(2019-T1) - FINS1613 - Tutorial Slides - Week 07a - Incremental CFs PDF

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Tutorial Week 7a Capital Budgeting: Incremental Cash Flow Calculations BDHFMF: Chapters 2 + 9 RTBWJ: Chapter 9 BDHFMF: BERK, DEMARZO, HARFORD, FORD, MOLLICA, & FINCH — Fundamentals of Corporate Finance (3E Aus), & RTBWJ: ROSS, TRAYLOR, BIRD, WESTERFIELD, & JORDAN — Essentials of Corporate Finance (4E Aus & NZ)

YO YOUR UR TUTOR & TUTOR IN CHARGE Peter Kjeld Andersen [email protected]

Peter Kjeld Andersen

So far in this course we’ve just given you the cash flows for each year. Now it’s time to calculate them. Q. Broadly, what cash flows should be included in project evaluation? A. All incremental cash inflows or outflows flows that result from our acceptance of the project. Q. What cash flows should be excluded? A. Sunk costs – These have already paid or committed to be paid prior to accepting the project (i.e. they’re not incremental). A. Interest expenses – These are accounted for in the discount rate (in WACC).

Peter Kjeld Andersen

CASH FLOW CALCULATIONS Revenue

Less: Variable Costs = Gross Profit

In questions that use accounting terminology, you’ll often see “COGS” (Cost of Goods Sold) and “SG&A” (Selling, General, and Administrative) up here instead of Variable & Fixed costs

Less: Fixed Costs = EBITDA

EBITDA: Earnings Before Interest, Taxes, Depreciation & Amortization

Less: Depreciation = EBIT

EBIT: Earnings Before Interest & Taxes aka “Pre-Tax Operating Income”

Less: Taxes on EBIT @ ??% = NOPLAT

NOPLAT: Net Operating Profit Less Adjusted Taxes aka “Net Operating Income”

Add: Depreciation

= Operating Cash Flows Less: Δ Non-cash Working Capital Less: Capital Expenditure

Add: After-Tax Savage Value

In addition to the OCF component of your Net Free Cash Flow, in any year of the project you could also have changes in working capital AND capital expenditure occurring. These things can happen anytime, not just at the start/end of the project. Similarly you could dispose of assets and have an after-tax salvage value at any point in time; NOT just at the end. It always depends on the particulars of the project in question.

= Project Net Free Cash Flows Peter Kjeld Andersen

Your projected income statement shows: • Sales of $986,000 • Cost of goods sold as $509,000 • Depreciation expense of $95,000 • Taxes of $114,600 (due to a 30% tax rate) Q. Complete the pro-forma income statement below. A. The completed statement takes the form below: INCOME STATEMENT

t=1

+ Sales Revenue

+ $986,000

– Cost of Goods Sold

– $509,000

= Gross Profit – Depreciation = EBIT

– Taxes @ 30% = NOPAT

= $477,000 – $95,000 = $382,000

– $114,600 = $267,400 Peter Kjeld Andersen

Your projected income statement shows: • Sales of $986,000 • Cost of goods sold as $509,000 • Depreciation expense of $95,000 • Taxes of $114,600 (due to a 30% tax rate) Q. What are your projected earnings? A. The NOPAT (i.e. Net Operating Profit After Tax) calculated in the table on the previous slide are our projected earnings for the next year. Or via the formula: NOPAT = EBIT ( 1 − tax% )

= Sales − COGS − Depreciation ( 1 − tax%) = $986,000 − $509,000 − $95,000( 1− 0.30) = $267,400

NOTE: This is a highly simplified version of what you could expect to see on an actual income statement. For example, we are given no information about any selling, general, & administrative expenses (i.e. “SG&A”). Nor any financing expenses (…which would be ignored in our Cash Flow calculation anyway) Peter Kjeld Andersen

Your projected income statement shows: • Sales of $986,000 • Cost of goods sold as $509,000 • Depreciation expense of $95,000 • Taxes of $114,600 (due to a 30% tax rate) Q. What is your projected free cash flow? A. Generally, free cash flow (FCF) in a particular year can be calculated as: FCF = EBIT ( 1 − tax% ) + Depreciation − Working Capital − Capital Expenditure + After-Tax Salvage

In this question, we have no working capital changes or capital expenditure or after-tax salvage, and our EBIT calculation has no SG&A. So we can calculate FCF as: FCF = EBIT ( 1 − tax% ) + Depreciation

=  Sales − COGS − Depreciation( 1 − tax% ) + Depreciation

=  $986,000 − $509,000 − $95,000( 1− 0.30) + $95,000 = $362,400

This is just the $267,400 of NOPAT with the $95,000 of depreciation added back (because it was never actually a cash outflow in the first place). Peter Kjeld Andersen

Consider the following income statement: INCOME STATEMENT Sales Costs Depreciation EBIT Tax (30%) Net Operating Profit After Tax

t=1 $822,375 $441,125 $121,875 ? ? ?

