreciation: (11.2) The net fixed asset investment (NFAI) is the investment made in fixed assets each period, or, equivalently, the change in gross fixed assets from one period to the next. It captures purchases and sales of fixed assets as Equation 11.3 shows: (11.3) For most investment projects, net fixed assets increase at first as the firm incurs a significant cash outflow to make the initial investment required to get a project started. In subsequent years, net fixed assets may increase if the firm continues to acquire new fixed assets or decrease if it sells assets in excess of the depreciation charge. The net working capital investment (NWCI) is the change in net working capital from one period to the next. Equation 11.4 shows that “net” refers to the difference between the change in current assets and the change in current liabilities:2 (11.4) When forecasting project cash flows for capital budgeting analysis, it is useful to group the incremental cash flows into categories that apply to most investments. Figure 11.1 shows that a typical investment has an up-front, initial cash flow, which is the net incremental after-tax cash flow occurring at the beginning of a project’s life (i.e., at time zero). Sometimes referred to as the initial investment or initial cash outlay, the initial cash flow may include the purchase of new fixed assets, the sale of old fixed assets, or the buildup or recovery of working capital. Once the investment is in place, it generates periodic cash flows, which typically include the project’s incremental operating cash flows and any additional changes in fixed assets or working capital. Most investments have finite lives, and in such a case the final cash flow is called the terminal cash flow. The terminal cash flow typically includes any after-tax proceeds from selling used assets, costs of cleaning up or shutting down facilities, and recovering working capital invested in earlier periods. Sometimes, an investment project has an indefinite (or infinite) life span. For example, the chapter opener discussed Fiserv’s acquisition of First Data. When one company buys another, it usually expects to generate cash flows from that investment indefinitely. In that case, rather than producing a terminal cash flow, the investment has a terminal value equal to the present value of the expected cash flows over an infinite horizon. In other words, for an investment with an infinite lifespan, the terminal value is the value of a (possibly growing) perpetuity. Figure 11.1Typical Project Cash Flows to Identify for a Capital Budgeting Project

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Figure 11.1 Full Alternative Text Incremental Cash Flows When analyzing an investment opportunity, it is critical to focus only on the project’s incremental cash flows, which are the additional after-tax cash flows—outflows or inflows—that will occur only if the firm makes the investment. In deciding which cash flows are incremental and which are not, it is helpful to think in the following way. First, forecast all the cash flows that a firm will generate if it makes a particular investment. Next, estimate the cash flows the firm will generate if it does not make the investment. The investment’s incremental cash flow is just the difference between those two sets of projections—the cash flow the firm produces if it invests minus the cash flow it produces without investing. Incremental cash flows are easier to think about conceptually for some projects than others. If a firm is making an investment that expands its activities in some way, say by building new manufacturing capacity, opening new retail space, or launching a new product, then the incremental cash flows are exclusively the result of the expansion project. For example, if Target Corporation opens a new retail store in a town that previously had no Target stores, the initial cash flow would include the cost of opening the new store and stocking it with inventory. Once the store is open, it will generate periodic cash flows (operating cash flows and changes in net working capital) normally associated with running a Target store. The project’s incremental cash flows consist only of the new cash flows created by the investment because Target’s cash flows from its existing stores were not affected by the decision to build a new one. A more difficult situation arises when a firm must decide whether to replace some asset that it already owns with a new asset. Such decisions might include replacing old equipment, upgrading computers or software, remodeling facilities, or releasing new versions of older products. Identifying the net incremental cash flows for these replacement projects is more complicated because the firm must compare the cash flows that result from the new investment to the cash flows that would have occurred if no investment had been made. For instance, if a company buys new equipment to replace existing machinery, the initial cash flow includes the cost of the new equipment as well as any cash flows associated with the removal and sale of the old equipment. Similarly, identifying the periodic cash flows that an investment produces is more complex if the new investment replaces an asset that is already in service. If Target Corporation remodels one of its existing stores, that is a kind of replacement decision because the cash flows from the remodeled store “replace” the cash flows from the old store. To estimate this project’s incremental cash flows, financial analysts at Target must forecast the cash flows from the new store and compare those to the cash flows the old store would have generated had it not been remodeled.ify the project cash flows, which are the free cash flows associated with an investment opportunity. Recall from Chapter 4 that free cash flow (FCF) is the cash available to investors after meeting all operating needs and net investments in fixed assets and working capital. Project cash flows are the incremental free cash flows (after taxes) that a firm expects a project to generate over its life. A general equation for project cash flow is:

