Lecture Essentials of corporate finance (2/e) – Chapter 9: Making capital investment decisions

The topic discussed in this chapter is making capital investment decisions. In this chapter, you will learn: Understand how to determine the relevant cash flows for a proposed investment, understand how to analyse a project’s projected cash flows, understand how to evaluate an estimated NPV.

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Making capital investment

decisions

Chapter 9

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Key concepts and skills

• Understand how to determine the

relevant cash flows for a proposed

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Chapter outline

• Project cash flows: A first look

• Incremental cash flows

• Pro forma financial statements and project cash flows

• More on project cash flow

• Evaluating NPV estimates

• Scenario and other what-if analyses

• Additional considerations in capital

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Relevant cash flows

• The cash flows that should be included

in a capital budgeting analysis are

those that will occur only if the project

is accepted.

• These cash flows are called

incremental cash flows.

• The stand-alone principle allows us to

analyse each project in isolation from

the firm, simply by focusing on

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Asking the right question

• 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.

– If the answer is ‘in part’, then we should

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Common types of cash

flows

• Sunk costs—costs that have accrued in the

past

– Should not be considered in investment decision

• Opportunity costs—costs of lost options

• Side effects

– Positive side effects—benefits to other projects

– Negative side effects—costs to other projects

• Changes in net working capital

• Financing costs

– Not a part of investment decision

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Pro forma statements

and cash flow

• Pro forma financial statements

– Project future operations

• Capital budgeting relies heavily on pro

forma accounting statements, particularly income statements.

• Computing cash flows—refresher

– Operating cash flow (OCF) = EBIT +

Depreciation – Taxes

– OCF = Net income + Depreciation when there

is no interest expense

– Cash flow from assets (CFFA) = OCF – Net

capital spending (NCS) – Changes in NWC

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Shark attractant project

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Pro forma income statement

Shark attractant project—Table 9.1

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Projected capital requirements

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Projected total cash flows—

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Shark attractant project

Net Capital Spending -90,000

Cash Flow From Assets -110,000 53,100 53,100 73,100

Net Present Value $13,428.24

Pro Forma Income Statement

Cash Flows

OCF = EBIT + Depreciation – Taxes

OCF = Net Income + Depreciation (if no interest)

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Making the decision

• Now that we have the cash flows, we can

apply the techniques that we learned in

Chapter 8.

• Enter the cash flows into the calculator and

compute NPV and IRR.

– CF 0 = -110 000; C01 = 53 100; F01 = 2; C02 = 73 100

– [NPV]; I = 20; [CPT] [NPV] = 13 428

– [CPT] [IRR] = 27.3%

• Do we accept or reject the project?

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The tax shield approach

• You can also find operating cash flow using

the tax shield approach.

• OCF = (Sales – Costs)(1 – T)

+Depreciation*T

• This form may be particularly useful when the major incremental cash flows are the

purchase of equipment and the associated

depreciation tax shield, such as when you

are choosing between two different

machines.

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More on NWC

• Why do we have to consider changes in

NWC separately?

– AAS require that sales be recorded on the

income statement when made, not when cash

is received.

– AAS also require that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet.

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Depreciation and capital

budgeting

• The depreciation expense used for

capital budgeting should be the

depreciation schedule required by the

ATO for tax purposes.

• Depreciation itself is a non-cash

expense Consequently, it is only

relevant because it affects taxes.

• Depreciation tax shield = DT

– D = depreciation expense

– T = marginal tax rate

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Computing depreciation

• Prime cost (straight-line) depreciation

– D = (Initial cost –Salvage)/Number of

years

– Most assets are depreciated straight-line

to zero for tax purposes.

• Diminishing value depreciation

– Need to know which depreciation rate is

appropriate for tax purposes.

– Multiply percentage by the written-down

value at the beginning of the year.

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• After-tax salvage = Salvage –

T(salvage – book value).

