Capital Budgeting: Cash Flow, NPV, and WACC
Chapter 12: Cash Flow in Capital Budgeting Projects
Opportunity Costs
Allocation of a firm’s resources represents lost opportunities.
Sunk Cost
An expense or obligation the firm is compelled to pay regardless of whether a project is undertaken.
Straight-Line Depreciation Method
Depreciation = (Depreciable basis – Ending book value) / Life of asset
Operating Cash Flow (OCF)
OCF = EBIT * (1 – Tax rate) + Depreciation
Gross Fixed Asset Changes
Almost always change at the beginning and end of a project. At the beginning, it equals the asset’s depreciable basis. At the end, one must consider the tax consequences of the sale.
After-Tax Cash Flow (ATCF)
ATCF = Book Value + (Market value – Book value) * (1 – Tc)
Net Working Capital Changes
Typical product unit sales follow a bell-shaped curve. Changes in levels of NWC throughout the project’s life are what need to be financed.
MACRS Depreciation
Accelerated depreciation (double-declining balance method). It is the most common method of calculation.
Depreciable Basis
Cost, amount paid for the item, freight charges, installation, and testing fees.
Section 179 Deductions
Assets can be expensed immediately up to $500k. This is targeted at helping small businesses.
Free Cash Flow (FCF)
FCF = Operating cash flow – Investment in operating capital
or
FCF = [EBIT(1 – Tax rate) + Depreciation] – [Change in gross fixed assets + Change in net operating working capital]
Weighted Average Flotation Cost
Weighted Average Floatation Cost = E/(E+P+D)*Fe + P/(E+P+D)*Fp + D/(E+P+D)*Fd
Adjusted CF
Adjusted CF = CF0 / (1 – Fa)
Chapter 12 Examples
Estimating the Present Value of Tax Benefits from Depreciation
Use the straight-line depreciation formula, multiply depreciation by the tax rate, and plug tax savings into CF. Calculate PV for X number of years.
Calculating the EAC with a 12% Cost of Capital
Calculate the NPV for both options. Plug the number into PV and solve for PMT. EAC is PMT (negative).
Determining Project Cash Flows
To calculate the change in Fixed Assets at the last year, find the cash flow from selling the item.
Calculating the Depreciation Tax Shield for Year 3
Multiply the unit cost by the depreciation cost in the last year, then multiply by the tax rate to find the tax shield.
Chapter 13: NPV & Other Capital Budgeting Projects
Financial Decision Drivers
- Currency
- Time
- Rate of return
Payback
The break-even calculation for the costs of financing a new project. Measured based on whether the calculated payback meets the maximum allowable payback.
Discounted Payback
Compensates for the Time Value of Money (TVM).
Pros and Cons of Payback (PB) and Discounted Payback (DPB)
Pros: Easy to calculate.
Cons: Benchmarks are arbitrary, ignores cash flows after the payback period, and PB ignores TVM.
Net Present Value (NPV)
Measures the value created by the project.
Pros: Not a ratio, works well with independent and mutually exclusive projects.
Cons: Managers can misinterpret results. If NPV > 0, accept.
Internal Rate of Return (IRR)
Most popular. Gives the same accept/reject decision as NPV when used with normal cash flow projects. Accept if IRR > cost of capital.
Cons: Normal cash flows, is independent. IRR and NPV are not recommended for non-normal cash flows. Both IRR and NPV assume cash flows are reinvested into the firm. NPV investment rate is superior.
Modified Internal Rate of Return (MIRR)
Fixes the investment rate problem. Uses the cost of capital to move cash flows. Not appropriate for mutually exclusive projects.
Cons: Does not correct IRR issues with choosing the wrong project for a range of rates.
Profitability Index (PI)
Based on NPV. Use when a firm has resource constraints on the capital available for new projects.
Chapter 13 Examples
Calculating Payback
Find the bridge and divide the total by the break-even year.
Calculating Discounted Payback
Calculate NPV for each year, find the bridge, and divide the total by the break-even year.
Calculating IRR
Enter the number into CF, then hit the IRR button and calculate. Deny if less than the cost of capital.
Calculating MIRR
Find the PV of all negative cash flows, then find the FV for all positive cash flows. Then use the following formula:
0 = PV of negatives / (1+IRR)^0 + FV of positives / (1+IRR)^N
Then solve for IRR.
Calculating PI
Solve for NPV, then add the initial investment at time 0. Then, divide by year 0 to find the profitability index.
Chapter 11: Weighted Average Cost of Capital (WACC)
WACC Formula
The weighted average cost of capital is the average cost per dollar of capital raised. Weights are based on market values, not book values. WACC = weighted average flotation cost plus! Multiply Debt ONLY by (1 – Tax rate).
Component Cost of Equity and CAPM
Ie = Rf + B(Rm – Rf)
Not appropriate to use when historical data is lacking or is not a good indicator of the future. Generally the most accurate measurement.
Component Cost of Equity and Constant Growth Model
Ie = D1/P0 + G
Use when constant dividend growth is expected on a limited number of stocks.
Component Cost of Preferred Stock
Ip = D1/P0
Component Cost of Debt
Two-part calculation:
1. Estimate the before-tax cost of debt by using YTM.
2. Solve for the interest rate that makes the price equal to the sum of the present values for the coupons and the face value of the bond.