(11.1) Operating cash flow ( OCF ) refers to the periodic incremental cash flows that most projects generate by enabling the firm to produce and sell goods or services. A project’s operating cash flow equals its after-tax operating profit plus depreciation: (11.2) The net fixed asset investment ( NFAI ) is the investment made in fixed assets each period, or, equivalently, the change in gross fixed assets from one period to the next. It captures purchases and sales of fixed assets as Equation 11.3 shows: (11.3) For most investment projects, net fixed assets increase at first as the firm incurs a significant 11.1.2: Sunk Costs and Opportunity Costs When estimating an investment’s incremental cash flows, the firm must take care to treat sunk costs and opportunity costs properly. These costs are easy to mishandle, classifying costs as incremental when they are not or ignoring costs that should be counted as part of a project’s incremental cash flows. Sunk costs are cash outflows that have already occurred (past outlays) and cannot be recovered, regardless of the final investment decision. Suppose that before building a new store, managers at Target first invest a lot of time and money to assess the market for the proposed store. This analysis might look at the population and average income in the surrounding community, the local cost of labor, taxes, and many other factors. This preliminary analysis may cost tens of thousands of dollars. However, once it is completed, those costs are sunk and should not influence the company’s decision to open a new store. Whether Target opens a new store or not, it cannot recover the costs of analyzing the investment opportunity in the local market. Sunk costs are irrelevant and should not be included in a project’s incremental cash flows. Opportunity costs are cash flows that the firm could have realized from the best alternative use of assets already in place. When a firm undertakes a replacement project, it repurposes or replaces some portion of its existing assets to generate a new cash flow stream and, in doing so, forgoes any of the future c 11.1.2: Sunk Costs and Opportunity Costs When estimating an investment’s incremental cash flows, the firm must take care to treat sunk costs and opportunity costs properly. These costs are easy to mishandle, classifying costs as incremental when they are not or ignoring costs that should be counted as part of a project’s incremental cash flows. Sunk costs are cash outflows that have already occurred (past outlays) and cannot be recovered, regardless of the final investment decision. Suppose that before building a new store, managers at Target first invest a lot of time and money to assess the market for the proposed store. This analysis might look at the

population and average income in the surrounding community, the local cost of labor, taxes, and many other factors. This preliminary analysis may cost tens of thousands of dollars. However, once it is completed, those costs are sunk and should not influence the company’s decision to open a new store. Whether Target opens a new store or not, it cannot recover the costs of analyzing the investment opportunity in the local market. Sunk costs are irrelevant and should not be included in a project’s incremental cash flows. Opportunity costs are cash flows that the firm could have realized from the best alternative use of assets already in place. When a firm undertakes a replacement project, it repurposes or replaces some portion of its existing assets to generate a new cash flow stream and, in doing so, forgoes any of the future cash inflows that the existing assets would have provided had they not been replaced. Thus, the incremental operating cash flows for a replacement project will be the difference between the new operating cash flows and the forgone operating cash flows. For example, suppose a company owns a warehouse that is currently empty. The company might refurbish the warehouse and lease it as retail space. The cost of doing so is more than just the refurbishment expenses because the building itself, even though the company already owns it, is not free. If the company did not refurbish the space, it could sell it, and the proceeds that it gives up by refurbishing the space rather than selling it represent an opportunity cost that should be deducted from the project’s other cash flows. Focus on EthicsFumbling Sunk Costs A core concept in economics is marginal analysis—decisions should depend on incremental costs and benefits. Costs already incurred that cannot be recovered—sunk costs—are irrelevant. Surprisingly, businesses often wrongly consider sunk costs, a practice sometimes called the Concorde Fallacy after the most notorious case. Long after the Supersonic Transport Aircraft proved a commercial disaster, the British and French governments continued funding it because no senior official wanted to concede the project had been folly. When considering project renewal, managers have an ethical duty to focus on net present value and avoid letting emotional factors or concerns about their own reputations distort investment decisions. Professional sports offer the best-known example of the Concorde Fallacy—a team signs a marquee player to an expensive long-term contract, then sticks with him no matter what. Consider the case of Robert Griffin III (RGIII), the 2011 Heisman Trophy-winning quarterback drafted second by the National Football League (NFL) Washington Redskins. Griffin cost the Redskins plenty—a four-year guaranteed contract worth $21.1 million as well as numerous draft picks traded to obtain the second overall pick in the draft. The deal also gave the Redskins an option to keep RGIII around a fifth year for a hefty sum; here sunk costs entered the equation. In the first year of the contract, the investment paid off handsomely—Griffin was named Offensive Rookie of the Year, and the Redskins won their division for the first time in 13 years. But late that season, RGIII suffered the first of many injuries that kept him from regaining rookie form. Just before the 2015 season (the fourth and final year of the initial contract) the Redskins took advantage of their right to sign Griffin for 2016, promising a cool $16.2 million. At the time, the move was called “the biggest blunder in NFL history” because of the injury risk. The Redskins tried to hedge by not guaranteeing the salary— meaning the full amount would be owed only if RGIII stayed healthy the entire 2016 season. But under the terms of the initial contract, the team was on the hook if a 2015 injury prevented him from playing in 2016. Sure enough, in the 2015 preseason, Griffin suffered a concussion—forcing the Redskins to bench

