LEARNING OBJECTIVES  After reading this chapter, you should be able to 1. Identify the guidelines by which we measure cash flows. 2. Explain how a project’s benefits and costs—that is, its incremental after- tax cash flows—are calculated. 3. Explain how the capital-budgeting decision process changes when a limit is placed on the dollar size of the capital budget, or there are mutually exclusive projects. LEARNING OBJECTIVES  After reading this chapter, you should be able to 1. Identify the guidelines by which we measure cash flows. 2. Explain how a project’s benefits and costs—that is, its incremental after- tax cash flows—are calculated. 3. Explain how the capital-budgeting decision process changes when a limit is placed on the dollar size of the capital budget, or there are mutually exclusive projects. Copyright Harley-Davidson Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 CHAPTER 10 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting A major capital-budgeting decision led Harley-Davidson to introduce the Buell Blast in 2000 and the Lightning Low XB95 in 2003. This multi-million dollar investment by Harley in smaller, lighter motorcycles designed for the new or novices rider who is not yet ready for the traditionally heavier Harley- Davidson bike was targeted directly at younger and female riders. Although this capital-budgeting decision may, on the surface, seem like a relatively simple decision, the forecasting of the expected cash flows associated with the Buell Blast were, in fact, quite complicated. To begin with, Harley-Davidson had two goals in mind when it introduced the Buell Blast. First, it was trying to expand into a new market made up of Generation X-ers. Second, it wanted to expand the market for existing products by introducing more people to motorcycling. That is, the Buell Blast was meant to not only produce its own sales, but eventually result in increased sales in Harley’s heavier cruiser and touring bikes as the Blast customers move up to these larger bikes. The Lightning Low was also aimed at bringing in new riders, specifically female riders. While the motorcycle industry has enjoyed tremendous growth over the past 12 years with over 7 million riders out there now, representing an increase of 30 percent in just 12 years, the demographics of the motorcycle rider has changed considerably. In particular, the median age of a rider has risen 8 years over the past 12 years. This aging of the motorcycle-riding population played a major role in the decision to go forward with the Blast, and from early returns, it looks like it was, in fact, an excellent decision. How exactly do you measure the cash flows that come from the introduction of a new product line? What do you do about cash flows that the new product brings to other product lines? In the previous chapter, we looked at decision criteria, assuming the cash flows were known. In this chapter, we will see how difficult and complex it is estimating those cash flows. We will also gain an understanding of what a relevant cash flow is. We will evaluate projects relative to their base case—that is, what will happen to the company as a whole if the project is not carried out. In the case of Harley’s Buell Blast and Lightning Low, we will also look at the sales that these new products brought down the line to Harley’s cruising and touring bikes. Did the introduction of the Buell Blast and Lightning Low result in eventual sales to Harley’s other lines? What is the future level of cash flows to Harley-Davidson as a whole versus the level without the introduction of the Buell Blast and Lightning Low? Questions such as these lead us to an understanding of what are and what are not relevant cash flows. As you will see in the future, these questions are generally answered by those in marketing and management, but regardless of your area of concentration, they are important questions to understand. CHAPTER PREVIEW  This chapter continues our discussion of decision rules for deciding whether to invest in new projects. First we will examine what is a relevant cash flow and how to calculate the relevant cash flow. This will be followed by a discussion of the problems created when the number of projects that can be accepted or the total budget is limited. This chapter will rely on Principle 3: Cash—Not Profits—Is King, Principle 4: Incremental Cash Flows—It’s only what changes that counts, and Principle 5: The Curse of Competitive Markets. Be on the lookout for these important concepts. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 328 PART 3 INVESTMENT IN LONG-TERM ASSETS Objective 1 GUIDELINES FOR CAPITAL BUDGETING To evaluate investment proposals, we must first set guidelines by which we measure the value of each proposal. In effect, we will be deciding what is and what isn’t a relevant cash flow. USE FREE CASH FLOWS RATHER THAN ACCOUNTING PROFITS We will use free cash flows, not accounting profits, as our measurement tool. The firm receives and is able to reinvest free cash flows, whereas accounting profits are shown when they are earned rather than when the money is actually in hand. Unfortunately, a firm’s accounting profits and cash flows may not be timed to occur together. For example, capital expenses, such as vehicles and plant and equipment, are depreciated over several years, with their annual depreciation subtracted from profit. Free cash flows correctly reflect the timing of benefits and costs—that is, when the money is received, when it can be reinvested, and when it must be paid out. BACK TO THE PRINCIPLES If we are to make intelligent capital-budgeting decisions, we must accurately measure the timing of the benefits and costs, that is, when we receive money and when it leaves our hands. Principle 3: Cash—Not Profits—Is King speaks directly to this. Remember, it is cash inflows that can be reinvested and cash outflows that involve paying out money. THINK INCREMENTALLY Unfortunately, calculating cash flows from a project may not be enough. Decision makers must ask: What new cash flows will the company as a whole receive if the company takes on a given project? What if the company does not take on the project? Interestingly, we may find that not all cash flows a firm expects from an investment proposal are incremental in nature. In measuring cash flows, however, the trick is to think incrementally. In doing so, we will see that only incremental after-tax cash flows matter. As such, our guiding rule in deciding if a cash flow is incremental will be to look at the company with, versus without, the new product. These incremental after-tax cash flows to the company as a whole are many times referred to as free cash flows. As you will see in the upcoming sections, this may be easier said than done. BACK TO THE PRINCIPLES In order to measure the true effects of our decisions, we will analyze the benefits and costs of projects on an incremental basis, which relates directly to Principle 4: Incremental Cash Flows—It’s only what changes that counts. In effect, we will ask ourselves what the cash flows will be if the project is taken on versus what they will be if the project is not taken on. BEWARE OF CASH FLOWS DIVERTED FROM EXISTING PRODUCTS Assume for a moment that we are managers of a firm considering a new product line that might compete with one of our existing products and possibly reduce its sales. In deter- mining the cash flows associated with the proposed project, we should consider only the incremental sales brought to the company as a whole. New-product sales achieved at the ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 329 cost of losing sales of other products in our line are not considered a benefit of adopting the new product. For example, when General Foods Post Cereal Division introduced its Dino Pebbles, the product competed directly with the company’s Fruity Pebbles. (In fact, the two were actually the same product, with an addition to the former of dinosaur- shaped marshmallows.) Post meant to target the market niche held by Kellogg’s Marshmallow Krispies, but there was no question that sales recorded by Dino Pebbles bit into—literally cannibalized—Post’s existing product line. Remember that we are only interested in the sales dollars to the firm if this project is accepted, as opposed to what the sales dollars would be if the project is rejected. Just moving sales from one product line to a new product line does not bring anything new into the company, but if sales are captured from our competitors or if sales that would have been lost to new competing products are retained, then these are relevant incremental cash flows. In each case, these are the incremental cash flows to the firm—looking at the firm as a whole with the new product versus without the new product. LOOK FOR INCIDENTAL OR SYNERGISTIC EFFECTS Although in some cases a new project may take sales away from a firm’s current projects, in other cases a new effort may actually bring new sales to the existing line. For example, in 2000 GM’s Pontiac division introduced the Aztek, an in-your-face looking sport-ute. The idea was not only to sell lots of Azteks, but also to help lure back young customers to Pontiac’s other car lines. From 1994 until the introduction of the Aztek, the average age of Pontiac buyers had risen from 40 to 42. Thus, the hope was that Aztek would bring younger customers into showrooms, who would in turn either buy an Aztek, or lock onto another one of Pontiac’s products. Thus, in evaluating the Aztek, if managers were to look only at the revenue from new Aztek sales, they would miss the incremental cash flow to Pontiac as a whole that results from new customers who would not have otherwise purchased a Pontiac automobile, but did so only after being lured into a Pontiac showroom to see an Aztek. This is called a synergistic effect. The cash flow comes from any Pontiac sale that would not have occurred if a customer had not visited a Pontiac showroom to see an Aztek. This is very similar to what Harley-Davidson did with the Buell Blast and Lightning Low. This youth-oriented sports bike is not only intended to generate sales on its own, but also to serve as a feeder for Harley-Davidson’s cruising and touring bikes, as Blast riders grow older and trade up. Thus, the incremental sales from the Buell Blast and Lightning Low can only be measured by looking at all cash flows that accrue to Harley-Davidson as a whole from its introduction. The bottom line: Any cash flow to any part of the company that may result from the decision at hand must be considered when making that decision. WORK IN WORKING-CAPITAL REQUIREMENTS Many times, a new project will involve additional investment in working capital. This may take the form of new inventory to stock a sales outlet, additional investment in accounts receivable resulting from additional credit sales, or increased investment in cash to operate additional cash registers, and more. For most projects, some of the funds to support the new level of working capital will come from money owed to suppliers (accounts receivable). Still, the firm will generally have to provide some funds to working capital. Working-capital requirements are considered a cash flow even though they do not leave the company. How can investment in inventory be considered a cash outflow when the goods are still in the store? Because the firm does not have access to the inventory’s cash value, the firm cannot use the money for other investments. Generally, working-capital requirements are tied up over the life of the project. When the project terminates, there is usually an offsetting cash inflow as the working capital is recovered. (Although this offset is not perfect because of the time value of money.) ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 330 PART 3 INVESTMENT IN LONG-TERM ASSETS CONSIDER INCREMENTAL EXPENSES Just as cash inflows from a new project are measured on an incremental basis, expenses should also be measured on an incremental basis. For example, if introducing a new product line necessitates training the sales staff, the after-tax cash flow associated with the training program must be considered a cash outflow and charged against the project. If accepting a new project dictates that a production facility be reengineered, the after-tax cash flows associated with that capital investment should be charged against the project. Again, any incremental after-tax cash flow affecting the company as a whole is a relevant cash flow whether it is flowing in or flowing out. For example, Harley-Davidson offered buyers of the Buell Blast a “Riders Edge” schooling program to help them learn how to drive a motorcycle safely and minimize any fear of the unknown. The idea here is, of course, to make it easier for nonriders or novices to enter biking. This is also an incremental expense, one that would not have happened if the Buell Blast had not been introduced. As such it is a relevant cash flow. The bottom line is to look at the company’s cash flows as a whole with this project versus without this project. The decision is then based on the difference in those cash flows. REMEMBER THAT SUNK COSTS ARE NOT INCREMENTAL CASH FLOWS Only cash flows that are affected by the decision made at the moment are relevant in capital budgeting. The manager asks two questions: (1) Will this cash flow occur if the project is accepted? (2) Will this cash flow occur if the project is rejected? Yes to the first question and no to the second equals an incremental cash flow. For example, let’s assume you are considering introducing a new taste treat called “Puddin’ in a Shoe.” You would like to do some test marketing before production. If you are considering the decision to test market and have not yet done so, the costs associated with the test marketing are relevant cash flows. Conversely, if you have already test marketed, the cash flows involved in test marketing are no longer relevant in project evaluation. It’s a matter of timing. Regardless of what you might decide about future production, the cash flows allocated to marketing have already occurred. Cash flows that have already taken place are often referred to as “sunk costs” because they have been sunk into the project and cannot be undone. As a rule, any cash flows that are not affected by the accept-reject decision should not be included in capital-budgeting analysis. ACCOUNT FOR OPPORTUNITY COSTS Now we will focus on the cash flows that are lost because a given project consumes scarce resources that would have produced cash flows if that project had been rejected. This is the opportunity cost of doing business. For example, a product may use valuable floor space in a production facility. Although the cash flow is not obvious, the real question remains: What else could be done with this space? The space could have been rented out, or another product could have been stored there. The key point is that opportunity-cost cash flows should reflect net cash flows that would have been received if the project under consideration were rejected. Again, we are analyzing the cash flows to the company as a whole, with or without the project. DECIDE IF OVERHEAD COSTS ARE TRULY INCREMENTAL CASH FLOWS Although we certainly want to include any incremental cash flows resulting in changes from overhead expenses such as utilities and salaries, we also want to make sure that ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 331 FINANCE MATTERS In 1999, a major capital-budgeting decision led Universal Studios to build its Islands of Adventure theme park. The purpose of this $2.6 billion investment by Universal was to take direct aim at the first crack of the tourist’s dollar in Orlando. Although this capital-budgeting decision may, on the surface, seem like a relatively simple decision, forecast- ing the expected cash flows associated with this theme park was, in fact, quite complicated. To begin with, Universal was introducing a product that competes directly with itself. The original Universal Studios features rides like “Back to the Future” and “Jaws.” Are there enough tourist dollars to support both theme