Making Capital Investment Decisions
Chapter 9
TINKU
IBMR - H
1
Topics
1. Relevant Cash Flows For A Project
2. Cash Flows From Accounting Numbers
3. MACRS Tax Law for Depreciation
4. Sen...
Relevant Cash Flows For A Project
• Incremental Cash Flows = difference between future cash
flows with a project & without...
Relevant Cash Flows
• Include only cash flows that will only
occur if the project is accepted
• Incremental cash flows
• T...
Relevant Cash Flows:
Incremental Cash Flow for a Project
Corporate cash flow with the project
Minus
Corporate cash flow wi...
Relevant Cash Flows
• “Sunk” Costs ………………………… N
• Opportunity Costs …………………... Y
• Side Effects/Erosion……..…………… Y
• Net W...
Stand-along Principal
• The assumption that evaluation of a project
may be based on the project’s incremental
cash flows, ...
Relevant Cash Flows For A Project
• Sunk Costs
– A cost that we have already paid or have already
incurred the liability t...
Relevant Cash Flows For A Project
• Opportunity Costs
– Give up a benefit.
– The most valuable alternative that is given u...
Relevant Cash Flows For A Project
• Erosion (Cannibalism)
–The cash flows of a new project that come
at the expense of oth...
Relevant Cash Flows For A Project
• NWC
– Short-term NWC (cash, inventory, AR, AP) that project
will need.
– Firm supplies...
Cash Flows From Accounting Numbers
• Pro Forma Financial Statements:
– Projected Financial Statements estimating the
unkno...
Tax Shield Method (Good For Cost
Savings Projects):
OCF = (Sales – VC – FC)*(1-T) + Depr*T
 VC = Variable Costs (costs th...
Example 1: NPV calculation From Pro
Forma Data
14
Example 1: NPV calculation From Pro Forma Data
15
(Sales - Costs)*(1-T) = Cash Flow Without Depr Depr*T = Depreciation tax...
Example 1: NPV calculation From Pro Forma Data
16
Reminder of How Transactions are Recorded with
Accrual Accounting
Record Sales Transaction in Journal
Account DR CR
AR $10...
Example of How Accrual Accounting Must Be Un-done to get at Cash Flows
Total Sales $1,000
Total Costs = VC + FC $800
Sales...
Undo Accrual Accounting
19
a AR Sales -$20
remove AR increase from Sales - sales were
recorded on Income Statement with no...
NWC and OCF*NWC = Net Working Capital, OCF = Operating Cash Flows
• Usually there are differences between accrual
accounti...
NWC and OCF*NWC = Net Working Capital, OCF = Operating Cash Flows
• Expenses may have to much or too little recorded on
th...
Rule for how CA & CL affect OCF*CA = Current Assets, CL = Current Liabilities
• Increase in CA  Subtract from OCF
• Decre...
NWC and OCF
• Remember from chapter 2:
– NWC = Net Working Capital (Short term assets and
liabilities)
– CA = Current Asse...
Formula for Total Project Cash Flow
Total Project Cash Flow = EBIT + Depreciation – Taxes –
Change NWC – Capital Spending
...
Depreciation & Cash Flow Analysis
• Because Depreciation is a non-cash expense that has
cash flow implications, we must us...
MACRS Property Class (abbreviated)
Class (years) Example1 Example2
3-Year Research Equipment Special Tools
5-Year Autos Co...
MACRS Example
27
Tax Effect on Sale Of Asset
Net Cash Flow from Sale Of Asset =
SP - (SP-BV)*(T)
Where:
SP = MV = Selling Price
BV = Book V...
MACRS Example continue
29
MACRS Example continue
30
Comprehensive Example of Pro Forma Financial
Statements and NPV see video
Assumptions:
31
Comprehensive Example Pro Forma:
32
Comprehensive Example Cash Flows:
33
Estimates About Unknown Future
• We can only estimate what might happen in
the future.
• The actual Future Cash Flows are ...
Positive NPV
• If we find positive NPV projects, we must be
skeptical.
• Finding Positive NPV projects in competitive
mark...
If We Find Positive NPV Projects, We Should Be
Able To Point To Why:
• Is it a better product (iPod)?
• Totally new produc...
+NPV Projects Indicate We Should Take A Closer Look.
• Scenario Analysis (Easy to do in Excel)
– Change assumptions (formu...
Problems with Scenario Analysis
• Considers only a few possible out-comes
• Assumes perfectly correlated inputs
–All “bad”...
• Sensitivity Analysis (Easy to do in Excel)
– Investigation of what happens to NPV when only one
variable is changed
– If...