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him to prevent further injury that could carry over and cost $16.2 million. The team owned up to the mistake by releasing a now-healthy RGIII after the 2015 season. Recent research suggests NFL teams routinely fail to ignore sunk costs. One study looked at factors influencing the number of games started by defensive players. The empirical model included performance measures like solo tackles for linebackers as well as contract size to test for the Concorde Fallacy. Other things being equal, performance rather than compensation should determine which players should start more games—contracts are sunk because a player is paid the same dollars whether he begins the game on the field or the bench. Contracts turned out to have a large impact—a 15% increase in a defensive player’s compensation boosted the number of starts as much as nine extra solo tackles would. In other words, more expensive players were more likely to start even if they did not perform better than players on the bench. From an economic perspective, choosing starters based on sunk costs deserves a flag for illegal procedure.3 Recommitting to a losing project for emotional or reputational reasons can destroy shareholder wealth. What safeguards could a firm use to remove such bias from recommitment decisions? Example 11.1 Jankow Equipment is considering enhancing its drill press X12, which it purchased three years earlier for $237,000, by retrofitting it with the computerized control system from an obsolete piece of equipment it owns. The obsolete equipment could be sold today for $42,000, but without its computerized control system, it would be worth nothing. Jankow is in the process of estimating the labor and materials costs of retrofitting the system to drill press X12 and the benefits expected from the retrofit. The $237,000 cost of drill press X12 is a sunk cost because it represents an earlier cash outlay. It would not be included as a cash outflow when determining the cash flows relevant to the retrofit decision. However, if Jankow uses the computerized control system of the obsolete machine, then Jankow will have an opportunity cost of $42,000, which is the cash the company could have received by selling the obsolete equipment in its current condition. By retrofitting the drill press, Jankow gives up the opportunity to sell the old equipment for $42,000. This opportunity cost would be included as a cash outflow associated with using the computerized control system. 11.1.3: Financing Costs Equation 11.2 says that part of an investment project’s cash flow includes earnings before interest and taxes. Interest expenses and other financing costs are important, so we must account for them in capital budgeting analysis. Discounting cash flows accomplishes that objective. That is, the discount rate itself accounts for the costs that firms must pay lenders and shareholders for the capital they provide. Deducting interest expense separately from project cash flows would not be accounting for these costs— it would be double counting them, as the next example illustrates. Example 11.2 Hofstadter Sciences Inc. is considering a $40 million investment in land that will never depreciate and will generate revenues of $6 million per year in perpetuity. Partially offsetting those revenues are $2