The $121,875 of depreciation saves you from paying $121,875 x 0.30 = $36,562.5 of tax to the government that you would have had to otherwise pay.

Q. Fill in the numbers and calculate the OCF. What is the depreciation tax shield? A. EBIT = Sales − Costs − Depreciation = $822,375 − $441,125 − $121,875 = $259,375 Taxes on EBIT = EBIT  tc = $259,375 30% = $77,812.50 NOPAT = EBIT( 1 − t c ) = $259,375  ( 1 − 0.30 ) = $181,562.50

OCF = NOPAT + Depreciation = $181,562.50 + $121,875 = $303,437.5 Peter Kjeld Andersen

Q. Which of the following best defines incremental cash flows? a) The cash flows from a particular project, evaluated independently from how the project may affect a firm’s other lines of business

b) The cash flows arising from all projects that a company plans to undertake in a fixed timespan c) The net present value (NPV) of net operating profits that a firm is expected to receive as the result of an investment decision d) The amount by which a firm’s cash flows are expected to change as the result of an investment decision A. The answer is d) Incremental cash flows need to consider the impact on other lines of business, so A is not the answer. B is the TOTAL cash flows for the whole firm, which is not what we care about.

C has two issues. It is concerned with the NPV and looks at operating profits. However, we should be concerned with cash flows, NOT accounting profits. Peter Kjeld Andersen

Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in NSW. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse on it. Last month, the marketing department spent $15,000 on market research to determine the extent of the customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store? Q. The original purchase price of the land where the store will be located? A. No, this is a sunk cost. It is non-incremental. It is not an additional cash inflow or outflow that results for the company from the decision to say yes to building the new retail store.

Peter Kjeld Andersen

Q. The cost of demolishing the abandoned warehouse and clearing the lot. A. Yes. This is an incremental cash outflow that will occur if the company decides to build the new retail store, but that won’t occur if they don’t. Q. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. A. Yes. This is incremental cash outflow is an example of a negative side effect / negative externality. It’s often called cannibalization or erosion of sales. Q. The $15,000 in market research spent to evaluate customer demand.

A. No, as this is again an example of a non-incremental sunk cost. Regardless of whether the company says yes or no to the retail store, that money has already been spent. What is relevant are the future cash flows that are contingent on the decision to say yes.

Peter Kjeld Andersen

Q. Construction costs for the new store. A. Yes. As these costs would only occur if the firm chose to develop the store, they are incremental.

Q. The value of the land if sold. A. Yes. This is an opportunity cost. We are assuming that this is the base-case scenario for the land if the project is to be rejected. By subtracting this out as a cash flow forgone at time t=0, the NPV of the project will better represent the value that the retail store project adds to the firm itself. Alternatively, instead of subtracting the value of the land out, we can compare NPVBuild Store to NPVSell Land and choose the higher. Q. Interest expense on the debt borrowed to pay the construction costs. A. No, as this is a financing cash flow, which will be incorporated into our weighted-average cost of capital (“WACC”... the discount rate).

Peter Kjeld Andersen

Q. What should be used to determine whether a potential project is acceptable? i. Its effect on incremental revenues ii. Its effect on gross profit iii. Its effect on the amount of taxes owed iv. Its effect on the firm’s cash flows A. The answer is (iv) Ultimately, in finance, all we care about is the impact on the firm’s cash flows, which in turn affects the wealth of the shareholders whose wealth we are trying to maximize.

Peter Kjeld Andersen

The Juarez Cartel is considering expanding its production & distribution of illicit substances beyond their traditional cocaine & methamphetamine products into the burgeoning designer drug sector. The Cartel estimates that this would see the their total annual revenue increase from $1.20 billion to $1.65 billion, but that the decision would cause annual methamphetamine & cocaine sales to decrease by $500 million. Q. What is the incremental effect on Cartel revenue p.a. of designer drugs sales? A. As “incremental” simply means the difference between what a firm would have had if they had not made the decision compared to what they will have as a result of making the decision, we can find the effect on incremental revenue as: Incremental Revenue = Total Cartel Sales Post-Decision − Total Cartel Sales Pre-Decision = $1.65 billion − $1.20 billion = $0.45 billion

