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    1. 1. Making Capital Investment Decisions Chapter 9
    2. 2. Prepare for Capital Budgeting <ul><li>Part 2: Understand financial statement & cash flow </li></ul><ul><li>C2-Identify cash flow from financial statement </li></ul><ul><li>C3-Financial statement and comparison </li></ul><ul><li>Part 3: Valuation of future cash flow </li></ul><ul><li>C4-Basic concepts </li></ul><ul><li>C5-More exercise </li></ul><ul><li>Part 4: Valuing stocks and bonds </li></ul><ul><li>C6-Bond </li></ul><ul><li>C7-Stock </li></ul><ul><li>Part 5: Capital budgeting </li></ul><ul><li>C8-NPV and other investment criteria </li></ul>
    3. 3. Chapter Outline <ul><li>Analyze A Project’s Projected Cash Flows Based on Pro Forma Financial Statements </li></ul><ul><li>Relevant Cash Flows </li></ul><ul><li>Tax Shield Approach </li></ul><ul><li>Scenario and Sensitivity Analyses </li></ul><ul><li>Managerial Options </li></ul>
    4. 4. 1. Pro Forma Statements and Cash Flow <ul><li>Capital budgeting relies heavily on pro forma accounting statements, particularly income statements </li></ul><ul><li>Computing cash flows – refresher </li></ul><ul><ul><li>Operating Cash Flow (OCF) = EBIT + depreciation – taxes </li></ul></ul><ul><ul><li>Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC </li></ul></ul>
    5. 5. Cash Flow Illustration
    6. 6. Table 9.1 Pro Forma Income Statement $ 21,780 Net Income 11,220 Taxes (34%) $ 33,000 EBIT 30,000 Depreciation ($90,000 / 3) 12,000 Fixed costs $ 75,000 Gross profit 125,000 Variable Costs ($2.50/unit) $200,000 Sales (50,000 units at $4.00/unit)
    7. 7. Calculating OCF <ul><li>Operating Cash Flow (OCF) = EBIT + depreciation – taxes </li></ul><ul><li>OCF=33,000+30,000-11,220=51,780 </li></ul>
    8. 8. Table 9.2 Projected Capital Requirements 0 30,000 60,000 90,000 Net Fixed Assets $20,000 $20,000 $20,000 $20,000 NWC 3 2 1 0 Year
    9. 9. Cash Flow Illustration $71,780 $51,780 $51,780 -$110,00 CFFA -$90,000 Capital Spending 20,000 -$20,000 Change in NWC $51,780 $51,780 $51,780 OCF 3 2 1 0 Year
    10. 10. Cash Flow Illustration <ul><li>Now that we have the cash flows, we can apply the techniques that we learned in chapter 8 </li></ul><ul><li>Enter the cash flows into the calculator and compute NPV when I/Y=20% </li></ul><ul><ul><li>NPV = 10,648 </li></ul></ul><ul><li>Should we accept or reject the project? </li></ul>
    11. 11. 2. Relevant Cash Flows <ul><li>Stand-alone principle </li></ul><ul><ul><li>The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted </li></ul></ul><ul><li>These cash flows are called incremental cash flows </li></ul><ul><li>The stand-alone principle, which simply focuses on incremental cash flows, allows us to analyze each project in isolation from the firm simply </li></ul>
    12. 12. Asking the Right Question <ul><li>You should always ask yourself “Will this cash flow occur ONLY if we accept the project?” </li></ul><ul><ul><li>If the answer is “yes”, it should be included in the analysis because it is incremental </li></ul></ul><ul><ul><li>If the answer is “no”, it should not be included in the analysis because it will occur anyway </li></ul></ul><ul><ul><li>If the answer is “part of it”, then we should include the part that occurs because of the project </li></ul></ul>
    13. 13. Common Types of Cash Flows <ul><li>Opportunity costs – costs of lost options </li></ul><ul><li>Side effects </li></ul><ul><ul><li>Positive side effects – benefits to other projects </li></ul></ul><ul><ul><li>Negative side effects – costs to other projects </li></ul></ul><ul><li>Changes in net working capital </li></ul><ul><li>Taxes </li></ul><ul><li>Sunk costs – costs that have accrued in the past </li></ul>
