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- cash flows should always be considered on a after tax basis. - what are relevant cash flows? o CF from erosion effects o CF from beneficial spillover effects o CF from external costs - incremental cash flows come about as a direct consequence of taking a project under consideration. - first in estimating cash flow is to determine the relevant CF. - the stand-alone principle assumes that evaluation of a project may be based on the project's incremental CF - investment in net working capital arises when: o cash is kept from unexpected expenditures o inventory is purchased o credit sales are made - cash flows used in project estimation should always reflect: o cash flows when they occur o after tax cash flows - In the context of capital budgeting, what is an opportunity cost? o Opportunity Cost. In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire. - Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why? o Depreciation. For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs. o Straight-line depreciation is a more conservative technique, as it is not accelerated, with the big cash flows front-loaded on the timeline. It thus does not produce as high a present value of the tax benefit of depreciation. o There is one technical difference between MACRS and straight-line depreciation. MACRS requires that the asset is fully depreciated. Straight-line does permit a residual salvage value, which means that the entire cost of the asset would not be fully depreciated. - IN our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid? o Net Working Capital. It's probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables won't be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project's life) acts to increase working capital. These effects tend to offset - "When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement. o Cash Flow and Depreciation. Depreciation is a non-cash expense, but it is tax-deductible on the income

statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield TCD. o A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows. - Inflation Premium: The extra rate of return required by investors to compensate them for the loss of purchasing power of the currency. - Real interest rate: an interest rate reflecting the real change in purchasing power of a currency. - Nominal interest rate: an interest rate that is not adjusted for inflation. - Deflation: an increase in the purchasing power of unit of a currency - Inflation: a decrease in the purchasing power of a unit of a currency. - Specie money: a metallic money that posses an intrinsic value and is naturally limited in supply. - Flat money: money issued by a government that is not backed by a physical commodity such as gold or silver - Terminal cash flows: cash flows incurred in closing down a capital budgeting project - Operating cash flows: cash flows received from the operating of the capital budgeting project - Indirect expenditures: which result from our decision to purchase the asset, should also be included at the projects inception - Direct expenditure: are those directly connected with obtaining the capital asset - Initial cash flows: expenditures that are undertaken to obtain assets and begin a capital budgeting project - Capital spending: is the cash that must be invested in the projects capital assets. Operating cash flow is earnings before interest plus depreciation- taxes. In capital budgeting OCF measures the cash flows from operating the project, but do not include the cash flows related to capital spending or changes in NWC. - Additions to Net Working Capital: are investments in the projects short term assets. A project may reuire investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short term assets and is thus not available (free) to be paid to the security holders. - Capital spending: is the cash that must be invested in the projects capital assets to produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the companys security holders, so the projected capital expenditures must be subtracted from the operating cash flow. - Operating cash flow: is earnings before interest plus depreciation minus taxes. And its important to remember that these cash flows have not yet occurred- we estimate what they would be if the project were to be adopted. - Free cash flow (FCF)/Cash flow from assets: the amount of cash generated by a company that is available to distribute to the firms creditiprs and owners - Regulatory requirements project: governments regulate economic activity to protect society from harmful effects. The most cost effective way to handle toxic waste from a production process is to dump it into lake lady bird. These projects are undertaken because they are required. - Corporate social responsibility project: the exxonmobil project is an example of corporation contributing to society. While the corporations function in society is to efficiently produce goods and services, corporations are expected to be good citizen. These projects do not help society, and enhance the reputation of the company.

