Making capital investment decisions Chapter 9. Key concepts and skills Understand how to determine...

Making capital investment decisions

Chapter 9

Key concepts and skills

• Understand how to determine the relevant cash flows for a proposed investment

• Understand how to analyse a project’s projected cash flows

• Understand how to evaluate an estimated NPV

9-2 Copyright ©2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline

• Project cash flows: A first look• Incremental cash flows• Pro forma financial statements and project

cash flows• More on project cash flow• Evaluating NPV estimates• Scenario and other what-if analyses• Additional considerations in capital budgeting


Relevant cash flows

• The cash flows that should be included in a capital budgeting analysis are those that will occur only if the project is accepted.

• These cash flows are called incremental cash flows.

• The stand-alone principle allows us to analyse each project in isolation from the firm, simply by focusing on incremental cash flows.


Asking the right question

• You should always ask yourself ‘Will this cash flow occur ONLY if we accept the project?’– If the answer is ‘yes’, it should be included in

the analysis because it is incremental.– If the answer is ‘no’, it should not be included

in the analysis because it will occur anyway.– If the answer is ‘in part’, then we should

include the part that occurs because of the project.


Common types of cash flows

• Sunk costs—costs that have accrued in the past– Should not be considered in investment decision

• Opportunity costs—costs of lost options• Side effects

– Positive side effects—benefits to other projects– Negative side effects—costs to other projects

• Changes in net working capital• Financing costs

– Not a part of investment decision• Tax effects


Pro forma statements and cash flow

• Pro forma financial statements – Project future operations

• Capital budgeting relies heavily on pro forma accounting statements, particularly income statements.

• Computing cash flows—refresher– Operating cash flow (OCF) = EBIT + Depreciation –

Taxes– OCF = Net income + Depreciation when there is

no interest expense– Cash flow from assets (CFFA) = OCF – Net capital

spending (NCS) – Changes in NWC


Shark attractant project• Estimated sales 50 000 cans• Sales price per can $4.00• Cost per can $2.50• Estimated life 3 years• Fixed costs $12 000/year• Initial equipment cost $90,000

– 100% depreciated over 3-year life• Investment in NWC $20 000• Tax rate 30%• Cost of capital 20%


Pro forma income statementShark attractant project—Table 9.1

Sales (50 000 units at $4.00/unit)

$200 000

Variable Costs ($2.50/unit) 125 000

Gross profit $ 75 000

Fixed costs 12 000

Depreciation ($90 000 / 3) 30 000

EBIT $ 33 000

Taxes (30%) 9 900

Net Income $ 23 100


Projected capital requirements—Table 9.2

Year

0 1 2 3

NWC $20 000 $20 000 $20 000 $20 000

Net fixed assets

90 000 60 000 30 000 0

Total investment

$110 000 $80 000 $50 000 $20 000

NFA declines by the amount of depreciation each year.

Investment = book or accounting value, not market value.


Projected total cash flows—Table 9.5

Year

0 1 2 3

OCF $53 100 $53 100 $53 100

Change in NWC

-$20 000 20 000

Capital spending

-$90 000

Total project cash flow

-$110 00 $53 100 $53 100 $73 100


Shark attractant project

Year 0 1 2 3Sales 200,000 200,000 200,000Variable Costs 125,000 125,000 125,000Gross Profit 75,000 75,000 75,000Fixed Costs 12,000 12,000 12,000Depreciation 30,000 30,000 30,000EBIT 33,000 33,000 33,000Taxes 9,900 9,900 9,900Net Income 23,100 23,100 23,100

Operating Cash Flow 53,100 53,100 53,100Changes in NWC -20,000 20,000Net Capital Spending -90,000Cash Flow From Assets -110,000 53,100 53,100 73,100

Net Present Value $13,428.24IRR 27.25%

Pro Forma Income Statement

Cash Flows

OCF = EBIT + Depreciation – Taxes

OCF = Net Income + Depreciation (if no interest)


Making the decision

• Now that we have the cash flows, we can apply the techniques that we learned in Chapter 8.

• Enter the cash flows into the calculator and compute NPV and IRR.– CF0 = -110 000; C01 = 53 100; F01 = 2; C02 = 73 100– [NPV]; I = 20; [CPT] [NPV] = 13 428– [CPT] [IRR] = 27.3%

• Do we accept or reject the project?


The tax shield approach

• You can also find operating cash flow using the tax shield approach.

• OCF = (Sales – Costs)(1 – T) +Depreciation*T• This form may be particularly useful when the

major incremental cash flows are the purchase of equipment and the associated depreciation tax shield, such as when you are choosing between two different machines.