million in annual operating expenses. Hofstadter plans to finance this investment by selling $20 million in stock that has a required return of 13% and $20 million in bonds that pay investors a 7% return. Thus, Hofstadter’s capital structure weights are 50% debt and 50% equity. Does this investment satisfy Hofstadter’s investors? For simplicity, assume there are no taxes. First recognize that the company’s weighted-average cost of capital is 10%, reflecting equal weights on the costs of equity and debt. Suppose we calculate this project’s annual cash flow by deducting interest expense. In that case, the investment produces an annual cash flow of $2.6 million. If the project earns $2.6 million in cash flow each year in perpetuity, then its net present value is negative, so the firm should not go forward with the investment. Suppose Hofstadter ignores the negative NPV and invests anyway. Does the project bring in enough cash to satisfy investors? Each year after paying operating expenses and interest expense, there is $2.6 million in extra cash. If Hofstadter pays that to shareholders as a dividend, it represents a return on their $20 million investment of . That’s exactly the return that shareholders require, so both they and the bondholders (who are receiving the promised 7% return) are satisfied. If the project meets the expectations of both equity and debt investors, why does it have a negative NPV? The answer is that we should have excluded interest expense from the cash flow calculation. With interest excluded, the project’s annual cash flow is $4 million and its NPV is $0. Recall that a $0 NPV means that the project just satisfies all investors. This example demonstrates how deducting the cost of financing (interest expense) from the project cash flows understates the project’s value and sends managers an incorrect signal to reject a good project. Thus, we ignore the cost of financing when determining project cash flows. Review Questions 11–1 Why is it important to evaluate capital budgeting projects on the basis of incremental cash flows? 11–2 What three types of project cash flows may exist for a given project? How are expansion and replacement decisions different? Explain. 11–3 What effect do sunk costs and opportunity costs have on a project’s cash flows? 11–4 Why is the cost of financing not reflected in a project’s cash flows?

11.2 Finding the Initial Cash Flow LG3 Calculate the initial cash flow associated with an investment project. LG4 Discuss the tax implications associated with the sale of an old asset. The term initial cash flow refers to the up-front net incremental cash flow associated with a prospective investment opportunity. For expansion projects, there are cash outflows from the purchase of new assets or an increase in net working capital. For replacement projects, cash inflows may also occur that involve selling off old assets before bringing new ones into service. The initial cash flow nets all of the incremental cash flows that occur at the start of a project, subtracting all the cash outflows from any cash inflows. A simple template based on Equation 11.1 for determining the initial cash flow appears in Table 11.1. Because the initial cash flow occurs at time zero, there will not be an operating cash flow, so calculating the initial cash flow typically begins with the installed cost of any new assets. Next, if the new investment involves selling old assets, include the after-tax proceeds from that sale. Finally, include any change in working capital that the project requires up front. Table 11.1 A Template for Determining the Initial Cash Flow (1) (2) (3) Change in net working capital Installed Cost of the New Asset

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As Table 11.1 shows, a new asset’s installed cost equals the sum of the asset’s cost and the installation cost. The cost of the new asset is the cash outflow necessary to acquire the new asset, which is just its purchase price. Installation costs include all costs necessary to bring the asset into service, which may include shipping costs, installation costs, or setup costs. The IRS requires the firm to add installation costs to an asset’s purchase price to determine its depreciable value, which may be expensed over the project’s life. The installed cost of the new asset, the sum of its purchase price and its installation costs, equals its depreciable value. 11.2.2: After-Tax Proceeds from the Sale of the Old Asset Table 11.1 shows that the after-tax proceeds from the sale of the old asset decrease the firm’s initial cash outflow. Equation 11.5 shows that the after-tax proceeds from the sale of the old asset include the old asset’s sale proceeds and any applicable tax liability or refund related to its sale. (11.5) The proceeds from the sale of an asset are the before-tax cash inflows net of any removal costs that result from selling the asset. Normally, selling an asset triggers a tax-related cash flow. The tax on the sale of an asset is either an additional tax payment when the sales proceeds exceed the asset’s book value or a tax refund when sale proceeds are less than the asset’s book value. The book value of an asset is the asset’s value on the firm’s balance sheet as determined by accounting principles.4 An asset’s book value is usually just the difference between what the asset cost (including installation costs) and the accumulated depreciation on the asset. (11.6) Example 11.3 Hudson Industries, a small electronics company, acquired a machine tool two years ago with an installed cost of $100,000. The asset was not eligible for 100% bonus depreciation under then-current tax law, so it was being depreciated under MACRS, using a five-year recovery period. Table 4.2 shows that under MACRS for a five-year recovery period, 20% and 32% of the installed cost would be depreciated in years one and two, respectively. In other words, of the $100,000 cost, or , would be the accumulated depreciation after two years. Substituting into Equation 11.6, we get The book value of Hudson’s asset at the end of year two is therefore $48,000. Three tax treatments are possible and depend on the asset’s selling price: The asset may be sold for (1) more than its book value, (2) its book value, or (3) less than its book value. In the first case, the firm generates a gain on the sale of the asset, in the second case it breaks even, and in the third case it realizes a loss. Only in the breakeven case is there no tax consequence of the sale. Table 11.2 summarizes the tax consequences for the sale of an asset for more or less than book value. Table 11.2 Tax Treatments for the Sales of Assets

