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.