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1、Chapter Outline,7.1 Incremental Cash Flows 7.2 The Baldwin Company: An Example 7.3 Inflation and Capital Budgeting 7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method 7.5 Summary and Conclusions,7.1 Incremental Cash Flows,Cash flows matternot accounting earnings. Sunk costs dont matt
2、er. Incremental cash flows matter. Opportunity costs matter. Side effects like cannibalism and erosion matter. Taxes matter: we want incremental after-tax cash flows. Inflation matters.,Cash FlowsNot Accounting Earnings.,Consider depreciation expense. You never write a check made out to “depreciatio
3、n”. Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.,Incremental Cash Flows,Sunk costs are not relevant Just because “we have come this far” does not mean that we should continue to throw good money after bad. Opportunity costs do matter. Just bec
4、ause a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed. Side effects matter. Erosion and cannibalism are both bad things. If our new product causes existing
5、 customers to demand less of current products, we need to recognize that.,Estimating Cash Flows,Cash Flows from Operations Recall that: Operating Cash Flow = EBIT Taxes + Depreciation Net Capital Spending Dont forget salvage value (after tax, of course). Changes in Net Working Capital Recall that wh
6、en the project winds down, we enjoy a return of net working capital.,Interest Expense,Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value. For now, its enough to assume that the firms level of debt (hence interest expense) is in
7、dependent of the project at hand.,7.2 The Baldwin Company: An Example,Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Increase in net working
8、 capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation
9、rate: 5% Working Capital: initially $10,000 changes with sales.,The Worksheet for Cash Flows of the Baldwin Company,Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investments: (1) Bowling ball machine 100.00 21.76* (2) Accumulated 20.00 52.00 71.20 82.72 94.24 depreciation (3) Adjusted basis of 80.00 48.
10、00 28.80 17.28 5.76 machine after depreciation (end of year) (4) Opportunity cost 150.00 150.00 (warehouse) (5) Net working capital 10.00 10.00 16.32 24.97 21.22 0 (end of year) (6) Change in net 10.00 6.32 8.65 3.75 21.22 working capital (7) Total cash flow of 260.00 6.32 8.65 3.75 192.98 investmen
11、t (1) + (4) + (6),* We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gai
12、n is $24,240 (= $30,000 $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 0.34 ($30,000 $5,760). The after-tax salvage value is $30,000 0.34 ($30,000 $5,760)
13、 = 21,760.,($ thousands) (All cash flows occur at the end of the year.),The Worksheet for Cash Flows of the Baldwin Company,At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.,($ thousands) (All cash flows occur at the end of the year.),Year 0 Year 1 Year 2 Yea
14、r 3 Year 4 Year 5 Investments: (1) Bowling ball machine 100.00 21.76* (2) Accumulated 20.00 52.00 71.20 82.72 94.24 depreciation (3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76 machine after depreciation (end of year) (4) Opportunity cost 150.00 150.00 (warehouse) (5) Net working capital 10.00 10
15、.00 16.32 24.97 21.22 0 (end of year) (6) Change in net 10.00 6.32 8.65 3.75 21.22 working capital (7) Total cash flow of 260.00 6.32 8.65 3.75 192.98 investment (1) + (4) + (6),The Worksheet for Cash Flows of the Baldwin Company (continued),Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Income: (8) Sale
16、s Revenues 100.00 163.00 249.72 212.20 129.90,($ thousands) (All cash flows occur at the end of the year.),Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000$20(1.02)2