- Cost reduction project: These projects focus on reducing costs. Outsourcing of business functions or production, improving supply chains, employing machine learning lead to lower costs and thus higher income. - Revenue enhancing project: These projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign. - Sunk costs: Costs that have already been incurred. As such they would not be affected by the capital budgeting decision and are thus not incremental cash flows. - Erosion: The negative effect where adopting the project would decrease the cash flows from existing operations. - Synergy: The positive effect where adopting the project would increase the cash flows from existing operation. - Economic interdependencies: Adopting a project would change the cash flows in other parts of the company. - Incremental cash flows after taxes (ICFAT): are the periodic cash outflows and inflows that occur if, and only if, an investment project is accepted. Incremental cash flow focus on the project, not the company as a whole. - Indivisible projects: a company may adopt a project in its entirely or not, but cannot take a portion of a project. - Divisible projects: a company may take on a portion of a project and get proportional benefits from the project. - Hard rationing: funds are not available and managers must choose the best set of projects given their capital constraints. - Soft rationings: limits on investments are made by managers for better control of the firm. - Capital rationing: The case where funds are limited to a fixed dollar amount and must be allocated among competing projects. Managers need a method of ranking projects, or portfolio of projects, by their desirability and selecting the higher ranked projects until funds are fully committed. - Mutually exclusive projects: are projects where choosing one project precludes the adoption of other projects. Managers must rank these projects by some criteria and select the best project. - Economically independent projects: are ones where making one choice is independent of other choices. Managers can accept all projects that are wealth-increasing. - The average accounting return: is the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR. If the project earns more than this specified rate, it is accepted. If the ARR is less, the project will be rejected. While useful for some purposes the AAR is not based on future cash flows, and does not use the opportunity cost. It is thus of limited use in making decisions about the future. - Payback: calculates the amount of time it takes for a project to "payback" its initial investment. The shorter the payback period the quicker the company gets its initial investment back and begins to see profit. Managers set the maximum payback period they will accept. Projects with payback periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected. - Profitability index (PI): A ratio that calculates the relative wealth created per dollar invested.. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications

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- Internal Rate of Return(IRR): The rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost. They should only accept the project if it earns (IRR) more that should be expected (RRR) given other projects of equivalent risk. - Net Present Value (NPV): A dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable. - Capital Budgeting process: is a formal way for managers to guide their capital expenditure decisions. This process consists of six steps or phases. - Capital expenses: involve obtaining the major productive asset: a company will pay a substantial amount today to obtain the equipment, technology or other resource and will use this asset as part of the production process over several years. - Operating expenses: are short term expenses where the benefits are enjoyed in the same period as the expense are incurred. o 5- include only after-tax cash flows in the cash flow calculation. you can only spend what you keep each project should be evaluated using marginal tax rates - A capital budgeting project is no more than: doing things, and developing a project to accomplish some goal - 4 categories of capital budgeting projects: o 1 revenue enhancing projects o 2 cost reduction projects o 3 corporate social responsibility o 4 regulatory requirements - Depreciation is a noncash expense charged against accounting earnings to write off the cost of an asset during its estimated useful life. - Depreciation is not a cash flow and is not relevant for capital budgeting EXCEPT that depreciation is a tax-deductible expense and therefore reduces taxes, which are a cash flow. - Thus depreciation causes taxes paid, an actual cash outflow, to be reduced and thus increases the net cash flow. This is the reason that we compute net income and then add back the depreciation expense - Capital Budgeting Considerations: the first is erosion and the second is competition - erosion, sometimes called cannibalization, is where the sale of a product reduces sales in other parts of a business. Erosion is definitely a factor when reputation plays such a large part in demand. - Market timing: Companies may enter a market at different times based on several factors. One company may have an existing advantage in that they might have a well- developed supply chain and be able to produce a new product at lower incremental cost. Others may have a strong market presence that may attract customers to something new. Some companies also seem to have a better feel for the movements in consumer interests, or be willing to try a new concept and see how it develops - survivor bias, where we look at the performance of existing companies to gauge the historical performance of all companies. - NPV description: NPV is the sum of the present values of a project’s cash flows. It’s a way of doing cost-benefit analysis. o For most projects their cash flows occur at different points in time. A valid comparison is possible only if these cash flows can be restated as of a single point in time. This involves using the opportunity cost, which reflects the basic time value of money (risk free interest rate) and an appropriate risk premium.

