Transcript No Slide Title
Chapter 10
Making Capital Investment Decisions
Chapter 9 REVIEW I. Discounted cash flow criteria A. Net present value (NPV).
The NPV of an investment is the difference between its market value and its cost. The NPV rule is to take a project if its NPV is positive. NPV has no serious flaws; it is the preferred decision criterion.
B. Internal rate of return (IRR).
The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. The IRR rule is to take a project when its IRR exceeds the required return. When project cash flows are not conventional, there may be no IRR or there may be more than one.
C. Profitability index (PI).
The PI, also called the
benefit-cost ratio
, is the ratio of present value to cost. The profitability index rule is to take an investment if the index exceeds 1.0. The PI measures the present value per dollar invested.
II. Payback criteria A.
Payback period
. The payback period is the length of time until the sum of an investment’s cash flows equals its cost. The payback period rule is to take a project if its payback period is less than some pre-specified cutoff.
B.
Discounted payback period
. The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some pre-specified cutoff.
III. Accounting criterion A.
Average accounting return (AAR).
The AAR is a measure of accounting profit relative to book value. The AAR rule is to take an investment if its AAR exceeds a benchmark.
Chapter 10
Making Capital Investment Decisions Chapter Organization
•Incremental Cash Flows •Terminology •Cash Flows vs. Accounting Income •Pro Forma Financial Statements and Project Cash Flows •More on Project Cash Flows •Alternative Definitions of Operating Cash Flow •Some Special Cases of Discounted Cash Flow Analysis •Summary and Conclusions
Fundamental Principles of Project Evaluation:
Project evaluation
- the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision.
Relevant cash flows
- the
incremental cash flows
associated with the decision to invest in a project.
The incremental cash flows for project evaluation consist of
any and all
changes in the firm’s future cash flows that are a direct consequence of taking the project.
Stand-alone principle
- evaluation of a project based on the project’s incremental cash flows.
Incremental Cash Flows
Incremental Cash Flow = cash flow with project cash flow without project
IMPORTANT
Ask yourself this question Would the cash flow still exist if the project does not exist?
•If yes, do not include it in your analysis.
•If no, include it.
Terminology A.
Sunk costs B.
C.
D.
E.
F.
Opportunity costs Side effects Net working capital Financing costs Other issues
A. Sunk costs
Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis?
• NO. This is a sunk cost, already spent and irretrievable, so “forget it”, “water under the bridge”,
SUNK
. Focus on incremental investment and operating cash flows.
B. Opportunity costs
Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis?
• Yes. Accepting the project means we will not receive the $25,000. This is an
opportunity cost
to the project.
and it should be charged
C. Side effects
If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis?
• Yes. The effects on the other projects’ CFs are “
externalities
” or “
spillover effects
”.
• Net CF loss per year on other lines would be a cost to this project.
• Externalities will be positive if new projects are complements to existing assets, negative if substitutes.
D. Net working capital
NWC
CA
CL
In estimating cash flows we must account for the fact that some of the incremental sales associated with a project will be on credit, and that some costs won’t be paid at the time of investment. How? Answer: Estimate changes in NWC. Assume: 1.
2.
Fixed asset spending is zero.
The change in net working capital spending is $200: 0 1 Change A/R INV $100 100 $100 350 0 +250 - A/P 50 100 -50 NWC $150 $350 Change in NWC = $200
E. Financing costs
Should CFs include interest expense? Dividends?
• NO. The costs of capital are already incorporated in the analysis since we use them in discounting. • If we included them as cash flows, we would be double counting them.
F. Other issues
Depreciation Basics Depreciable Basis = Cost + Shipping + Installation
T10.7 Modified ACRS Property Classes (Table 10.6)
Class Examples 3-year Equipment used in research 5-year Autos, computers 7-year Most industrial equipment
Year 1 2 3 4 5 6 7 8 T10.8 Modified ACRS Depreciation Allowances (Table 10.7) 3-Year
Property Class
5-Year 7-Year 33.33% 44.44
14.82
7.41
20.00% 32.00
19.20
11.52
11.52
5.76
14.29% 24.49
17.49
12.49
8.93
8.93
8.93
4.45
Cash flow estimation bias
• CFs are estimated for many future periods.
• If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK).
• Studies show that forecasts often are biased upward (overly optimistic revenues, underestimated costs). Agency Problems?
What steps can management take to eliminate the incentives for cash flow estimation bias?
• Routinely compare CF estimates with those actually realized and reward managers who are forecasting well, penalize those who are not.
• When evidence of bias exists, the project’s CF estimates should be lowered or the cost of capital raised to offset the bias.
Option value
• Investment in a project may lead to other valuable opportunities.
• Investment now may extinguish opportunity to undertake same project in the future.
• True project NPV = NPV + Value of options.
