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%.)