Change in Expenses When a firm takes on a new project, the costs associated with it will
Change in Expenses When a firm takes on a new project, the costs associated with it will
change the firm’s expenses. If the investment changes the sales of an existing product, the decision maker must estimate the change in unit sales. Based on that estimate, the estimate of the additional costs of pro- ducing the additional number of units is derived by consulting with pro- duction management. In addition, an estimate of how the product’s inventory may change when production and sales of the product change is also needed.
If the investment involves changes in the costs of production, we compare the costs without this investment with the costs with this investment. For example, if the investment is the replacement of an assembly line machine with a more efficient machine, we need to esti- mate the change in the firm’s overall production costs such as electricity, labor, materials, and management costs.
A new investment may change not only production costs but also operating costs, such as rental payments and administration costs. Changes in operating costs as a result of a new investment must be con- sidered as part of the changes in the firm’s expenses.
Increasing cash expenses are cash outflows, and decreasing cash expenses are cash inflows.
Change in Taxes Taxes figure into the operating cash flows in two ways. First, if revenues
and expenses change, taxable income and therefore, taxes change. That means we need to estimate the change in taxable income resulting from the changes in revenues and expenses resulting from a new project to determine the effect of taxes on the firm.
Second, the deduction for depreciation reduces taxes. Depreciation itself is not a cash flow, but depreciation reduces the taxes that must be paid, shielding income from taxation. The tax shield from depreciation is like a cash inflow.
Suppose a firm is considering a new product that is expected to gen- erate additional sales of $200,000 and increase expenses by $150,000. If the firm’s tax rate is 40%, considering only the change in sales and
LONG-TERM INVESTMENT DECISIONS
expenses, taxes go up by $50,000 × 40% or $20,000. This means that the firm is expected to pay $20,000 more in taxes because of the increase in revenues and expenses.
Let’s change this around and consider that the product will generate $200,000 in revenues and $250,000 in expenses. Considering only the change in revenues and expenses, if the tax rate is 40%, taxes go down by $50,000
× 40%, or $20,000. 5 This means that we reduce our taxes by $20,000, which is like having a cash inflow of $20,000 from taxes.
Now, consider depreciation. When a firm buys an asset that pro- duces income, the tax laws allow it to depreciate the asset, reducing tax- able income by a specified percentage of the asset’s cost each year. By reducing taxable income, the firm is reducing its taxes. The reduction in taxes is like a cash inflow since it reduces the firm’s cash outflow to the government.
Suppose a firm has taxable income of $50,000 before depreciation and a flat tax rate of 40%. If the firm is allowed to deduct depreciation of $10,000, how has this changed the taxes it pays?
Without Depreciation With Depreciation
Taxable income $50,000 $40,000 Tax rate
0.40 0.40 Taxes
$20,000 $16,000 Depreciation reduces the firm’s tax-related cash outflow by $20,000 −
$16,000 = $4,000 or, equivalently, by $10,000 × 40% = $4,000. A reduction is an outflow (taxes in this case) is an inflow. We refer to the effect depreciation has on taxes as the depreciation tax shield.
Depreciation itself is not a cash flow. But in determining cash flows, we are concerned with the effect depreciation has on our taxes—and we all know that taxes are a cash outflow. Because depreciation reduces tax- able income, depreciation reduces the tax outflow, which amounts to a cash inflow. For tax purposes, firms are permitted to use accelerated depreciation (specifically the rates specified under the Modified Acceler- ated Cost Recovery System [MACRS]) or straight-line. An accelerated method is preferred in most situations since it results in larger deductions
5 This loss creates an immediate cash inflow if (1) the firm has other income in the same tax year to apply the $50,000 loss against, or (2) the firm has income in prior
tax years so it can carry back this loss and apply for a refund of prior year’s taxes. Otherwise, this loss is carried forward to reduce future tax years’ income. In this case, this loss is worth less because the benefit from the loss (the reduction in taxable income) is realized in the future, not today.
Capital Budgeting: Cash Flows
sooner in the asset’s life than using straight-line depreciation. Therefore, accelerated depreciation, if available, is preferable to straight-line due to the time value of money.
Under the present tax code, assets are depreciated to a zero book value. Salvage value—what we expect the asset to be worth at the end of its life—is not considered in calculating depreciation. So is salvage value totally irrelevant to the analysis? No. Salvage value is our best guess today of what the asset will be worth at the end of its useful life some time in the future. Salvage value is our estimate of how much we can get when we dispose of the asset. Just remember you can ignore it to figure depreciation for tax purposes.
Let’s look at another depreciation example, this time considering the effects that replacing an asset has on the depreciation tax shield cash flow. Suppose you are replacing a machine that you bought five years ago for $75,000. You were depreciating this old machine using straight- line depreciation over ten years, or $7,500 depreciation per year. If you replace it with a new machine that costs $50,000 and is depreciated over five years, or $10,000 each year, how does the change in deprecia- tion affect the cash flows if the firm’s tax rate is 30%?
We can calculate the effect two ways:
1. We can compare the depreciation and related tax shield from the old and the new machines. The depreciation tax shield on the old machine is 30% of $7,500, or $2,250. The depreciation tax shield on the new machine is 30% of $10,000, or $3,000. Therefore, the change in the cash flow from depreciation is $3,000 − $2,250 = $750.
2. We can calculate the change in depreciation and calculate the tax shield related to the change in depreciation. The change in depreciation is $10,000 − 7,500 = $2,500. The change in the depreciation tax shield is 30% of $2,500, or $750.
Let’s look at another example. Suppose a firm invests $50,000 in an asset. And suppose the firm has a choice of depreciating the asset using either:
■ An accelerated method over four years, with the rates of 33.33%, 44.45%, 14.81%, and 7.41%, respectively, where these depreciation rates are a percentage of the original cost of the asset; or
■ The straight-line method over four years. If the firm’s tax rate is 40% and the cost of capital is 10%, what is the
present value of the difference in the cash flows from the depreciation tax shield each year? It is $796 as shown below:
LONG-TERM INVESTMENT DECISIONS
Depreciation Depreciation Difference Present Using the
in Value Accelerated Straight-Line
Using the
Difference
Depreciation of Year
Depreciation Tax Shield Difference
$0 $796 Using both the accelerated and straight-line methods, the entire asset’s
cost is depreciated over the four years. But the accelerated method pro- vides greater tax shields in the first and second years than the straight- line method. Since larger depreciation tax shields are generated under the accelerated method in the earlier years, the present value of the tax shields using the accelerated method is more valuable than the present value of the tax shields using the straight-line method. How much more? $796.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more