Cash Flow -VS- Accounting Income •Discount actual cash flows •Using accounting income, rather than cash flow, could lead to erroneous decisions.
Cash Flow -VS- Accounting Income
Example A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income.
Cash Flow -VS- Accounting Income Cash Income Depreciation Accounting Income Year 1 $1500 - $1000 + 500 Year 2 $ 500 - $1000 - 500
Cash Flow -VS- Accounting Income Cash Income Depreciation Accounting Income Year 1 $1500 - $1000 + 500 Year 2 $ 500 - $1000 - 500 500 Accounting NPV = 1.10
500 2 $41.
32
Cash Flow -VS- Accounting Income Cash Income Project Cost Free Cash Flow Today - 2000 - 2000 Year 1 $1500 + 1500 Year 2 $ 500 + 500
Cash Flow -VS- Accounting Income Cash Income Project Cost Free Cash Flow Today - 2000 - 2000 Year 1 $1500 + 1500 Year 2 $ 500 + 500 Cash NPV = 2000 1500 ( 1 .
10 ) 1 500 ( 1 .
10 ) 2 $ 223 .
14
3.
4.
5.
Pro Forma Financial Statements and Project Cash Flows
Suppose we want to prepare a set of pro forma financial statements for a project for Norma Desmond Enterprises. In order to do so, we must have some background information. In this case, assume: 1.
Sales of 10,000 units/year @ $5/unit. 2.
Variable cost per unit is $3. Fixed costs are $5,000 per year. The project has no salvage value. Project life is 3 years.
Project cost is $21,000. Depreciation is $7,000/year. Additional net working capital is $10,000. The firm’s required return is 20%. The tax rate is 34%.
Pro Forma Financial Statements Projected Income Statements Sales $______ Var. costs Fixed costs Depreciation EBIT Taxes (34%) ______ $20,000 5,000 7,000 $______ 2,720 Net income $______
Pro Forma Financial Statements Projected Income Statements Sales $50,000 Var. costs 30,000 $20,000 Fixed costs Depreciation EBIT Taxes (34%) Net income 5,000 7,000 $ 8,000 2,720 $ 5,280
Projected Balance Sheets 0 NWC NFA $______ 21,000 Total Invest $31,000 1 $10,000 ______ $24,000 2 $10,000 ______ $17,000 3 $10,000 0 $10,000
Projected Balance Sheets 0 NWC NFA $10,000 21,000 Total $31,000 1 $10,000 14,000 $24,000 2 $10,000 7,000 $17,000 3 $10,000 0 $10,000
Now let’s use the information from the previous example to do a capital budgeting analysis.
Project operating cash flow (OCF): EBIT $8,000 Depreciation +7,000 Taxes OCF -2,720 $12,280
Project Cash Flows 0 OCF Chg. NWC Cap. Sp.
Total ______ -21,000 ______ 1 $12,280 2 $12,280 3 $12,280 ______ $12,280 $12,280 $______
Project Cash Flows 0 OCF Chg. NWC -10,000 Cap. Sp.
Total -21,000 -31,000 1 $12,280 2 $12,280 3 $12,280 10,000 $12,280 $12,280 $22,280
Capital Budgeting Evaluation: NPV = -$31,000 + $12,280/1.20
1 + $12,280/1.20 2 + $22,280/1.20 3 IRR = = $655 21% PBP AAR = = 2.3 years $5280/{(31,000 + 24,000 + 17,000 + 10,000)/4} = 25.76% Should the firm invest in this project? Why or why not?
Yes -- the NPV > 0, and the IRR > required return
Proposed Project
• Cost: $200,000 + $10,000 shipping +$30,000 installation.
• Depreciable cost $240,000.
• Inventories will rise by $25,000 and payables will rise by $5,000.
• Economic life = 4 years.
• Salvage value = $25,000.
• MACRS 3-year class.
Incremental gross sales = $250,000.
Incremental cash operating costs = $125,000.
Tax rate = 40%.
Cost of capital = WACC = 10%
0
Initial Outlay NCF 0 Set up without numbers a time line for the project CFs.
1
OCF 1 NCF 1
2
OCF 2 NCF 2
3 4
OCF 3 OCF 4 + Terminal CF NCF 3 NCF 4
What is the annual depreciation?
Year Rate 1 2 3 4 0.33
0.45
0.15
0.07
1.00
x Basis $240 240 240 240 Depreciation $ 79 108 36 17 $240 Due to half-year convention, a 3-year asset is depreciated over 4 years.
