Chapter 9 - Making Capital Investment Decisions
Estimating the Projects Cash Flows
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.
Corporate cash flow with the project minus corporate cash flow without the project.
Estimating the Projects Cash Flows
Relevant Cash FlowsSunk Cost
Opportunity Cost
Externalities
Estimating the Projects Cash Flows
Relevant Cash Flows - Continued Inflation
Net Working Capital
Financing costs
Use After-Tax Cash Flows!
Estimating the Projects Cash Flows
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 50,000 cansSales Price per can $4.00Cost per can $2.50Estimated life 3 yearsFixed costs $12,000/yearInitial equipment cost $90,000
100% depreciated over 3 year life
Investment in NWC $20,000Tax rate 34%Cost of capital 20%
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
Investment ProjectYear 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 11,220 11,220 11,220Net Income 21,780 21,780 21,780
Operating Cash Flow 51,780 51,780 51,780Changes in NWC -20,000 20,000Net Capital Spending -90,000Cash Flow From Assets -110,000 51,780 51,780 71,780
Net Present Value $10,647.69IRR 25.76%
Pro Forma Income Statement
Cash Flows
OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation (if no interest)
Making the decisionNet Income 21,780 21,780 21,780
Operating Cash Flow 51,780 51,780 51,780Changes in NWC -20,000 20,000Net Capital Spending -90,000Cash Flow From Assets -110,000 51,780 51,780 71,780
Net Present Value $10,647.69IRR 25.76%
Cash Flows
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
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
Computing Depreciation
Salvage Value, Book Value, and Depreciation Salvage Value versus Book Value: Tax Implication
If (Salvage Value) > (Book Value), then taxes are due on (Salvage Value – Book Value).
Reason: Excess depreciation must be recaptured!
If (Salvage Value) < (Book Value), then taxes savings are credited on (Book Value – Salvage Value).
Reason: Assets were under-depreciated!
Bottom Line:After-tax Salvage Value = Salvage Value –
Taxes= SV – (SV – BV)
(T). Example:
Example: Depreciation and After-tax Salvage
Car purchased for $12,000 5-year property Marginal tax rate = 34%.
Depreciation 5-year Asset
Year Beg BV Depr % Deprec End BV1 12,000.00$ 20.00% 2,400.00$ 9,600.00$ 2 9,600.00$ 32.00% 3,840.00$ 5,760.00$ 3 5,760.00$ 19.20% 2,304.00$ 3,456.00$ 4 3,456.00$ 11.52% 1,382.40$ 2,073.60$ 5 2,073.60$ 11.52% 1,382.40$ 691.20$ 6 691.20$ 5.76% 691.20$ -$
100.00% 12,000.00$
Salvage Value & Tax EffectsDepreciation 5-year Asset
Year Beg BV Depr % Deprec End BV1 12,000.00$ 20.00% 2,400.00$ 9,600.00$ 2 9,600.00$ 32.00% 3,840.00$ 5,760.00$ 3 5,760.00$ 19.20% 2,304.00$ 3,456.00$ 4 3,456.00$ 11.52% 1,382.40$ 2,073.60$ 5 2,073.60$ 11.52% 1,382.40$ 691.20$ 6 691.20$ 5.76% 691.20$ -$
100.00% 12,000.00$
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 = $2,215.01If 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 Forecasting risk:
Sensitivity of NPV to changes in cash flow estimates
The more sensitive, the greater the forecasting risk
Sources of value Be able to articulate why this project creates value
Scenario Analysis
Examines several possible situations:Worst case
Base case or most likely case
Best 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: Strengths
Provides indication of stand-alone risk. Identifies dangerous variables.Gives some breakeven information.
WeaknessesDoes 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: 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
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 Opportunity Cost Rate*
“High Risk” Projects
“Medium Risk” Projects
“Low Risk” Projects
* This is the rate used for 1) The discount rate in NPV Calculations, and 2) The cutoff rate for IRR analysis
Analyzing the project:
Break even
Sensitivity Analysis
Scenario Analysis
Replacement analysis ExampleThe 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%.)