Tax case Definition Tax treatment Tax consequence Gain on the sale of asset Portion of the sale price that is greater than book value. All gains above book value are taxed as ordinary income. 21% of gain is a tax liability. Loss on the sale of asset Amount by which sale price is less than book value. If the asset is depreciable and used in business, then loss is deducted from ordinary income. 21% of loss is a tax savings. Example 11.4 The old asset purchased two years ago for $100,000 by Hudson Industries has a current book value of $48,000. What will happen if the firm now decides to sell the asset and replace it? The tax consequences depend on the sale price. Figure 11.2 depicts the taxable income resulting from four possible sale prices in light of the asset’s initial purchase price of $100,000 and its current book value of $48,000. The tax consequences of each of these sale prices are described in the following paragraphs. Figure 11.2Tax Consequences from the Sale of an Asset

Tax consequences from the sale of an asset at various sale prices for Hudson Industries Figure 11.2 Full Alternative Text The sale of the asset for more than its book value If Hudson sells the old asset for $110,000, it realizes a gain of . Technically, this gain is made up of two parts: a capital gain and recaptured depreciation, which is the portion of the sale price that is above book value and below the initial purchase price. For Hudson, the capital gain is ; recaptured depreciation is $52,000 . The tax treatment of capital gains can be quite complex, so to keep things simple we assume that the total $62,000 gain is taxed at Hudson’s ordinary corporate income tax rate of 21%, resulting in incremental taxes of . Hudson would not have paid these taxes had they not replaced the old equipment, so the taxes are part of the incremental cash flows at time zero. That is, the taxes constitute a portion of the project’s initial investment. If Hudson instead sells the old asset for $70,000, it experiences a gain above book value (in the form of recaptured depreciation) of , as shown under the $70,000 sale price in Figure 11.2 This gain is taxed as ordinary income, which triggers in incremental taxes for Hudson. Again, these taxes add to the cost of the initial investment. The sale of the asset for its book value If Hudson sells the old asset for $48,000, there is no gain or loss on the sale, as Figure 11.2 shows. Because there is no gain or loss, there is no incremental tax effect of the sale. The sale of the asset for less than its book value If Hudson sells the asset for $30,000, it experiences a loss of , as shown under the $30,000 sale price in Figure 11.2. The firm may use the loss to offset ordinary operating income, which saves the firm in taxes. And, if current operating earnings are not sufficient to offset the loss, the firm may be able to apply these losses to prior or future years’ taxes.5 Keep in mind that there are subtle opportunity costs here. If the firm makes an investment that involves selling an old asset, it misses the opportunity to leave that asset in service. Leaving it in service would generate two sources of cash flow—periodic operating cash flow and cash flow from selling the old asset at some future date at the end of its useful life. We will address both of these opportunity costs later in this chapter. 11.2.3: Change in Net Working Capital Net working capital is the difference between the firm’s current assets and its current liabilities. Changes in net working capital often accompany capital budgeting decisions. If a firm acquires