Sensitivity Analysis:
• Strengths
– Provides indication of stand-alone risk.
– Identifies dangerous variables.
– Gives som...
Disadvantages of Sensitivity and Scenario
Analysis
• Neither provides a decision rule.
–No indication whether a project’s ...
Managerial Options
• So far our analysis has been static, but as projects
move forward, elements can always be changed suc...
Managerial Options
• Contingency Planning
– Planning what to do if some event occurs in the future
(like sales are below b...
Capital Rationing
• Capital rationing occurs when a firm or
division has limited resources
– Soft rationing – the limited ...
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Business Finance Chapter 9

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Business Finance Chapter 9

  1. 1. Making Capital Investment Decisions Chapter 9 TINKU IBMR - H 1
  2. 2. Topics 1. Relevant Cash Flows For A Project 2. Cash Flows From Accounting Numbers 3. MACRS Tax Law for Depreciation 4. Sensitivity Analysis to Show Range Of NPV (Because the Future is Unknown) 2
  3. 3. Relevant Cash Flows For A Project • Incremental Cash Flows = difference between future cash flows with a project & without the project. • Any cash flow that exists regardless of whether or not a project is undertaken in not relevant. • Incremental Cash Flows = Aftertax Incremental Cash Flows • Sunk Costs not relevant • Opportunity Costs are relevant • Side Effects/Erosion are relevant • Change in Net Working Capital is relevant • Financing Costs are dealt with as a managerial variable and are not considered with the projects cash flows (Cash Flow To/From Creditors or Stockholders. 3
  4. 4. Relevant Cash Flows • Include only cash flows that will only occur if the project is accepted • Incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows 4
  5. 5. Relevant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the project Minus Corporate cash flow without the project 5
  6. 6. Relevant Cash Flows • “Sunk” Costs ………………………… N • Opportunity Costs …………………... Y • Side Effects/Erosion……..…………… Y • Net Working Capital………………….. Y • Financing Costs….………..…………. N • Tax Effects ………………………..….. Y 6
  7. 7. Stand-along Principal • The assumption that evaluation of a project may be based on the project’s incremental cash flows, and is evaluated separately from other projects. • The project has its own: – Future revenues and costs – Assets – Cash flows • Evaluate the project on its own merits. 7
  8. 8. Relevant Cash Flows For A Project • Sunk Costs – A cost that we have already paid or have already incurred the liability to pay. – Sunk costs cannot be changed as a result of accepting or rejecting the project. – Sunk Costs are not considered in an investment decision. – We already paid for the consultant on the new product line. Isn’t that a relevant cost for the project? No, because it is already paid for and does not change regardless of whether we accept or reject the project. 8
  9. 9. Relevant Cash Flows For A Project • Opportunity Costs – Give up a benefit. – The most valuable alternative that is given up if a particular project is undertaken. – If you give up a job to go to school, you must add lost wages to the cost of the school. – If you use land that is already paid for, to create an organic farm, what other use for the land did you give up? • At minimum, an opportunity cost is what you could have sold it for. 9
  10. 10. Relevant Cash Flows For A Project • Erosion (Cannibalism) –The cash flows of a new project that come at the expense of other projects. • Think of new product line that takes away from sales of an existing product line. • Cash Flow relevant only when it would not otherwise be lost: existing product line or competition. 10
  11. 11. Relevant Cash Flows For A Project • NWC – Short-term NWC (cash, inventory, AR, AP) that project will need. – Firm supplies NWC at beginning of project and recovers it at end of project (like a loan). • Financing Costs – Interest and Dividends are not analyzed as part of the project. They are analyzed separately. – They are not cash flow from or to assets. – They are cash flows from or to creditors or stockholders (chapter 2) 11
  12. 12. Cash Flows From Accounting Numbers • Pro Forma Financial Statements: – Projected Financial Statements estimating the unknown future. • Operating Cash Flow: OCF = EBIT + Depr – Taxes OCF = NI + Depr if no interest expense • Cash Flow From Assets: CFFA = OCF – NCS –ΔNWC NCS = Net capital spending 12
  13. 13. Tax Shield Method (Good For Cost Savings Projects): OCF = (Sales – VC – FC)*(1-T) + Depr*T  VC = Variable Costs (costs that increase as you sell more)  FC = Fixed Costs (costs that do not change as you sell more)  T = Marginal Tax Rate 13