parks, or will the new Islands of Adventure park simply cannibalize ticket sales to the older Universal Studios? In addition, what happens when Disney counters with a new park of its own? We will evaluate projects relative to their base case—that is, what will happen if the project is not carried out? In the case of Universal’s Islands of Adventure, we could ask what would happen to attendance at the original Universal Studios if the new park was not opened, versus what the attendance would be with the new park. Will tourist traffic through the Islands of Adventure lead to additional sales of the brands and businesses visibly promoted and available in the new park that fall under Universal’s and Seagrams’s cor- porate umbrella? From Universal’s point of view, the objective may be threefold: to increase its share of the tourist market; to keep from losing market share as the tourists look for the latest in technological rides and entertainment; and to promote Universal’s, and its parent company Seagrams’, other brands and products. However, for companies in very competitive markets, the evolution and introduction of new products may serve more to preserve market share than to expand it. Certainly, that’s the case in the computer market, where Dell, Compaq, and IBM introduce upgraded models that continually render current models obsolete. The bottom line here is that, with respect to estimating cash flows, things are many times more complicated than they first appear. As such, we have to dig deep to understand how a firm’s free cash flows are affected by the decision at hand. How did all this turn out? . . . It must have turned out rea- sonably well because Universal followed up this investment by dropping another $100 million on new rides based on Universal franchises: the Mummy, Shrek, and Jimmy Neutron. Then in October of 2003, Universal’s theme parks changed ownership as NBC signed a deal to merge with Universal with the new media conglomerate called NBC Universal which will control NBC, more than a dozen local television stations, sev- eral cable networks, and five theme parks and will be owned by NBC’s parent company, General Electric. UNIVERSAL STUDIOS these are truly incremental cash flows. Many times, overhead expenses—heat, light, rent—would occur whether a given project were accepted or rejected. There is often not a single specific project to which these expenses can be allocated. Thus, the question is not whether the project benefits from overhead items, but whether the overhead costs are incremental cash flows associated with the project—and relevant to capital budgeting. IGNORE INTEREST PAYMENTS AND FINANCING FLOWS In evaluating new projects and determining cash flows, we must separate the investment decision from the financing decision. Interest payments and other financing cash flows that might result from raising funds to finance a project should not be considered incremental cash flows. If accepting a project means we have to raise new funds by issuing bonds, the interest charges associated with raising funds are not a relevant cash outflow. When we discount the incremental cash flows back to the present at the required rate of return, we are implicitly accounting for the cost of raising funds to finance the new project. In essence, the required rate of return reflects the cost of the funds needed to support the project. Managers first determine the desirability of the project and then determine how best to finance it. See the Finance Matters box, “Universal Studios.” ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 332 PART 3 INVESTMENT IN LONG-TERM ASSETS CONCEPT CHECK 1. What is an incremental cash flow? What is a sunk cost? What are opportunity costs? 2. If Ford introduces a new auto line, might some of the cash flows from that new car line be diverted from existing product lines? How should you deal with this? 2 Objective AN OVERVIEW OF THE CALCULATIONS OF A PROJECT’S FREE CASH FLOWS In measuring cash flows, we will be interested only in the incremental, or differential, after-tax cash flows that can be attributed to the proposal being evaluated. That is, we will focus our attention on the difference in the firm’s after-tax cash flows with versus without the project—the project’s free cash flows. The worth of our decision depends on the accuracy of our cash flow estimates. For this reason, we first examined the question of what cash flows are relevant. Now we will see that, in general, a project’s free cash flows will fall into one of three categories: (1) the initial outlay, (2) the annual free cash flows, and (3) the terminal cash flow. Once we have taken a look at these categories, we will take on the task of measuring these free cash flows. INITIAL OUTLAY Initial outlay The initial outlay involves the immediate cash outflow necessary to purchase the asset The immediate cash outflow and put it in operating order. This amount includes the cost of installing the asset (the necessary to purchase the asset asset’s purchase price plus any expenses associated with shipping or installation) and any and put it in operating order. nonexpense cash outlays, such as increased working-capital requirements. If we are considering a new sales outlet, there might be additional cash flows associated with net investment in working capital in the form of increased inventory and cash necessary to operate the sales outlet. Although these cash flows are not included in the cost of the asset or even expensed on the books, they must be included in our analysis. The after-tax cost of expense items incurred as a result of new investment must also be included as cash outflows—for example, any training expenses or special engineering expenses that would not have been incurred otherwise. Finally, if the investment decision is a replacement decision, the cash inflow associ ated with the selling price of the old asset, in addition to any tax effects resulting from its sale, must be included. Determining the initial outlay is a complex matter. Table 10-1 summarizes some of the more common calculations involved in determining the initial outlay. This list is by no means exhaustive, but it should give you a framework for thinking about the initial outlay. At this point, we should realize that the incremental nature of the cash flow is of great TABLE 10-1 Summary of Typical Initial Outlay Incremental After-Tax Cash Flows 1. Installed cost of asset 2. Additional nonexpense outlays incurred (for example, working-capital investments) 3. Additional expenses on an after-tax basis (for example, training expenses) 4. In a replacement decision, the after-tax cash flow associated with the sale of the old machine ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 333 importance. In many cases, if the project is not accepted, then status quo for the firm will simply not continue. In calculating incremental cash flows, we must be realistic in estimating what the cash flows to the company would be if the new project is not accepted. TAX EFFECTS—SALE OF OLD MACHINE Potentially, one of the most confusing initial outlay calculations is for a replacement project involving the incremental tax payment associated with the sale of an old machine. There are three possible tax situations dealing with the sale of an old asset: 1. The old asset is sold for a price above the depreciated value. Here the difference between the old machine’s selling price and its depreciated value is considered a taxable gain and taxed at the marginal corporate tax rate. If, for example, the old machine was originally purchased for $15,000, had a book value of $10,000, and was sold for $17,000, assuming the firm’s marginal corporate tax rate is 34 percent, the taxes due from the gain would be ($17,000 - $10,000) × (.34), or $2,380. 2. The old asset is sold for its depreciated value. In this case, no taxes result, as there is neither a gain nor a loss in the asset’s sale. 3. The old asset is sold for less than its depreciated value. In this case, the difference between the depreciated book value and the salvage value of the asset is a taxable loss and may be used to offset capital gains and thus results in tax savings. For example, if the depreciated book value of the asset is $10,000 and it is sold for $7,000 we have a $3,000 loss. Assuming the firm’s marginal corporate tax rate is 34 percent, the cash inflow from tax savings is ($10,000 - $7,000) × (.34), or $1,020. ANNUAL FREE CASH FLOWS Annual free cash flows come from operating cash flows, changes in working capital, and any capital spending that might take place. In our calculations we’ll begin with our pro forma statements and work from there. From there we will have to make adjustments for interest, depreciation, and working capital, along with any capital expenditures that might occur. ACCOUNTING FOR INTEREST Any increase in interest payments incurred as a result of issuing bonds to finance the project will not be included, as the costs of funds needed to support the project are implicitly accounted for by discounting the project back to the present using the required rate of return. ACCOUNTING FOR DEPRECIATION AND TAXES Finally, an adjustment for the incremental change in taxes should be included that reflect the fact that while depreciation is considered an expense from an accounting perspective, it does not involve any cash flows. Depreciation plays an important role in the calculation of cash flows. Although it is not a cash flow item, it lowers profits, which in turn lowers taxes. For students developing a foundation in corporate finance, it is the concept of depreciation, not the calculation of it, that is important. The reason the calculation of depreciation is deemphasized is that it is extremely complicated, and its calculation changes every few years as Congress enacts new tax laws. Through all this, bear in mind that although depreciation is not a cash flow item, it does affect cash flows by lowering the level of profits on which taxes are calculated. DEPRECIATION CALCULATION The Revenue Reconciliation Act of 1993 largely left intact the modified version of the Accelerated Cost Recovery System introduced in the Tax Reform Act of 1986. Although this was examined earlier, a review is appropriate here. This modified version of the old accelerated cost recovery system (ACRS) is used for most tangible depreciable property placed in service beginning in 1987. Under this ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 334 PART 3 INVESTMENT IN LONG-TERM ASSETS method, the life of the asset is determined according to the asset’s class life, which is assigned by the IRS; for example, most computer equipment has a five-year asset life. It also allows for only a half-year’s deduction in the first year and a half-year’s deduction in the year after the recovery period. The asset is then depreciated using the 200 percent declining balance method or an optional straight-line method. For our purposes, depreciation is calculated using a simplified straight-line method. This simplified process ignores the half-year convention that allows only a half-year’s deduction in the year the project is placed in service and a half-year’s deduction in the first year after the recovery period. By ignoring the half-year convention and assuming a zero salvage value, we are able to calculate annual depreciation by taking the project’s initial depreciable value and dividing by its depreciable life as follows: annual depreciation using the initial depreciable value = simplified straight-line method depreciable life The initial depreciable value is equal to the cost of the asset plus any expenses necessary to get the new asset into operating order. This is not how depreciation would actually be calculated. The reason we have simplified the calculation is to allow you to focus directly on what should and should not be included in the cash flow calculations. Moreover, because the tax laws change rather frequently, we are more interested in recognizing the tax implications of depreciation than in understanding the specific depreciation provisions of the current tax laws. Our concern with depreciation is to highlight its importance in generating cash flow estimates and to indicate that the financial manager must be aware of the current tax pro visions when evaluating capital-budgeting proposals. WORKING CAPITAL While depreciation is an expense, but not a cash-flow item, working capital is a cash-flow item, but not an expense. In fact, very few projects do not require some increased investment in working capital. It is only natural for inventory levels to increase as a firm begins production of a new product. Likewise, much of the sales of the new product may be on credit, resulting in an increase in accounts receivable. Offsetting some of this may be a corresponding increase in accounts payable, as the firm buys raw materials on credit. The increased working capital minus any additional short-term liabilities that were generated is the change in net working capital. Thus, we need only look at the difference between the beginning and ending levels of investment in working capital less any additional short-term liabilities to calculate the change in net working capital. Complicating all of this are two things: the current portion of long-term debt and cash. Because the current portion of long-term debt is already counted as part of the financing for the project, including it as part of working capital would double-count it. Cash is more complicated. The only change in the level of cash held that should be considered to be a cash flow is cash that is required for the operation of the business and does not earn interest. For example, an increase in teller cash associated with opening a new sales outlet would be a relevant cash-flow item. However, if as a result of the operation of the new project the firm increases its level of idle cash, this would not be considered a cash-flow item. The firm can earn interest on this idle cash, so it would be inappropriate to consider it a cash-outflow item. TERMINAL CASH FLOW The calculation of the terminal cash flow is a bit unique in that it generally includes the salvage value of the project plus or minus any taxable gains or losses associated with its sale. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 335 TABLE 10-2 Summary of Typical Terminal Cash Flows on After-Tax Basis 1. The after-tax salvage value of the project 2. Cash outlays associated with the project’s termination 3. Recapture of nonexpense outlays that occurred at the project’s initiation (for example, working capital investments) Under the current tax laws, in most cases there will be tax payments associated with the salvage value at termination. This is because the current laws allow all projects to be depreciated to zero, and if a project has a book value of zero at termination and a positive salvage value, then that salvage value will be taxed. The tax effects associated with the salvage value of the project at termination are determined exactly like the tax effects on the sale of the old machine associated with the initial outlay. The salvage value proceeds are compared with the depreciated value, in this case zero, to determine the tax. In addition to the salvage value, there may be a cash outlay associated with the project termination. For example, at the close of a strip-mining operation, the mine must be refilled in an ecologically acceptable manner. Finally, any working capital outlay required at the initiation of the project—for example, increased inventory needed for the operation of a new plant—will be recaptured at the termination of the project. In effect, the increased inventory required by the project can be liquidated when the project expires. Table 10-2 provides a general list of some of the factors that might affect a project’s terminal cash flow. CASH FLOWS: WHY ACCOUNTING INCOME DOESN’T MEASURE UP Why not use profits after tax as our measure of these cash flows? The answer is that we can, but first we’ve got to correct four problems: . Depreciation (and any other non-cash flow charges). When accountants calculate a firm’s net income, one of the expenses they subtract out is depreciation. However, depreciation is a non-cash flow expense. If you think about it, depreciation comes about because you bought a fixed asset (for example, you built a plant) in an earlier period, and now, through depreciation, you’re expensing it over time—but depreciation does not actually involve a cash flow. That means net income understates cash flows by this amount. Therefore, we’ll want to compensate for this by adding depreciation back in to our measure of accounting income when calculating cash flows. . Interest expenses. There’s no question that if you take on a new project, you’ll have to pay for it somehow—either through internal cash flow or selling new stocks or bonds. In other words, there’s a cost to that money. We will recognize that when we discount future cash flows back to the present at the required rate of return. Remember, the project’s required rate of return is the rate of return that you must earn to justify taking on the project. It recognizes the risk of the project and the fact that there is an opportunity cost of money. If we discount the future cash flows back to the present and also subtract out interest expenses, then we’d be double counting for the cost of money—accounting for the cost of money once when we subtracted out interest expenses and once when we discounted the cash flows back to the present. Therefore, we want to make sure interest expenses aren’t subtracted out. That means we’ll want to ignore interest and make sure that financing flows are not included. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 336 PART 3 INVESTMENT IN LONG-TERM ASSETS . Changes in net working capital. Many projects require an increased investment in working capital. For example, some of the new sales may be credit sales resulting in an increased investment in accounts receivable. Also, in order to produce and sell the product, the firm may have to increase its investment in inventory. However, some of this increased working capital investment may be financed by an increase in accounts payable. Since all these potential changes are changes in assets and liabilities, they don’t affect accounting income. The bottom line here is that if this project brings with it a positive change in net working capital, then it means money is going to be tied up in increased working capital, and this would be a cash outflow. That means we’ll have to make sure we account for any changes in net working capital that might occur. . Changes in capital spending. From an accounting perspective, the cash flow associated with the purchase of a fixed asset is not an expense. That means that when Marriott spends $50 million building a new hotel resort there is a significant cash outflow, but there is no accompanying expense. Instead, the $50 million cash outflow creates an annual depreciation expense over the life of the hotel. We’ll want to make sure we include any changes in capital spending in our cash flow calculations. Now let’s put this all together and measure the project’s free cash flows. MEASURING THE CASH FLOWS Cash flow calculations can be broken down into three basic parts: cash flows from operations, cash flows associated with working capital requirements, and capital spending cash flows. Let’s begin our discussion by looking at three different, but equivalent, methods for measuring cash flows from operations, then move on and discuss measuring cash flows from working capital requirements and capital spending. PROJECT’S CHANGE IN OPERATING CASH FLOWS There are a number of different ways that are used to calculate operating cash flows, all getting at the same thing—the after-tax differential cash flows that the project’s operations bring in. We’ll begin by looking at the pro forma approach because it is the one used most frequently, with its inputs taken directly from pro forma statements. OCF Calculation: The Pro Forma Approach An easy way to calculate operating cash flows is to take the information provided on the project’s pro forma income statement where interest payments are ignored and simply convert the accounting information into cash- flow information. To do this we take advantage of the fact that the difference between the change in sales and the change in costs should be equal to the change in EBIT plus depreciation. Under this method, the calculation of a project’s operating cash flow involves three steps. First, we determine the company’s Earnings Before Interest and Taxes (EBIT ) with and without this project. Second, we subtract out the change in taxes. Keep in mind that in calculating the change in taxes, we will ignore any interest expenses. Third, we adjust this value for the fact that depreciation, a non-cash flow item, has been subtracted out in the calculation of EBIT. We do this by adding back depreciation. Thus, operating cash flows are calculated as follows: operating cash flows = change in earnings before interest and taxes - change in taxes + change in depreciation Now let’s take a look at three alternative methods for calculating the change in operating cash flows. The reason we’ve presented alternative methods for calculating operating ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 337 cash flows is because they are all used and talked about in the real world; hence, you should be familiar with them. In addition, you’ll notice that they all give you the same result. That’s because they all do the same thing—they just do it in different ways. Alternative OCF Calculation 1: Add Back Approach Since financing flows (for example, interest payments) are not included in our pro forma income statement, we can go directly to the bottom line of our income statement and adjust for the fact that depreciation, a non-cash flow item, has been subtracted out in the calculations: operating cash flows = net income + depreciation This method for determining operating cash flows is commonly used. That’s because it is so simple—and if financing flows are ignored, it is also correct. Alternative OCF Calculation 2: Definitional Approach Since we are trying to measure the change in operating cash flows, we can simply calculate the change in revenues minus cash expenses minus taxes: operating cash flows = change in revenues - change in cash expenses - change in taxes All we’ve done here is to take the definition of operating cash flows and put it into practice. Alternative OCF Calculation 3: Depreciation Tax Shield Approach Under the depreciation tax shield approach we begin by ignoring depreciation and calculating net profits after tax as revenues less cash expenses. We then adjust for the fact that incremental depreciation will reduce taxes—referred to as the depreciation tax shield, which is calculated as depreciation times tax rate: operating cash flows = (revenues - cash expenses) × (1 - tax rate) + (change in depreciation × tax rate) EXAMPLE: CALCULATING OPERATING CASH FLOWS Let’s look at an example to show the equivalency of the three methods. Assume that a new project will annually generate revenues of $1,000,000 and cash expenses including both fixed and variable costs of $500,000, while increasing depreciation by $150,000 per year. In addition, let’s assume that the firm’s marginal tax rate is 34 percent. Given this, the firm’s change in net profit after tax can be calculated as: revenue $1,000,000 - cash expenses 500,000 - depreciation 150,000 = EBIT $ 350,000 - taxes (34%) 119,000 = net income $ 231,000 As you can see, regardless of which method you use to calculate operating cash flows, you get the same answer: OCF Calculation: Pro Forma Approach operating cash flows = change in earnings before interest and taxes - change in taxes + change in depreciation 350 000 119 000 + 150 000 $381 000 = $, - $, $, = , (continued) ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 338 PART 3 INVESTMENT IN LONG-TERM ASSETS Alternative OCF Calculation 1: Add Back Approach operating cash flows = net income + depreciation ,, = $231 000 , + $150 000 = $381 000 Alternative OCF Calculation 2: Definitional Approach operating cash flows = change in revenues - change in cash expenses - change in taxes = $, , - $, - , = 500000 119000 $ , 1 000 000 381 000 Alternative OCF Calculation 3: Depreciation Tax Shield Approach operating cash flows = (revenues - cash expenses) × (1 - tax rate) + (change in depreciation × tax rate) = ($, , - 500 000 ) × 1 - .34 1000000 $ , ( ) + ($ , × .) = 381 000 150000 34 $ , You’ll notice that interest payments are nowhere to be found. That’s because we ignore them when we’re calculating operating cash flows. You’ll also notice that we end up with the same answer regardless of how we work the problem. CASH FLOWS FROM THE CHANGE IN NET WORKING CAPITAL As we mentioned earlier in this chapter, many times a new project will involve additional investment in working capital—perhaps new inventory to stock a new sales outlet or simply additional investment in accounts receivable. There also may be some spontaneous short- term financing—for example, increases in accounts payable—that result from the new project. Thus, the change in net working capital is the additional investment in working capital minus any additional short-term liabilities that were generated. CASH FLOWS FROM THE CHANGE IN CAPITAL SPENDING While there is generally a large cash outflow associated with a project’s initial outlay, there may also be additional capital spending requirements over the life of the project. For example, you may know ahead of time that the plant will need some minor retooling in the second year of the project in order to keep the project abreast of new technological changes that are expected to take place. In effect, we will look at the company with and without the new project, and any changes in capital spending that occur are relevant. PUTTING IT TOGETHER: CALCULATING A PROJECT’S FREE CASH FLOWS Thus, a project’s free cash flows are: project’s free cash flows = project’s change in operating cash flows - change in net working capital - change in capital spending The question now becomes: Which method should we use for estimating the change in operating cash flows? The answer is that it doesn’t matter, but the most commonly used method is method 1, the pro forma approach. Generally, that’s how the information is presented by those in marketing and accounting who work on the sales forecasts for new products. Thus, we can rewrite the formula for a project’s free cash flows given above, inserting the pro forma approach for calculating a project’s change in operating cash flows, and we get: ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 339 project’s free cash flows = change in earnings before interest and taxes - change in taxes + change in depreciation - change in net working capital - change in capital spending To estimate the changes in EBIT, taxes, depreciation, net working capital, and capital spending, we start with estimates of how many units we expect to sell, what the costs— both fixed and variable—will be, what the selling price will be, and what the required capital investment will be. From there we can put together a pro forma statement that should provide us with the data we need to estimate the project’s free cash flows. However, you must keep in mind that our capital budgeting decision will only be as good as our estimates of the costs and future demand. In fact, most capital budgeting decisions that turn out to be bad decisions are not bad decisions because the decision maker used a bad decision rule, but because the estimates of future demand and costs were inaccurate. Let’s look at an example. EXAMPLE: CALCULATING A PROJECT’S FREE CASH FLOWS You are considering expanding your product line, which currently consists of Lee’s Press On Nails, to take advantage of the fitness craze. The new product you are considering introducing is called “Press On Abs.” You feel you can sell 100,000 of these per year for four years (after which time this project is expected to shut down as forecasters predict healthy looks will no longer be in vogue, being replaced with the couch potato look). The Press On Abs would sell for $6.00 each with variable costs of $3.00 for each one produced, while annual fixed costs associated with production would be $90,000. In addition, there would be a $200,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over four years. This project will also require a one-time initial investment of $30,000 in net working capital associated with inventory. Finally, assume that the firm’s marginal tax rate is 34 percent. Initial Outlay Let’s begin by estimating the initial outlay. In this example, the initial outlay will be the $200,000 initial expenditure plus the investment of $30,000 in net working capital, for a total of $230,000. Annual Free Cash Flows Next, Table 10-3 calculates the annual change in earnings before interest and taxes. This calculation begins with the change in sales (. Sales) and subtracts the change in fixed and variable costs, in addition to the change in depreciation to calculate the change in earnings before interest and taxes or EBIT. Annual depreciation was calculated using the simplified straight-line method, which is simply the depreciable value of the asset ($200,000) divided by the asset’s expected life, which is four years. Taxes are then calculated assuming a 34 percent marginal tax rate. Once we have calculated EBIT and taxes, we don’t need to go any further, since these are the only two values from the pro forma income statement that we need. In addition, in this example there is not any annual increase in working capital associated with the project under consideration. Also notice that we have ignored any interest payments and financing flows that might have occurred. As mentioned earlier, when we discount the free cash flows back to the present at the required rate of return, we are implicitly accounting for the cost of the funds needed to support the project. (continued) ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 340 PART 3 INVESTMENT IN LONG-TERM ASSETS The project’s annual change in operating cash flow is calculated using all four methods in Table 10-4. The project’s annual free cash flow is simply the change in operating cash flow less any change in net working capital and less any change in capital spending. In this exam- ple there are no changes in net working capital and capital spending over the life of the project. This is not the case for all projects that you will consider. For example, on a project where sales increased annually, it is likely that working capital will also increase each year to support a larger inventory and a higher level of accounts receivable. Similarly, on some projects the capital expenditures may be spread out over several years. The point here is that what we are trying to do is look at the firm with this TABLE 10-3 Calculation of the Annual Change in Earnings Before Interest and Taxes for the Press On Abs Project . sales (100,000 units at $6.00/unit) $600,000 Less: . variable costs (variable cost $3.00/unit) 300,000 Less: . fixed costs 90,000_________ Equals: $210,000 Less: . depreciation ($200,000/4 years) 50,000_________ Equals: . EBIT $160,000 Less: . taxes (taxed at 34%) 54,400_________ Equals: . net income $105,600_________ _________ TABLE 10-4 Annual Change in Operating Cash Flow, Press On Abs Project OCF CALCULATION: PRO FORMA APPROACH . Earnings before interest and taxes (EBIT) $160,000 Minus: . taxes -54,400 Plus: . depreciation +50,000________ Equals: . operating cash flow $155,600________ ________ ALTERNATIVE CALCULATION 1: ADD BACK APPROACH . net income $105,600 Plus: . depreciation +50,000________ Equals: . operating cash flow $155,600________ ________ ALTERNATIVE CALCULATION 2: DEFINITIONAL APPROACH . revenues (100,000 units at $6.00/unit) $600,000 Minus: . cash expenses (. variable and . fixed costs) -390,000 Minus: . taxes -54,400________ Equals: . operating cash flow $155,600________ ________ ALTERNATIVE CALCULATION 3: DEPRECIATION TAX SHIELD APPROACH . revenues (100,000 units at $6.00/unit) $600,000 Minus: . cash expenses (. variable