Chapter 9 Lecture - Making Capital Investment Decisions
CHAPTER 9 LECTURE - MAKING CAPITAL
INVESTMENT DECISIONS
SECTIONS (9.1, 9.2, 9.6)
Learning Objectives
After studying this chapter, you should be able to:
LO1 Determine the relevant cash flows for a proposed
investment.
LO2 Analyze a project's projected cash flows.
LO3 Evaluate an estimated NPV.
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9-2
Relevant Cash Flows
Relevant Cash Flows
• Include only cash flows that will only occur if the project is
accepted
• Incremental cash flows
• The stand-alone principle allows us to analyze each project in
isolation from the firm simply by focusing on
•
•
•
•
•
•
Incremental Cash Flows
Corporate cash flow with the project
Minus (-)
Corporate cash flow without the project
9-3
“Sunk” Costs ………………………… N
Opportunity Costs …………………... Y
Side Effects/Erosion……..…………… Y
Net Working Capital………………….. Y
Financing Costs….………..…………. N
Tax Effects ………………………..….. Y
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Chapter 9 Lecture - Making Capital Investment Decisions
Opportunity Costs (Y)
Sunk Costs (N)
•
A sunk cost, by definition, is a cost we have already paid or have
already incurred the liability to pay.
•
Such a cost cannot be changed by the decision today to accept
or reject a project.
•
Put another way, the firm will have to pay this cost no matter
what.
•
Based on our general definition of incremental cash flow, such a
cost is clearly not relevant to the decision at hand.
•
So, we will always be careful to exclude sunk costs from our
analysis.
• An opportunity cost is slightly different; it requires us to give up a
benefit.
• A common situation arises where a firm already owns some of the
assets a proposed project will be using.
• For example, we might be thinking of converting an old rustic cotton mill
we bought years ago for $100,000 into “upmarket” condominiums.
• If we undertake this project, there will be no direct cash outflow
associated with buying the old mill since we already own it.
• For purposes of evaluating the condo project, should we then treat the
mill as “free”? The answer is no. The mill is a valuable resource used by
the project. If we didn't use it here, we could do something else with it.
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9-6
Side Effects (Y)
Net Working Capital (Y)
• Remember that the incremental cash flows for a project
include all the changes in the firm's future cash flows. It would
not be unusual for a project to have side, or spillover, effects,
both good and bad.
• Net Working Capital Normally, a project will require that the
firm invest in net working capital in addition to long-term
assets.
• For example, a project will generally need some amount of
cash on hand to pay any expenses that arise. In addition, a
project will need an initial investment in inventories and
accounts receivable (to cover credit sales).
• In this case, the cash flows from the new line should be
adjusted downward to reflect lost profits on other lines.
• In accounting for erosion, it is important to recognize that any
sales lost as a result of our launching a new product might be
lost anyway because of future competition. Erosion is only
relevant when the sales would not otherwise be lost.
• This balance represents the investment in net working capital.
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Chapter 9 Lecture - Making Capital Investment Decisions
Financing Costs (N) and Other Issues (Y)
Pro Forma Statements and Cash Flow
• Financing Costs. In analyzing a proposed investment, we will not include
interest paid or any other financing costs such as dividends or principal
repaid, because we are interested in the cash flow generated by the assets
of the project
• More generally, our goal in project evaluation is to compare the cash flow
from a project to the cost of acquiring that project in order to estimate
NPV.
• Pro Forma Financial Statements
– Projects future operations
• Operating Cash Flow:
OCF = EBIT + Depreciation – Taxes
OCF = NI + Depreciation if no interest expense
• Other Issues. First, we are only interested in measuring cash flow.
• Moreover, we are interested in measuring it when it actually occurs, not
when it accrues in an accounting sense.
• Second, we are always interested in aftertax cash flow since taxes are
definitely a cash outflow. In fact, whenever we write “incremental cash
flows,” we mean aftertax incremental cash flows.