o Again drawing on the concept of cost-benefit analysis, NPV measures whether or not the project increases wealth. Wealth is command over economic assets. Wealth is increased if cash inflows stated as of today exceed the cash outflows also stated as of today: the cash available—wealth—has increased. o NPV takes into account all aspects of economic value: cash flows, the timing of these cash flows, and the risk-adjusted opportunity cost. o The NPV decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. o 2. NPV desirability: NPV is superior to the other methods of analysis presented in our course because it directly measures a decision’s impact on wealth. o The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. o A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted. This does not mean the shareholders get a check for that amount: it is a statement of the expected increase in wealth given the project, which should be reflected by an increase in the stock price. - IRR description: The IRR is the rate of return earned on an investment. It is the discount rate that causes the NPV of a series of cash flows to be equal to zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. o For investments, the IRR decision rule is to accept projects with IRRs greater than the opportunity cost. o For example, if a project has an IRR = 12%, and projects of equivalent risk earn a return of 8%, then the project is earning above what would be expected of a similar project and should be accepted. Projects earning less than the opportunity cost should be rejected. If the opportunity cost is 8%, but a project’s IRR = 6%, then the project should be rejected, as the investor should be able to obtain a project earning 8%. o 2. Relationship between IRR and NPV: IRR is the interest rate that a project earns, whereas the required rate of return is the opportunity cost of the project: the rate of return the project should earn given its risk. NPV directly uses the opportunity cost to evaluate the project’s cash flows, and is thus is preferred in all situations to IRR. For stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques; however, IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects. o 3. Appropriate uses of the IRR: IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as “12%”, than in absolute terms, such as “$46,000.” o IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR might provide more information about the project than would NPV. - PI description: The profitability index is the present value of the future cash flows, discounted by the opportunity cost, divided by the initial investment. It measures the wealth created per dollar invested, providing a measure of the relative profitability of a project. o The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. A PI greater than one

indicates that the project will return more than a dollar for each dollar invested, with this comparison using proper time value analysis. o 2. Relationship between NPV and PI: Whereas NPV measures the total wealth creation of a project, PI gives the wealth creation per dollar invested. o Most firms, like all organizations and most everyone other than Warren Buffet or Bill Gates, have limited capital. If capital is limited (a situation called capital rationing we’ll see in Lesson 2) then the firm has more acceptable projects than investments funds available. In these situations PI may provide a good ranking measure of the projects, indicating the “bang for the buck” of each particular project. Projects would be ranked by PI. The highest PI-project would be selected, then the next highest PI-project, until all available funds have been committed. - Estimating cash flows: The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Every company operates in a market environment and is subject to changes in fiscal policies (taxes) and regulations not just for their government, but major governments throughout the world. Technology, consumer preferences and competitive pressures also make cash flow estimates difficult. - Estimating opportunity cost: Determining an appropriate discount rate is also not a simple task. Most major governments have an active monetary and exchange-rate policy that affect interest rates. The discount rate is also subject to inflationary pressures. We have not seen inflation get out of hand in this century, but have experienced inflation shocks in the past. - Concerning payback: o a. Information and procedures. Payback period is simply the break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. For example, while you may be paid at the end of the month, you actually earn income for each day worked. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. o b. Difficulties with payback. The worst problem associated with payback period is that it ignores the time value of money. In not using time value, it also does not use an opportunity cost which would reflect the uncertainty of the cash flows. Additionally, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method, such as the market-based opportunity cost. The payback period is biased towards short-term projects as it ignores any cash flows that occur after the cutoff point. o c. Advantages of payback. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. Payback may be sufficient for some small projects that are not of great consequence. Also, projects concerned with maintenance are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. It may also be used when opportunity cost would be difficult to estimate, such as risky investments in an unstable country, - Concerning AAR: o a. Information and procedures. The average accounting return is interpreted as an average measure of the accounting performance of a project over time,

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computed as the average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. o b. Difficulties with AAR. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals. - This concept thus underlies the five rules for capital budgeting projects. o Rule 1: Include only incremental cash flows. What cash flow would you have to give up to obtain productive assets? What cash inflows would result if you were to take on the project? o Rule 2: Include economic interdependencies. A project may increase the cash flows or decrease the cash flows from your existing business operations. These synergies and erosions must be considered. o Rule 3: If you’re using it, it is an opportunity cost. The cost of any asset used in the project is a cost and should be included. o Rule 4: Forget sunk costs. Get over it! Only future cash flows count. o Rule 5: Taxes count. Taxes are a cost and if the project doesn’t work on an after- tax basis don’t do it.