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The most important, but also the most difficult, step in capital budgeting is estimating
projects’ cash flows—the investment outlays and the annual net cash flows after a
project goes into operation. Many variables are involved, and many individuals and
departments participate in the process. For example, the forecasts of unit sales and
sales prices are normally made by the marketing group, based on their knowledge of
price elasticity, advertising effects, the state of the economy, competitors’ reactions,
and trends in consumers’ tastes. Similarly, the capital outlays associated with a new
product are generally obtained from the engineering and product development staffs,
while operating costs are estimated by cost accountants, production experts, personnel
specialists, purchasing agents, and so forth.
It is difficult to forecast the costs and revenues associated with a large, complex
project, so forecast errors can be quite large. For example, when several major oil
companies decided to build the Alaska Pipeline, the original cost estimates were in the
neighborhood of $700 million, but the final cost was closer to $7 billion. Similar (or
even worse) miscalculations are common in forecasts of product design costs, such as
the costs to develop a new personal computer. Further, as difficult as plant and equipment
costs are to estimate, sales revenues and operating costs over the project’s life are
even more uncertain. Just ask Polaroid, which recently filed for bankruptcy, or any of
the now-defunct dot-com companies.
A proper analysis includes (1) obtaining information from various departments
such as engineering and marketing, (2) ensuring that everyone involved with the forecast
uses a consistent set of economic assumptions, and (3) making sure that no biases
are inherent in the forecasts. This last point is extremely important, because some
managers become emotionally involved with pet projects, and others seek to build empires.
Both problems cause cash flow forecast biases which make bad projects look
good—on paper.
It is almost impossible to overstate the problems one can encounter in cash flow
forecasts. It is also difficult to overstate the importance of these forecasts.
The first step in capital budgeting is to identify the relevant cash flows, defined as
the specific set of cash flows that should be considered in the decision at hand. Analysts
often make errors in estimating cash flows, but two cardinal rules can help you
minimize mistakes: (1) Capital budgeting decisions must be based on cash flows, not accounting
income. (2) Only incremental cash flows are relevant.
Free cash flow is the cash flow available for distribution to investors. In a nutshell,
the relevant cash flow for a project is the additional free cash flow that the company can
expect if it implements the project. It is the cash flow above and beyond what the company
could expect if it doesn’t implement the project. The following sections discuss
the relevant cash flows in more detail.
Project Cash Flow versus Accounting Income
Free cash flow is calculated as follows:
Just as a firm’s value depends on its free cash flows, so does the value of a project. It is important for you to understand that project cash flow differs from
accounting income.
Costs of Fixed AssetsMost projects require assets, and asset purchases represent
negative cash flows. Even though the acquisition of assets results in a cash outflow, accountants
do not show the purchase of fixed assets as a deduction from accounting income.
Instead, they deduct a depreciation expense each year throughout the life of the
asset.
Note that the full cost of fixed assets includes any shipping and installation
costs. When a firm acquires fixed assets, it often must incur substantial costs for
shipping and installing the equipment. These charges are added to the price of the
equipment when the project’s cost is being determined. Then, the full cost of the
equipment, including shipping and installation costs, is used as the depreciable
basis when depreciation charges are being calculated. For example, if a company
bought a computer with an invoice price of $100,000 and paid another $10,000 for
shipping and installation, then the full cost of the computer (and its depreciable
basis) would be $110,000. Note too that fixed assets can often be sold at the end
of a project’s life. If this is the case, then the after-tax cash proceeds represent a
positive cash flow.
Noncash ChargesIn calculating net income, accountants usually subtract depreciation
from revenues. So, while accountants do not subtract the purchase price of fixed
assets when calculating accounting income, they do subtract a charge each year for depreciation.
Depreciation shelters income from taxation, and this has an impact on cash
flow, but depreciation itself is not a cash flow. Therefore, depreciation must be added
to NOPAT when estimating a project’s cash flow.
Changes in Net Operating Working CapitalNormally, additional inventories
are required to support a new operation, and expanded sales tie up additional funds in
accounts receivable. However, payables and accruals increase as a result of the expansion,
and this reduces the cash needed to finance inventories and receivables. The difference
between the required increase in operating current assets and the increase in
operating current liabilities is the change in net operating working capital. If this
change is positive, as it generally is for expansion projects, then additional financing,
over and above the cost of the fixed assets, will be needed.
Toward the end of a project’s life, inventories will be used but not replaced, and receivables
will be collected without corresponding replacements. As these changes occur,
the firm will receive cash inflows, and as a result, the investment in net operating
working capital will be returned by the end of the project’s life.
Interest Expenses Are Not Included in Project Cash Flows The cost of
capital is a weighted average (WACC) of the costs of debt, preferred stock, and common
equity, adjusted for the project’s risk. Moreover, the WACC is the rate of return
necessary to satisfy all of the firm’s investors—debtholders and stockholders. In other
words, the project generates cash flows that are available for all investors, and we find
the value of the project by discounting those cash flows at the average rate required by
all investors. Therefore, we do not subtract interest when estimating a project’s cash
flows.
If you did not take our advice and instead were to subtract interest (or interest plus
principal payments), then you would be calculating the cash flows available only for
equity investors, which should be discounted at the rate of return required by equity
investors. One problem with this approach, though, is that you must adjust the
amount of debt each year by exactly the right amount. If you were extremely careful
doing this, then you should get the correct result. However, this is a very complicated
process, and we do not recommend that you try it. Here is one final caution: If you did
subtract interest, you would definitely be wrong to discount that cash flow, which is
available only for equity holders, at the project’s WACC, since the project’s WACC is
the average rate expected by all investors, not just the equity investors.