Q. What are the Cartel’s forecast annual sales of their new designer drugs? A. As the “incremental” revenue above factors in both the sales of the new products and the lost sales of their old existing products: Incremental Revenue = Sales of New Designer Drugs − Lost Sales of Coke & Meth $0.45 billion = Sales of New Designer Drugs − $0.50 billion

Sales of New Designer Drugs = $0.45 billion + $0.50 billion = $0.95 billion Peter Kjeld Andersen

A. Graphically, we can depict what’s happening to the Cartel’s revenue as:

ii. SALES OF NEW DESIGNER DRUGS

LOST COKE + METH SALES

$0.50 billion i. INCREMENTAL REVENUE

$0.95 billion

TOTAL CARTEL REVENUE IF THEY STICK TO SELLING COKE + METH ONLY

$1.20 billion

In Example #1 we: i. Calculate incremental revenue from the difference between total firm revenue with the new product and without the new product, THEN ii. Find use that incremental revenue to find how much we’re selling of the new product given the lost sales of our existing products Peter Kjeld Andersen

TOTAL CARTEL REVENUE IF THEY SELL COKE, METH, AND DESIGNER DRUGS

$1.65 billion

$0.45 billion

Responding to demand in the market for new and exciting experiences, the Tijuana Cartel is considering expanding its production & distribution of illicit substances beyond their traditional cocaine & methamphetamine products (of which they currently sell $1.50 billion p.a.) into the burgeoning designer drug sector. They estimate designer drug sales of $1.2 billion p.a., but that the new products would cause annual methamphetamine & cocaine sales to decrease by $500 million. Q. What is the incremental effect on Cartel revenue p.a. of designer drugs sales? A. “Incremental” revenue must factor in both the sales of the new products and the lost sales of their old existing products: Incremental Revenue = Sales of New Designer Drugs − Lost Sales of Coke & Meth = $1.20 billion − $0.50 billion = $0.70 billion

Q. What is the Cartel’s estimated total annual revenue once they introduce the new products? A. Total sales will be the original estimated total sales figures prior to introducing the new products plus any incremental effect resulting from the decision: Total Cartel Sales Post-Decision = Total Cartel Sales Pre-Decision+ Incremental Revenue = $1.50 billion + $0.70 billion = $2.20 billion Peter Kjeld Andersen

A. Graphically, we can depict what’s happening to the Cartel’s revenue as: LOST SALES SALES OF NEW DESIGNER DRUGS

$0.50 billion i. INCREMENTAL REVENUE

$1.20 billion

TOTAL CARTEL REVENUE IF THEY STICK TO SELLING COKE + METH ONLY

$1.50 billion

In Example #2 we: i. Calculate incremental revenue from sales of the new product and lost sales of the old product, THEN ii. Find total firm revenue after introducing the new product by adding incremental revenue to the firm’s total revenue without the product Peter Kjeld Andersen

ii. TOTAL CARTEL REVENUE IF THEY SELL COKE, METH, AND DESIGNER DRUGS

$2.20 billion

$0.70 billion

Cudgegong Manufacturing Ltd is considering setting up a new manufacturing plant in South Australia. The company bought some land six years ago for $9.3 million in anticipation of using it as a warehouse and distribution site. However, the company has since decided to rent facilities elsewhere. The land would sell for $12.9 million if it were sold today. The company now wants to build its new manufacturing plant on this land: • The plant would cost $30 million to build • The site requires $1,218,000 of grading before it is suitable for construction. Q. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating the project? Why?

Peter Kjeld Andersen

A. Let’s break this down. • The $9.3 million acquisition cost of the land six years ago ▪ This is a SUNK COST ▪ We IGNORE this figure. Whether we accept the project or reject the project, this is GONE and nothing changes • The $12.9 million current after-tax value of the land if sold instead of used ▪ This is an OPPORTUNITY COST ▪ We must INCLUDE this figure. Our firm’s value already includes this market price of the land on the assumption that we can sell it ▪ But if we use it, we can no longer sell it. So it’s a cost of doing the project • The $30 million cash outlay & $1,218,000 grading expenses ▪ These are initial fixed asset investments needed to get the project going ▪ They are INCREMENTAL and thus must be INCLUDED Thus the total initial incremental cash outflow at t=0 is: CF0 = − ( $12.9 million + $30.0 million+ $1.218 million) = -$44.118 million Peter Kjeld Andersen

