FCF012345SensitivityMarket Size0%0%0%0%0%0%Market Share0%0%0%0%0%0%Price0%0%0%0%0%0%Cost of Goods Sold0%0%0%0%0%0%Research and Development0%Total Available Market400,000,000400,000,000400,000,000400,000,000400,000,000400,000,000Target Market Segment15%15%15%15%15%15%Company Share of Market Segment0%2.0%4.0%5.0%3.0%0.0%Estimated units volume- 01,200,0002,400,0003,000,0001,800,000- 0Estimated Selling Price / Unit$70.00$70.00$70.00$70.00$70.00$70.00INCOME STATEMENT% of SalesRevenue- 084,000,000168,000,000210,000,000126,000,000- 0Cost of Goods Sold 40%- 033,600,00067,200,00084,000,00050,400,000- 0Depreciation (3 year MACRS)41,250,00056,250,00018,750,0008,750,000- 0Total Cost of goods sold74,850,000123,450,000102,750,00059,150,000- 0Gross Margin- 09,150,00044,550,000107,250,00066,850,000- 0Research & Development35,000,000- 0- 0- 0- 0- 0Sales & Marketing10%- 08,400,00016,800,00021,000,00012,600,000- 0General & Administrative5%- 04,200,0008,400,00010,500,0006,300,000- 0 Operating Expense35,000,00012,600,00025,200,00031,500,00018,900,000- 0Operating Margin(35,000,000)(3,450,000)19,350,00075,750,00047,950,000- 0Taxes35%(12,250,000)(1,207,500)6,772,50026,512,50016,782,500- 0Profit After Tax(22,750,000)(2,242,500)12,577,50049,237,50031,167,500- 0BALANCE SHEET A/R10%- 08,400,00016,800,00021,000,00012,600,000- 0 Inventory15%- 012,600,00025,200,00031,500,00018,900,000- 0 Current Assets- 021,000,00042,000,00052,500,00031,500,000- 0Gross PP&E125,000,000125,000,000125,000,000125,000,000125,000,000125,000,000MACRS 3 year schedule33.0%45.00%15.00%7.00%Annual Depreciation41,250,00056,250,00018,750,0008,750,000- 0Accumulated Deprecaition41,250,00097,500,000116,250,000125,000,000125,000,000 Net PP&E125,000,00083,750,00027,500,0008,750,000- 0- 0Total Assets125,000,000104,750,00069,500,00061,250,00031,500,000- 0A/P8%- 06,720,00013,440,00016,800,00010,080,000- 0 Current Liabilities- 06,720,00013,440,00016,800,00010,080,000- 0Retained Earnings(22,750,000)(24,992,500)(12,415,000)36,822,50067,990,00067,990,000Memo: Net Working Capital Required- 014,280,00028,560,00035,700,00021,420,000- 0FREE CASH FLOW (FCF)OCF (EBIT less taxes plus non cash items)(22,750,000)39,007,50068,827,50067,987,50039,917,500- 0Investment in NWC (change in NWC from prior period)- 014,280,00014,280,0007,140,000(14,280,000)(21,420,000)PPE Expenditures (change in LT Assets from prior period)125,000,000- 0- 0- 0- 0(6,500,000)Free Cash Flow (FCF)(147,750,000)24,727,50054,547,50060,847,50054,197,50027,920,000DECISION CRITERIAPayback3.14(123,022,500)(68,475,000)(7,627,500)46,570,00074,490,000NPV19,879,496IRR15.0%MRR12.8%Profitability Index1.13(147,750,000)22,479,54545,080,57945,715,62737,017,62217,336,123WACC10% Salvage ValueEquipment Purchase Price125,000,00010 year straight line depreciationSalvage Value at year 510,000,000Tax Rate35%0123456Equipment Cost125,000,0003 year MACRS Depreciation33.0%45.00%15.00%7.00%0%0%Depreciation Expense41,250,00056,250,00018,750,0008,750,000- 0- 0Book Va ...

