Transcript Chapter 7: Making capital investment decisions Corporate Finance Ross, Westerfield, and

Chapter 7: Making capital
investment decisions
Corporate Finance
Ross, Westerfield, and
Jaffe
Outline
7.1 Relevant cash flows
7.2 A comprehensive example
So far, we have learned…
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We need to evaluate a new project using the TVM
technique.
That is, we should discount future expected cash
flows (specifically, FCFs) back to present time and
compare PV to initial costs: whether NPV > 0?
The appropriate discount rate is WACC, which is a
function of the cost of debt and the cost of equity.
We can use the CAPM to estimate the cost of equity.
In 7.2, we would like to put all these into a
comprehensive example.
Relevant cash flows
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But before we do this, a few notions about
cash flows need to be addressed.
The cash flows in the capital-budgeting time
line need to be relevant cash flows; that is
they need to be incremental in nature.
The cash flows that should be included in a
capital budgeting analysis are those that will
only occur if the project is accepted.
Ask the right question before you
make a mistake
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You should always ask yourself “Will this
cash flow occur ONLY if we accept the
project?”
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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.
Sunk costs
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A sunk cost is a cost that has already
occurred regardless of whether the project is
accepted.
Example: consulting fee for evaluating a
project.
Sunk costs should not be taken into
consideration when evaluating a project.
Opportunity costs
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Opportunity costs (OCs) are the costs of
giving up the second best use of resources.
Example: a vacant land.
Opportunity costs should be taken into
consideration when evaluating the project.
Side effects
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Accepting a new project may have side effects.
Erosion occurs when a new project reduces the
sales and cash flows of existing projects.
Synergy occurs when a new project increases the
sales and cash flows of existing projects.
Cash flows due to erosion and synergy are
incremental cash flows.
A comprehensive example, I
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Suppose that we are considering a new project
which has a life of 3 years.
The firm uses no debt; i.e., no interest expenses.
The initial capital investment is $90,000. The firms
use 3-year straight-line depreciation to write off the
$90,000 capital investment.
Suppose that the pro forma income statements for
year 1, year 2, and year 3 look the same (in real life,
they are of course unlikely to be identical).
For each year, it looks like the following:
A comprehensive example, II
Sales (50,000 units at $6.00/unit)
Variable Costs ($4/unit)
Gross profit
Fixed costs
Depreciation ($90,000 / 3)
EBIT
Taxes (30%)
Net Income
$300,000
$200,000
$100,000
$40,000
$30,000
$30,000
$9,000
$ 21,000
A comprehensive example, III
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Operating cash flow (OCF) = EBIT + depreciation –
taxes = 30,000 + 30,000 – 9,000 = 51,000.
Suppose that the firm needs to invest $25,000 in net
working capital (NWC) and expects to recover this
investment at the end of the project.
Suppose that in addition to the initial capital
investment and the investment in NWC, this project
also require the use of vacant facility, which the firm
can lease it out for a total of $10,000 over the 3-year
period.
A comprehensive example, IV
Year
0
1
2
3
OCF
$51,000 $51,000 $51,000
NWC -$25,000
$25,000
C0
-$90,000
OC
-$10,000
CF
-$125,000 $51,000 $51,000 $76,000
A comprehensive example, V
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Suppose the WACC for the project is 10%.
NPV = -125,000 + 51,000 / (1 + 10%) +
51,000 / (1 + 10%)2 + 76,000 / (1 + 10%)3 =
$20,612.32.
Should we accept the project ?
Because the firm uses no debt, what is the
WACC?