Chapter 10 Making Capital Investment Decisions 10.1Project Cash Flows: A First Look 10.2Incremental Cash Flows 10.3Pro Forma Financial Statements and Project Cash Flows 10.4More on Project Cash Flows 10.5Alternative Definitions of Operating Cash Flow 10.6Some Special Cases of Discounted Cash Flow Analysis 10.7Summary and Conclusions Vigdis Boasson Mgf301, School of Management, SUNY at Buffalo

10.2 Fundamental Principles of Project Evaluation 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 - 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.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.3 Incremental Cash Flows Incremental Cash Flows We are concerned only with those cash flows that are incremental and that result from a project. Incremental cash flows Do Not include:  Sunk costs  Opportunity costs  Side Effects  Net working capital  Financing costs

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.4 Incremental Cash Flows Non-Incremental Cash Flows:  Sunk costs :A cost that has already been incurred and cannot be removed.  Opportunity costs: Any cash flows lost or foregone by taking one course of action rather than another.  Side effects: Erosion: New project revenues gained at the expense of existing products /services.  Net working capital: New projects often require incremental investments in cash, inventories, and receivables that need to be included in cash flows if they are not offset by changes in payables. Later, as projects end, this investment is often recovered.  Financing costs: Cash flows associated with interest payments or principal on debt, dividends. Financing costs are reflected in the discount rate used to discount the project cash flows.  Other issues: Use After-tax cash flows.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.5 Example: Preparing Pro Forma Statements Prepare a set of pro forma financial statements for the following project:  1. Sales of 10,000 $5/unit = 50,000.  2. Variable cost/unit is $3 = 30,000.  Fixed costs are $5,000/year.  Project has no salvage value. Project life is 3 years.  3. Project cost is $21,000. Depreciation is $7,000/year.  4. Net working capital is $10,000.  5. The firm’s required return is 20%. The tax rate is 34%.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.5 Example: Preparing Pro Forma Statements (continued) Pro Forma Financial Statements Projected Income Statements Sales$50,000 Var. costs $30,000 $20,000 Fixed costs5,000 Depreciation7,000 EBIT $8, 000 Taxes (34%)2,720 Net income$5,280

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.5 Example: Preparing Pro Forma Statements (concluded) Projected Balance Sheets 0123 NWC $10,000 $10,000$10,000$10,000 NFA21,00014,0007,0000 Total$31,000$24,000$17,000$10,000

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.6 Project Cash Flows From the Pro Forma statements, compute: Cash flow from assets: = + operating cash flows - capital spending - additions to net working capital Operating cash flow (OCF) = + EBIT + depreciation - taxes

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.7 Example: Using Pro Formas for Project Evaluation Project operating cash flow (OCF): EBIT$8,000 Depreciation+7,000 Taxes-2,720 OCF$12,280

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.7 Example: Using Pro Formas for Project Evaluation (continued) Project Cash Flows 0123 OCF$12,280$12,280$12,280 NWC Sp.-10,00010,000 Cap. Sp.-21,000 Total-31,000$12,280$12,280$22,280

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.7 Example: Using Pro Formas for Project Evaluation (concluded) Capital Budgeting Evaluation: NPV = -$31,000 + $12,280/ $12,280/ $22,280/ = $655 IRR = 21% PB = 2.3 years AAR = $5280/{(31, , , ,000)/4} = 25.76% Should the firm invest in this project? Why or why not?

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.8 Calculating Initial Outlay Initial outlay includes:  + purchase price of the new assets  - selling price of the asset replaced  + costs of site preparation, setup, and startup  +/- increase (decrease) in tax liability due to sale of old asset at other than book value  = Net Capital Spending

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.9 Estimating Changes in Net Working Capital 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. Estimate changes in NWC. Assume: 1.Fixed asset spending is zero. 2.Net working capital spending is $200: 01ChangeS/U A/R$100$ U INV U -A/P U NWC$100$300 Chg. NWC = $200

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.9 Example: Estimating Changes in Net Working Capital (continued) Now, estimate operating and total cash flow: Sales$300 Costs200 Depreciation0 EBIT$100 Tax0 Net Income$100 OCF = EBIT + Dep. - Taxes = $100 Total Cash flow = OCF - Change in NWC - Capital Spending = = -$100

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo 10.10Modified ACRS Property Classes (Table 10.6) Accelerated cost recovery system (ACRS): a depreciation method under US tax law allowing for the accelerated write-off of property under various classification. ClassExamples 3-yearEquipment used in research 5-yearAutos, computers 7-yearMost industrial equipment

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Modified ACRS Depreciation Allowances (Table 10.7) Property Class Year 3-Year 5-Year 7-Year %20.00%14.29%

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo MACRS Depreciation: An Example Calculate the depreciation deductions on an asset which costs $30,000 and is in the 5-year property class: YearMACRS %Depreciation 120%$6, % 9, % 5, % 3, % 3, % 1, %$ 30,000

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Alternative Definitions of OCF Let: OCF = operating cash flow S= sales C= operating costs D= depreciation T c = corporate tax rate

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Alternative Definitions of OCF. 3 Alternative approaches:  Tax-shield approach  Bottom-up approach  Top-down approach A. The Tax-Shield Approach: OCF = (S - C - D) + D - (S - C - D) x T c = (S - C) x ( 1 - T c ) + (D x T c ) = (S - C) x (1 - T c ) + depreciation tax shield Suppose: S= $1000, C= $600, D= $200, T c = $34% Then, OCF = ( ) x (1 -.34) + (200 x.34) = = $332.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Alternative Definitions of OCF (concluded) B. The Bottom-Up Approach OCF =(S - C - D) + D - (S - C - D) x T c = (S - C - D) x (1 - T c ) + D = Net income + depreciation S= $1000, C= $600, D= $200, T c = $34% Then, OCF = ( ) x (1 -.34) = $332. C. The Top-Down Approach OCF = (S - C - D) + D - (S - C - D) x T c = (S - C) - (S - C - D) x T c = Sales - costs - taxes = ( ) - 68 = $332.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Chapter 10 Example: Calculate the project’s NPV and payback period. 1. Required NWC investment = $40; cost = $60; 3 year life 2.Annual sales = $100; annual costs = 50; 3. Straight line depreciation to $0 = $60/3= $20 per year. 3.Salvage value = $10; tax rate = 34%, required return = 12%  The after-tax salvage is: Market value -(Market value - Book value) x T c = $10 - ($ )(.34) = $6.6  OCF = ( ) ( )(.34) = $39.80

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Chapter 10 Example (concluded) Project cash flows are thus: 0123 OCF$39.8$39.8$39.8 Add. NWC-4040 Cap. Sp $39.8$39.8$86.4 Discount rate: 12% NPV = $28.76 Payback period = 2.24 years

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Example: A Cost-Cutting Proposal Using the tax-shield approach to find OCF OCF = (S - C) x (1 - T c ) + (D x T c ) = (0 - (-3,000))(.66) + (2,000 x.34) = $1,980 + $680 = $2,660 The after-tax salvage value = market value - (market value - book value) x (T c ) = $1,000 - ($1, )(.34) = $660 Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a scrap 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%.

Vigdis Boasson Mgf 301, School of Management, SUNY at Buffalo Example: A Cost-Cutting Proposal (concluded) The cash flows are: Year OCF Capital spendingTotal 00-10,000-10, ,66002,660 22,66002,660 32,66002,660 42,66002,660 52, ,320 NPV= Payback period =