Operating cash flows ($000): Sales 1 2 3 4 $250 $250 $250 $250 Cash costs Depreciation EBIT Taxes (40%) 125 125 125 125 79 108 18 7 36 36 17 $ 46 $ 17 $ 89 $108 43 Net Income Add: Depreciation 28 79 10 108 53 36 65 17 Operating Cash flow $107 $118 $ 89 $ 82
Net Investment Outlay At t=0
Equipment Ship + Install ($200,000) (40,000) Change in NWC Net CF
0
(20,000) ($260,000)
NWC = $25,000 - $5,000
Net Terminal Cash Flow At t = 4
Salvage value Tax on SV Recovery on NWC Net Termination CF $25,000 (10,000) 20,000 $35,000
0
Project net CFs on a time line:
1 2 3 4 (260) 107 118 89 117
Enter CFs in CFLO register and I = 10.
NPV = $81,573 IRR = 23.8%
0
What is the project’s MIRR?
1 2 3 4 (260)
(260)
107 118 89 117
97.9
142.8
142.4
500.1
MIRR = ?
0
What is the project’s payback?
1 2 3 4 (260) 107 118 89 117
Cumulative: (260) (153) (35) 54 Payback = 2 + 35/89 = 2.4 years 171
If this were a replacement rather than a new project, would the analysis change?
Yes. The old equipment would be sold and the incremental CFs would be the changes from the old to the new situation.
• The relevant depreciation would be the change with the new equipment.
• Also, if the firm sold the old machine now, it would not receive the salvage value at the end of the machine’s life.
T10.15 Alternative Definitions
• The Tax-Shield Approach
of OCF (concluded)
OCF = (S - C - D) + D - (S - C - D) T = (S - C) (1 - T) + (D T) = (S - C) (1 - T) + Depreciation x T • The Bottom-Up Approach OCF = (S - C - D) + D - (S - C - D) T = (S - C - D) (1 - T) + D = Net income + Depreciation • The Top-Down Approach OCF = (S - C - D) + D - (S - C - D) T
T10.16 Chapter 10 Quick Quiz - Part 1 of 3
Assume we have the following background information for a project being considered by Gillis, Inc. • See if we can calculate the project’s NPV and payback period. Assume: Required NWC investment = $40; project cost = $60; 3 year life Annual sales = $100; annual costs = $50; straight line depreciation to $0 Tax rate = 34%, required return = 12%
T10.16 Chapter 10 Quick Quiz -
0 1 2 3 OCF Chg. in NWC -40 Cap. Sp.
-60 $39.8 $39.8
40 $39.8
-$100 $39.8 $39.8 $79.8
Payback period = ___________
T10.17 Example: A Cost-Cutting
Consider a $10,000 machine that will reduce pretax operating costs
Proposal
in net working capital and a scrap (i.e., market) value of $1,000 after five years. For simplicity, assume straight-line depreciation. The marginal tax rate is 34% and the appropriate discount rate is 10%.
Using the
tax-shield approach
to find OCF: OCF = (S - C)(1 - T) + (Dep T) = [$0 - (-3,000)](.66) + (2,000 .34)
T
= $1,980 + $680 = $2,660
= $1,000 - ($1,000 - 0)(.34) = $660
T10.17 Example: A Cost-Cutting Proposal (concluded)
The cash flows are Year OCF Capital spendingTotal 0 $ 0 1 2,660 2 2,660 3 4 2,660 2,660 -$10,000 0 0 0 0 -$10,000 2,660 2,660 2,660 2,660
T10.18 Chapter 10 Quick Quiz -
Cost Life Evaluating Cost Cutting Proposals
- Part 2 of 3
Depreciation= $180,000 per year = 5 years Salvage = $330,000 Cost savings = $500,000 per year, before taxes Tax rate
sign)
= 34 percent $220,000
(note the minus
1.
2.
3.
After-tax
cost saving: $500K
(______) = $______ per year.
Depreciation
tax shield
: $180K
______ = $______ per year.
After-tax
salvage value: $330K - ($330K - 0)(.34) = $______
T10.18 Chapter 10 Quick Quiz -
5 AT saving $330.0K
$330.0K$330.0K$330.0K$330.0K
Tax shield 61.2K 61.2K 61.2K 61.2K 61.2K
OCF $391.2K
_____ _____$391.2K$391.2K
Chg. in NWC____ Cap. Sp.-900K _____ 217.8K
- ____$391.2K$391.2K$391.2K$391.2K
T10.19 Example: Setting the Bid
The Army is seeking bids on Multiple Use Digitizing Devices (MUDDs). The contract calls for 4 units per year for 3 years. Labor and material costs are estimated at $10,000 per MUDD.
Price
equipment which is expected to have a salvage value of $10,000 after 3 years. Making MUDDs will require a $10,000 increase in net working capital. Assume a 34% tax rate and a required return of 15%. Use straight-line depreciation to zero.