1. FCF012345SensitivityMarket Size0%0%0%0%0%0%Market
Share0%0%0%0%0%0%Price0%0%0%0%0%0%Cost of Goods
Sold0%0%0%0%0%0%Research and Development0%Total
Available
Market400,000,000400,000,000400,000,000400,000,000400,000
,000400,000,000Target Market
Segment15%15%15%15%15%15%Company Share of Market
Segment0%2.0%4.0%5.0%3.0%0.0%Estimated units volume-
01,200,0002,400,0003,000,0001,800,000- 0Estimated Selling
Price / Unit$70.00$70.00$70.00$70.00$70.00$70.00INCOME
STATEMENT% of SalesRevenue-
084,000,000168,000,000210,000,000126,000,000- 0Cost of
Goods Sold 40%- 033,600,00067,200,00084,000,00050,400,000-
0Depreciation (3 year
MACRS)41,250,00056,250,00018,750,0008,750,000- 0Total
Cost of goods
sold74,850,000123,450,000102,750,00059,150,000- 0Gross
Margin- 09,150,00044,550,000107,250,00066,850,000-
0Research & Development35,000,000- 0- 0- 0- 0- 0Sales &
Marketing10%- 08,400,00016,800,00021,000,00012,600,000-
0General & Administrative5%-
04,200,0008,400,00010,500,0006,300,000- 0 Operating
Expense35,000,00012,600,00025,200,00031,500,00018,900,000
- 0Operating
Margin(35,000,000)(3,450,000)19,350,00075,750,00047,950,00
0-
0Taxes35%(12,250,000)(1,207,500)6,772,50026,512,50016,782,
500- 0Profit After
Tax(22,750,000)(2,242,500)12,577,50049,237,50031,167,500-
0BALANCE SHEET A/R10%-
08,400,00016,800,00021,000,00012,600,000- 0 Inventory15%-
012,600,00025,200,00031,500,00018,900,000- 0 Current
Assets- 021,000,00042,000,00052,500,00031,500,000- 0Gross
PP&E125,000,000125,000,000125,000,000125,000,000125,000,

2. 000125,000,000MACRS 3 year
schedule33.0%45.00%15.00%7.00%Annual
Depreciation41,250,00056,250,00018,750,0008,750,000-
0Accumulated
Deprecaition41,250,00097,500,000116,250,000125,000,000125,
000,000 Net
PP&E125,000,00083,750,00027,500,0008,750,000- 0- 0Total
Assets125,000,000104,750,00069,500,00061,250,00031,500,000
- 0A/P8%- 06,720,00013,440,00016,800,00010,080,000- 0
Current Liabilities-
06,720,00013,440,00016,800,00010,080,000- 0Retained
Earnings(22,750,000)(24,992,500)(12,415,000)36,822,50067,99
0,00067,990,000Memo: Net Working Capital Required-
014,280,00028,560,00035,700,00021,420,000- 0FREE CASH
FLOW (FCF)OCF (EBIT less taxes plus non cash
items)(22,750,000)39,007,50068,827,50067,987,50039,917,500-
0Investment in NWC (change in NWC from prior period)-
014,280,00014,280,0007,140,000(14,280,000)(21,420,000)PPE
Expenditures (change in LT Assets from prior
period)125,000,000- 0- 0- 0- 0(6,500,000)Free Cash Flow
(FCF)(147,750,000)24,727,50054,547,50060,847,50054,197,500
27,920,000DECISION
CRITERIAPayback3.14(123,022,500)(68,475,000)(7,627,500)46
,570,00074,490,000NPV19,879,496IRR15.0%MRR12.8%Profita
bility
Index1.13(147,750,000)22,479,54545,080,57945,715,62737,017
,62217,336,123WACC10%
Salvage ValueEquipment Purchase Price125,000,00010 year
straight line depreciationSalvage Value at year 510,000,000Tax
Rate35%0123456Equipment Cost125,000,0003 year MACRS
Depreciation33.0%45.00%15.00%7.00%0%0%Depreciation
Expense41,250,00056,250,00018,750,0008,750,000- 0- 0Book
Value125,000,00083,750,00027,500,0008,750,000- 0- 0- 0Sell
Equipment at end of Year 5Selling Price10,000,000Book Value-
0Gain on sale10,000,000Less taxes on Gain3,500,000Net
Cash6,500,000