and . fixed costs) -390,000________ Equals: $210,000________ Times: one minus the tax rate (1 - .34) $138,600 Plus: . depreciation times the tax rate ($50,000 × .34) 17,000________ Equals: . operating cash flow $155,600________ ________ ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 341 TABLE 10-5 Terminal Free Cash Flow, Press On Abs Project . earnings before interest and taxes (EBIT) $160,000 Minus: . taxes -54,400 Plus: . depreciation +50,000 Minus: change in net working capital -(30,000)_________ Equals: . free cash flow $185,600_________ _________ project and without this project and measure the change in cash flows other than any interest payments and financing flows that might have occurred. Terminal Cash Flow For this project, the terminal cash flow is quite simple. The only unusual cash flow at the project’s termination is the recapture of the net working capital associated with the project. In effect, the investment in inventory of $30,000 is liquidated when the project is shut down in four years. Keep in mind that in calculat- ing free cash flow we subtract out the change in net working capital, but since the change in net working capital is negative (we are reducing our investment in inven- tory), we are subtracting a negative number, which has the effect of adding it back in. Thus, working capital was a negative cash flow when the project began and we invested in inventory, and at termination it became a positive offsetting cash flow when the inventory was liquidated. The calculation of the terminal free cash flow using method 1, the pro forma approach is illustrated in Table 10-5. If we were to construct a free cash flow diagram from this example (Figure 10-1), it would have an initial outlay of $230,000, the free cash flows during years 1 through 3 would be $155,600, and the free cash flow in the terminal year would be $185,600. Free cash flow diagrams similar to Figure 10-1 will be used through the remainder of this chapter with arrows above the time line indicating cash inflows and arrows below the time line denoting outflows. $230,000 (Outflow) $155,600 1$155,600 2$155,600 3$185,600 4(Inflow) FIGURE 10-1 Free Cash Flow Diagram for Press On Abs A COMPREHENSIVE EXAMPLE: CALCULATING FREE CASH FLOWS Now let’s put what we know about capital budgeting together and look at a capital- budgeting decision for a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. The project we are considering involves the introduction of a new electric scooter line by Raymobile. Our first task is that of estimating cash flows. This project is expected to last five years and then, because this is somewhat ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 342 PART 3 INVESTMENT IN LONG-TERM ASSETS TABLE 10-6 Raymobile Scooter Line Capital-Budgeting Example Cost of new plant and equipment: $9,700,000 Shipping and installation costs: $ 300,000 Unit Sales: Year Units Sold 1 50,000 2 100,000 3 100,000 4 70,000 5 50,000 Sales price per unit: $150/unit in years 1–4, $130/unit in year 5 Variable cost per unit: $80/unit Annual fixed costs: $500,000 Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. Then, for each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: We use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. Thus, annual depreciation is $2,000,000/year for five years. of a fad project, to be terminated. Thus, our first task becomes that of estimating the initial outlay, the annual free cash flows, and the terminal free cash flow. Given the information in Table 10-6, we want to determine the free cash flows associated with the project. Once we had that, we could easily calculate the project’s net present value, the profitability index, and the internal rate of return, and apply the appropriate decision criteria. SECTION I, TABLE 10-7: CALCULATING CHANGE IN EBIT, TAXES, AND DEPRECIATION To determine the differential annual free cash flows, we first need to determine the annual change in operating cash flow. To do this we will take the change in EBIT, subtract out the change in taxes, and then add in the change in depreciation. This is shown in Section I of Table 10-7 on page 343. We first determine what the change in sales revenue will be by multiplying the units sold times the sale price. From the change in sales revenue we subtract out variable costs, which were given as dollars per unit sold. Then, the change in fixed costs is subtracted out, and the result is earnings before depreciation, interest, and taxes (EBDIT). Subtracting the change in depreciation from EBDIT then leaves us with the change in earnings before interest and taxes (EBIT). From the change in EBIT we can then calculate the change in taxes, which are assumed to be 34 percent of EBIT. SECTION II, TABLE 10-7: CALCULATING OPERATING CASH FLOW Using the calculations provided in Section I of Table 10-7, we then calculate the operating cash flow in Section II of Table 10-7. As you recall, the operating cash flow is simply EBIT minus taxes, plus depreciation. SECTION III, TABLE 10-7: CALCULATING CHANGE IN NET WORKING CAPITAL To calculate the free cash flow from this project, we subtract the change in net working capital and the change in capital spending from operating cash flow. Thus, the first step becomes determining the change in net working capital, which is shown in Section III of Table 10-7. The change in net working capital generally includes both increases in inventory and increases in accounts receivable that naturally occur as sales ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 343 TABLE 10-7 Calculation of Free Cash Flow for Raymobile Scooters YEAR 01234 Section I. Calculate the change in EBIT, taxes, and depreciation (this becomes an input in the calculation of operating cash flow in Section II) Units sold 50,000 100,000 100,000 70,000 50,000 Sale price $150 $150 $150 $150 $130 Sales revenue 7,500,000 15,000,000 15,000,000 10,500,000 6,500,000 Less: variable costs 4,000,000 8,000,000 8,000,000 5,600,000 4,000,000 Less: fixed costs 500,000 500,000 500,000 500,000 500,000 Equals: EBDIT 3,000,000 6,500,000 6,500,000 4,400,000 2,000,000 Less: depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 Equals: EBIT 1,000,000 4,500,000 4,500,000 2,400,000 0 Taxes (@34%) 340,000 1,530,000 1,530,000 816,000 0 Section II. Calculate operating cash flow (this becomes an input in the calculation of free cash flow in Section IV) Operating Cash Flow: EBIT $1,000,000 $4,500,000 $4,500,000 $2,400,000 0 Minus: taxes 340,000 1,530,000 1,530,000 816,000 0 Plus: depreciation 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 Equals: operating cash flows 2,660,000 4,970,000 4,970,000 3,584,000 2,000,000 Section III. Calculate the net working capital (this becomes an input in the calculation of free cash flows in Section IV) Change in Net Working Capital: Revenue $7,500,000 $15,000,000 $15,000,000 $10,500,000 $6,500,000 Initial working capital requirement 100,000 Net working capital needs 750,000 1,500,000 1,500,000 1,050,000 650,000 Liquidation of working capital 650,000 Change in working capital 100,000 650,000 750,000 0 (450,000) (1,050,000) Section IV. Calculate free cash flow (using information calculated in Sections II and III, in addition to the change in capital spending) Free Cash Flow: Operating cash flow $2,660,000 $4,970,000 $4,970,000 $3,584,000 $2,000,000 Minus: change in net working capital 100,000 650,000 750,000 0 (450,000) (1,050,000) Minus: change in capital spending 10,000,000 0 0 0 0 0 Free cash flow (10,100,000) 2,010,000 4,220,000 4,970,000 4,034,000 3,050,000 increase from the introduction of the new product line. Some of the increase in accounts receivable may be offset by increases in accounts payable, but, in general, most new projects involve some type of increase in net working capital. In this example, there is an initial working capital requirement of $100,000. In addition, for each year the total investment in net working capital will be equal to 10 percent of sales for each year. Thus, the investment in working capital for year 1 is $750,000 (because sales are estimated to be $7,500,000). Working capital will already be at $100,000, so the change in net working capital will be $650,000. Net working capital will continue to increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. SECTION IV, TABLE 10-7: CALCULATING FREE CASH FLOW With the operating cash flow and the change in net working capital already calculated, the calculation of the project’s free cash flow becomes easy. All that is missing is the change in capital spending, which in this example will simply be the $9,700,000 for plant and equipment plus the $300,000 for shipping and installation. Thus, change in capital spending ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 344 PART 3 INVESTMENT IN LONG-TERM ASSETS FIGURE 10-2 Free Cash-Flow Diagram for the Raymobile Scooter Line $2,010,000 $4,220,000 $4,970,000 $4,034,000 $3,050,000 1 2345 $10,100,000 becomes $10,000,000. We then need to merely take operating cash flow and subtract from it both the change in net working capital and the change in capital spending. This is done in Section IV of Table 10-7. A free cash-flow diagram for this project is provided in Figure 10-2. CASH FLOW DIAGRAM Using the information provided in Section IV of Table 10-7 and Figure 10-2, we easily calculate the NPV, PI, and IRR for this project. BACK TO THE PRINCIPLES In this chapter, it is easy to get caught up in the calculations and forget that before the calcula- tions can be made, someone has to come up with the idea for the project. In some of the exam- ple problems, you may see projects that appear to be extremely profitable. Unfortunately, as we learned in Principle 5: The Curse of Competitive Markets—Why it’s hard to find exception- ally profitable projects, it is unusual to find projects with dramatically high returns because of the very competitive nature of business. Thus, keep in mind that capital budgeting not only involves the estimation and evaluation of the project’s cash flows, but it also includes the process of coming up with the idea for the project in the first place. CONCEPT CHECK 1. In general, a project’s cash flows will fall into one of three categories. What are these categories? 2. What is a free cash flow? How do we calculate it? 3. What is depreciation? Where does it come from? 4. Although depreciation is not a cash flow item, it plays an important role in the calculation of cash flows. How does depreciation affect a project’s cash flows? Objective COMPLICATIONS IN CAPITAL BUDGETING: CAPITAL RATIONING AND MUTUALLY EXCLUSIVE PROJECTS 3 The use of our capital-budgeting decision rules implies that the size of the capital Capital rationing budget is determined by the availability of acceptable investment proposals. The placing of a limit by the firm on the dollar size of the However, a firm may place a limit on the dollar size of the capital budget. This situa capital budget. tion is called capital rationing. As we will see, an examination of capital rationing Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 FIGURE 10-3 FIGURE 10-3 CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 345 Projects Ranked by IRR Required rate of return (cutoff criterion without capital rationing) IRR (%) A $X Dollars B C D E F G H I J Dollar budget constraint (cutoff criterion under capital rationing) will not only enable us to deal with complexities of the real world but will also serve to demonstrate the superiority of the NPV method over the IRR method for capital budgeting. Using the internal rate of return as the firm’s decision rule, a firm accepts all projects with an internal rate of return greater than the firm’s required rate of return. This rule is illustrated in Figure 10-3, where projects A through E would be chosen. However, when capital rationing is imposed, the dollar size of the total investment is limited by the budget constraint. In Figure 10-3, the budget constraint of $X precludes the acceptance of an attractive investment, project E. This situation obviously contradicts prior decision rules. Moreover, the solution of choosing the projects with the highest internal rate of return is complicated by the fact that some projects may be indivisible; for example, it is meaningless to recommend that half of project D be acquired. RATIONALE FOR CAPITAL RATIONING We will first ask why capital rationing exists and whether or not it is rational. In general, three principal reasons are given for imposing a capital-rationing constraint. First, management may think market conditions are temporarily adverse. In the period surrounding the stock market crash of 1987, this reason was frequently given. At that time, interest rates were high, and stock prices were depressed, which made the cost of funding projects high. Second, there may be a shortage of qualified managers to direct new projects; this can happen when projects are of a highly technical nature. Third, there may be intangible considerations. For example, management may simply fear debt, wishing to avoid interest payments at any cost. Or perhaps issuance of common stock may be limited to maintain a stable dividend policy. Despite strong evidence that capital rationing exists in practice, the question remains as to its effect on the firm. In brief, the effect is negative, and to what degree depends on the severity of the rationing. If the rationing is minor and short-lived, the firm’s share price will not suffer to any great extent. In this case, capital rationing can probably be excused, although it should be noted that any capital rationing that rejects projects with positive net present values is contrary to the firm’s goal of maximization of shareholders’ wealth. If the capital rationing is a result of the firm’s decision to dramatically limit the number of new projects or to limit total investment to internally generated funds, then this policy will eventually have a significantly negative effect on the firm’s share price. For example, a lower share price will eventually result from lost competitive advantage if, owing to a decision to arbitrarily limit its capital budget, a firm fails to upgrade its products and manufacturing process. Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 346 PART 3 INVESTMENT IN LONG-TERM ASSETS TABLE 10-8 Capital-Rationing Example of Five Indivisible Projects PROJECT INITIAL OUTLAY PROFITABILITY INDEX NET PRESENT VALUE A B C D E $200,000 200,000 800,000 300,000 300,000 2.4 2.3 1.7 1.3 1.2 $280,000 260,000 560,000 90,000 60,000 Mutually exclusive projects A set of projects that perform essentially the same task, so that acceptance of one will necessarily mean rejection of the others. CAPITAL RATIONING AND PROJECT SELECTION If the firm decides to impose a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects with the highest net present value subject to the capital constraint. In effect, you are selecting the projects that increase shareholder wealth the most, because the net present value is the amount of wealth that is created when a project is accepted. This guideline may preclude merely taking the highest-ranked projects in terms of the profitability index or the internal rate of return. If the projects shown in Figure 10-3 are divisible, the last project accepted may be only partially accepted. Although partial acceptances may be possible in some cases, the indivisibility of most capital investments prevents it. If a project is a sales outlet or a truck, it may be meaningless to purchase half a sales outlet or half a truck. To illustrate this procedure, consider a firm with a budget constraint of $1 million and five indivisible projects available to it, as given in Table 10-8. If the highest-ranked projects were taken, projects A and B would be taken first. At that point, there would not be enough funds available to take project C; hence, projects D and E would be taken. However, a higher total net present value is provided by the combination of projects A and C. Thus, projects A and C should be selected from the set of projects available. This illustrates our guideline: to select the set of projects that maximize the firm’s net present value. PROJECT RANKING In the past, we have proposed that all projects with a positive net present value, a profitability index greater than 1.0, or an internal rate of return greater than the required rate of return be accepted, assuming there is no capital rationing. However, this acceptance is not always possible. In some cases, when two projects are judged acceptable by the discounted cash flow criteria, it may be necessary to select only one of them, as they are mutually exclusive. Mutually exclusive projects occur when a set of investment proposals perform essentially the same task; acceptance of one will necessarily mean rejection of the others. For example, a company considering the installation of a computer system may evaluate three or four systems, all of which may have positive net present values; however, the acceptance of one system will automatically mean rejection of the others. In general, to deal with mutually exclusive projects, we will simply rank them by means of the discounted cash flow criteria and select the project with the highest ranking. On occasion, however, problems of conflicting ranking may arise. As we will see, in general the net present value method is the preferred decision-making tool because it leads to the selection of the project that increases shareholder wealth the most. PROBLEMS IN PROJECT RANKING There are three general types of ranking problems: the size disparity problem, the time disparity problem, and the unequal lives problem. Each involves the possibility of conflict ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 347 in the ranks yielded by the various discounted cash flow capital-budgeting decision criteria. As noted previously, when one discounted cash flow criterion gives an accept signal, they will all give an accept signal, but they will not necessarily rank all projects in the same order. In most cases, this disparity is not critical; however, for mutually exclusive projects, the ranking order is important. SIZE DISPARITY The size disparity problem occurs when mutually exclusive projects of unequal size are examined. This problem is most easily clarified with an example. Project A Project B (Inflow) $1,900(Inflow) $300 1 year 1 year $1,500 (outflow)$200 (outflow) NPV = $72.70 PI = 1.36 IRR = 50% NPV = $227.10 PI = 1.15 IRR = 27% FIGURE 10-4 Size Disparity Ranking Problem EXAMPLE: THE SIZE DISPARITY RANKING PROBLEM Suppose a firm is considering two mutually exclusive projects, A and B, both with required rates of return of 10 percent. Project A involves a $200 initial outlay and cash inflow of $300 at the end of one year, whereas project B involves an initial outlay of $1,500 and a cash inflow of $1,900 at the end of one year. The net present value, prof- itability index, and internal rate of return for these projects are given in Figure 10-4. In this case, if the net present value criterion is used, project B should be accepted, whereas if the profitability index or the internal rate of return criterion is used, project A should be chosen. The question now becomes: Which project is bet- ter? The answer depends on whether capital rationing exists. Without capital rationing, project B is better because it provides the largest increase in shareholders’ wealth; that is, it has a larger net present value. If there is a capital constraint, the problem then focuses on what can be done with the additional $1,300 that is freed if project A is chosen (costing $200, as opposed to $1,500). If the firm can earn more on project A plus the proj-ect financed with the additional $1,300 ($1,500 - $200) freed up if project A as opposed to project B is chosen, then project A and the marginal project should be accepted. In effect, we are attempting to select the set of projects that maximize the firm’s NPV. Thus, if the marginal project has a net present value greater than $154.40 ($227.10 - $72.70), selecting it plus project A with a net present value of $72.70 will provide a net present value greater than $227.10, the net present value for project B. ISBN: 0-536-18213-2 In summary, whenever the size disparity problem results in conflicting rankings between mutually exclusive projects, the project with the largest net present value will be selected, provided there is no capital rationing. When capital rationing exists, the firm should select the set of projects with the largest net present value. Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 348 PART 3 INVESTMENT IN LONG-TERM ASSETS FIGURE 10-5 Time Disparity Ranking Problem Project A Project B $100 $200 $2,000 $650 $650 $650 1 2 3 years 1 2 3 years $1,000 $1,000 NPV = $758.10 NPV = $616.55 PI = 1.758 PI = 1.617 IRR = 35% IRR = 43% TIME DISPARITY The time disparity problem and the conflicting rankings that accompany it result from the differing reinvestment assumptions made by the net present value and internal rate of return decision criteria. The NPV criterion assumes that cash flows over the life of the project can be reinvested at the required rate of return or cost of capital, whereas the IRR criterion implicitly assumes that the cash flows over the life of the project can be reinvested at the internal rate of return. Again, this problem may be illustrated through the use of an example. Suppose a firm with a required rate of return or cost of capital of 10 percent and with no capital constraint is considering the two mutually exclusive projects illustrated in Figure 10-5. The net present value and profitability index indicate that project A is the better of the two, whereas the internal rate of return indicates that project B is the better. Project B receives its cash flows earlier than project A, and the different assumptions made as to how these flows can be reinvested result in the difference in rankings. Which criterion should be followed depends on which reinvestment assumption is used. The net present value criterion is preferred in this case because it makes the most acceptable assumption for the wealth-maximizing firm. It is certainly the most conservative assumption that can be made, because the required rate of return is the lowest possible reinvestment rate. Moreover, as we have already noted, the net present value method maximizes the value of the firm and the shareholders’ wealth. An alternate solution, as discussed in Chapter 9, is to use the MIRR method. UNEQUAL LIVES The final ranking problem to be examined centers on the question of whether it is appropriate to compare mutually exclusive projects with different life spans. Suppose a firm with a 10 percent required rate of return is faced with the problem of replacing an aging machine and is considering two replacement machines, one with a three-year life and one with a six-year life. The relevant cash flow information for these projects is given in Figure 10-6. Examining the discounted cash flow criteria, we find that the net present value and profitability index criteria indicate that project B is the better project, whereas the internal rate of return favors project A. This ranking inconsistency is caused by the different life spans of the projects being compared. In this case, the decision is a difficult one because the projects are not comparable. The problem of incomparability of projects with different lives arises because future profitable investment proposals may be rejected without being included in the analysis. This can easily be seen in a replacement problem such as the present example, in which two mutually exclusive machines with different lives are being considered. In this case, a ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 349 FIGURE 10-6 Unequal Lives Ranking Problem Project A Project B $500 $500 $500 $300 $300 $300 $300 $300 123 years 12345 $1,000 $1,000 NPV = $243.50 NPV = $306.50 PI = 1.2435 PI = 1.306 IRR = 23% IRR = 20% comparison of the net present values alone on each of these projects would be misleading. If the project with the shorter life were taken, at its termination the firm could replace the machine and receive additional benefits, whereas acceptance of the project with the longer life would exclude this possibility, a possibility that is not included in the analysis. The key question thus becomes: Does today’s investment decision include all future profitable investment proposals in its analysis? If not, the projects are not comparable. In this case, if project B is taken, then the project that could have been taken after three years when project A terminates is automatically rejected without being included in the analysis. Thus, acceptance of project B not only forces rejection of project A, but also forces rejection of any replacement machine that might have been considered for years 4 through 6 without including this replacement machine in the analysis. There are several methods to deal with this situation. The first option is to assume that the cash inflows from the shorter-lived investment will be reinvested at the required rate of return until the termination of the longer-lived asset. Although this approach is the simplest, merely calculating the net present value, it actually ignores the problem at hand—that of allowing for participation in another replacement opportunity with a positive net present value. The proper solution thus becomes the projection of reinvestment opportunities into the future—that is, making assumptions about possible future investment opportunities. Unfortunately, whereas the first method is too simplistic to be of any value, the second is extremely difficult, requiring extensive cash flow forecasts. The final technique for confronting the problem is to assume that reinvestment opportunities in the future will be similar to the current ones. The two most common ways of doing this are by creating a replacement chain to equalize life spans or calculating the project’s equivalent annual annuity (EAA). Using a replacement chain, the present example would call for the creation of a two-chain cycle for project A; that is, we assume that project A can be replaced with a similar investment at the end of three years. Thus, project A would be viewed as two A projects occurring back to back, as illustrated in Figure 10-7. The net present value on this replacement chain is $426.50, which can be compared with project B’s net present value. Therefore, project A should be accepted because the net present value of its replacement chain is greater than the net present value of project B. One problem with replacement chains is that, depending on the life of each project, it can be quite difficult to come up with equivalent lives. For example, if the two projects had 7- and 13-year lives, because the lowest common denominator is 7 × 13 = 91, a 91year replacement chain would be needed to establish equivalent lives. In this case, it is easier to determine the project’s equivalent annual annuity (EAA). A project’s EAA is simply an annuity cash flow that yields the same present value as the project’s NPV. To calculate a project’s EAA, we need only calculate a project’s NPV and then divide that $300 6 years Equivalent annual annuity (EAA) An annual cash flow that yields the same present value as the project’s NPV. It is calculated by dividing the project’s NPV by the appropriate PVIFAi,n. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 350 PART 3 INVESTMENT IN LONG-TERM ASSETS FIGURE 10-7 Replacement Chain Illustration: Two Project A’s Back to Back $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 $500 or 12 456 456 Simplified 12 years years $1,000 $1,000 $1,000 $500 3 3 NPV = $426.50 number by the PVIFAi,n to determine the dollar value of an n-year annuity that would produce the same NPV as the project. This can be done in two steps as follows: Step 1. Calculate the project’s NPV. In Figure 10-6 we determined that project A had an NPV of $243.50, whereas project B had an NPV of $306.50. Step 2. Calculate the EAA. The EAA is determined by dividing each project’s NPV by the PVIFAi,n where i is the required rate of return and n is the project’s life. This determines the level of an annuity cash flow that would produce the same NPV as the project. For project A the PVIFA10%,3yrs is equal to 2.487, whereas the PVIFA10%,6yrs for project B is equal to 4.355. By dividing each project’s NPV by the appropriate PVIFAi,n we determine the EAA for each project: EAA = NPV PVIFA , A / in = $ ./. 243 50 2 487 = $. 97 91 EAAB = $ ./. 30650 4355 = $. 70 38 How do we interpret the EAA? For a project with an n-year life, it tells us what the dollar value is of an n-year annual annuity that would provide the same NPV as the project. Thus, for project A, it means that a three-year annuity of $97.91 given a discount rate of 10 percent would produce a net present value the same as project A’s net present value, which is $243.50. We can now compare the equivalent annual annuities directly to determine which project is better. We can do this because we now have found the level of annual annuity that produces an NPV equivalent to the project’s NPV. Thus, because they are both annual annuities, they are comparable. An easy way to see this is to use the EAAs to create infinite-life replacement chains. To do this, we need only calculate the present value of an infinite stream or perpetuity of equivalent annual annuities. This is done by using the present value of an infinite annuity formula—that is, simply dividing the equivalent annual annuity by the appropriate discount rate. In this case we find: NPV8, A = $./. 9791 10 = $979 10 . NPV = $./. 7038 10 8, B = $703 80 . Here we have calculated the present value of an infinite-life replacement chain. Because the EAA method provides the same results as the infinite-life replacement chain, it really doesn’t matter which method you prefer to use. CALCULATOR SOLUTION CALCULATING PVIFA10%,3 Data Input Function Key 3 10 - 1 0 N I/Y PMT PV Function Key Answer CPT PV 2.4869 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 351 CONCEPT CHECK 1. What is capital rationing and why does it occur? 2. What are mutually exclusive projects? Give an example. OPTIONS IN CAPITAL BUDGETING The use of our discounted cash-flow decision criteria like the NPV method provides an excellent framework within which to evaluate projects. However, what happens if the project being analyzed has the potential to be modified after some future uncertainty has been resolved? For example, if a project that had an expected life of 10 years turns out to be better than anticipated, it may be expanded or continued past 10 years, perhaps going for 20 years. However, if its cash flows do not meet expectations, it may not last a full 10 years—it might be scaled back, abandoned, or sold. In addition, it might be delayed for a year or two. This flexibility is something that the NPV and our other decision criteria had a difficult time dealing with. In fact, the NPV may actually understate the value of the project because the future opportunities associated with the possibility of modifying the project may have a positive value. It is this value of flexibility that we will be examining using options. Three of the most common option types that can add value to a capital-budgeting project are (1) the option to delay a project until the future cash flows are more favorable—this option is common when the firm has exclusive rights, perhaps a patent, to a product or technology; (2) the option to expand a project, perhaps in size or even to new products that would not have otherwise been feasible; and (3) the option to abandon a project if the future cash flows fall short of expectations. THE OPTION TO DELAY A PROJECT There is no question that the estimated cash flows associated with a project can change over time. In fact, as a result of changing expected cash flows, a project that currently has a negative net present value may have a positive net present value in the future. Let’s look at the example of an eco-car—a car with a hybrid gasoline engine and an electric motor. Perhaps you’ve developed a high- voltage nickel-metal hydride battery that you plan on using, coupled with a gasoline engine, to power an automobile. However, as you examine the costs of introducing an eco-car capable of producing 70 miles per gallon, you realize that it is still relatively expensive to manufacture the nickel-metal hydride battery and the market for such a car would be quite small. Thus, this project seems to have a negative net present value. Does that mean that the rights to the high-voltage nickel-metal hydride battery have no value? No, they have value because you may be able to improve on this technology in the future and make the battery more efficient and less expensive, and they also have value because oil prices may rise, which would lead to a bigger market for fuel-efficient cars. In effect, the ability to delay this project with the hope that technological and market conditions will change, making this project profitable, lends value to this project. Another example of the option to delay a project until the future cash flows are more favorable involves a firm that owns the oil rights to some oil-rich land and is considering an oil-drilling project. After all of the costs and the expected oil output are considered, this project may have a negative net present value. Does that mean the firm should give away its oil rights or that those oil rights have no value? Certainly not; there is a chance that in the future oil prices could rise to the point that this negative net present value project could become a positive net present value project. It is this ability to delay development that provides value. Thus, the value in this seemingly negative NPV project is provided by the option to delay the project until the future cash flows are more favorable. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 352 PART 3 INVESTMENT IN LONG-TERM ASSETS THE OPTION TO EXPAND A PROJECT Just as we saw with the option to delay a project, the estimated cash flows associated with a project can change over time, making it valuable to expand a project. Again, this flexibility to adjust production to demand has value. For example, a firm may build a production plant with excess capacity so that if the product has more than anticipated demand, it can simply increase production. Alternatively, taking on this project may provide the firm with a foothold in a new industry and lead to other products that would not have otherwise been feasible. This reasoning has led many firms to expand into e-businesses, hoping to gain know-how and expertise that will lead to other profitable projects down the line. It also provides some of the rationale for research and development expenditures in which the future project is not well defined. Let’s go back to our example of the eco-car and examine the option to expand that project. One of the reasons that most of the major automobile firms are introducing eco-cars is that they feel that if gas prices surge beyond the $2 per gallon price, these hybrids may be the future of the industry, and the only way to gain the know-how and expertise to produce an eco-car is to do it. If the cost of technology declines and the demands increase—perhaps pushed on by increases in gas prices—then they will be ready to expand into full-fledged production. This point becomes clear when you look at the Honda Insight, which is a two- passenger, three-cylinder car with a gas engine and electric motor. It provides 65 miles per gallon, and Honda expects to sell between 7,000 and 8,000 a year. On every Insight that Honda sells, analysts estimate that Honda loses about $8,000. A Honda spokesman says that Honda expects to break even “in a couple of years.” Still, this project makes sense because only through it can Honda gain the technological and production expertise to produce an eco-car profitably. Moreover, the technology Honda develops with the Insight may have profitable applications for other cars or in other areas. In effect, it is the option of expanding production in the future that brings value to this project. THE OPTION TO ABANDON A PROJECT The option to abandon a project as the estimated cash flows associated with a project can change over time also has value. Again, it is this flexibility to adjust to new information that provides the value. For example, a project’s sales in the first year or two may not live up to expectations, with the project being barely profitable. The firm may then decide to liquidate the project and sell the plant and all of the equipment, and that liquidated value may be more than the value of keeping the project going. Again, let’s go back to our example of the eco-car and, this time, examine the option to abandon that project. If after a few years the cost of gas falls dramatically while the cost of technology remains high, the eco-car may not become profitable. At that point Honda may decide to abandon the project and sell the technology, including all the patent rights it has developed. In effect, the original project, the eco-car, may not be of value, but the technology that has been developed may be. In effect, the value of abandoning the project and selling the technology may be more than the value of keeping the project running. Again, it is the value of flexibility associated with the possibility of modifying the project in the future—in this case abandoning the project—that can produce positive value. OPTIONS IN CAPITAL BUDGETING: THE BOTTOM LINE Because of the potential to be modified in the future after some future uncertainty has been resolved, we may find that a project with a negative net present value based upon its expected free cash flows is a “good” project and should be accepted—this demonstrates the value of options. In addition, we may find that a project with a positive net present value may be of more value if its acceptance is delayed. Options also explain the logic that drives firms to take on negative net present value projects that allow them to enter new markets. The option to abandon a project explains why firms hire employees on a temporary basis rather than ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 353 permanently, why they may lease rather than buy equipment, and why they may enter into contracts with suppliers on an annual basis rather than long term. CONCEPT CHECK 1. Give an example of an option to delay a project. Why might this be of value? 2. Give an example of an option to expand a project. Why might this be of value? 3. Give an example of an option to abandon a project. Why might this be of value? THE MULTINATIONAL FIRM: INTERNATIONAL COMPLICATIONS IN CALCULATING EXPECTED FREE CASH FLOWS The process of measuring the incremental after-tax cash flows to the company as a whole gets a bit more complicated when we are dealing with competition from abroad. One area in which this is certainly true is in calculating the right base case; that is, what the firm’s free cash flows would be if the project is not taken on. In determining what free cash flows will be in the future, we must always be aware of potential competition from abroad. We need only look to the auto industry to see that competition from abroad can be serious. During the 1970s, who would have thought that firms like Toyota, Honda, and Nissan could enter the U.S. markets and actually challenge the likes of Ford and GM? The end result of this is that the opening of the markets to international competition has not only led to increased opportunities, but it has also led to increased difficulties in estimating expected free cash flows. There are also other intangible benefits from investing in countries like Germany and Japan, where cutting-edge technology is making its way into the marketplace. Here, investment abroad provides a chance to observe the introduction of new innovations on a firsthand basis. This allows firms like IBM, GE, and 3Com to react more quickly to any technological advances and product innovations that might come out of Germany or Japan. Finally, international markets can be viewed as an option to expand if a product is well received at home. For example, McDonald’s was much more of a hit at home than anyone ever expected 30 years ago. Once it conquered the United States, it moved abroad. There is much uncertainty every time McDonald’s opens a new store in another country; it is unlikely that any new store will be without problems stemming from cultural differences. What McDonald’s learns in the first store opened in a new country is then used in modifying any new stores that it opens in that country. In effect, opening that first store in a new country provides the option to expand, and that option to expand and the value of the flexibility to adjust to the future make opening that first store in a new country a good project. HOW FINANCIAL MANAGERS USE THIS MATERIAL ISBN: 0-536-18213-2 Not only is the financial manager responsible for finding and then properly evaluating new projects, but the financial manager must be certain that the numbers going into the analysis are correct. Let’s look at what the financial managers at Burger King faced when they decided to introduce the Big King, a new burger that looks an awful lot like the Big Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 354 PART 3 INVESTMENT IN LONG-TERM ASSETS Mac. The first task they face is to estimate what the sales from this new product will be— a task that is easier said than done. Not only will sales be dependent upon how good the product is, or in this case, how good the product tastes, but they will also be dependent upon how good a job the marketing department does in selling the public on this new product. But just looking at sales is not enough. To properly perform the analysis on this product, Burger King needs to know what portion of sales will simply be sales diverted from Whoppers, and what portion of sales will be new to Burger King as a whole. In other words, when it introduces the Big King, how much of the sales are from new customers— those “Big Mac attack” eaters? This is truly an area where finance and marketing meet. Much of the job of the financial manager is to make sure that the numbers are correct. That is, have the marketing people considered any synergistic effects? If new customers are drawn into Burger King, are they likely to buy a drink and some fries—two very high markup sales? Will they bring in their families or friends when they make their Big King purchase? How about the increased inventory associated with carrying the Big King line? If it all sounds pretty complex, that’s because it is complex. But more important, it is a decision that has a dramatic effect on the future direction of the firm, and it is an ongoing decision. That is, once the product is introduced and you see how the public reacts, you will continuously reevaluate the product to determine if it should be abandoned or expanded. Look at the “New Coke.” Cola-Cola spent an enormous amount of money test marketing and promoting that product, only to find the public didn’t really like it after all. Once it realized that, the next capital-budgeting decision it made was, given the new sales estimates, to abandon the product. In effect, capital budgeting involves reinventing the company, and in order to make a good decision, you’ve got to have good information going into your capital-budgeting decision model. An awful lot of time and many jobs— maybe your job—revolve around making these decisions. SUMMARYSUMMARY Objective 1 Objective 2 In this chapter, we examined the measurement of free cash flows associated with a firm’s investment proposals that are used to evaluate those proposals. Relying on Principle 3: Cash—Not Profits—Is King, and Principle 4: Incremental Cash Flows—It’s only what changes that counts, we focused only on free cash flows—that is, the incremental or different after-tax cash flows attributed to the investment proposal. Care was taken to be wary of cash flows diverted from existing products, look for incidental or synergistic effects, consider working-capital requirements, consider incremental expenses, ignore sunk costs, account for opportunity costs, examine overhead costs carefully, and ignore interest payments and financing flows. In general, a project’s free cash flows fall into one of three categories: (1) the initial outlay, (2) the annual free cash flows, and (3) the terminal cash flow. To measure a project’s benefits, we use the project’s free cash flows. These free cash flows include: project’s free cash flows = project’s change in operating cash flows - change in net working capital - change in capital spending We can rewrite this, inserting our calculation for project’s change in operating cash flows: project’s free cash flows = change in earnings before interest and taxes - change in taxes + change in depreciation - change in net working capital - change in capital spending ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 355 We also examined capital rationing and the problems it can create by imposing a limit on the Objective dollar size of the capital budget. Although capital rationing does not, in general, lead to the goal of maximization of shareholders’ wealth, it does exist in practice. We discussed problems associated with the evaluation of mutually exclusive projects. Mutually exclusive projects occur when we have a set of investment proposals that perform essentially the same task. In general, to deal with mutually exclusive projects, we rank them by means of the discounted cash flow criteria and select the project with the highest ranking. Conflicting rankings may arise because of the size disparity problem, the time disparity problem, and unequal lives. The problem of incomparability of projects with different lives is not simply a result of the different lives; rather, it arises because future profitable investment proposals may be rejected without being included in the analysis. Replacement chains and equivalent annual annuities are possible solutions to this problem. How do we deal with a project that has the potential to be modified after some future uncertainty has been resolved? This flexibility to be modified is something that the NPV and our other decision criteria had a difficult time dealing with. It is this value of flexibility that we examined using options. Three of the most common types of options that can add value to a capital budgeting project are (1) the option to delay a project until the future cash flows are more favorable—this option is common when the firm has exclusive rights, perhaps a patent, to a product or technology; (2) the option to expand a project, perhaps in size or even to new products that would not have otherwise been feasible; and (3) the option to abandon a project if the future cash flows fall short of expectations. 3 KEY TERMSKEY TERMS Capital rationing, 344 Initial outlay, 332 Mutually exclusive Equivalent annual annuity projects, 346 (EAA), 349 STUDY QUESTIONSSTUDY QUESTIONS 10-1. Why do we focus on cash flows rather than accounting profits in making our capital- budgeting decisions? Why are we interested only in incremental cash flows rather than total cash flows? 10-2. If depreciation is not a cash flow item, why does it affect the level of cash flows from a proj ect in any way? 10-3. If a project requires additional investment in working capital, how should this be treated in calculating cash flows? 10-4. How do sunk costs affect the determination of cash flows associated with an investment proposal? 10-5. What are mutually exclusive projects? Why might the existence of mutually exclusive projects cause problems in the implementation of the discounted cash flow capital-budgeting decision criteria? 10-6. What are common reasons for capital rationing? Is capital rationing rational? 10-7. How should managers compare two mutually exclusive projects of unequal size? Would your approach change if capital rationing existed? 10-8. What causes the time disparity ranking problem? What reinvestment rate assumptions are associated with the net present value and internal rate of return capital-budgeting criteria? 