Year Operating cash flow 0 1 2 3 $ 0 OCF OCF OCF Increases in NWC – $10,000 0 0 10,000 Capital spending Total = cash flow – $50,000 0 – $60,000 OCF 0 OCF + 6,600 OCF + 16,600
T10.19 Example: Setting the Bid
year 3 ( = $10,915 at 15%) and netting against the initial outlay of – $60,000 gives Total Year cash flow 0 1 2 – $49,085 OCF OCF
T10.19 Example: Setting the Bid
• The PV annuity factor for 3 years at 15% is 2.283.
Price (continued)
NPV = $0 = – $49,085 + (OCF 2.283), thus
$21,500 = Net income + $50,000/3 = Net income + $16,667 Net income = $4,833
Next, since annual costs are $40,000 + $12,000 = $52,000 Net income = (S
-
C
-
D)
(1 - T) $4,833 = (S
.66) - (52,000
.66) - (16,667
.66) S = $50,153/.66 = $75,989.73
Hence, sales need to be at least $76,000 per year (or $19,000 per MUDD)!
T10.19 Example: Setting the Bid
information.
Price (continued)
• 1. The bid calls for 20 MUDDs per year for 3 years.
• 2. Our costs are $35,000 per unit.
• 3. Capital spending required is $250,000; and depreciation = $250,000/5 = $50,000 per year • 4. We can sell the equipment in 3 years for half its original cost: $125,000.
• 5. The after-tax salvage value equals the cash in from the sale of the equipment, less the cash out due to the increase in our tax liability associated with the sale of the equipment for more than its book value:
T10.19 Example: Setting the Bid
• The cash flows ($000) are:
Price (continued)
0 1 2 3 OCF $OCF Chg. in NWC - $ 60 Capital Spending - 250 +115.25
$OCF $OCF + 60 ______
+$310,000 - 175,250/1.16
3 $197,724.74
= OCF
(1 - 1/1.16
3 )/.16
- $310 $OCF $OCF $OCF +
= OCF
2.2459
OCF =
175.25
$88,038.50/year
T10.19 Example: Setting the Bid
If the required OCF is $88,038.50, what price must we bid?
Price (concluded)
Sales Costs Depreciation EBIT Tax Net income $_________ 700,000.00
50,000.00
$_________ 24,319.70
$ 38,038.50
Sales = $62,358.20 + 50,000 + 700,000 = $812,358.20 per year, and
T10.20 Example: Equivalent Annual Cost Analysis
• Two types of batteries are being considered for use in electric golf carts at City Country Club. Burnout brand batteries cost $36, have a useful life of 3 years, will cost $100 per year to keep charged, and have a salvage value of $5. Longlasting brand batteries cost $60 each, have a life of 5 years, will
T10.20 Example: Equivalent Annual Cost Analysis (continued)
• Using the
tax shield
approach, cash flows for Burnout are: OCF = (Sales - Costs)(1 - T) + Depreciation(T) = (0 - 100)(.66) + 12(.34) = -$66 + 4 = -$62 Operating Capital Total Yearcash flow- spending= cash flow
T10.20 Example: Equivalent Annual Cost Analysis (continued)
for Longlasting are: OCF = (Sales - Costs)(1 - T) + Depreciation(T) $54 = (0 - 88)(.66) + 12(.34) = -$58 + 4 = Operating Capital Total Year flow OCF - spending = cash
T10.20 Example: Equivalent Annual Cost Analysis (continued)
• Using a 15% required return, calculate the cost per year for the two batteries.
Calculate the PV of the cash flows:
The present value of total cash flows for Burnout is -$175.40
The present value of total cash flows for
T10.20 Example: Equivalent Annual Cost Analysis (concluded)
What 3 year annuity has the same PV as Burnout?
The PV annuity factor for 3 years at 15% is 2.283: -$175.40 = EAC 2.283
EAC = -$175.40/2.283 = -$76.83
What 5 year annuity has the same PV as
T10.21 Chapter 10 Quick Quiz -
skills. Von Stroheim Manufacturing is considering investing in a lathe that is expected to reduce costs by $70,000 annually. The equipment costs $200,000, has a four-year life (but will be depreciated as a 3-year MACRS asset), requires no additional investment in net working capital, and has a salvage value of $50,000. The firm’s tax rate is 39% and the required return on investments in
T10.21 Chapter 10 Quick Quiz -
YearDep (%) Dep ($) 1 33.33%$_______ 2 44.44% 88,880 3 14.82% 4 7.41% 29,640 14,820 100% $200,000
T10.21 Chapter 10 Quick Quiz -
0 1 2 3 4 AT saving $42,700.0
$42,700.0$42,700.0$42,700.0
Tax shield 25,997.4 34,663.2 11,559.6 5,779.8
OCF $48,479.8
$68,697.4$77,363.2$54,259.6
Cap. Sp.-200,000 _______ -$200,000$68,697.4$77,363.2$54,259.6