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9-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

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Presentation on theme: "9-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin."— Presentation transcript:

1 9-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2 9-2 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

3 9-3 Re levant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the project Minus Corporate cash flow without the project

4 9-4 Relevant Cash Flows “Sunk” Costs ………………………… N Opportunity Costs …………………... Y Side Effects/Erosion……..…………… Y Net Working Capital………………….. Y Financing Costs….………..…………. N Tax Effects ………………………..….. Y

5 9-5 Sunk costs Costs that have already been incurred Won’t change if the project is accepted or rejected NOT relevant

6 9-6 Opportunity Costs alternatives that will be given up if the project is undertaken Undertaking project A means you won’t have the resources to do activity B

7 9-7 Side Effects/Erosion Positive side effects: benefits to other projects Negative side effects: costs to other projects –Erosion: cash flows of new project come at the expense of an existing project –Need to adjust cash flows downward to reflect lost profits

8 9-8 Net Working Capital P roject requires investment in net working capital in addition to long term assets –Inventories and accounts receivable may be needed for the project –Accounts payable will be incurred to cover some of the inventory and accounts receivable, but company will need to make an investment to cover the rest Firm’s investment in Net Working Capital resembles a loan

9 9-9 Financing Costs The mixture of debt and equity impacts how the project cash flow is divided between owners and creditors

10 9-10 Tax Effects Consider after tax cash flow

11 9-11 Pro Forma Statements and Cash Flow Pro Forma Financial Statements –Projects future operations 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 9-12 Shark Attractant Project Estimated sales50,000 cans Sales Price per can$4.00 Cost per can$2.50 Estimated life3 years Fixed costs$12,000/year Initial equipment cost$90,000 –100% depreciated over 3 year life Investment in NWC$20,000 Tax rate34% Cost of capital20%

13 9-13 Pro Forma Income Statement Table 9.1 Sales Variable Costs Gross profit Fixed costs Depreciation EBIT Taxes (34%) Net Income

14 9-14 Operating Cash Flow OCF = EBIT + Depreciation – Taxes OCF when there is no interest expense = Net income + depreciation

15 9-15 Projected Total Cash Flows Table 9.5 Year 0123 OCF$51,780  NWC -$20,00020,000 Capital Spending -$90,000 CFFA-$110,00$51,780 $71,780 Note:Investment in NWC is recovered in final year Equipment cost is a cash outflow in year 0

16 9-16 Projected Total Cash Flows Table 9.5 Year 0123 OCF$51,780  NWC -$20,00020,000 Capital Spending -$90,000 CFFA-$110,00$51,780 $71,780 Calculate PV of Cash flows

17 9-17 Making The Decision Should we accept or reject the project?

18 9-18 The Tax Shield Approach to OCF OCF = (Sales – costs)(1 – T) + Deprec*T OCF is broken down into 1- Cash flow without depreciation 2- Depreciation tax shield: tax savings resulting from the depreciation deduction Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield –i.e., choosing between two different machines

19 9-19 Depreciation & Capital Budgeting Use the schedule required by the IRS for tax purposes Depreciation = non-cash expense –Only relevant due to tax affects Depreciation tax shield = D*T –D = depreciation expense –T = marginal tax rate

20 9-20 Computing Depreciation Straight-line depreciation D = (Initial cost – salvage) / number of years Straight Line  Salvage Value MACRS Depreciate  0 Recovery Period = Class Life 1/2 Year Convention Multiply percentage in table by the initial cost

21 9-21 After-Tax Salvage If the salvage value is different from the book value of the asset, then there is a tax effect –If book value is higher than selling price, the fixed asset is sold at a __________ –If book value is lower than selling price, the fixed asset is sold at a __________

22 9-22 After-Tax Salvage Loss X tax rate = tax savings from loss Gain X tax rate = tax on gain

23 9-23 Cash Flow When Fixed Asset is Sold Fixed Asset sold at a loss: Cash flow in the year of the sale = selling price + tax savings from loss Fixed Asset sold at a gain: Cash flow in the year of the sale = selling price – tax on gain

24 9-24 Evaluating NPV Estimates NPV estimates are only estimates Forecasting risk: the possibility that errors in projected cash flows will lead to incorrect decisions; also called estimation risk –Sensitivity of NPV to changes in cash flow estimates The more sensitive, the greater the forecasting risk

25 9-25 Evaluating NPV Estimates Sources of value Be able to articulate why this project creates value A positive NPV is rare in a highly competitive market View a positive NPV with some suspicion

26 9-26 Scenario Analysis Examines several possible situations: –Worst case –Base case or most likely case –Best case Provides a range of possible outcomes

27 9-27 Sensitivity Analysis Shows how changes in an input variable affect NPV Each variable is fixed except one – Change one variable to see the effect on NPV If NPV is sensitive to small changes to one variable, then forecasting risk is high for that variable Can identify the variable that deserves the most attention

28 9-28 Sensitivity Analysis: Strengths –Provides indication of stand-alone risk. –Identifies dangerous variables. –Gives some breakeven information. Weaknesses –Says nothing about the likelihood of change in a variable, –Ignores relationships among variables.

29 9-29 Making a Decision Beware of “paralysis of analysis” If the majority of your scenarios have positive NPVs, you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, than you may want to forgo the project

30 9-30 Managerial Options Contingency planning Option to expand Option to abandon Option to wait Strategic options

31 9-31 Contingency planning What actions do we take if things don’t go as planned?

32 9-32 Option to expand if project has positive NPV, can the project be expanded or repeated to get an even larger NPV –Can sales be increased? –Can production be increased? –Can the selling price be raised?

33 9-33 Option to abandon if project doesn’t cover expenses, then abandon it Discounted cash flow analysis assumes operations will continue to the end –Instead, sell or redesign

34 9-34 Option to wait Could wait for a more favorable discount rate Could make changes to the project

35 9-35 Strategic options Project may be undertaken in order to develop future related projects or strategies Hard to put value on projects that allow the company to gain experience or entrance into a new market

36 9-36 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

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