3. FIN 319 – Case #2
Capital Budgeting – New Product Decision
Precision Castparts
Precision Castparts Corporation has long been a leader in
supplying complex metal components and
parts to the aerospace and other markets. However the
aerospace market has matured with growth
slowing and some analysts even forecasting a flat or declining
market. One growth area in the
aerospace market is occurring in drones, namely unmanned
aircraft used in a wide range of applications
to include: defense, agriculture, firefighting, general
commercial and personal / recreational uses.
Precision Castparts currently does not have any significant
market share in the drone market. Precision
Castparts is considering launching a new set of products to be
sold into the drone market. The drone
market was relatively nonexistent ten years ago, but has grown
quite rapidly and is expected to do so
into the future. Precision Castparts has already invested $15
million in research, $5M in test marketing

4. and believes their products will be competitive with product
offerings from other companies. You have
been approached by the president of the company to analyze the
proposed project and make a
recommendation on whether Precision Castparts should launch
the initial line drone products for the
commercial and defense sectors (Precision Castparts does not
plan to introduce produces for drones
used in the personal / recreational sector).
In the current year 20,000 drones are expected to be sold
worldwide and estimated to grow at rapid
rate of 45% per year. Of that total, 75% of the sales are
currently classified as being used in commercial
and defense and the mix of commercial and defense is expected
to decrease by 2.5 percentage points
each year in the future. Being a relatively new entrant to the
market, Precision Castparts expects to
initially get a 5% share of the commercial and defense drone
market and that market share will grow by
one percentage point per year. Once ready for sale, Precision
Castparts’s first product line is expected
to be sold for 5 years, in the 6
th

5. year Precision Castparts plans to transition to a second
generation of
drone products. In that 6
th
year half of the sales are expected to be comprised of the initial
product line
and the other half comprised of the second generation. The set
of products that Precision Castparts is
planning for the drone market could currently have a combined
average selling price of $40,000 / drone
unit based on competitive offerings and the price is forecast to
decrease by 4% per year. The company
is fairly confident in most of its projections, but market share
and price are the two items with the most
variability.
The variable cost of goods sold is forecast to be $19,000 /drone
unit at time of product launch and is
forecast to decrease by 5% / year as the company gains
experience with the manufacturing process.
Selling and administrative expenses are expected to be 8% of
sales each year.
Prior to launching the new product line, Precision Castparts will
need to spend an additional $75 million
on R&D over the next two years to complete the design ($50M

6. in the current year and $25M next year),
$10 million on test marketing and $100M on capital equipment
to support the manufacturing process.
The equipment purchase and test marketing will be done one
year prior to the start of sales. The
equipment will be depreciated using the seven year MACRS
schedule. The equipment will have a $15
million salvage value after all sales of the initial product line
have been completed and might be able to
be used in a future company project. Also, the company will
need to invest $20 million in net working
capital prior to the first year of sales. Once sales begin the
company will plan to maintain 55 days of
accounts receivable, 180 days of inventory and 60 days of
accounts payable.
The corporate tax rate is 32%. To establish a discount rate,
please use the Industry Approach (Pure Play)
to estimate the cost of equity. Please use The Boeing Company
(BA) as the comparable company as the
majority of its business is in the commercial and defense
segments of aerospace.
In your recommendation please include the payback period,
NPV, IRR, MIRR and profitability index. Also

7. include an analysis to assess potential risk.
I am interested in the structured frameworks you use to solve
the problem/s, assumptions made,
analysis, recommendation and ability to clear communicate.
Grading will consider:
• Critical Thinking: Have you formulated meaningful questions
(what are the critical issues or
problem), synthesized information and financial data,
considered alternatives or improvements,
proposed position / solutions.
• Analysis: Have you chosen the appropriate analytical
framework/s to utilize and appropriately
applied them. Assess quality of supporting evidence, key
assumptions are identified and a clear
recommendation supported by the analysis.
• Communication: The paper must be written clearly with a
central message and logical
organization. Ideas and recommendations are well supported.
The case should contain an
executive summary, framing of the problem, analysis,
consideration of alternative solutions and
recommendation. Please ensure correct spelling, grammar and
clear formatting of financial
exhibits. Use of tables and charts are often an efficient means

