Cash Flows—Not Accounting Income
You may not have thought about it, but there is a big difference between corporate finance courses and financial accounting courses. Techniques in corporate finance generally use cash flows, whereas financial accounting generally stresses income or earnings numbers.
Certainly, our text has followed this tradition since our net present value techniques discounted cash flows, not earnings. When considering a single project, we discounted the cash flows that the firm receives from the project. When valuing the firm as a whole, we discounted dividends—not earnings— because dividends are the cash flows that an investor receives.
There are many differences between earnings and cash flows. In fact, much of a standard financial accounting course delineates these differences. Because we have no desire to duplicate such course material, we merely discuss one example of the differences. Consider a firm buying a building for $100,000 today. The entire $100,000 is an immediate cash outflow.
However, assuming straight-line depreciation over 20 years, only $5,000 ($100,000/20) is considered an accounting expense in the current year. Current earnings are thereby reduced only by $5,000. The remaining $95,000 is expensed over the following 19 years.
Because the seller of the property demands immediate payment, the cost at date 0 of the project to the firm is $100,000. Thus, the full $100,000 figure should be viewed as an immediate outflow for capital budgeting purposes. This is not merely our opinion but the unanimous verdict of both academics and practitioners.
In addition, it is not enough to use cash flows. In calculating the NPV of a project, only cash flows that are incremental to the project should be used. These cash flows are the changes in the firm’s cash flows that occur as a direct consequence of accepting the project. That is, we are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
The use of incremental cash flows sounds easy enough, but pitfalls abound in the real world. In this section we describe how to avoid some of the pitfalls of determining incre- mental cash flows.
Sunk Costs
A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. Just as we “let bygones be bygones,” we should ignore such costs. Sunk costs are not incremental cash outflows.
Opportunity Costs
Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.
Side Effects
Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. The most important side effect is erosion. Erosion is the cash flow transferred to a new project from customers and sales of other products of the firm.
THE BALDWINCOMPANY : AN EXAMPLE
We next consider the example of a proposed investment in machinery and related items. Our example involves the Baldwin Company and colored bowling balls. The Baldwin Company, originally established in 1965 to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company introduced “High Flite,” its first line of high-performance golf balls. The Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. In 1999 W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed a large number of bowlers valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of Baldwin’s cost advantages and because of its ability to use its highly developed marketing skills.
As a result, in late 2000 the Baldwin Company decided to evaluate the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling ball could achieve a 10- to 15-percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. However,
Meadows argued that it was a sunk cost and should not be included in project evaluation. In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be produced in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold to net $150,000 after taxes. The adjusted basis of this property, the original purchase price of the property less depreciation, is zero.
Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000. The machine has an estimated market value at the end of five years of $30,000.
Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based upon Baldwin’s taxable income,
that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent. Net working capital is defined as the difference between current assets and current liabilities. Baldwin finds that it must maintain an investment in working capital. Like any manufacturing firm, it will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. Its credit sales will generate accounts receivable. Management believes that the investment in the different items of working capital totals $10,000 in year 0, rises somewhat
in the early years of the project, and falls to $0 by the project’s end. In other words, the investment in working capital is completely recovered by the end of the project’s life.
An Analysis of the Project
Investments The investment outlays required for the project are summarized in the top segment of Table 7.1. They consist of three parts:
1. The Bowling Ball Machine. The purchase requires a cash outflow of $100,000 at year 0. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold.
2. The Opportunity Cost of Not Selling the Warehouse. If Baldwin accepts the bowlingball project, it will use a warehouse and land that could otherwise be sold. The estimated sales price of the warehouse and land is therefore included as an opportunity cost, as budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected. Increases in working capital in the early years must be funded by cash generated elsewhere in the firm. Hence, these increases are viewed as cash outflows. Conversely, decreases in working capital in the later
years are viewed as cash inflows. All of these cash flows are presented in line 6. A more complete discussion of working capital is provided later in this section. The total cash flow from the above three investments is shown in line 7.
Income and Taxes Next, the determination of income is presented in the bottom segment of Table 7.1. While we are ultimately interested in cash flow—not income—we need the income calculation in order to determine taxes. Lines 8 and 9 of Table 7.1 show sales revenues and operating costs, respectively. The projections in these lines are based on the sales revenues and operating costs computed in columns 4 and 6 of Table 7.2. The estimates of revenues and costs follow from assumptions made by the corporate planning staff at Baldwin.
In other words, the estimates critically depend on the fact that product prices are projected to increase at 2 percent per year and costs are projected to increase at 10 percent per year.
Depreciation of the $100,000 capital investment is based on the amount allowed by the 1986 Tax Reform Act.2 Depreciation schedules under the act for three-year, five-year, and seven-year recovery periods are presented in Table 7.3. The IRS ruled that Baldwin is to depreciate its capital investment over five years, so the middle column of the table applies to this case.