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new machinery to expand its production output, it will experience an increase in levels of cash, accounts receivable, inventories, accounts payable, and expense accruals. These increases result from the need for more cash to support expanded operations, more accounts receivable and inventories to support increased sales, and more accounts payable and expense accruals to support increased outlays made to meet expanded product demand. As noted in Chapter 4 , increases in cash, accounts receivable, and inventories are outflows of cash , whereas increases in accounts payable and expense accruals are inflows of cash . Matter of Fact Inventory Management Lowers Working Capital Investment Requirement for Large Firms A 2019 survey by PwC found that for the first time since 2014, firms were reducing their investments in net working capital, freeing up resources for other uses. One of the drivers of lower working capital was improved inventory management, especially among large firms. Compared to small firms, large companies had 27.8 fewer days of inventory on hand, though the gap between small and large firms was narrowing, suggesting that smaller firms were increasing their focus on inventory management techniques. 6 11.2.4: Summary: Calculating the Initial Cash Flow An investment’s initial cash flow starts with the cost of acquiring new assets, but as we have seen it may also include after-tax proceeds from sales of old assets as well as changes in working capital investment. The following example follows the template in Table 11.1 and includes all of these factors. Example 11.6 Powell Corporation is trying to determine the initial cash flow required to replace an old machine with a new one capable of producing a higher rate of output. The purchase price of the new machine is $380,000 and it costs $20,000 to install, so its installed cost is $400,000. It will be depreciated under MACRS, using a five-year recovery period. The old machine was purchased three years ago at a cost of $240,000 and was being depreciated under MACRS, using a five-year recovery period. The firm can sell the old machine for $280,000. Putting the new machine into service will trigger an immediate $35,000 increase in current assets and an $18,000 increase in current liabilities, resulting in a $17,000 ($35,000$18,000) increase in net working capital. The firm’s tax rate is 21%. The only component of the initial cash flow calculation that is difficult to obtain is taxes. The tax consequence of the sale of the old machine depends on the asset’s selling price relative to its

book value. To find the old machine’s book value, use the depreciation percentages from Table 4.2 of 20%, 32%, and 19% for years 1, 2, and 3, resp 11.3 Finding the Periodic Cash Flows 1. LG5 Find the periodic cash flows associated with an investment project. After a firm makes a new investment, it will generate a stream of periodic cash flows. Those cash flows could include incremental revenues and operating expenses as business activity grows. Some investments generate incremental cost savings without additional revenue. In either case, there will be incremental taxes to account for, and there may also be additional periodic investments in fixed assets or working capital necessary to sustain the project cash flow stream over time. A common way to make projections of these periodic cash flows is to build year-by- year pro forma income statements over the investment’s life. Remember though that what matters in deciding whether an investment creates or destroys value is the investment’s cash flows, not its net income or earnings. Therefore, in building out pro forma income statements for a project, it is important to treat depreciation deductions properly. Depreciation is a noncash expense, but it impacts cash flows because it reduces taxes by an amount known as the depreciation tax shield . The depreciation tax shield in any given year equals (11.7) This means that there are two ways of handling depreciation expense when forecasting project cash flows: 1. Deduct depreciation expense along with all other expenses when calculating net income, and then add depreciation back because it was not an actual outlay of cash. 2. Ignore 11.4 Finding the Terminal Cash Flow 1. LG6 Determine the terminal cash flow associated with an investment project. An investment’s terminal cash flow typically takes one of two forms. In the simplest case, the investment reaches the end of its useable life and is liquidated. In the other case, the lifespan of the investment is indefinite, so there is no terminal cash flow per se, but rather a terminal value that captures the present value of cash flows that an asset will produce over an infinite horizon. When an investment project reaches the end of its life, the incremental cash flow that comes from liquidating the investment in its final year of service is the terminal cash flow. This terminal cash flow might include the original asset’s salvage value net of any removal or cleanup costs, as well as any previous working capital investments that the firm recovers when the investment