More on NWC

• Why do we have to consider changes in NWC separately?– AAS require that sales be recorded on the income

statement when made, not when cash is received.– AAS also require that we record cost of goods sold

when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet.

– Finally, we have to buy inventory to support sales although we haven’t collected cash.


Depreciation and capital budgeting

• The depreciation expense used for capital budgeting should be the depreciation schedule required by the ATO for tax purposes.

• Depreciation itself is a non-cash expense. Consequently, it is only relevant because it affects taxes.

• Depreciation tax shield = DT– D = depreciation expense– T = marginal tax rate


Computing depreciation

• Prime cost (straight-line) depreciation– D = (Initial cost –Salvage)/Number of years– Most assets are depreciated straight-line to

zero for tax purposes.• Diminishing value depreciation

– Need to know which depreciation rate is appropriate for tax purposes.

– Multiply percentage by the written-down value at the beginning of the year.

– Depreciate to zero.


After-tax salvage

• If the salvage value is different from the book value of an asset, there is a tax effect.

• Book value = Initial cost – Accumulated depreciation.

• After-tax salvage = Salvage – T(salvage – book value).


Tax effect on salvage

• Net salvage cash flow = SP - (SP-BV)(T)

• Where:– SP = selling price– BV = book value– T = corporate tax rate


Example: Depreciation and after-tax salvage

• Car purchased for $12 000 • 8-year property• Marginal tax rate = 30%


Prime Cost @12.5% Diminishing Value @18.75%

Year Depreciation End BV Beg BV Deprec End BV0 - 12000 - $12,0001 1500 10500 12,000.00$ 2,250.00$ 9,750.00$ 2 1500 9000 9,750.00$ 1,828.13$ 7,921.88$ 3 1500 7500 7,921.88$ 1,485.35$ 6,436.52$ 4 1500 6000 6,436.52$ 1,206.85$ 5,229.68$ 5 1500 4500 5,229.68$ 980.56$ 4,249.11$ 6 1500 3000 4,249.11$ 796.71$ 3,452.40$ 7 1500 1500 3,452.40$ 647.33$ 2,805.08$ 8 1500 0 2,805.08$ 525.95$ 2,279.13$

Salvage value and tax effects


Prime Cost @12.5% Diminishing Value @18.75%

Year Depreciation End BV Beg BV Deprec End BV0 - 12000 - $12,0001 1500 10500 12,000.00$ 2,250.00$ 9,750.00$ 2 1500 9000 9,750.00$ 1,828.13$ 7,921.88$ 3 1500 7500 7,921.88$ 1,485.35$ 6,436.52$ 4 1500 6000 6,436.52$ 1,206.85$ 5,229.68$ 5 1500 4500 5,229.68$ 980.56$ 4,249.11$ 6 1500 3000 4,249.11$ 796.71$ 3,452.40$ 7 1500 1500 3,452.40$ 647.33$ 2,805.08$ 8 1500 0 2,805.08$ 525.95$ 2,279.13$

Net salvage cash flow = SP - (SP-BV)(T)If sold at EOY 5 for $5100:

NSCF = 5100 - (5100 – 4249.11)(.3) = $4844.733 = $5100 – 255.267= $ 4844.733If sold at EOY 2 for $4600:

NSCF = 4600 - (4600 – 7921.88)(.3) = $ 5596.564 = $4600 – ( -996.564) = $ 5596.564

Majestic Mulch and Compost Co. (MMCC)


Majestic Mulch and Compost Company (MMCC)

YEAR 0 1 2 3 4 5 6 7 8

Background Data:Unit Sales Estimates 3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000 Variable Cost /unit 60.00$ Fixed Costs per year 25,000.00$ Sale Price per unit 120.00$ 120.00$ 120.00$ 120.00$ 110.00$ 110.00$ 110.00$ 110.00$ 110.00$ Tax Rate 30.0%Required Return on Project 15.0%Yr 0 NWC 20,000.00$ NWC % of sales 15%Equipment cost - installed800,000$ Salvage Value in year 8 20% of equipment cost

Depreciation Calculations:Equipment Depreciable Base800,000

Prime Cost % (Eqpt-7 yr) 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%Recovery Allowance 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

Book Value 680,000 560,000 440,000 320,000 200,000 80,000 0 0

After-Tax Salvage ValueSalvage Value 20% 160,000Book Value (Year 8) 0Capital Gain/Loss 160,000Taxes 48,000Net SV (SV-Taxes) 112,000

Required Net Working Capital Investment20,000 54,000 90,000 108,000 107,250 99,000 82,500 66,000 49,500

MMCC—Depreciation and after-tax salvage Table 9.9



YEAR 0 1 2 3 4 5 6 7 8

Background Data:

Unit Sales Estimates 3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000 Variable Cost /unit 60.00$ Fixed Costs per year 25,000.00$ Sale Price per unit 120.00$ 120.00$ 120.00$ 120.00$ 110.00$ 110.00$ 110.00$ 110.00$ 110.00$ Tax Rate 30.0%Required Return on Project 15.0%Yr 0 NWC 20,000.00$ NWC % of sales 15%Equipment cost - installed 800,000$ Salvage Value in year 8 20% of equipment cost



Book Value 680,000 560,000 440,000 320,000 200,000 80,000 0 0



MMCC—Net working capital Table 9.11



YEAR 0 1 2 3 4 5 6 7 8

Background Data:

Unit Sales Estimates 3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000 Variable Cost /unit 60.00$ Fixed Costs per year 25,000.00$ Sale Price per unit 120.00$ 120.00$ 120.00$ 120.00$ 110.00$ 110.00$ 110.00$ 110.00$ 110.00$ Tax Rate 30.0%Required Return on Project 15.0%Yr 0 NWC 20,000.00$ NWC % of sales 15%Equipment cost - installed 800,000$ Salvage Value in year 8 20% of equipment cost



Book Value 680,000 560,000 440,000 320,000 200,000 80,000 0 0



MMCC—Pro forma income statements


YEAR 0 1 2 3 4 5 6 7 8Initial Investment

Equipment Cost -800,000Sales 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000Variable Costs 180,000 300,000 360,000 390,000 360,000 300,000 240,000 180,000Fixed Costs 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000Depreciation (Eqpt)) 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

EBIT 35,000 155,000 215,000 180,000 155,000 105,000 95,000 125,000Taxes 10,500 46,500 64,500 54,000 46,500 31,500 28,500 37,500Net Operating Income 24,500 108,500 150,500 126,000 108,500 73,500 66,500 87,500Add back Depreciation 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

CASH FLOW from Operations 144,500 228,500 270,500 246,000 228,500 193,500 146,500 87,500NWC investment & Recovery -20,000 -34,000 -36,000 -18,000 750 8,250 16,500 16,500 66,000Salvage Value 112,000

TOTAL PROJECTED CF -820,000 110,500 192,500 252,500 246,750 236,750 210,000 163,000 265,500

Discounted Cash Flows -820,000 96,087 145,558 166,023 141,080 117,707 90,789 61,278 86,792

Cumulative Cash flows -820,000 -709,500 -517,000 -264,500 -17,750 219,000 429,000 592,000 857,500

NPV $85,313IRR 17.85%

Payback 4.07

MMCC—Projected cash flows Table 9.12


YEAR 0 1 2 3 4 5 6 7 8

Initial InvestmentEquipment Cost -800,000Sales 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000Variable Costs 180,000 300,000 360,000 390,000 360,000 300,000 240,000 180,000Fixed Costs 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000Depreciation (Eqpt)) 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

EBIT 35,000 155,000 215,000 180,000 155,000 105,000 95,000 125,000Taxes 10,500 46,500 64,500 54,000 46,500 31,500 28,500 37,500

Net Operating Income 24,500 108,500 150,500 126,000 108,500 73,500 66,500 87,500Add back Depreciation 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

CASH FLOW from Operations 144,500 228,500 270,500 246,000 228,500 193,500 146,500 87,500NWC investment & Recovery -20,000 -34,000 -36,000 -18,000 750 8,250 16,500 16,500 66,000Salvage Value 112,000

TOTAL PROJECTED CF -820,000 110,500 192,500 252,500 246,750 236,750 210,000 163,000 265,500

Discounted Cash Flows -820,000 96,087 145,558 166,023 141,080 117,707 90,789 61,278 86,792

Cumulative Cash flows -820,000 -709,500 -517,000 -264,500 -17,750 219,000 429,000 592,000 857,500

NPV $85,313IRR 17.85%

Payback 4.07

Evaluating NPV estimates

• The NPV estimates are just that— estimates.

• A positive NPV is a good start—now we need to take a closer look.– Forecasting risk—how sensitive is our NPV to

changes in the cash flow estimates? The more sensitive, the greater the forecasting risk.

– Sources of value—why does this project create value?


Scenario analysis

• What happens to the NPV under different cash flow scenarios?

• At the very least, look at:– Best case—revenues are high and costs are low– Worst case—revenues are low and costs are high– Measure of the range of possible outcomes

• Best case and worst case are not necessarily probable, but they are still possible.