10-9. When might two mutually exclusive projects having unequal lives be incomparable? How should managers deal with this problem? Go To: www.prenhall.com/keown for downloads and current events associated with this chapter ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 356 PART 3 INVESTMENT IN LONG-TERM ASSETS SELF-TEST PROBLEMSSELF-TEST PROBLEMS ST-1. The Easterwood Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad project, to be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Cost of new plant and equipment: $20,900,000 Shipping and installation costs: $ 300,000 Unit sales: Year Units Sold 1 100,000 2 130,000 3 160,000 4 100,000 5 60,000 Sales price per unit: $500/unit in years 1–4, $380/unit in year 5 Variable cost per unit: $260/unit Annual fixed costs: $300,000 Working-capital requirements: There will be an initial working-capital requirement of $500,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. ST-2. The J. Serrano Corporation is considering signing a one-year contract with one of two computer-based marketing firms. Although one is more expensive, it offers a more extensive program and thus will provide higher after-tax net cash flows. Assume these two options are mutually exclusive and that the required rate of return is 12 percent. Given the following after-tax net cash flows: YEAR OPTION A OPTION B 0 -$50,000 -$100,000 1 70,000 130,000 a. Calculate the net present value. b. Calculate the profitability index. c. Calculate the internal rate of return. d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made? STUDY PROBLEMS (SET A)STUDY PROBLEMS (SET A) 10-1A. (Capital gains tax) The J. Harris Corporation is considering selling one of its old assembly machines. The machine, purchased for $30,000 five years ago, had an expected life of 10 years and an expected salvage value of zero. Assume Harris uses simplified straight-line depreciation, creating depreciation of $3,000 per year, and could sell this old machine for $35,000. Also assume a 34 percent marginal tax rate. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 357 a. What would be the taxes associated with this sale? b. If the old machine were sold for $25,000, what would be the taxes associated with this sale? c. If the old machine were sold for $15,000, what would be the taxes associated with this sale? d. If the old machine were sold for $12,000, what would be the taxes associated with this sale? 10-2A. (Relevant cash flows) Captins’ Cereal is considering introducing a variation of its current breakfast cereal, Crunch Stuff. This new cereal will be similar to the old with the exception that it will contain sugarcoated marshmallows shaped in the form of stars. The new cereal will be called Crunch Stuff n’ Stars. It is estimated that the sales for the new cereal will be $25 million; however, 20 percent of those sales will be former Crunch Stuff customers who have switched to Crunch Stuff n’ Stars who would not have switched if the new product had not been introduced. What is the relevant sales level to consider when deciding whether or not to introduce Crunch Stuff n’ Stars? 10-3A. (Calculating free cash flows) Racin’ Scooters is introducing a new product and has an expected change in EBIT of $475,000. Racin’ Scooters has a 34 percent marginal tax rate. This project will also produce $100,000 of depreciation per year. In addition, this project will also cause the following changes: WITHOUT THE PROJECT WITH THE PROJECT Accounts receivable $45,000 $63,000 Inventory 65,000 80,000 Accounts payable 70,000 94,000 What is the project’s free cash flow? 10-4A. (Calculating free cash flows) Visible Fences is introducing a new product and has an expected change in EBIT of $900,000. Visible Fences has a 34 percent marginal tax rate. This project will also produce $300,000 of depreciation per year. In addition, this project will also cause the following changes: WITHOUT THE PROJECT WITH THE PROJECT Accounts receivable Inventory Accounts payable $55,000 55,000 90,000 $63,000 70,000 106,000 What is the project’s free cash flow? 10-5A. (Calculating operating cash flows) Assume that a new project will annually generate revenues of $2,000,000 and cash expenses, including both fixed and variable costs, of $800,000, while increasing depreciation by $200,000 per year. In addition, let’s assume that the firm’s marginal tax rate is 34 percent. Calculate the operating cash flows using the pro forma and 3 alternatives. 10-6A. (Calculating operating cash flows) Assume that a new project will annually generate revenues of $3,000,000 and cash expenses, including both fixed and variable costs, of $900,000, while increasing depreciation by $400,000 per year. In addition, let’s assume that the firm’s marginal tax rate is 34 percent. Calculate the operating cash flows using all three methods. 10-7A. (Calculating free cash flows) You are considering expanding your product line that currently consists of skateboards to include gas-powered skateboards, and you feel you can sell 10,000 of these per year for 10 years (after which time this project is expected to shut down with solar-powered skateboards taking over). The gas skateboards would sell for $100 each with variable costs of $40 for each one produced, while annual fixed costs associated with production would be $160,000. In addition, there would be a $1,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over 10 years. This project will also require a one-time initial investment of $50,000 in net working capital associated with inventory and that working capital investment will be recovered when the project is shut down. Finally, assume that the firm’s marginal tax rate is 34 percent. a. What is the initial outlay associated with this project? b. What are the annual free cash flows associated with this project for years 1 through 9? ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 358 PART 3 INVESTMENT IN LONG-TERM ASSETS c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. What is the project’s NPV given a 10 percent required rate of return? 10-8A. (Calculating free cash flows) You are considering new elliptical trainers and you feel you can sell 5,000 of these per year for five years (after which time this project is expected to shut down when it is learned that being fit is unhealthy). The elliptical trainers would sell for $1,000 each with variable costs of $500 for each one produced, while annual fixed costs associated with production would be $1,000,000. In addition, there would be a $5,000,000 initial expenditure associated with the purchase of new production equipment. It is assumed that this initial expenditure will be depreciated using the simplified straight-line method down to zero over five years. This project will also require a one-time initial investment of $1,000,000 in net working capital associated with inventory and that working capital investment will be recovered when the project is shut down. Finally, assume that the firm’s marginal tax rate is 34 percent. a. What is the initial outlay associated with this project? b. What are the annual free cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (that is, what is the free cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. What is the project’s NPV given a 10 percent required rate of return? 10-9A. (New project analysis) The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although the machine being considered will result in an increase in earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and it would cost an additional $5,000 after tax to properly install this machine. In addition, to properly operate this machine, inventory must be increased by $5,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? 10-10A. (New project analysis) Raymobile Motors is considering the purchase of a new production machine for $500,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $150,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $25,000 after tax. In addition, it would cost $5,000 after tax to install this machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $30,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? 10-11A. (New project analysis) Garcia’s Truckin’ Inc. is considering the purchase of a new production machine for $200,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $50,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5,000 after tax. In addition, it would cost $5,000 after tax to install this machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $20,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $100,000 at 8 percent interest from its local bank, resulting in additional interest payments of $8,000 per year. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 10 percent. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 359 a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? 10-12A. (Comprehensive problem) Traid Winds Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad project, to be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Cost of new plant and equipment: $14,800,000 Shipping and installation costs: $ 200,000 Unit sales: Year Units Sold 1 70,000 2 120,000 3 120,000 4 80,000 5 70,000 Sales price per unit: $300/unit in years 1–4, $250/unit in year 5 Variable cost per unit: $140/unit Annual fixed costs: $700,000 Working-capital requirements: There will be an initial working-capital requirement of $200,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. 10-13A. (Comprehensive problem) The Shome Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad project, to be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Cost of new plant and equipment: $6,900,000 Shipping and installation costs: $ 100,000 Unit sales: Year Units Sold 1 80,000 2 100,000 3 120,000 4 70,000 5 70,000 Sales price per unit: $250/unit in years 1–4, $200/unit in year 5 Variable cost per unit: $130/unit Annual fixed costs: $300,000 Working-capital requirements: There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 360 PART 3 INVESTMENT IN LONG-TERM ASSETS 10-14A. (Size disparity ranking problem) The D. Dorner Farms Corporation is considering purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of the two is better and will produce a higher yield. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following after-tax net cash flows: YEAR PROJECT A PROJECT B 0 -$500 -$5,000 1 700 6,000 a. Calculate the net present value. b. Calculate the profitability index. c. Calculate the internal rate of return. d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made? 10-15A. (Time disparity ranking problem) The State Spartan Corporation is considering two mutually exclusive projects. The cash flows associated with those projects are as follows: YEAR PROJECT A PROJECT B 0 -$50,000 -$50,000 1 15,625 0 2 15,625 0 3 15,625 0 4 15,625 0 5 15,625 $100,000 The required rate of return on these projects is 10 percent. a. What is each project’s payback period? b. What is each project’s net present value? c. What is each project’s internal rate of return? d. What has caused the ranking conflict? e. Which project should be accepted? Why? 10-16A. (Unequal lives ranking problem) The B. T. Knight Corporation is considering two mutually exclusive pieces of machinery that perform the same task. The two alternatives available provide the following set of after-tax net cash flows: YEAR EQUIPMENT A EQUIPMENT B 0 -$20,000 -$20,000 1 12,590 6,625 2 12,590 6,625 3 12,590 6,625 4 6,625 5 6,625 6 6,625 7 6,625 8 6,625 9 6,625 Equipment A has an expected life of three years, whereas equipment B has an expected life of nine years. Assume a required rate of return of 15 percent. a. Calculate each project’s payback period. b. Calculate each project’s net present value. c. Calculate each project’s internal rate of return. d. Are these projects comparable? e. Compare these projects using replacement chains and EAA. Which project should be selected? Support your recommendation. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 361 10-17A. (EAAs) The Andrzejewski Corporation is considering two mutually exclusive projects, one with a three-year life and one with a seven-year life. The after-tax cash flows from the two projects are as follows: YEAR PROJECT A PROJECT B 0 -$50,000 -$50,000 1 20,000 36,000 2 20,000 36,000 3 20,000 36,000 4 20,000 5 20,000 6 20,000 7 20,000 a. Assuming a 10 percent required rate of return on both projects, calculate each project’s EAA. Which project should be selected? b. Calculate the present value of an infinite-life replacement chain for each project. 10-18A. (Capital rationing) Cowboy Hat Company of Stillwater, Oklahoma, is considering seven capital investment proposals, for which the funds available are limited to a maximum of $12 million. The projects are independent and have the following costs and profitability indexes associated with them: PROFITABILITY PROJECT COST INDEX A $4,000,000 1.18 B 3,000,000 1.08 C 5,000,000 1.33 D 6,000,000 1.31 E 4,000,000 1.19 F 6,000,000 1.20 G 4,000,000 1.18 a. Under strict capital rationing, which projects should be selected? b. What problems are there with capital rationing? WEB WORKSWEB WORKS If you’re an automaker, you’ve got to be ready for the next generation of cars. While they may be extremely efficient gas-powered vehicles, they could also be a hybrid—gas and electricity powered or even propelled by electricity generated by a hydrogen-oxygen chemical reaction. Given all the uncertainty associated with the future direction of automobiles and how they will be powered, it only makes sense to explore all avenues and make sure you’re not left behind. That is, if you want to be a leader in this market and if it does in fact develop, you’ll have an early presence in it, developing and refining your potential product line. That’s the whole idea behind an option to expand a product line. In the fuel-efficient automobile market, the Toyota Prius and the Honda Insight have taken the initial lead, with Ford’s Prodigy, GM’s Precipt, and now Daimler’s ESX3 entering the competition. This is not an inexpensive effort; in fact, it has been estimated that the Toyota Prius, which employs an expensive electric-alone drive for much of its duty cycle, produces a loss per vehicle sold of approximately $10,000. Thinking about the discussion in this chapter dealing with the option to expand a product, why do you think they are willing to take on this type of loss- producing project? Does this make sense to you? Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 362 PART 3 INVESTMENT IN LONG-TERM ASSETS Now take a look at some of the different products being developed in this area. Which ones do you think have the highest chance of success? For example, Honda’s new FCX car (hondacorporate.com/?onload=fcx) works on fuel cells. Check out how they work at www.howstuffworks.com/fuel-cell.htm. Also, take a look at what Toyota is doing at www.toyota.com and also look at what Ford is doing (www.ford.com/en/innovation/engineFuelTechnology/default.htm). In addition, check out GM’s new efforts (www.gmev.com/). Has your opinion on whether or not these are appropriate projects to take on changed at all? INTEGRATIVE PROBLEMINTEGRATIVE PROBLEM It’s been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation, but also to respond to a number of questions aimed at judging your understanding of the capital- budgeting process. The memorandum you received outlining your assignment follows: TO: The Assistant Financial Analyst FROM: Mr. V. Morrison, CEO, Caledonia Products RE: Cash Flow Analysis and Capital Rationing We are considering the introduction of a new product. Currently we are in the 34 percent mar ginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last five years and then, because this is somewhat of a fad project, to be terminated. The following information describes the new project: Cost of new plant and equipment: $7,900,000 Shipping and installation costs: $ 100,000 Unit sales: Year Units Sold 1 70,000 2 120,000 3 140,000 4 80,000 5 60,000 Sales price per unit: $300/unit in years 1–4, $260/unit in year 5 Variable cost per unit: $180/unit Annual fixed costs: $200,000 Working-capital requirements: There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. 1. Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits? 2. How does depreciation affect free cash flows? 