8. to communicate financial
information.
Papers should be between 3-5 pages in length plus any exhibits
in an appendix.
Absent Satisfactory Excellent
WACC 0 1 2 3 4 Comment
Overall framework and WACC
Cost of Equity (industry approach)
FCF Forecast
Overall framework
Proforma Income Statement
Proforma Balance Sheet
FCF Forecast
Decision Criteria
Decision Frmework
NPV, IRR, MIRR, PI
Risk Assessment

9. Communication
Overall Presentation
Executive Summary
Supporting evidence
Synthesis & Recommendation
Grammar, spelling
Use of Exhibits, Charts
Agenda
Comprehending risk when modeling investment (project)
decisions
Standalone Risk
Market Risk
1
1
Project Risk
Standalone Risk: Risk based on uncertainty of a projects cash
flows

10. Sensitivity
Scenarios
Breakeven
Simulations
Market Risk: Risk of the project as seen by a well diversified
investor
Beta
2
Sensitivity, Scenario, and Break-Even
Each allows us to look behind the NPV number to see how
stable our estimates are.
Breakeven: sales required to breakeven
Accounting break-even: sales volume at which net income = 0
Cash break-even: sales volume at which operating cash flow = 0
Financial break-even: sales volume at which net present value =
0
Sensitivity: how sensitive a particular NPV calculation is to
changes in an input variable holding all other assumptions are
held constant
Scenario: examine impact on NPV given a confluence of factors
When working with spreadsheets, try to build your model so
that you can adjust variables in a single cell and have the NPV
calculations update accordingly.
3
3

11. Monte Carlo Simulation
A more sophisticated variation of the scenario analysis is
Monte Carlo simulation.
In a Monte Carlo simulation, analysts specify a range or a
distribution of potential outcomes for each of the model’s
assumptions.
Pick a probability distribution for each input variable (units,
price, variable costs, etc).
The computer program will pick a random value from each input
variable, calculate the NPV and store the result. This is a trial.
Repeat the process many times, saving the input variables and
the output (NPV).
End result: Probability distribution of NPV based on sample of
simulated values.
4
Example
5
6
When a firm with both debt and equity invests in an asset
similar to its existing assets (business), the WACC is the
appropriate discount rate to use in NPV calculations.
In conglomerates, the WACC reflects the return that the firm
must earn on average across all its assets to satisfy investors,
but using the WACC to discount cash flows of a particular
investment leads to mistakes.
Any project’s cost of capital depends on the use to which the

12. capital is being put—not the source.
Therefore, it depends on the risk of the project and not the risk
of the company.
When a firm invests in an asset that is different from its
existing assets, it should look for pure-play firms to find the
right discount rate.
6
Finding the Right Discount Rate
6
You are a financial analyst at General Electric and are preparing
a cost of equity estimate for a project analysis using NPV:
CAPM = Risk Free Rate + Beta * Market Risk Premium
9.5% = 3.0% + 1.1 * 5.9%
Lines of Business
Financial Services
Power Generation
Aviation
Transportation
Health Care
Consumer Goods
When evaluating a new power generation investment for GE,
which cost of capital should be used?
Capital Budgeting & Project Risk
7
Beta
1.8
0.6

13. 1.2
1.3
0.8
1.1
7
17
Capital Budgeting & Project Risk
Project IRR
Project’s risk (b)
9.5%
1.1
1.8
0.6
R = 3% + 0.6×(5.9% ) = 6.5%
6.5% reflects the opportunity cost of capital on an investment in
power generation, given the unique risk of the project.

