Making Capital Investment Decisions Chapter 9 Mc GrawHillIrwin

Making Capital Investment Decisions Chapter 9 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Prepare for Capital Budgeting Part 2: Understand financial statement & cash flow C 2 -Identify cash flow from financial statement C 3 -Financial statement and comparison Part 3: Valuation of future cash flow C 4 -Basic concepts C 5 -More exercise Part 4: Valuing stocks and bonds C 6 -Bond C 7 -Stock Part 5: Capital budgeting C 8 -NPV and other investment criteria 1 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Chapter Outline 1. 2. 3. 4. 5. Analyze A Project’s Projected Cash Flows Based on Pro Forma Financial Statements Relevant Cash Flows Tax Shield Approach Scenario and Sensitivity Analyses Managerial Options 2 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

1. Pro Forma Statements and Cash Flow n Capital budgeting relies heavily on pro forma accounting statements, particularly income statements n Computing cash flows – refresher Operating Cash Flow (OCF) = EBIT + depreciation – taxes n Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC n 3 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Cash Flow Illustration 4 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Table 9. 1 Pro Forma Income Statement 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 (34%) 11, 220 Net Income $ 21, 780 5 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Calculating OCF n Operating Cash Flow (OCF) = EBIT + depreciation – taxes n OCF=33, 000+30, 000 -11, 220=51, 780 6 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Table 9. 2 Projected Capital Requirements Year 0 NWC Net Fixed Assets 1 2 3 $20, 000 90, 000 60, 000 30, 000 0 7 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Cash Flow Illustration Year 0 OCF 1 2 $51, 780 Change in NWC Capital Spending -$20, 000 CFFA -$110, 00 $51, 780 3 $51, 780 20, 000 -$90, 000 $51, 780 $71, 780 8 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Cash Flow Illustration n Now that we have the cash flows, we can apply the techniques that we learned in chapter 8 n Enter the cash flows into the calculator and compute NPV when I/Y=20% n NPV = 10, 648 n Should we accept or reject the project? 9 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

2. Relevant Cash Flows n Stand-alone n principle The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted n These cash flows are called incremental cash flows n The stand-alone principle, which simply focuses on incremental cash flows, allows us to analyze each project in isolation from the firm simply 10 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Asking the Right Question n 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 n If the answer is “no”, it should not be included in the analysis because it will occur anyway n If the answer is “part of it”, then we should include the part that occurs because of the project n 11 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Common Types of Cash Flows n Opportunity n Side costs – costs of lost options effects Positive side effects – benefits to other projects n Negative side effects – costs to other projects n n Changes in net working capital n Taxes n Sunk costs – costs that have accrued in the past 12 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

3. After-tax Salvage n If the salvage value is different from the book value of the asset, then there is a tax effect n Book value = initial cost – accumulated depreciation n After-tax salvage = salvage – T*(salvage – book value) 13 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Example n Consider the previous example, if the company sells out the equipment at $10, 000 when the project is done and the company’s marginal tax rate is 40%. What is the after-tax salvage? n After-tax salvage = salvage – T*(salvage – book value) n After-tax salvage=10, 000 -. 4*(10, 000 -0)=6, 000 14 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Cash Flow Illustration Year 0 OCF 1 2 $51, 780 3 $51, 780 Change in NWC Capital Spending -$20, 000 -$90, 000 6, 000 CFFA -$110, 00 $51, 780 $77, 780 15 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

4. Scenario Analysis n What happens to the NPV under different cash flows scenarios? n At the very least look at: Best case – revenues are high and costs are low n Worst case – revenues are low and costs are high n Measure of the range of possible outcomes n n Best case and worst case are not necessarily probable, they can still be possible 16 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Sensitivity Analysis n What happens to NPV when we vary one variable at a time n This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV n 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 17 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

New Project Example n Consider the project discussed in the text n The initial cost is $200, 000 and the project has a 5 -year life. There is no salvage. Depreciation is straight-line, the required return is 12% and the tax rate is 34% n The base case NPV is 15, 567 18 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Summary of Scenario Analysis Scenario Net Income Cash Flow NPV IRR Base case 19, 800 59, 800 15, 567 15. 1% Worst Case 24, 490 -111, 719 -14. 4% 99, 730 159, 504 40. 9% -15, 510 Best Case 59, 730 19 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Summary of Sensitivity Analysis Scenario Unit Sales Cash Flow NPV IRR Base case 6000 59, 800 15, 567 15. 1% Worst case 5500 53, 200 -8, 226 10. 3% Best case 6500 66, 400 39, 357 19. 7% 20 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

5. Managerial Options n Capital budgeting projects often provide other options that we have not yet considered Contingency planning (“what if ” option) n Option to expand n Option to abandon n Option to wait n Strategic options (“testing” project) n 21 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Capital Rationing n Capital rationing occurs when a firm or division has limited resources Soft rationing – the limited resources are temporary, often self-imposed n Hard rationing – capital will never be available for this project n n The profitability index is a useful tool when faced with soft rationing 22 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Review Questions 1. Know how to calculate OCF based on pro forma statements to find out NPV of a project 2. How do we determine if cash flows are relevant to the capital budgeting decision? Is a sunk cost a relevant cash flow for project evaluation? Is an opportunity cost a relevant cash flow for project evaluation? Are benefits and costs to other project, and taxes relevant cash flows for project evaluation? 23 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved

Review Questions (cont. . ) 3. Know how to calculate after-tax salvage. 4. What is scenario analysis and what is sensitivity analysis? 5. What are the major types of typical managerial option? What is capital rationing? 24 Mc. Graw-Hill/Irwin © 2004 The Mc. Graw-Hill Companies, Inc. All rights reserved