Presentation on theme: "Making Capital Investment Decisions"— Presentation transcript:
1 Making Capital Investment Decisions Chapter 10Making Capital Investment Decisions
2 Relevant Cash FlowsA change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project.These cash flows are called incremental cash flowsIncremental cash flows: the difference between a firm’s future cash flows with a project and those without the projectIrrelevant cash flows
3 The stand-alone principle The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
4 Asking the Right Question You should always ask yourself “Will this cash flow occur ONLY if we accept the project?”If the answer is “yes,” it should be included in the analysis because it is incrementalIf the answer is “no,” it should not be included in the analysis because it will occur anywayIf the answer is “part of it,” then we should include the part that occurs because of the project
5 Common Types of Cash Flows Sunk cost: a cost that has already been incurred and can’t be removed.Opportunity cost: the cost of giving up a valuable alternative if a particular investment is undertaken.Side effects: a) negative impact on the cash flows of an existing product from the introduction of a new product (erosion)b) Positive impact
6 Common Types of Cash Flows Net working capital:Financing costs:
7 Notes Financial manager is interested in: Cash flows When these cash flows actually occursAfter-tax cash flowsNote thatIncremental cash flows are after-tax cash flowsDifferentiate between: after-tax cash flows, accounting profit and net income
8 Pro Forma Statements and Cash Flow Financial statements projecting future years’ operationsCapital budgeting relies heavily on pro forma accounting statements, particularly income statementsComputing cash flows – refresherOperating Cash Flow (OCF) = EBIT + depreciation – taxesOCF = Net income + depreciation (when there is no interest expense)Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC
9 ExampleIf Pepsi can sell 50,000 cans per year of a new product line for 4$ per can. It costs 2.5$ per can, this product line has three- year life with a required rate of return of 20%. There will be 12,000$ fixed costs per year, Pepsi will need to invest a total of 90,000$ in manufacturing equipment which will be 100 percent depreciated. In addition the project will require an initial 20,000$ investment in networking capital, and the tax rate is 34 percentPrepare a pro forma income statementCalculate the total investment for each yearCalculate the total project cash flowsCalculate the NPV
10 Ex 1 Page 327Parker & stone Inc., is looking at setting up a new manufacturing plant in south park to produce garden tools. The company bought some land six years ago for 6$ million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net 6.4$ million. The company wants to build its manufacturing plant on this land; the plant will cost 14.2$ million to build, and the site requires 890,000$ worth of grading before its suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating the project? Why?
11 Ex 3 Page 328A proposed new investment has projected sales of 830,000$. Variable costs are 60 percent of sales, and fixed costs are 181,000$; depreciation is 77,000$. Prepare a pro forma income statement assuming a tax rate of 35 percent. What is the projected net income?
12 Ex 4 Page 328 Consider the following income statement: 824,500sales538,900costs126,500Depreciation?EBITTaxes(34%)Net incomeFill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
13 Ex 9,10 Page 328Summer Tyme, Inc., is considering a new three-year expansion project that requires an initial fixed asst investment of 3.9$ million. That fixed asset will be depreciated straight-line to zero over the three-year tax life. After which time it will be worthless. the project is estimated to generate 2,650,000$ in annual sales, with the cost of 840,000$. If the tax rate is 35 percent, what is the OCF for this project?Suppose that the required rate of return is 12 percent, what is the NPV?
14 More on NWC Why do we have to consider changes in NWC separately? GAAP requires that sales be recorded on the income statement when made, not when cash is receivedGAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yetFinally, we have to buy inventory to support sales, although we haven’t collected cash yet
15 ExampleSuppose that during a particular year of a project we have the following simplified income statementDepreciation and taxes are zero, no fixed assets are purchased during the year. Also assume that the only components of networking capital are account receivables and payable. The beginning and ending amount for these accounts are as follows500Sales310Costs190Net incomechangeEnding of yearBeginning of year30910880AR55605550AP-25305330NWC
16 DepreciationDepreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxesDepreciation tax shield = DTD = depreciation expenseT = marginal tax rate
17 Computing Depreciation Straight-line depreciationD = (Initial cost – salvage) / number of yearsVery few assets are depreciated straight-line for tax purposesMACRSNeed to know which asset class is appropriate for tax purposesMultiply percentage given in table by the initial cost
18 ExampleConsider an automobile costing 12,000$. What is the depreciation using the MACRS method?examplesclassEquipments used in researchThree-yearAutos, computersFive-yearMost industrial industriesSeven-yearProperty classSeven-yearFive-yearThree-yearyear14.29%20.00%33.33%124.493244.45217.4919.2014.81312.4911.527.4148.9358.925.76674.468
19 After-tax SalvageIf the salvage value is different from the book value of the asset, then there is a tax effectBook value = initial cost – accumulated depreciationAfter-tax salvage = salvage – T(salvage – book value)
20 MARCS Book values Ending book value depreciation Beginning book value Year9,6002,40012,000123456
21 Example: Depreciation and After-tax Salvage You purchase equipment for $100,000, and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following situations?Suppose the appropriate depreciation schedule is straight-lineWhat is the depreciation using the MACRS method (three years)? What is the end-year book value? What is the after-tax salvage?What is the depreciation using the MACRS method (seven years)? What is the end-year book value? What is the after-tax salvage?