  14. 14. Example 1: NPV calculation From Pro Forma Data 14
  15. 15. Example 1: NPV calculation From Pro Forma Data 15 (Sales - Costs)*(1-T) = Cash Flow Without Depr Depr*T = Depreciation tax shield = "Non-cash expense saves on our tax bill". *sometimes is eaiser (analyzing Cost Cutting projects)
  16. 16. Example 1: NPV calculation From Pro Forma Data 16
  17. 17. Reminder of How Transactions are Recorded with Accrual Accounting Record Sales Transaction in Journal Account DR CR AR $100 Sales $100 COGS $50 Inv $50 Record Incur Expense Transaction in Journal Expense $25 AP $25 Accrual Accounting V Cash Flow: Revenues and Expenses Can Be Recorded Without Cash Movement. 17
  18. 18. Example of How Accrual Accounting Must Be Un-done to get at Cash Flows Total Sales $1,000 Total Costs = VC + FC $800 Sales - (VC + FC) $200 Balance Sheet Beg. Balance Balance Sheet End. Balance a AR $200 $220 AR went up by 20.00. This accrual accounting must be un-done. b Inventory $100 $90 Inventory went down by -10.00. This accrual accounting must be un-done. c AP $200 $180 AP went down by -20.00. This accrual accounting must be un-done. Net Working Capital $100 $130 Accrual Accounting Must Be Undone to Get At Cash Flows 18
  19. 19. Undo Accrual Accounting 19 a AR Sales -$20 remove AR increase from Sales - sales were recorded on Income Statement with no associated cash in. b Inventory COGS Expenses $10 add back Inventory decrease to COGS Expenses - expenses were recorded on Income statement with no associated cash out. c AP Expenses -$20 remove AP decrease from Expenses - cash went out with no associated expense in Income Statement. Total Adjustment -$30 OCF 170 Adjustment to OCF $140 Total Cash Flow = OCF - NWC - Cap Spending Adjustment to OCF $140
  20. 20. NWC and OCF*NWC = Net Working Capital, OCF = Operating Cash Flows • Usually there are differences between accrual accounting sales and expenses and actual cash sales and expenses. • Because of this we must make adjustments to our OCF. – Revenues may have to much or too little recorded on the Income Statement. • If the Accounts Receivable (AR) account (on Balance Sheet) goes up during the year, we have non-cash revenue on the Income Statement. We must subtract out the non-cash revenue to reflect the true cash flow – subtract the increase in AR from OCF. • If the AR goes down during the year, we received cash in that has no associated revenue recorded on the Income Statement. We must add in decrease (positive number) in AR to OCF to reflect the true cash flow. 20
  21. 21. NWC and OCF*NWC = Net Working Capital, OCF = Operating Cash Flows • Expenses may have to much or too little recorded on the Income Statement. – If the Inventory account (on Balance Sheet) goes up during the year, we have spent more cash on inventory than we have sold. We must subtract the increase in Inventory from the OCF to reflect the true cash flow. – If Inventory goes down during year, we have recorded too much expense on Income Statement, we must add the decrease (positive number) to OCF. – If the Accounts Payable (AP) account (on Balance Sheet) goes up during the year, we have non-cash expense on the Income Statement. We must add back the non-cash expense to reflect the true cash flow: add the increase in AP to OCF. – If the AP goes down during the year, we have cash paid out cash that has no associated expense on the Income Statement. We must subtract the decrease in AP from OCF.21
  22. 22. Rule for how CA & CL affect OCF*CA = Current Assets, CL = Current Liabilities • Increase in CA  Subtract from OCF • Decrease in CA  Add to OCF • Increase in CL  Add to OCF • Increase in CL  Add to OCF 22
  23. 23. NWC and OCF • Remember from chapter 2: – NWC = Net Working Capital (Short term assets and liabilities) – CA = Current Assets – CL = Current Liabilities – Change NWC = End NWC – Beg NWC – Change NWC = (End CA – End CL) – (Beg CA – Beg CL) 23
  24. 24. Formula for Total Project Cash Flow Total Project Cash Flow = EBIT + Depreciation – Taxes – Change NWC – Capital Spending OCF = EBIT + Depreciation – Taxes – (End NWC – Beg NWC) – Capital Spending Or OCF = EBIT + Depreciation – Taxes – (Change in CA) + (Change in CL) – Capital Spending OCF = EBIT + Depreciation – Taxes – (End CA – Beg CA) + (End CL – Beg CL) – Capital Spending 24
  25. 25. Depreciation & Cash Flow Analysis • Because Depreciation is a non-cash expense that has cash flow implications, we must use the IRS rules for depreciation, Not GAAP Rules. • Modified Accelerated Cost Recovery System (MACRS). – We will look at somewhat simplified MACRS tables – MACRS does not consider the life of asset or salvage value that GAAP does. • Calculate Depreciation to find tax cash flow implication. • Calculate Book Value (BV) to find tax implication for sale of asset at end of life. – MV (Sale Price) > BV  Pay Tax (Cash Out) – MV (Sale Price) < BV  Tax Saving (Cash In) 25