Note that this differs from the procedures used to calculate accounting income.
Accountants measure the profit available for stockholders, so interest expenses are
subtracted. However, project cash flow is the cash flow available for all investors,
bondholders as well as stockholders, so interest expenses are not subtracted.
Incremental Cash Flows
In evaluating a project, we focus on those cash flows that occur if and only if we accept
the project. These cash flows, called incremental cash flows, represent the change in
the firm’s total cash flow that occurs as a direct result of accepting the project. Three
special problems in determining incremental cash flows are discussed next.
Sunk CostsA sunk cost is an outlay that has already occurred, hence is not affected
by the decision under consideration. Since sunk costs are not incremental costs, they
should not be included in the analysis. To illustrate, in 2002, Northeast BankCorp was
considering the establishment of a branch office in a newly developed section of
Boston. To help with its evaluation, Northeast had, back in 2001, hired a consulting
firm to perform a site analysis; the cost was $100,000, and this amount was expensed
for tax purposes in 2001. Is this 2001 expenditure a relevant cost with respect to the
2002 capital budgeting decision? The answer is no—the $100,000 is a sunk cost, and it
will not affect Northeast’s future cash flows regardless of whether or not the new
branch is built. It often turns out that a particular project has a negative NPV if all the
associated costs, including sunk costs, are considered. However, on an incremental basis,
the project may be a good one because the future incremental cash flows are large
enough to produce a positive NPV on the incremental investment.
Opportunity Costs A second potential problem relates to opportunity costs, which
are cash flows that could be generated from an asset the firm already owns provided it is
not used for the project in question. To illustrate, Northeast BankCorp already owns a
piece of land that is suitable for the branch location. When evaluating the prospective
branch, should the cost of the land be disregarded because no additional cash outlay
would be required? The answer is no, because there is an opportunity cost inherent in the
use of the property. In this case, the land could be sold to yield $150,000 after taxes. Use
of the site for the branch would require forgoing this inflow, so the $150,000 must be
charged as an opportunity cost against the project. Note that the proper land cost in this
example is the $150,000 market-determined value, irrespective of whether Northeast
originally paid $50,000 or $500,000 for the property. (What Northeast paid would, of
course, have an effect on taxes, hence on the after-tax opportunity cost.)
Effects on Other Parts of the Firm: ExternalitiesThe third potential problem involves
the effects of a project on other parts of the firm, which economists call externalities.
For example, some of Northeast’s customers who would use the new branch
are already banking with Northeast’s downtown office. The loans and deposits, hence
profits, generated by these customers would not be new to the bank; rather, they would
represent a transfer from the main office to the branch. Thus, the net income produced
by these customers should not be treated as incremental income in the capital budgeting
decision. On the other hand, having a suburban branch would help the bank attract
new business to its downtown office, because some people like to be able to bank both
close to home and close to work. In this case, the additional income that would actually
flow to the downtown office should be attributed to the branch. Although they are often
difficult to quantify, externalities (which can be either positive or negative) should be
considered.
When a new project takes sales from an existing product, this is often called cannibalization.
Naturally, firms do not like to cannibalize their existing products, but it
often turns out that if they do not, someone else will. To illustrate, IBM for years refused
to provide full support for its PC division because it did not want to steal sales
from its highly profitable mainframe business. That turned out to be a huge strategic
error, because it allowed Intel, Microsoft, Dell, and others to become dominant forces
in the computer industry. Therefore, when considering externalities, the full implications
of the proposed new project should be taken into account.
A few young firms, including Dell Computer, have been successful selling their
products only over the Internet. Many firms, however, had established retail channels
long before the Internet became a reality. For these firms, the decision to begin selling
directly to consumers over the Internet is not a simple one. For example, Nautica Enterprises
Inc. is an international company that designs, sources, markets, and distributes
sportswear. Nautica sells its products to traditional retailers such as Saks Fifth Avenue
and Parisian, who then sell to consumers. If Nautica opens its own online
Internet store, it could potentially increase its profit margin by avoiding the substantial
markup added by dealers. However, Internet sales would probably cannibalize
sales through its retailer network. Even worse, retailers might react adversely to Nautica’s
Internet sales by redirecting the marketing effort and display space they now
provide Nautica to other brands that do not compete over the Internet. Nautica, and
many other producers, must determine whether the new profits from Internet sales
will compensate for lost profits from existing channels. Thus far, Nautica has decided
to stay with its traditional retailers.
Rather than focusing narrowly on the project at hand, analysts must anticipate the
project’s impact on the rest of the firm, which requires imagination and creative thinking.
As the IBM and Nautica examples illustrate, it is critical to identify and account
for all externalities when evaluating a proposed project.
Timing of Cash Flow
We must account properly for the timing of cash flows. Accounting income statements
are for periods such as years or months, so they do not reflect exactly when during
the period cash revenues or expenses occur. Because of the time value of money,
capital budgeting cash flows should in theory be analyzed exactly as they occur. Of
course, there must be a compromise between accuracy and feasibility. A time line with
daily cash flows would in theory be most accurate, but daily cash flow estimates would
be costly to construct, unwieldy to use, and probably no more accurate than annual
cash flow estimates because we simply cannot forecast well enough to warrant this degree
of detail. Therefore, in most cases, we simply assume that all cash flows occur at
the end of every year. However, for some projects, it may be useful to assume that cash
flows occur at mid-year, or even quarterly or monthly. |
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