    14. 14. 3. After-tax Salvage <ul><li>If the salvage value is different from the book value of the asset, then there is a tax effect </li></ul><ul><li>Book value = initial cost – accumulated depreciation </li></ul><ul><li>After-tax salvage = salvage – T*(salvage – book value) </li></ul>
    15. 15. Example <ul><li>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? </li></ul><ul><li>After-tax salvage = salvage – T*(salvage – book value) </li></ul><ul><li>After-tax salvage=10,000-.4*(10,000-0)=6,000 </li></ul>
    16. 16. Cash Flow Illustration $77,780 $51,780 $51,780 -$110,00 CFFA 6,000 -$90,000 Capital Spending 20,000 -$20,000 Change in NWC $51,780 $51,780 $51,780 OCF 3 2 1 0 Year
    17. 17. 4. Scenario Analysis <ul><li>What happens to the NPV under different cash flows scenarios? </li></ul><ul><li>At the very least look at: </li></ul><ul><ul><li>Best case – revenues are high and costs are low </li></ul></ul><ul><ul><li>Worst case – revenues are low and costs are high </li></ul></ul><ul><ul><li>Measure of the range of possible outcomes </li></ul></ul><ul><li>Best case and worst case are not necessarily probable, they can still be possible </li></ul>
    18. 18. Sensitivity Analysis <ul><li>What happens to NPV when we vary one variable at a time </li></ul><ul><li>This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV </li></ul><ul><li>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 </li></ul>
    19. 19. New Project Example <ul><li>Consider the project discussed in the text </li></ul><ul><li>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% </li></ul><ul><li>The base case NPV is 15,567 </li></ul>
    20. 20. Summary of Scenario Analysis 40.9% 159,504 99,730 59,730 Best Case -14.4% -111,719 24,490 -15,510 Worst Case 15.1% 15,567 59,800 19,800 Base case IRR NPV Cash Flow Net Income Scenario
    21. 21. Summary of Sensitivity Analysis 19.7% 39,357 66,400 6500 Best case 10.3% -8,226 53,200 5500 Worst case 15.1% 15,567 59,800 6000 Base case IRR NPV Cash Flow Unit Sales Scenario
    22. 22. 5. Managerial Options <ul><li>Capital budgeting projects often provide other options that we have not yet considered </li></ul><ul><ul><li>Contingency planning (“what if ” option) </li></ul></ul><ul><ul><li>Option to expand </li></ul></ul><ul><ul><li>Option to abandon </li></ul></ul><ul><ul><li>Option to wait </li></ul></ul><ul><ul><li>Strategic options (“testing” project) </li></ul></ul>
    23. 23. Capital Rationing <ul><li>Capital rationing occurs when a firm or division has limited resources </li></ul><ul><ul><li>Soft rationing – the limited resources are temporary, often self-imposed </li></ul></ul><ul><ul><li>Hard rationing – capital will never be available for this project </li></ul></ul><ul><li>The profitability index is a useful tool when faced with soft rationing </li></ul>
    24. 24. Review Questions <ul><li>1. Know how to calculate OCF based on pro forma statements to find out NPV of a project </li></ul><ul><li>2. How do we determine if cash flows are relevant to the capital budgeting decision? </li></ul><ul><li>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? </li></ul>
    25. 25. Review Questions (cont ..) <ul><li>3. Know how to calculate after-tax salvage. </li></ul><ul><li>4. What is scenario analysis and what is sensitivity analysis? </li></ul><ul><li>5. What are the major types of typical managerial option? What is capital rationing? </li></ul>