  26. 26. MACRS Property Class (abbreviated) Class (years) Example1 Example2 3-Year Research Equipment Special Tools 5-Year Autos Computers 7-Year Industrial Equipment Office Furniture Depreciation Allowances Class Years 3-Year 5-Year 7-Year 1 0.3333 0.2 0.1429 2 0.4445 0.32 0.2449 3 0.1481 0.192 0.1749 4 0.0741 0.1152 0.1249 5 0.1152 0.0893 6 0.0576 0.0892 7 0.0893 8 0.0446 MACRS 26
  27. 27. MACRS Example 27
  28. 28. Tax Effect on Sale Of Asset Net Cash Flow from Sale Of Asset = SP - (SP-BV)*(T) Where: SP = MV = Selling Price BV = Book Value T = Marginal tax rate 28
  29. 29. MACRS Example continue 29
  30. 30. MACRS Example continue 30
  31. 31. Comprehensive Example of Pro Forma Financial Statements and NPV see video Assumptions: 31
  32. 32. Comprehensive Example Pro Forma: 32
  33. 33. Comprehensive Example Cash Flows: 33
  34. 34. Estimates About Unknown Future • We can only estimate what might happen in the future. • The actual Future Cash Flows are NOT known. • Forecasting Risk: – The possibility that errors in projected cash flows will lead to incorrect decisions. • Think of: GM buying Hummer, Warner letting AOL buy it, B of A buying Countywide – Sensitivity of NPV to changes in cash flow estimates • The more sensitive, the greater the forecasting risk 34
  35. 35. Positive NPV • If we find positive NPV projects, we must be skeptical. • Finding Positive NPV projects in competitive markets is hard to do. 35
  36. 36. If We Find Positive NPV Projects, We Should Be Able To Point To Why: • Is it a better product (iPod)? • Totally new product (Wii)? • Do we have a great marketing plan (MrExcel.com free online videos) • Can we manage supply and demand more effectively (Wal-Mart) • Do we control the market (Microsoft) • Can we leverage the long-tail of the internet (Amazon)? 36
  37. 37. +NPV Projects Indicate We Should Take A Closer Look. • Scenario Analysis (Easy to do in Excel) – Change assumptions (formula inputs) to create: • Pessimistic case (Price & Units up, Costs down) • Base Case • Optimistic Case (Price & Units down, Costs up) – Change a number of variables to gage what will happen on the up or down side. – This gives a range of values you can look at. – You can run multiple scenarios: • If cases look good, maybe the project will be good. • If cases look bad, maybe forecast risk is high and we should investigate further. 37
  38. 38. 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 38
  39. 39. • Sensitivity Analysis (Easy to do in Excel) – Investigation of what happens to NPV when only one variable is changed – If the NPV is very sensitive to a particular variable, it means we better take a closer look at our estimates for that variable. – If variable is sensitive (small change in variable means big change in NPV – “steeper the plotted line”), then the forecast risk associated with that variable is high. – Line steepness can be measured by Slope (SLOPE function in Excel) • =SLOPE(y-values (vertical),x-values (horizontal)) +NPV Projects Indicate We Should Take A Closer Look. 39
  40. 40. Sensitivity Analysis: • Strengths – Provides indication of stand-alone risk. – Identifies dangerous variables. – Gives some breakeven information. • Weaknesses – Does not reflect diversification. – Says nothing about the likelihood of change in a variable – Ignores relationships among variables. 40
  41. 41. 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. 41
  42. 42. Managerial Options • So far our analysis has been static, but as projects move forward, elements can always be changed such as: – Lower or raise price – Change marketing – Change manufacturing process • Managerial Options (Real Options) – Opportunities that managers can exploit if certain things happen in the future. – NPV will tend to be underestimated when we ignore options. – No reliable way to estimate $ figures for these sorts of options. 42
  43. 43. Managerial Options • Contingency Planning – Planning what to do if some event occurs in the future (like sales are below break even). • Option to expand – If things go well (think of iPod, Wii). • Option to abandon – If things go badly (Think of Hummer and AOL). • Option to wait – Maybe after the recession would be a better time to launch the new product. • Strategic option – Think: manufacturer tries their hand at retailing to see if it is a good idea. The info gained is difficult to translate into a $ figure in order to do DCF analysis. 43
  44. 44. 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 44

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