LG 2 11.1 Relevant Cash Flows

LG 1 LG 2 11.1 Relevant Cash Flows

Chapter 10 introduced the capital budgeting process and the techniques financial managers use for evaluating and selecting long-term investments. To evaluate invest-

relevant cash flows ment opportunities, financial managers must determine the relevant cash flows asso-

The incremental cash outflow

ciated with the project. These are the incremental cash outflows (investment) and

(investment) and resulting

inflows (return). The incremental cash flows represent the additional cash flows—

subsequent inflows associated

outflows or inflows—expected to result from a proposed capital expenditure. As

with a proposed capital expenditure.

noted in Chapter 4, cash flows rather than accounting figures are used because cash flows directly affect the firm’s ability to pay bills and purchase assets. The nearby

incremental cash flows Focus on Ethics box discusses the accuracy of cash flow estimates and cites one

The additional cash flows—

reason that even well-estimated deals may not work out as planned.

outflows or inflows—expected to result from a proposed

The remainder of this chapter is devoted to the procedures for measuring the

capital expenditure.

relevant cash flows associated with proposed capital expenditures. MAJOR CASH FLOW COMPONENTS

The cash flows of any project may include three basic components: (1) an initial investment, (2) operating cash inflows, and (3) terminal cash flow. All projects— whether for expansion, replacement or renewal, or some other purpose—have the first two components. Some, however, lack the final component, terminal cash flow.

focus on ETHICS

A Question of Accuracy

in practice The process of capital (extraordinary) cash flows—for example, “They’re not just taking the company’s

audited and unaudited financial state- projected cash flows has been a part of tougher environmental standards, or the

budgeting based on

the cost of litigation, compliance with

ments at face value; they are really div- the investment decision process for more costs of disposal or recycling of an asset ing into the numbers and trying to than 40 years. This procedure for evalu- at the completion of the project.

understand not just their accuracy, but ating investment opportunities works

All too often, the initial champagne what they mean in terms of trends.” well when cash flows can be estimated celebration gives way once the final

If valuation has improved so much, with certainty, but in real-world corpo-

cost of a deal is tallied. In fact, taken

why do analyses show that companies

rate practice, many investment decisions as a whole, mergers and acquisitions in often overpay? The answer lies in the involve a high degree of uncertainty.

imperial CEO. Improvements in valuation The decision is even more complicated ening negative 12 percent return on

recent years have produced a disheart-

techniques can be negated when the when the project under consideration is investment. While the financial data

process deteriorates into a game of the acquisition of another company or

tweaking the numbers to justify a deal part of another company.

necessary to generate discounted cash

the CEO wants to do, regardless of Because estimates of the cash flows available, these days more attention is

flow estimates are ever more readily

price. This “make it work” form of capital from an investment project involve mak-

being paid to the accuracy of the num- budgeting often results in building the ing assumptions about the future, they

empire under the CEO’s control at the may be subject to considerable error.

bers. Inspired in part by post-Enron

expense of the firm’s shareholders. The problem becomes more compli-

focus on governance and the threat of

shareholder lawsuits, board members

cated as the period of time under con- What would your options be when have been pushing corporate managers 3 sideration becomes longer and when faced with the demands of an impe- to make a stronger case for the deals the project is unique in nature with no rial CEO who expects you to “make they propose. Says Glenn Gurtcheff, comparables. Other complications may it work”? Brainstorm several managing director and co-head of mid- arise involving accounting for additional options. dle market M&A for Piper Jaffray & Co.,

CHAPTER 11

Capital Budgeting Cash Flows

FIGURE 11.1

$25,000 Cash Flow Components

Terminal

Operating

Cash Flow

Time line for major cash

Cash Inflows

flow components

End of Year

Investment

initial investment Figure 11.1 depicts on a time line the cash flows for a project. The initial

The relevant cash outflow for a

investment for the proposed project is $50,000. This is the relevant cash outflow at

proposed project at time zero.

time zero. The operating cash inflows, which are the incremental after-tax cash operating cash inflows

inflows resulting from implementation of the project during its life, gradually

The incremental after-tax cash

increase from $4,000 in its first year to $10,000 in its tenth and final year. The

inflows resulting from

terminal cash flow is the after-tax nonoperating cash flow occurring in the final

implementation of a project

year of the project. It is usually attributable to liquidation of the project. In this case

it is $25,000, received at the end of the project’s 10-year life. Note that the terminal terminal cash flow

during its life.

cash flow does not include the $10,000 operating cash inflow for year 10.

The after-tax nonoperating cash flow occurring in the final year of a project. It is usually

EXPANSION VERSUS REPLACEMENT DECISIONS

attributable to liquidation of

Developing relevant cash flow estimates is most straightforward in the case of

the project.

expansion decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflows associ- ated with the proposed capital expenditure.

Identifying relevant cash flows for replacement decisions is more compli- cated, because the firm must identify the incremental cash outflow and inflows that would result from the proposed replacement. The initial investment in the case of replacement is the difference between the initial investment needed to acquire the new asset and any after-tax cash inflows expected from liquidation of the old asset. The operating cash inflows are the difference between the operating cash inflows from the new asset and those from the old asset. The terminal cash flow is the difference between the after-tax cash flows expected upon termination of the new and the old assets. These relationships are shown in Figure 11.2.

Actually, all capital budgeting decisions can be viewed as replacement deci- sions. Expansion decisions are merely replacement decisions in which all cash flows from the old asset are zero. In light of this fact, this chapter focuses prima- rily on replacement decisions.

SUNK COSTS AND OPPORTUNITY COSTS When estimating the relevant cash flows associated with a proposed capital

expenditure, the firm must recognize any sunk costs and opportunity costs. These

PART 5

Long-Term Investment Decisions

FIGURE 11.2 Relevant Cash Flows for

After-tax cash inflows Replacement Decisions

Initial

Initial investment

⫽ needed to acquire ⫺ from liquidation

investment

Calculation of the three

of old asset components of relevant

new asset

cash flows for a replacement decision

Operating

Operating cash

Operating cash

⫽ inflows from ⫺ inflows from

cash inflows

new asset

old asset

Terminal

After-tax cash flows

After-tax cash flows

⫽ from termination ⫺ from termination

cash flow

of new asset

of old asset

sunk costs incremental cash flows. Sunk costs are cash outlays that have already been made

Cash outlays that have already been made (past outlays) and

(past outlays) and therefore have no effect on the cash flows relevant to the cur-

therefore have no effect on the

rent decision. As a result, sunk costs should not be included in a project’s incre- cash flows relevant to a current mental cash flows.

decision.

Opportunity costs are cash flows that could be realized from the best alter- opportunity costs

native use of an owned asset. They therefore represent cash flows that will not be

Cash flows that could be real-

realized as a result of employing that asset in the proposed project. Because of

ized from the best alternative

this, any opportunity costs should be included as cash outflows when one is

use of an owned asset.

determining a project’s incremental cash flows.