14. 6.5%
13.6%
Investments in Financial Services have higher risk and should
have higher discount rates
Security Market Line (SML)
8
8
Using an Industry Beta
Pure Play Approach
It can be argued that a better estimate of a firm’s beta or project
beta can be developed by analyzing companies in the industry.
If you believe that the operations of the firm are similar to the
operations of the rest of the industry you can use an industry
beta.
If you believe that the operations of the firm are fundamentally
different from the operations of the rest of the industry, you
should use the firm’s beta.
The Industry approach can also be used if
The company being analyzed is not public as Beta can not be
directly observed.
Attempting to estimate a Beta for a division or project
Steps to use an industry beta:
Indentify Comparable Firms and their beta

15. Calculate the unlevered (asset beta) for each comparable firm
(pure plays)
Beta is influenced by nature of industry, operating leverage,
financial leverage (debt)
Calculate an average asset beta based for the firms
Lever the beta (equity beta) based on the capital structure of the
firm of interest.
Controls for capital structure (amount of debt), which impacts
beta
9
Levered Beta = Unlevered Beta * [ 1 + ( 1- tax rate) * (Debt /
Equity Ratio)]
Or if your firm is private
9
Industry Beta Example
You want to estimate cost of equity for an energy project. You
have identified a comparable company in the energy industry
(Energy Inc)
Beta (levered) 0.43
Debt / Equity Ratio 0.75
Tax Rate 35%
Energy Inc’s unlevered (asset) beta = 0.29
0.29 = 0.43 / [1 + (1 - .35)
* (0.75)]
Unlevered Beta = Levered Beta / [ 1 + ( 1- tax rate) *
(Debt / Equity Ratio)]
General Electric has chosen to have more debt in their capital
structure.

16. GE Debt / Equity Ratio 1.4
GE Tax Rate 25%
An estimate of GE’s beta for it’s energy business is 0.6
0.6 = 0.29 * [ 1 + (1 - .25) *
(1.4)]
Levered Beta = Unlevered Beta * [ 1 + ( 1- tax rate) * (Debt /
Equity Ratio)]
The Beta of 0.6 would be appropriate to use for calculating the
cost of capital of a project in GE’s energy business unit.
10
Look at some online betas, are they asset or equity betas?
10
Assignments for Next Week
Monday, November 3rd
Case #2 Due and in class review
Mid term Exam overview.
Wednesday, November 5th
Mid Term Exam
11
12
Firms establish a “base-case” set of assumptions for a particular
project and calculate the NPV based on those assumptions.

17. Managers allow one variable to change while holding all others
fixed, and they recalculate the NPV based on that change.
Repeating this process for all the uncertain variables in an NPV
calculation:
Allows managers to see how sensitive the NPV is to changes in
baseline assumptions.
Understand which variables have the most impact on the NPV
Issues: Ignores relationships among variables
12
Sensitivity Analysis
12
13
Scenario Analysis
A more complex variation on sensitivity analysis
Rather than adjust one assumption up or down, analysts conduct
scenario analysis by calculating the project NPV when a whole
set of assumptions changes in a particular way.
Assign probabilities to the to scenarios
For Example: Best, Worse, Base Case Scenarios
Better understanding of project risk
Issues:
Only considers a few possible out-comes.
Assumes that inputs are perfectly correlated—all “bad” values
occur together and all “good” values occur together.
13

18. 13
Capital Budgeting & Project Risk
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.
Project IRR
Firm’s risk (beta)
rf
bFIRM
Incorrectly rejected positive NPV projects
Incorrectly accepted negative NPV projects
Hurdle rate

19. The SML can tell us why:
14
14
To estimate the cost of capital for a division, a “pure play”
approach could be used, although finding exactly similar firms
may be difficult, particularly considering underlying financial
and operational structure.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
($475,145)($339,389)($203,634)($67,878)$67,878$203,634$339
,389$475,145
NPV
Probability of NPV
SML
)(
F
M
FIRMF
Agenda
Capital Budgeting Decision Frameworks

20. 1
1
Capital Budgeting Process
Goal of management is to maximize value
Companies continually invests in a portfolio of projects
In theory all projects that create value should be approved
In reality, a company may not invest in all projects estimated to
create value
Capital budgeting is the process to assess:
if an investment will create value for the investors
Expected project return > cost of capital
If constrained, how to prioritize across investments.
Capital constraints
Non-Capital constraints
Estimation Bias
2
2
Describe process to create a budget
ZBB process
What would you like to see in approving a project