winds down. If the original investment involved replacing an old asset with a new one, the incremental terminal cash flow must take into account the proceeds from liquidating the new asset net of any proceeds that the firm might have received had it kept the old asset in service and liquidated it instead. Table 11.9 shows a basic format for calculating the terminal cash flow for an investment at the end of its useable life. Table 11.9 The Basic Format for Determining Terminal Cash Flow After-Tax Proceeds from the Sale of New and Old Assets 11.4.2: Change in Net Working Capital The initial cash flow calculation takes into account any change in net working capital at the beginning of the project life. Likewise, the terminal cash flow calculation includes any change in net working capital that occurs at the end of the investment’s life. Most often, this will show up as a cash inflow as the firm depletes inventories, collects accounts receivable, and pays accounts payable when the project ends. As long as no changes in working capital occur after the initial cash flow, the amount recovered at termination will equal what was invested up front and shown in the initial cash flow. If working capital changes year to year as a firm expands or contracts operations, then those changes should be incorporated into the yearly operating cash flows. Changes to working capital by themselves do not trigger incremental taxes, so there are no tax consequences to consider. Calculating the terminal cash flow involves the same procedures used to find the initial cash flow. In the following example, we calculate the terminal cash flow for Powell’s replacement decision. Example 11.10 The Powell Corporation expects to liquidate the new machine after five years, which brings in $50,000 after removal and cleanup costs. Had the new machine not replaced the old one, the old machine would have been liquidated after five years to net $10,000. This is an opportunity cost associated with Powell’s investment decision. The firm expects to recover its $17,000 net working capital investment upon termination of the project. The firm pays taxes at a rate of 21%. From the depreciation schedule in Table 11.5, we see that Powell’s new machine has not been fully depreciated after five years and has a book value remaining of $20,000. The old machine would have been fully depreciated and therefore would have had a book value of zero after five years. Because the sale price of $50,000 for the new machine is below its initial installed cost of $400,000, but greater than its book value of $20,000, the firm will pay taxes only on the recaptured depreciation of . Applying the ordinary tax rate of 21% to this $30,000 results in a tax of on the sale of the new machine. Its after-tax sale proceeds would therefore equal . Because the old machine would have been sold for $10,000 at

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termination, which is less than its original purchase price of $240,000 and above its book value of zero, it would have experienced a taxable gain of . Applying the 21% tax rate to the $10,000 gain, the firm would have owed a tax of on the sale of the old machine at the end of year 5. The firm’s after-tax sale proceeds from the old machine would have equaled . Substituting the appropriate values into the format in Table 11.9 results in the terminal cash inflow of $52,800. Please configure the terminal cash flow calculation as follows: Proceeds from the sale of the new machine $50,000 −Tax on the sale of the new machine +After-tax proceeds from the sale of the new machine $43,700 Proceeds from the sale of the old machine $10,000 −Tax on the sale of the old machine

2,100 −After-tax proceeds from the sale of the old machine $7,900 +Change in net working capital $17,000 Terminal cash flow $52,800 A different kind of terminal cash flow calculation is necessary for an investment with an infinite life. Fixed assets like equipment usually do not last for decades, but whole companies do. When one firm buys another, the acquiring company usually expects to operate the target company and generate cash flows from doing so indefinitely. This means that analysts for the acquiring firm need to calculate the NPV of the proposed acquisition over an infinite horizon. Obviously, it is not practical to construct year-by-year forecasts over such a long horizon. Instead, analysts typically make annual cash flow forecasts for a relatively short period, and then they make an assumption about how cash flows will grow in the years after the forecast horizon. With that assumption in place, the investment’s terminal value is the present value of that future cash flow stream. If analysts make annual cash flow projections for t years, the terminal value at time t, , equals the cash flow at time , divided by the discount rate minus the growth

rate of cash flows over the infinite horizon. The cash flow at time is equal to the cash flow at time t times one plus the growth rate. (11.8) Example 11.11 Nile.com is a large retail company that is considering the acquisition of a smaller competitor, Bull’s Eye Inc. Financial analysts at Nile believe that acquiring Bull’s Eye would require an up-front payment of $20 billion, and they have estimated the acquisition’s incremental cash flows for the first four years as shown below. Beyond the fourth year, analysts estimate that incremental cash flows will grow at 4% per year in perpetuity, and the appropriate discount rate for the acquisition is 10%. Year Cash Flow ($ millions) 0 1 650 2 900 3

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1,200 4 1,500 To calculate the terminal value, recognize that in year 5 cash flows will be 4% higher than in year 4, or $1.56 billion. Using Equation 11.8, the acquisition’s terminal value is the present value in year 4 of all the cash flows arriving in year 5 and beyond, which is $26 billion. Discounting the acquisition’s annual cash flow as well as its terminal value to the present gives the overall NPV of just over $1 billion.

Chapter 11

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