3. How do sunk costs affect the determination of cash flows? 4. What is the project’s initial outlay? ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 363 5. What are the differential cash flows over the project’s life? 6. What is the terminal cash flow? 7. Draw a cash flow diagram for this project. 8. What is its net present value? 9. What is its internal rate of return? 10. Should the project be accepted? Why or why not? You have also been asked for your views on three unrelated sets of projects. Each set of projects involves two mutually exclusive projects. These projects follow: 11. Caledonia is considering two investments with one-year lives. The more expensive of the two is the better and will produce more savings. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following after-tax net cash flows: YEAR PROJECT A PROJECT B 0 -$195,000 -$1,200,000 1 240,000 1,650,000 a. Calculate the net present value. b. Calculate the profitability index. c. Calculate the internal rate of return. d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made? 12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated with these projects are as follows: YEAR PROJECT A PROJECT B 0 -$100,000 -$100,000 1 32,000 0 2 32,000 0 3 32,000 0 4 32,000 0 5 32,000 $200,000 The required rate of return on these projects is 11 percent. a. What is each project’s payback period? b. What is each project’s net present value? c. What is each project’s internal rate of return? d. What has caused the ranking conflict? e. Which project should be accepted? Why? 13. The final two mutually exclusive projects that Caledonia is considering involve mutually exclusive pieces of machinery that perform the same task. The two alternatives available provide the following set of after-tax net cash flows: YEAR EQUIPMENT A EQUIPMENT B 0 -$100,000 -$100,000 1 65,000 32,500 2 65,000 32,500 3 65,000 32,500 4 32,500 5 32,500 6 32,500 7 32,500 8 32,500 9 32,500 ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 364 PART 3 INVESTMENT IN LONG-TERM ASSETS Equipment A has an expected life of three years, whereas equipment B has an expected life of nine years. Assume a required rate of return of 14 percent. a. Calculate each project’s payback period. b. Calculate each project’s net present value. c. Calculate each project’s internal rate of return. d. Are these projects comparable? e. Compare these projects using replacement chains and EAAs. Which project should be selected? Support your recommendation. STUDY PROBLEMS (SET B)STUDY PROBLEMS (SET B) 10-1B. (Capital gains tax) The R. T. Kleinman Corporation is considering selling one of its old assembly machines. The machine, purchased for $40,000 five years ago, had an expected life of 10 years and an expected salvage value of zero. Assume Kleinman uses simplified straight-line depreciation, creating depreciation of $4,000 per year, and could sell this old machine for $45,000. Also assume a 34 percent marginal tax rate. a. What would be the taxes associated with this sale? b. If the old machine were sold for $40,000, what would be the taxes associated with this sale? c. If the old machine were sold for $20,000, what would be the taxes associated with this sale? d. If the old machine were sold for $17,000, what would be the taxes associated with this sale? 10-2B. (Relevant cash flows) Fruity Stones is considering introducing a variation of its current breakfast cereal, Jolt ’n Stones. This new cereal will be similar to the old with the exception that it will contain more sugar in the form of small pebbles. The new cereal will be called Stones ’n Stuff. It is estimated that the sales for the new cereal will be $100 million; however, 40 percent of those sales will be from former Fruity Stones customers who have switched to Stones ’n Stuff who would not have switched if the new product had not been introduced. What is the relevant sales level to consider when deciding whether or not to introduce Stones ’n Stuff? 10-3B. (Calculating free cash flows) Tetious Dimensions is introducing a new product and has an expected change in EBIT of $775,000. Tetious Dimensions has a 34 percent marginal tax rate. This project will also produce $200,000 of depreciation per year. In addition, this project will also cause the following changes: WITHOUT THE PROJECT WITH THE PROJECT Accounts receivable $55,000 $89,000 Inventory 100,000 180,000 Accounts payable 70,000 120,000 What is the project’s free cash flow? 10-4B. (Calculating free cash flows) Duncan Motors is introducing a new product and has an expected change in EBIT of $300,000. Duncan Motors has a 34 percent marginal tax rate. This project will also produce $50,000 of depreciation per year. In addition, this project will also cause the following changes: WITHOUT THE PROJECT WITH THE PROJECT Accounts receivable $33,000 $23,000 Inventory 25,000 40,000 Accounts payable 50,000 86,000 What is the project’s free cash flow? Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 ISBN: 0-536-18213-2 CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 365 10-5B. (New project analysis) The Guo Chemical Corporation is considering the purchase of a chemical analysis machine. The purchase of this machine will result in an increase in earnings before interest and taxes of $70,000 per year. The machine has a purchase price of $250,000, and it would cost an additional $10,000 after tax to install this machine properly. In addition, to operate this machine properly, inventory must be increased by $15,000. This machine has an expected life of 10 years, after which it will have no salvage value. Also, assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flow associated with termination of the project)? d. Should this machine be purchased? 10-6B. (New project analysis) El Gato’s Motors is considering the purchase of a new production machine for $1 million. The purchase of this machine will result in an increase in earnings before interest and taxes of $400,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $100,000 after tax. In addition, it would cost $50,000 after tax to install this machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $150,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 12 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? 10-7B. (New project analysis) Weir’s Truckin’ Inc. is considering the purchase of a new production machine for $100,000. The purchase of this new machine will result in an increase in earnings before interest and taxes of $25,000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5,000 after tax. In addition, it would cost $5,000 after-tax to install this machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $25,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $80,000 at 10 percent interest from its local bank, resulting in additional interest payments of $8,000 per year. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 12 percent. a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for years 1 through 9? c. What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? d. Should this machine be purchased? 10-8B. (Comprehensive problem) The Dophical Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad product, to be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 366 PART 3 INVESTMENT IN LONG-TERM ASSETS Cost of new plant and equipment: $198,000,000 Shipping and installation costs: $ 2,000,000 Unit sales: Year Units Sold 1 1,000,000 2 1,800,000 3 1,800,000 4 1,200,000 5 700,000 Sales price per unit: $800/unit in years 1–4, $600/unit in year 5 Variable cost per unit: $400/unit Annual fixed costs: $10,000,000 Working-capital requirements: There will be an initial working-capital requirement of $2,000,000 just to get production started. For each year, the total investment in net working capital will equal 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. 10-9B. (Comprehensive problem) The Kumar Corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. This project involves the introduction of a new product. This project is expected to last five years and then, because this is somewhat of a fad product, to be terminated. Given the following information, determine the free cash flows associated with the project, the project’s net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Cost of new plant and equipment: $9,900,000 Shipping and installation costs: $ 100,000 Unit sales: Year Units Sold 1 70,000 2 100,000 3 140,000 4 70,000 5 60,000 Sales price per unit: $280/unit in years 1–4, $180/unit in year 5 Variable cost per unit: $140/unit Annual fixed costs: $300,000 Working-capital requirements: There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will equal 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. 10-10B. (Size disparity ranking problem) The Unk’s Farms Corporation is considering purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of the two is the better and will produce a higher yield. Assume these projects are mutually exclusive and that the required rate of return is 10 percent. Given the following after-tax net cash flows: YEAR PROJECT A PROJECT B 0 -$650 -$4,000 1 800 5,500 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. ISBN: 0-536-18213-2 CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 367 a. Calculate the net present value. b. Calculate the profitability index. c. Calculate the internal rate of return. d. If there is no capital-rationing constraint, which project should be selected? If there is a capital-rationing constraint, how should the decision be made? 10-11B. (Time disparity ranking problem) The Z. Bello Corporation is considering two mutually exclusive projects. The cash flows associated with those projects are as follows: YEAR PROJECT A PROJECT B 0 -$50,000 -$50,000 1 16,000 0 2 16,000 0 3 16,000 0 4 16,000 0 5 16,000 $100,000 The required rate of return on these projects is 11 percent. a. What is each project’s payback period? b. What is each project’s net present value? c. What is each project’s internal rate of return? d. What has caused the ranking conflict? e. Which project should be accepted? Why? 10-12B. (Unequal lives ranking problem) The Battling Bishops Corporation is considering two mutually exclusive pieces of machinery that perform the same task. The two alternatives available provide the following set of after-tax net cash flows: YEAR EQUIPMENT A EQUIPMENT B 0 -$20,000 -$20,000 1 13,000 6,500 2 13,000 6,500 3 13,000 6,500 4 6,500 5 6,500 6 6,500 7 6,500 8 6,500 9 6,500 Equipment A has an expected life of three years, whereas equipment B has an expected life of nine years. Assume a required rate of return of 14 percent. a. Calculate each project’s payback period. b. Calculate each project’s net present value. c. Calculate each project’s internal rate of return. d. Are these projects comparable? e. Compare these projects using replacement chains and EAAs. Which project should be selected? Support your recommendation. 10-13B. (EAAs) The Anduski Corporation is considering two mutually exclusive projects, one with a five-year life and one with a seven-year life. The after-tax cash flows from the two projects are as follows: YEAR PROJECT A PROJECT B 0 -$40,000 -$40,000 1 20,000 25,000 2 20,000 25,000 (continued) ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. 368 PART 3 INVESTMENT IN LONG-TERM ASSETS YEAR PROJECT A PROJECT B 3 4 5 6 7 20,000 20,000 20,000 20,000 20,000 25,000 25,000 25,000 a. Assuming a 10 percent required rate of return on both projects, calculate each project’s EAA. Which project should be selected? b. Calculate the present value of an infinite-life replacement chain for each project. 10-14B. (Capital rationing) The Taco Toast Company is considering seven capital investment projects, for which the funds available are limited to a maximum of $12 million. The projects are independent and have the following costs and profitability indexes associated with them: a. Under strict capital rationing, which projects should be selected? b. What problems are associated with imposing capital rationing? PROFITABILITY PROJECT COST INDEX A $4,000,000 1.18 B 3,000,000 1.08 C 5,000,000 1.33 D 6,000,000 1.31 E 4,000,000 1.19 F 6,000,000 1.20 G 4,000,000 1.18 SELF-TEST SOLUTIONSSELF-TEST SOLUTIONS ST-1. Step 1: First calculate the initial outlay. YEAR 012345 Section I. Calculate the change in EBIT, Taxes, and Depreciation (this becomes an input in the calculation of operating cash flow in Section II) Units sold 100,000 130,000 160,000 100,000 60,000 Sale price $500 $500 $500 $500 $380 Sales revenue $50,000,000 $65,000,000 $80,000,000 $50,000,000 $22,800,000 Less: variable costs 26,000,000 33,800,000 41,600,000 26,000,000 15,600,000 Less: fixed costs $ 300,000 $ 300,000 $ 300,000 $ 300,000 $ 300,000 Equals: EBDIT $23,700,000 $30,900,000 $38,100,000 $23,700,000 $ 6,900,000 Less: depreciation $ 4,240,000 $ 4,240,000 $ 4,240,000 $ 4,240,000 $ 4,240,000 Equals: EBIT $19,460,000 $26,660,000 $33,860,000 $19,460,000 $ 2,660,000 Taxes (@34%) $ 6,616,400 $ 9,064,400 $ 11,512,400 $ 6,616,400 $ 904,400 Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of free cash flow in Section IV) Operating Cash Flow: EBIT $19,460,000 $26,660,000 $33,860,000 $19,460,000 $ 2,660,000 Minus: taxes $ 6,616,400 $ 9,064,400 $ 11,512,400 $ 6,616,400 $ 904,400 Plus: depreciation $ 4,240,000 $ 4,240,000 $ 4,240,000 $ 4,240,000 $ 4,240,000 Equals: operating cash flow $17,083,600 $21,835,600 $26,587,600 $17,083,600 $ 5,995,600 ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc. CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 369 YEAR 01234 Section III. Calculate the Net Working Capital (this becomes an input in the calculation of free cash flows in Section IV) Change in Net Working Capital: Revenue: $ 50,000,000 $ 65,000,000 $ 80,000,000 $ 50,000,000 $ 22,800,000 Initial working-capital requirement $ 500,000 Net working-capital needs $ 5,000,000 $ 6,500,000 $ 8,000,000 $ 5,000,000 $ 2,280,000 Liquidation of working capital $ 2,280,000 Change in working capital $ 500,000 $ 4,500,000 $ 1,500,000 $ 1,500,000 ($ 3,000,000) ($ 5,000,000) Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to change in capital spending) Free Cash Flow: Operating cash flow $ 17,083,600 $ 21,835,600 $ 26,587,600 $ 17,083,600 $ 5,995,600 Minus: change in net working capital $ 500,000 $ 4,500,000 $ 1,500,000 $ 1,500,000 ($ 3,000,000) ($ 5,000,000) Minus: change in capital spending $ 21,200,000 0 0 0 0 0 Free cash flow ($ 21,700,000) $12,583,600 $20,335,600 $25,087,600 $20,083,600 $10,995,600 NPV $38,064,020 Step 2: Calculate the differential cash flows over the project’s life. Thus, the cash flow in the final year will be equal to the annual net cash flow in that year of $20,608 plus the terminal cash flow of $13,200 for a total of $33,808. ST-2. .. 1 a. NPV = $70,000 . .- $50,000 1 A .. (1 + .12) .. = $62,500 - $50,000 = 12, 500 .. 1 NPVB = $130 000 .- $100 000 , . , .(1 + .12 )1 . .. , 100 000 = 116 071 = $, = 160 071 , $, 62 500 b. PI = A $, 50 000 = . 1 250 $ , 116 071 PI B = $ , 100 000 = . 1 1607 c. $,50 000 = 70 000 ( i,1yr $, PVIF ) .7143 = PVIF i,1yr Looking for a value of PVIFi,1yr in Appendix C, a value of .714 is found in the 40 percent column. Thus, the IRR is 40 percent. $ , = $130 000 , PVIF ) 100 000 ( i,1yr .7692 = PVIFi,1yr Looking for a value of PVIFi,1yr in Appendix C, a value of .769 is found in the 30 percent column. Thus, the IRR is 30 percent. d. If there is no capital rationing, project B should be accepted because it has a larger net present value. If there is a capital constraint, the problem focuses on what can be done with the additional $50,000 (the additional money that could be invested if project A, with an initial outlay of $50,000, were selected over project B, with an initial outlay of $100,000). In the capital constraint case, if Serrano can earn more on project A plus the marginal project financed with the additional $50,000 than it can on project B, then project A and the marginal project should be accepted. ISBN: 0-536-18213-2 Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson Prentice Hall. Copyright © 2005 by Pearson Education, Inc.