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Tax effect on salvage

• Net salvage cash flow

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Example:

Depreciation and after-tax salvage

• Car purchased for $12 000

• 8-year property

• Marginal tax rate = 30%

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Salvage value and tax

effects

Prime Cost @12.5% Diminishing Value @18.75%

Year Depreciation End BV Beg BV Deprec End BV

Net salvage cash flow = SP - (SP-BV)(T)

If sold at EOY 5 for $5100:

NSCF = 5100 - (5100 – 4249.11)(.3) = $4844.733

If sold at EOY 2 for $4600:

NSCF = 4600 - (4600 – 7921.88)(.3) = $ 5596.564

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Majestic Mulch and Compost Co

Fixed Costs per year $ 25,000.00

Sale Price per unit $ 120.00 $ 120.00 $ 120.00 $ 120.00 $ 110.00 $ 110.00 $ 110.00 $ 110.00 $ 110.00 Tax Rate 30.0%

Required Return on Project 15.0%

Yr 0 NWC $ 20,000.00

NWC % of sales 15%

Equipment cost - installed 800,000 $

Salvage Value in year 8 20% of equipment cost

Depreciation Calculations:

Equipment Depreciable Base 800,000

Prime Cost % (Eqpt-7 yr) 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%

Recovery Allowance 120,000 120,000 120,000 120,000 120,000 120,000 80,000 0

Book Value 680,000 560,000 440,000 320,000 200,000 80,000 0 0 After-Tax Salvage Value

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MMCC—Depreciation and after-tax

salvage Table 9.9

Majestic Mulch and Compost Company (MMCC)

Background Data:

Unit Sales Estimates 3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000 Variable Cost /unit $ 60.00

Yr 0 NWC $ 20,000.00

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MMCC—Net working capital

Yr 0 NWC $ 20,000.00

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MMCC—Pro forma income statements

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MMCC—Projected cash flows

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– Forecasting risk—how sensitive is our

NPV to changes in the cash flow

estimates? The more sensitive, the greater the forecasting risk.

– Sources of value—why does this project

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Scenario analysis

• What happens to the NPV under different cash flow scenarios?

• At the very least, look at:

– Best case—revenues are high and costs are low

– Worst case—revenues are low and costs are high

– Measure of the range of possible outcomes

• Best case and worst case are not

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Sensitivity analysis

• What happens to NPV when we vary

one variable at a time?

• This is a subset of scenario analysis,

where we look at the effects of specific variables on NPV.

• 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.

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Sensitivity analysis: Unit

sales

Base Units Units Units 6,000 5,500 6,500 Price/unit $ 80 80 80 Variable cost/unit $ 60 60 60 Fixed cost/year $ 50,000 50,000 50,000

Sales $ 480,000 $ 440,000 $ 520,000 Variable Cost 360,000 330,000 390,000 Fixed Cost 50,000 50,000 50,000 Depreciation 40,000 40,000 40,000 EBIT 30,000 20,000 40,000 Taxes 9,000 6,000 12,000 Net Income 21,000 14,000 28,000 + Deprec 40,000 40,000 40,000

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Sensitivity analysis: Fixed

costs

Base Fixed Cost Fixed Cost Units 6,000 6,000 6,000 Price/unit $ 80 80 80 Variable cost/unit $ 60 60 60 Fixed cost/year $ 50,000 55,000 45,000

Sales $ 480,000 $ 480,000 $ 480,000 Variable Cost 360,000 360,000 360,000 Fixed Cost 50,000 55,000 45,000 Depreciation 40,000 40,000 40,000 EBIT 30,000 25,000 35,000 Taxes 9,000 7,500 10,500 Net Income 21,000 17,500 24,500 + Deprec 40,000 40,000 40,000

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Disadvantages of sensitivity and scenario

analysis

• Neither provides a decision rule

– No indication of 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.

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Making a decision

• Beware of ‘analysis paralysis’.

• At some point you have to make a

decision.

• If the majority of your scenarios have

positive NPVs, you may feel

reasonably comfortable about

accepting the project.

• If you have a crucial variable that leads

to a negative NPV with a small change

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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 (this also implies

an infinite cost of capital).

• The profitability index is a useful tool

when faced with soft rationing.

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Chapter 9

END

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