21. Capital Budgeting
3
New Product
Upgrade the Factory
Marketing Program
Open new Sales office
Leadership Training
‘Big Data’ Software
New Feature for existing product
Compliance with new Federal regulation
Capital Budgeting Process
Approved Projects
3
4
The Capital Budgeting Decision Process
The capital budgeting process involves a few basic steps:
Identifying potential investments
Ensure potential investments are linked to strategic direction
Types of Projects: Safety, Replacement, Contraction, Expansion
(products or markets), Mergers
Reviewing, analyzing, and selecting from the proposals that
have been generated
Strategic Alignment
Does the project create value?
Implementing and monitoring the proposals that have been
selected
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible

22. Web site, in whole or in part.
4
Analyzing involves valuing the project -> same principles as
valuing a security or business
5
A capital budgeting process should…
Be easy to apply and explain
Focus on cash flow
Account for the time value of money
Account for project risk
Lead to investment decisions that maximize shareholders’
wealth
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.
5
Investment Decision Frameworks
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index
Payback
Discounted Payback
All frameworks will require a financial forecast
Most require size of cash flows, timing of cash flows and risk.
6
Typical profile: investment in development, marketing, capital

23. and inventory
revenue ramp and then transition down
costs to support and then reclaim of some
investment
Does the profile make economic sense? Create value
6
7
What Companies Do Globally
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.
7
Project Analysis
General Framework
What are the cash flows associated with the project
Understand the strategy and operational assumptions related to
the project
Forecast the pro forma financials
Income statement and balance sheet
Percent of sales approach as starting point
Utilize ratios & competitive positioning to guide assumptions
Free Cash flow = CF from Operations - Investment in WC –
Investment in LT Assets
Only new, incremental cash flows should be included
Assess riskiness of cash flows: Discount Rate
WACC: Cost of Equity (CAPM) and Cost of Debt (after tax

24. yield)
Market based costs and Target or Market weights
Risk based on the project cash flows, not necessarily that of the
company
Apply decision criteria (NPV, IRR, payback)
NPV generally the best method
Test the decision and the critical assumptions
What are the key inputs that have the most uncertainty?
What causes the decision to change?
Utilize Scenarios, Sensitivity, Breakeven to focus on key
assumptions
Recommendation with key risks identified and suggestions to
mitigate
8
8
Capital Budgeting Decision Frameworks
9
Net Present Value
Present Value of all future cash flows
Discount rate based on risk of project
Acceptance Criteria: NPV > $0
NPV Amount = amount of value creation
IRR / MIRR
Discount rate that results in NPV = 0
Cash flow forecast same as NPV analysis
Acceptance Criteria: IRR > Cost of Capital
Profitability Index
Present Value of Cash Inflow divided by

25. Present Value of Cash Outflow
Cash flow forecast same as NPV analysis
Acceptance Criteria: PI > 1.0
Payback
Numbers of time periods required to
recoup the investment
Cash flow forecast same as NPV analysis
Acceptance Criteria: Arbitrary
NPV Profile
10
Project NPV
+$
$0
-$
Discount Rate
NPV > $0
IRR > Discount Rate
NPV < $0
IRR < Discount Rate

26. IRR of Project
NPV versus IRR
NPV and IRR will generally give the same decision.
Exceptions:
Mutually exclusive projects
Scale is substantially different
Timing of cash flows is substantially different
Non-conventional cash flows – cash flow signs change more
than once
Modified IRR can help with the non conventional cash flows
and re-investment rate assumptions
11
11
Profiles of non traditional CFs
Reinvest rate assumptions:
NPV= cost of capital
IRR= IRR
MIRR, define the reinvestment rate
MIRR
Example
Company is considering investing in a new product requiring
$35M in R&D and $125M in capital equipment.
Total available market (TAM) size is 400M units / year.
Company expects to address 15% of TAM and initially capture
2% market share.