Scenario analysis— Example


Base Lower UpperUnits 6,000 5,500 6,500 Price/unit 80.00$ 75.00$ 85.00$ Variable cost/unit 60.00$ 58.00$ 62.00$ Fixed cost/year 50,000$ 45,000$ 55,000$

BASE BEST WORST

Initial investment 200,000$ Depreciated to salvage value of 0 over 5 yearsDeprec/yr 40,000$

Project Life 5 yearsTax rate 30%Required return 12%

Scenario analysis—Example (cont.)


BASE WORST BESTUnits 6,000 5,500 6,500 Price/unit 80.00$ 75.00$ 85.00$ Variable cost/unit 60.00$ 62.00$ 58.00$ Fixed Cost 50,000$ 55,000$ 45,000$

Sales 480,000$ 412,500$ 552,500$ Variable Cost 360,000 341,000 377,000Fixed Cost 50,000 55,000 45,000Depreciation 40,000 40,000 40,000EBIT 30,000 -23,500 90,500Taxes 9,000 -7,050 27,150Net Income 21,000 -16,450 63,350 + Deprec 40,000 40,000 40,000

TOTAL CF 61,000 23,550 103,350

NPV 19,891 (115,108) 172,554

IRR 15.9% -15.4% 43.0%

Sensitivity analysis

• What happens to NPV when we vary one variable at a time?

• This is a subset of scenario analysis, where we look at the effects of specific variables on NPV.

• The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable and the more attention we want to pay to its estimation.


Sensitivity analysis: Unit sales


Base Units UnitsUnits 6,000 5,500 6,500 Price/unit 80$ 80 80Variable cost/unit 60$ 60 60Fixed cost/year 50,000$ 50,000 50,000


Tax rate 30%Required Return 12%

BASE UNITS UNITSUnits 6,000 5,500 6,500 Price/unit 80$ 80$ 80$ Variable cost/unit 60$ 60$ 60$ Fixed cost 50,000$ 50,000$ 50,000$

Sales 480,000$ 440,000$ 520,000$ Variable Cost 360,000 330,000 390,000 Fixed Cost 50,000 50,000 50,000 Depreciation 40,000 40,000 40,000 EBIT 30,000 20,000 40,000 Taxes 9,000 6,000 12,000 Net Income 21,000 14,000 28,000 + Deprec 40,000 40,000 40,000

TOTAL CF 61,000 54,000 68,000

NPV 19,891$ (5,342)$ 45,125$

$(5,342)

$19,891

$45,125

-10,000.00

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

5,500 6,000 6,500

NP

V

Unit Sales

Unit Sales Sensitivity

Sensitivity analysis: Fixed costs


Base Fixed Cost Fixed CostUnits 6,000 6,000 6,000 Price/unit 80$ 80 80Variable cost/unit 60$ 60 60Fixed cost/year 50,000$ 55,000 45,000


Tax rate 30%Required Return 12%

BASE FC FCUnits 6,000 6,000 6,000 Price/unit 80$ 80$ 80$ Variable cost/unit 60$ 60$ 60$ Fixed cost 50,000$ 55,000$ 45,000$

Sales 480,000$ 480,000$ 480,000$ Variable Cost 360,000 360,000 360,000 Fixed Cost 50,000 55,000 45,000 Depreciation 40,000 40,000 40,000 EBIT 30,000 25,000 35,000 Taxes 9,000 7,500 10,500 Net Income 21,000 17,500 24,500 + Deprec 40,000 40,000 40,000

TOTAL CF 61,000 57,500 64,500

NPV 19,891$ 7,275$ 32,508$

$32,508

$19,891

$7,275

0.00

5,000.00

10,000.00

15,000.00

20,000.00

25,000.00

30,000.00

35,000.00

$45,000 $50,000 $55,000

NP

V

Fixed Cost

Fixed Cost Sensitivity

Disadvantages of sensitivity and scenario analysis

• Neither provides a decision rule. – No indication of whether a project’s

expected return is sufficient to compensate for its risk.

• Ignores diversification. – Measures only stand-alone risk, which

may not be the most relevant risk in capital budgeting.


Making a decision

• Beware of ‘analysis paralysis’.• At some point you have to make a decision.• If the majority of your scenarios have

positive NPVs, you may feel reasonably comfortable about accepting the project.

• If you have a crucial variable that leads to a negative NPV with a small change in the estimates, you might want to forgo the project.


Managerial options• Contingency planning• Option to expand

– Expansion of existing product line– New products– New geographic markets

• Option to abandon– Contraction– Temporary suspension

• Option to wait• Strategic options


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 (this also implies an infinite cost of capital).

• The profitability index is a useful tool when faced with soft rationing.


Quick quiz

• How do we determine if cash flows are relevant to the capital budgeting decision?

• What is scenario analysis and why is it important?

• What is sensitivity analysis and why is it important?

• What are some additional managerial options that should be considered?


Chapter 9END

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