22 Ex 6 Page 328A piece of newly purchased industrial equipment costs 1,080,000$ and its classified as seven-year property under MARCS. Calculate the annual depreciation allowance and end-of-the year book values for this equipment
23 Book value versus Market value The book value of an asset can differ substantially from its actual market valueThe difference between book and market value will affect taxes
24 The Majestic Mulch and Compost Company (Example) the company is investigating the feasibility of a new line of power mulching tools. MMCC projects unit sales as follows:Unit salesyear3,00015,00026,00036,5004564,00078
25 The Majestic Mulch and Compost Company (Example) The new Mulcher will sell for 120$ per unit to start. After three years MMCC anticipates that the price will drop to 110$ due to competition. The company will require 20,000$ networking capital at the start. After that the networking capital will be about 15 percent of sales for that year. The variable cost per unit is 60$, and the total fixed costs are 25,000$ per year. It will cost about 800,000$ to buy the equipment and it will be worth about 20 percent of its cost in eight years. The relevant tax rate is 34 percent ant the required return is 15 percent. Based on this information, should MMCC proceed?
26 The Majestic Mulch and Compost Company (Example) Calculation of sales = unit price * number of unitsRevenuesUnit salesUnit priceyear360,000$3,000120$1600,0005,0001202720,0006,0003715,0006,5001104660,0005550,0006440,0004,0007330,0008
27 The Majestic Mulch and Compost Company (Example) Calculation of depreciation= MARCS percentage * initial costEnding book valuedepreciationMARCS percentageyear685,680114,32014.29%1489,760195,92024.492349,840139,92017.493249,92099,92012.494178,48071,4408.935107,12071,3608.92635,68074.468
28 The Majestic Mulch and Compost Company (Example) year87654321330,000440,000550,000660,000715,000720,000600,00036,000revenues180,000240,000300,000360,000390,000VC25,000FC35,68071,44071,36099,920139,920195,920114,320Dep89,320103,560153,640203,560200,080195,08079,08040,680EBIT30,36935,21052,23869,21068,02766,32726,88713,831Tax(34%)58,95168,350101,402134,350132,053128,75352,19326,849NI
29 The Majestic Mulch and Compost Company (Example) Calculation of OCF = EBIT + Dep - Taxyear8765432189,320103,560153,640203,560200,080195,08079,08040,680EBIT35,68071,44071,36099,920139,920195,920114,320Dep30,36935,21052,23869,21068,02766,32726,88713,831Tax(34%)94,631139,790172,762205,790231,973268,673248,113141,169OCF
30 The Majestic Mulch and Compost Company (Example) Calculation of NWC for each year= sales * 0.15Change in NWC= ending NWC – Beg NWCCash flowNWCRevenuesyear20,000360,000$1600,0002720,0003715,0004660,0005550,0006440,0007330,0008
31 The Majestic Mulch and Compost Company (Example) year87654321-20,000Initial NWCChange in NWCNWC recoveryTotal change in NWC
32 The Majestic Mulch and Compost Company (Example) Calculation of salvage = 0.2 * initial costAfter-tax salvage = salvage – T (salvage – BV)year87654321-800,000Initial costAfter-tax salvageCapital spending
33 The Majestic Mulch and Compost Company (Example) Calculation of total CF= OCF – change in NWC- NCSyear87654321OCFChange in NWCNCSTotal CFCumulative CFPv of CF
34 Other Methods for Computing OCF If you have the following information:Sales = 1,500$Costs = 700$Depreciation = 600$Tax rate = 34%No interestCalculate the OCF
35 Other Methods for Computing OCF Bottom-Up ApproachWorks only when there is no interest expenseOCF = NI + depreciationTop-Down ApproachOCF = Sales – Costs – TaxesDon’t subtract non-cash deductionsTax Shield ApproachOCF = (Sales – Costs)(1 – T) + Depreciation*T
36 Depreciation tax shield The tax saving that results from the depreciation deductionDepreciation * tax rate
37 Ex 8 Page 328An asset used in a four-year project falls in the five-year MARCS class for tax purpose. The asset has an acquisition cost of 7,900,000$ and will be sold for 1,400,000$ at the end of the project. If the tax rate is 35 percent. What is the after tax salvage value of the asset?
38 Ex 32 Page 332Aguilera Acoustics, Inc. (AAI), projects unit sales for a new seven-octave voice emulation implant as followsUnit salesyear93,0001105,0002128,0003134,000487,0005
39 Ex 32 Page 332Production of the implants will require 1,800,000$ in networking capital to start and additional networking capital investments each year equal to 15 percent of the projected sales increase for the following year. Total fixed costs are 1,200,000$ per year, variable production costs are 265$ per unit, and the units priced at 380$ each. The equipment needed to begin production has an installed cost of 24,000,000$.becasue the implants are intended for professional singers, this equipment is considered industrial machinery and thus qualified as seven-year MARCS property. In five years, this equipment can be sold about 20 percent of its acquisition cost.AAI is in the 35 percent marginal tax and has a required return on all its projects of 18 percent. Based on these estimates, what is the NPV?