You may not have thought about it, but there is a big difference between corporate finance courses and financial accounting courses. Techniques in corporate finance generally use cash flows, whereas financial accounting generally stresses income or earnings numbers.
Certainly, our text has followed this tradition since our net present value techniques discounted cash flows, not earnings. When considering a single project, we discounted the cash flows that the firm receives from the project. When valuing the firm as a whole, we discounted dividends—not earnings— because dividends are the cash flows that an investor receives.
There are many differences between earnings and cash flows. In fact, much of a standard financial accounting course delineates these differences. Because we have no desire to duplicate such course material, we merely discuss one example of the differences. Consider a firm buying a building for $100,000 today. The entire $100,000 is an immediate cash outflow.
However, assuming straight-line depreciation over 20 years, only $5,000 ($100,000/20) is considered an accounting expense in the current year. Current earnings are thereby reduced only by $5,000. The remaining $95,000 is expensed over the following 19 years.
Because the seller of the property demands immediate payment, the cost at date 0 of the project to the firm is $100,000. Thus, the full $100,000 figure should be viewed as an immediate outflow for capital budgeting purposes. This is not merely our opinion but the unanimous verdict of both academics and practitioners.
In addition, it is not enough to use cash flows. In calculating the NPV of a project, only cash flows that are incremental to the project should be used. These cash flows are the changes in the firm’s cash flows that occur as a direct consequence of accepting the project. That is, we are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
The use of incremental cash flows sounds easy enough, but pitfalls abound in the real world. In this section we describe how to avoid some of the pitfalls of determining incre- mental cash flows.
Sunk Costs
A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. Just as we “let bygones be bygones,” we should ignore such costs. Sunk costs are not incremental cash outflows.
Opportunity Costs
Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.
Side Effects
Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. The most important side effect is erosion. Erosion is the cash flow transferred to a new project from customers and sales of other products of the firm.
THE BALDWINCOMPANY : AN EXAMPLE
We next consider the example of a proposed investment in machinery and related items. Our example involves the Baldwin Company and colored bowling balls. The Baldwin Company, originally established in 1965 to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company introduced “High Flite,” its first line of high-performance golf balls. The Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. In 1999 W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed a large number of bowlers valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of Baldwin’s cost advantages and because of its ability to use its highly developed marketing skills.
As a result, in late 2000 the Baldwin Company decided to evaluate the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling ball could achieve a 10- to 15-percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. However,
Meadows argued that it was a sunk cost and should not be included in project evaluation. In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be produced in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold to net $150,000 after taxes. The adjusted basis of this property, the original purchase price of the property less depreciation, is zero.
Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000. The machine has an estimated market value at the end of five years of $30,000.
Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based upon Baldwin’s taxable income,
that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent. Net working capital is defined as the difference between current assets and current liabilities. Baldwin finds that it must maintain an investment in working capital. Like any manufacturing firm, it will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. Its credit sales will generate accounts receivable. Management believes that the investment in the different items of working capital totals $10,000 in year 0, rises somewhat
in the early years of the project, and falls to $0 by the project’s end. In other words, the investment in working capital is completely recovered by the end of the project’s life.
An Analysis of the Project
Investments The investment outlays required for the project are summarized in the top segment of Table 7.1. They consist of three parts:
1. The Bowling Ball Machine. The purchase requires a cash outflow of $100,000 at year 0. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold.
2. The Opportunity Cost of Not Selling the Warehouse. If Baldwin accepts the bowlingball project, it will use a warehouse and land that could otherwise be sold. The estimated sales price of the warehouse and land is therefore included as an opportunity cost, as budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected. Increases in working capital in the early years must be funded by cash generated elsewhere in the firm. Hence, these increases are viewed as cash outflows. Conversely, decreases in working capital in the later
years are viewed as cash inflows. All of these cash flows are presented in line 6. A more complete discussion of working capital is provided later in this section. The total cash flow from the above three investments is shown in line 7.
Income and Taxes Next, the determination of income is presented in the bottom segment of Table 7.1. While we are ultimately interested in cash flow—not income—we need the income calculation in order to determine taxes. Lines 8 and 9 of Table 7.1 show sales revenues and operating costs, respectively. The projections in these lines are based on the sales revenues and operating costs computed in columns 4 and 6 of Table 7.2. The estimates of revenues and costs follow from assumptions made by the corporate planning staff at Baldwin.
In other words, the estimates critically depend on the fact that product prices are projected to increase at 2 percent per year and costs are projected to increase at 10 percent per year.
Depreciation of the $100,000 capital investment is based on the amount allowed by the 1986 Tax Reform Act.2 Depreciation schedules under the act for three-year, five-year, and seven-year recovery periods are presented in Table 7.3. The IRS ruled that Baldwin is to depreciate its capital investment over five years, so the middle column of the table applies to this case.
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