27. Product price is $70 / unit
COGS is 40% of price
Sales and Marketing expense is estimated at 10% of revenue.
General and administrative is 5% of revenue
Working capital is forecast as:
A/R at 10% of sales, Inventory at 15% of sales, A/P at 8% of
sales
Depreciation based on 3 year MACRS
Tax rate is 35%
Product life is approx 4 years. Equipment will have a $10M
salvage value
Cost of capital = 10%
Should the company invest in the new product?
12
12
Which Cash Flows -> Incremental Cash Flows
Cash flows matter—not accounting earnings.
Incremental cash flows matter.
Sunk costs do not matter.
Don’t forget start-up and salvage value cash flows
Opportunity costs matter.
Externalities like cannibalism and erosion matter.
Inflation matters.
Taxes matter: we want incremental after-tax cash flows.

28. 13
13
14
14
Depreciation
Many countries allow firms to use one depreciation method for
tax purposes and another for reporting purposes.
Accelerated depreciation methods such as the modified
accelerated cost recovery system (MACRS) increase the present
value of an investment’s tax benefits.
Relative to MACRS, straight-line depreciation results in higher
reported earnings early in an investment’s life.
Which method would you expect companies to use when they
file their taxes, and which would they use when preparing
public financial statements?
For capital budgeting analysis, it is the depreciation method for
tax purposes that matters.
14
Assignments for Next Class
Investment Decisions and Risk Analysis Chapter 11
15

29. 15
Summary – Investment Decision Frameworks
Net present value
Difference between market value and cost
Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
MIRR can address the non-conventional cash flow issue
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Payback
Time required to recoup the initial investment
Does not account for timing, risk or cash flows beyond payback
period
Payback decision criteria is arbitrary
16
16
NPV is preferred

30. Benefits of other methods -> provide insight on margin of
safety
A B
NPV $10M $10.5M
IRR 30% 12%
Investment $5M $60M
Example
17
A company has two potential projects to invest in:
Each has a cost of capital of 10%
What would you recommend?
17
18
Net Present Value
r represents the minimum return that the project must earn to
satisfy investors.
r varies with the risk of the firm and/or the risk of the project.
A key input in NPV analysis is the discount rate.
Net Present Value (NPV) = Total PV of cash inflows – PV of
costs
Minimum Acceptance Criteria: Accept if NPV > 0
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scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.

31. 18
19
Internal Rate of Return
IRR found by computer/calculator or manually by trial and error
The IRR decision rule is:
If IRR is greater than the cost of capital, accept the
project.
If IRR is less than the cost of capital, reject the project.
Internal rate of return (IRR) is the discount rate that results in a
zero NPV for the project.
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scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.
19
Similar to a YTM calculation
Significance of IRR / NPV=0 ?
20
Pros and Cons of Using NPV as Decision Rule
NPV is the “gold standard” of investment decision rules.
NPV is the present value of cash inflows less present value of
cash outflows
How much the project contributes to shareholder wealth
Key benefits of using NPV as decision rule
Focuses on cash flows, not accounting earnings
Makes appropriate adjustment for time value of money

32. Can properly account for risk differences between projects
Though best measure, NPV has some drawbacks.
Lacks the intuitive appeal of payback
Doesn’t capture managerial flexibility (option value) well
20
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.
20
21
Pros and Cons of Payback Method
Computational simplicity
Easy to understand
Focus on cash flow
Disadvantages of payback method:
Does not account properly for time value of money
Does not account properly for risk
Cutoff period is arbitrary
Does not lead to value-maximizing decisions
Advantages of payback method:
© 2010 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.
21
The Profitability Index (PI)
Minimum Acceptance Criteria:
Accept if PI > 1

33. Ranking Criteria:
Select alternative with highest PI
Advantages:
Easy to understand and communicate
Correct decision when evaluating independent projects
Disadvantages:
Problems with mutually exclusive investments
22
Present Value of Future Cash Flows
Initial Investment
22
Initial Cost
01234
Project S
-$10,000$5,000$4,000$3,000$1,000
Project L
-$10,000$1,000$3,000$4,000$6,750
After-Tax, End of Year, Project Cash Flows, CF
t