• Cash Flow From Assets:
CFFA = OCF – NCS –ΔNWC
NCS = Net capital spending
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9-10
Shark Attractant Project
Estimated sales
Sales Price per can
Cost per can
Estimated life
Fixed costs
Initial equipment cost
Pro Forma Income Statement
50,000 cans
$4.00
$2.50
3 years
$12,000/year
$90,000
Sales (50,000 units at $4.00/unit)
Investment in NWC
Tax rate
Cost of capital
Variable Costs ($2.50/unit)
125,000
Gross profit
$ 75,000
Fixed costs
12,000
Depreciation ($90,000 / 3)
100% depreciated over 3 year life
EBIT
$20,000
34%
20%
9-11
$200,000
30,000
$ 33,000
Taxes (34%)
11,220
Net Income
$ 21,780
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Chapter 9 Lecture - Making Capital Investment Decisions
Projected Total Cash Flows
Projected Capital Requirements
Year
0
Year
0
NWC
Net Fixed
Assets
Total
Investment
OCF
1
2
3
$20,000
$20,000
$20,000
$20,000
90,000
60,000
30,000
0
$110,000
$80,000
$50,000
$20,000
1
$51,780
 NWC
-$20,000
Capital
Spending
-$90,000
CFFA
-$110,00
2
$51,780
20,000
$51,780
$51,780
Note: Investment in NWC is recovered in final year
Investment = book or accounting value, not market value
Equipment cost is a cash outflow in year 0
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Computing Depreciation
Shark Attractant Project
Pro Forma Income Statement
0
1
200,000
125,000
75,000
12,000
30,000
33,000
11,220
21,780
Operating Cash Flow
Changes in NWC
Net Capital Spending
Cash Flow From Assets
Cash Flows
51,780
-20,000
-90,000
-110,000
Net Present Value (20%) $10,647.69
IRR
25.76%
51,780
$71,780
OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780; or
OCF = NI + depreciation = 21,780 + 30,000 = 51,780
NFA declines by the amount of depreciation each year
Year
Sales
Variable Costs
Gross Profit
Fixed Costs
Depreciation
EBIT
Taxes
Net Income
3
$51,780
2
200,000
125,000
75,000
12,000
30,000
33,000
11,220
21,780
3
200,000
125,000
75,000
12,000
30,000
33,000
11,220
21,780
51,780
51,780
20,000
51,780
71,780
• Straight-line depreciation
D = (Initial cost – salvage) / number of years
Straight Line  Salvage Value
• MACRS - The Modified Accelerated Cost Recovery
System (MACRS) is the current tax depreciation
system in the United States. Under this system, the
capitalized cost (basis) of tangible property is
recovered over a specified life by annual deductions
for depreciation
Depreciate  0
Should we accept or reject the project?
OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation (if no interest)
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Chapter 9 Lecture - Making Capital Investment Decisions
Evaluating NPV Estimates
Scenario Analysis
• NPV estimates are only estimates
• Forecasting risk:
• Examines several possible situations:
– Worst case
– Sensitivity of NPV to changes in cash flow
estimates
– Base case or most likely case
• The more sensitive, the greater the forecasting
risk
– Best case
• Provides a range of possible outcomes
• Sources of value
• Be able to articulate why this project creates
value
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Scenario Analysis Example
Units
Price/unit
Variable cost/unit
Fixed cost/year
$
$
$
Base
6,000
80.00 $
60.00 $
50,000 $
BASE
Lower
5,500
75.00 $
58.00 $
45,000 $
BEST
Scenario Analysis Example
Upper
6,500
85.00
62.00
55,000
Units
Price/unit
Variable cost/unit
Fixed Cost
Sales
Variable Cost
Fixed Cost
Depreciation
EBIT
Taxes
Net Income
+ Deprec
WORST
Initial investment
$ 200,000
Depreciated to salvage value of 0 over 5 years
Deprec/yr
$
40,000
Project Life
5 years
Tax rate
34%
Required return
12%
Note: “Lower” ≠ Worst
$
$
$
$
BASE
6,000
80.00
60.00
50,000
480,000
360,000
50,000
40,000
30,000
10,200
19,800
40,000
TOTAL CF
59,800
NPV
15,566
IRR
15.1%
$
$
$
$
WORST
5,500
75.00
62.00
55,000
412,500
341,000
55,000
40,000
(23,500)
(7,990)
(15,510)
40,000
24,490
(111,719)
-14.4%
$
$
$
$
BEST
6,500
85.00
58.00
45,000
552,500
377,000
45,000
40,000
90,500
30,770
59,730
40,000
99,730
159,504
40.9%
“Upper” ≠ Best
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Chapter 9 Lecture - Making Capital Investment Decisions
Sensitivity Analysis
Problems with Scenario Analysis
•
•
• Considers only a few possible out-comes
• Assumes perfectly correlated inputs
– All “bad” values occur together and all “good”
values occur together
• Focuses on stand-alone risk, although subjective
adjustments can be made
•
Shows how changes in an input variable affect NPV or IRR
Each variable is fixed except one
• Change one variable to see the effect on NPV or IRR
Answers “what if” questions
• Definition of Stand-alone Risk - The risk associated
with a single operating unit of a company or asset.
Standalone involves the risks created by a specific
division or project, which would not exist if
operations in that area were to cease.
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Managerial Options
Sensitivity Analysis:
• Contingency planning
• Option to abandon
• Option to expand
– Contraction
– Expansion of existing product line
– Temporary
suspension
– New products
• Option to wait
– New geographic markets
• Strengths
– Provides indication of stand-alone risk.
– Identifies dangerous variables.
– Gives some breakeven information.
Capital Rationing
• Capital rationing occurs when a firm or division has limited
resources
• Soft rationing – the limited resources are temporary, often
self-imposed
• Hard rationing – capital will never be available for this
project
• The profitability index is a useful tool when faced with soft
rationing
• Weaknesses
– Does not reflect diversification.
– Says nothing about the likelihood of change in a
variable.
– Ignores relationships among variables.
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