Chapter 9 Making Capital Investment Decisions Estimating the

Chapter 9 - Making Capital Investment Decisions

Estimating the Projects Cash Flows n n Include only cash flows that will only occur if the project is accepted. What is the incremental Concept ¨ An incremental cash flow is the change in a firm’s cash flow attributable to an investment project. Use incremental cash flows. n Corporate cash flow with the project minus corporate cash flow without the project.

Estimating the Projects Cash Flows n Relevant Cash Flows ¨ Sunk Cost ¨ Opportunity Cost ¨ Externalities

Estimating the Projects Cash Flows n Relevant Cash Flows - Continued ¨ Inflation ¨ Net Working Capital ¨ Financing ¨ Use costs After-Tax Cash Flows!

Estimating the Projects Cash Flows n Identify incremental cash flows for all phases of the project: ¨ Initial Investment Outlay: The incremental cash flow that will occur only at the start of the project. ¨ Initial Operating Cash Flow: The changes in day to day cash flows that result from the project and continue until the project ends. ¨ Terminal Cash Flow: The net cash flow that occurs at the end of the project

Investment Project Estimated sales Sales Price per can Cost per can Estimated life Fixed costs Initial equipment cost ¨ 50, 000 cans $4. 00 $2. 50 3 years $12, 000/year $90, 000 100% depreciated over 3 year life Investment in NWC Tax rate Cost of capital $20, 000 34% 20%

Pro Forma Income Statement Sales (50, 000 units at $4. 00/unit) Variable Costs ($2. 50/unit) $200, 00 0 125, 000 Gross profit $ 75, 000 Fixed costs 12, 000 Depreciation ($90, 000 / 3) 30, 000 EBIT Taxes (34%) Net Income $ 33, 000 11, 220 $ 21, 780

Investment Project OCF = EBIT + Depreciation – Taxes OCF = Net Income + Depreciation (if no interest)

Making the decision n Should we accept or reject the project?

The Tax Shield Approach to OCF • OCF = (Gross Profit)(1 – T) + Deprec*TC OCF=(200, 000 -137, 000) x 66% + (30, 000 x. 34) OCF = 51, 780 • Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield • i. e. , choosing between two different machines

Depreciation & Capital Budgeting § § Use the schedule required by the IRS for tax purposes Depreciation = non-cash expense § § Only relevant due to tax affects Depreciation tax shield = DT D = depreciation expense § T = marginal tax rate §

Computing Depreciation § Straight-line depreciation D = (Initial cost – salvage) / number of years Straight Line Salvage Value § MACRS Depreciate 0 Recovery Period = Class Life 1/2 Year Convention Multiply percentage in table by the initial cost

Salvage Value, Book Value, and Depreciation n Salvage Value versus Book Value: Tax Implication ¨ If (Salvage Value) > (Book Value), then taxes are due on (Salvage Value – Book Value). n ¨ Reason: Excess depreciation must be recaptured! If (Salvage Value) < (Book Value), then taxes savings are credited on (Book Value – Salvage Value). n Reason: Assets were under-depreciated! Bottom Line: After-tax Salvage Value n Example: = Salvage Value – Taxes = SV – (SV – BV) (T).

Example: Depreciation and After-tax Salvage n n n Car purchased for $12, 000 5 -year property Marginal tax rate = 34%.

Salvage Value & Tax Effects Net Salvage Cash Flow = SP - (SP-BV)(T) If sold at EOY 5 for $3, 000: NSCF = 3, 000 - (3000 - 691. 20)(. 34) = $2, 215. 01 = $3, 000 – 784. 99 = $2, 215. 01 If sold at EOY 2 for $4, 000: NSCF = 4, 000 - (4000 - 5, 760)(. 34) = $4, 598. 40 = $4, 000 – (-598. 40) = $4, 598. 40

Evaluating NPV Estimates NPV estimates are only estimates n Forecasting risk: n ¨ Sensitivity estimates n n of NPV to changes in cash flow The more sensitive, the greater the forecasting risk Sources of value n Be able to articulate why this project creates value

Scenario Analysis n Examines several possible situations: ¨ Worst ¨ Base ¨ Best n case or most likely case Provides a range of possible outcomes

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

Sensitivity Analysis § § 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

Sensitivity Analysis: n Strengths ¨ Provides indication of stand-alone risk. ¨ Identifies dangerous variables. ¨ Gives some breakeven information. n Weaknesses ¨ Does not reflect diversification. ¨ Says nothing about the likelihood of change in a variable. ¨ Ignores relationships among variables.

Disadvantages of Sensitivity and Scenario Analysis § Neither provides a decision rule. § § No indication 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.

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

Example: n You have been asked by the president of your company to evaluate the proposed acquisition of a spectrometer for the firm’s R&D department. The equipment’s base price is $140, 000, and it would cost another $30, 000 to modify it. The spectrometer falls into the MACRS 3 -year class, and would be sold after 3 years for $60, 000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $8, 000. The spectrometer would have no effect on revenues, but is expected to save the firm $50, 000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 40%. ¨ What’s the initial investment outlay associated with this project? (That is, what is the Year 0 net cash flow? )

Example: ¨ What are the incremental operating cash flows in Years 1, 2, and 3?

Example: ¨ What is the terminal cash flow in Year 3?

Example: ¨ If the project’s required rate of return is 12%, should the spectrometer be purchased? (Calculate the project’s NPV and make a recommendation. )

Project Risk and Estimating the Project’s Required Rate of Return n Risk-adjusted discount rate approach: ¨ Increase the discount rate for projects that are riskier than the firm’s average projects, and ¨ Decrease the discount rate for projects that are less risky than the firm’s average projects.

Project Risk and Estimating the Project’s Required Rate of Return Many firms use this approach. Chevron Example: Examples n “High Risk” Projects n “Medium Risk” Projects n “Low Risk” Projects * This is the rate used for 1) 2) The discount rate in NPV Calculations, and The cutoff rate for IRR analysis Opportunity Cost Rate*

Analyzing the project: n Break even n Sensitivity Analysis n Scenario Analysis

Replacement analysis Example The Gehr Company is considering the purchase of a new machine tool to replace an obsolete one. The machine being used for the operation has both a tax book value and market value of 0. It is in good working order, however, and will physically last at least another 10 years. The proposed replacement machine will perform the operation more efficiently with estimated after-tax cash flows of $ 9, 000 per year in labor savings and depreciation. The new machine will cost $40, 000 delivered and installed and is expected to last 10 years. It will have zero salvage value. Should the firm purchase the new machine? (Assume the firm’s required rate of return is 10%. )