Duckmaloi Campers currently sells 31,000 caravans per year at $84,000 each, and 9,000 luxury caravans per year at $134,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 27,000 of these campers per year at $23,500 each. An independent consultant has determined that if Duckmaloi introduces the new campers, it should boost the sales of its existing caravans by 3,000 units per year, and reduce the sales of its luxury caravans by 800 units per year. Q. What is the amount to use as an annual sales figure when evaluating this project? Why? A. There are three things happening here: • Sales of the brand new cheaper model of caravan • Positive side effect to the existing middle-price model of caravan • Negative side effect to the luxury model of caravan Ultimately we need to factor these into our calculations such that the “annual sales figure [used] when evaluating this project” is the difference between: • Our WHOLE FIRM’s revenue WITH THE PROJECT, and • OUR WHOLE FIRM’S revenue WITHOUT THE PROJECT

Peter Kjeld Andersen

A. Finding the effect on revenue of each component… Introduction of the new cheaper model: RevenueCheap = PCheap QCheap = $23,500  27,000 = $634.5 million

Increased sales of the existing middle-range model: RevenueMiddle = PMiddle QMiddle = $84,000  3,000 = $252.0 million

Lost sales of the top-of-the-line luxury model: RevenueLuxury = PLuxury  QLuxury = $134,000 ( -800 ) = -$107.2 million

Finally we are able to calculate the effect of this project on firm’s revenue: Incremental Revenue =  RevenueCheap +  RevenueMiddle +  RevenueLuxury = $634.5 million+ $252.0 million+ ( -$107.2 million) = $779.3 million

Peter Kjeld Andersen

You are upgrading to better production equipment for your firm’s only product. The new equipment will allow you to make more of your product in the same amount of time. Thus, you forecast that total sales will increase next year by 19% over the current amount of 107,000 units. Q. If your sales price per is $19 per unit, what are the incremental sales next year from the upgrade? A. The key word here is INCREMENTAL. This means ONLY the NEW sales that I get from this equipment on TOP of what I already sell. That is, I would sell 19% x 107,000 = 20,330 new units ADDITIONALLY on top of my original 107,000 units. Given the constant price per unit, the easiest way to find incremental sales is: Revenue Incremental = P  Q = $19/unit  20,330 units = $386,270

Incremental sales is also the difference between our TOTAL revenue when we accept the upgrade vs. our TOTAL revenue when we reject the upgrade. Revenue Incremental = Revenue NewEquipment − Revenue ExistingEquipment = P  QNew  − P  Q Existing 

You would HAVE to do this second method if there was a different price under the two scenarios. Because what price would you put into “P x ΔQ” if there are two prices?!?

= $19/unit  107,000 units ( 1 + 0.19)  −  $19/unit 107,000 units = $386,270 Peter Kjeld Andersen

Hyperion Limited currently sells its latest high-speed colour printer, the Hyper 500, for $357. It plans to lower the price to $306 next year. Its cost of goods sold for the Hyper 500 is $204/unit and this year’s sales are expected to be 21,000 units. Q. Suppose that if Hyperion drops the price to $306 immediately, it can increase this year’s sales by 23% to 25,830 units. What would be the incremental impact on this year’s EBIT of such a price drop? A. The effect on our EBIT of the printers sales PRIOR to the price drop is: EBITpre-drop = ( P  Q) − ( VC  Q ) = ( P − VC) Q = ( $357 − $204)  21,000 = $3,213,000

…and after the price-drop the printers will contribute to our EBIT by: EBITpost-drop =( P −VC ) Q =( $306 −$204 ) 25,830 = $2,634,660

Thus the incremental impact on EBIT from the price drop is:  EBIT = EBITpost-drop − EBITpre-drop = $2,634,660 − $3,213,000 = −$578,340

Peter Kjeld Andersen

Suppose that for each printer sold, Hyperion expects additional sales of $76 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges. Q. What is the incremental impact on EBIT for the next 3 years of a price drop this year? A. When we factor in the ink, the pre-drop EBIT of $3,192,000 now becomes: EBITpre-drop = EBITprinters + EBITink = $3,213,000 + (PInk  MarginInk ) Q = $3,213,000 + ( $76 70% ) 21,000 = $3,213,000 + $1,117,200 = $4,330,200

…and the post-drop EBIT of $2,545,200 now becomes: EBITpost-drop = $2,634,660 + ( PInk  MarginInk ) Q = $2,634,660 + ( $76 70% ) 25,830 = $2,634,660 + $1,374,156 = $4,008,816

Thus the incremental impact on EBIT from the price drop is now:  EBIT = EBITpost-drop − EBITpre-dro...