Chapter 7 Making capital investment decisions Corporate Finance

Chapter 7: Making capital investment decisions Corporate Finance Ross, Westerfield, and Jaffe

Outline 7. 1 Relevant cash flows 7. 2 A comprehensive example

So far, we have learned… l l l We need to evaluate a new project using the TVM technique. That is, we should discount future expected cash flows (specifically, FCFs) back to present time and compare PV to initial costs: whether NPV > 0? The appropriate discount rate is WACC, which is a function of the cost of debt and the cost of equity. We can use the CAPM to estimate the cost of equity. In 7. 2, we would like to put all these into a comprehensive example.

Relevant cash flows l l l But before we do this, a few notions about cash flows need to be addressed. The cash flows in the capital-budgeting time line need to be relevant cash flows; that is they need to be incremental in nature. The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted.

Ask the right question before you make a mistake l 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.

Sunk costs l l l A sunk cost is a cost that has already occurred regardless of whether the project is accepted. Example: consulting fee for evaluating a project. Sunk costs should not be taken into consideration when evaluating a project.

Opportunity costs l l l Opportunity costs (OCs) are the costs of giving up the second best use of resources. Example: a vacant land. Opportunity costs should be taken into consideration when evaluating the project.

Side effects l l Accepting a new project may have side effects. Erosion occurs when a new project reduces the sales and cash flows of existing projects. Synergy occurs when a new project increases the sales and cash flows of existing projects. Cash flows due to erosion and synergy are incremental cash flows.

A comprehensive example, I l l l Suppose that we are considering a new project which has a life of 3 years. The firm uses no debt; i. e. , no interest expenses. The initial capital investment is $90, 000. The firms use 3 -year straight-line depreciation to write off the $90, 000 capital investment. Suppose that the pro forma income statements for year 1, year 2, and year 3 look the same (in real life, they are of course unlikely to be identical). For each year, it looks like the following:

A comprehensive example, II Sales (50, 000 units at $6. 00/unit) Variable Costs ($4/unit) Gross profit Fixed costs Depreciation ($90, 000 / 3) EBIT Taxes (30%) Net Income $300, 000 $200, 000 $100, 000 $40, 000 $30, 000 $9, 000 $ 21, 000

A comprehensive example, III l l l Operating cash flow (OCF) = EBIT + depreciation – taxes = 30, 000 + 30, 000 – 9, 000 = 51, 000. Suppose that the firm needs to invest $25, 000 in net working capital (NWC) and expects to recover this investment at the end of the project. Suppose that in addition to the initial capital investment and the investment in NWC, this project also require the use of vacant facility, which the firm can lease it out for a total of $10, 000 over the 3 -year period.

A comprehensive example, IV Year 0 1 2 3 OCF $51, 000 NWC -$25, 000 C 0 -$90, 000 OC -$10, 000 CF -$125, 000 $51, 000 $76, 000

A comprehensive example, V l l Suppose the WACC for the project is 10%. NPV = -125, 000 + 51, 000 / (1 + 10%)2 + 76, 000 / (1 + 10%)3 = $20, 612. 32. Should we accept the project ? Because the firm uses no debt, what is the WACC?