McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.0 Chapter 9 Making Capital Investment Decisions

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.1 Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation itself is a non-cash expense Consequently, it’s only relevant because it affects taxes Depreciation tax shield = DT D = depreciation expense T = marginal tax rate

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.2 Computing Depreciation Straight-line depreciation = (Initial cost – salvage) / number of years Very few assets are depreciated straight-line for tax purposes Accelerated Cost Recovery System (ACRS): Depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.3 Computing Depreciation Modified ACRS (MACRS) Depreciation: The depreciation method currently allowed under US tax law governing the accelerated write-off of property under various lifetime classifications. Tables 9.6 and 9.7 – Page 250 Review the Example on pages 250 – 257

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.4 Evaluating NPV Estimates The NPV estimates are just that – estimates A positive NPV is a good start – now we need to take a closer look Forecasting risk – the possibility that we will make a bad decision because of errors in the projected cash flows Note: Positive NPV investments will be rare in a highly competitive environment High NPV values in the face of stiff competition could be troublesome - recheck Competition reaction s/b be evaluated

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.5 Evaluating NPV Estimates Sources of value – why does this project create value? Are we certain that our new product is significantly better than the competition? Can we truly manufacture at lower cost? Can we distribute more effectively? Have we identified an undeveloped market niche? Will this lead to control of the market?

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.6 Scenario Analysis (Page 260) Scenario Analysis – The determination of what happens to NPV estimates when we ask “what-if” questions At the very least look at: Best case scenario – revenues are high and costs are low Worst case scenario – revenues are low and costs are high Measure of the range of possible outcomes

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.7 Sensitivity Analysis (Page 261) Sensitivity Analysis – is the investigation of what happens to NPV when only “one” variable is changed. The greater the volatility in NPV in relation to a “specific” variable: the larger the forecasting risk associated with that variable and the more attention we want to pay to its estimation

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.8 New Project Example Consider the project discussed in the text The initial cost is $200,000 and the project has a 5-year life. There is no salvage. Depreciation is straight-line, the required return is 12% and the tax rate is 34% The base case NPV is 15,567

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.9 Summary of Scenario Analysis ScenarioNet Income Cash Flow NPVIRR Base case19,80059,80015, % Worst Case -15,51024, , % Best Case59,73099,730159, %

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.10 Summary of Sensitivity Analysis ScenarioUnit Sales Cash Flow NPVIRR Base case600059,80015, % Worst case ,200-8, % Best case650066,40039, %

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.11 Making A Decision Beware “Paralysis of Analysis” At some point you have to make a decision If the majority of your scenarios have positive NPVs, then 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, then you may want to forego the project

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.12 Managerial Options and Capital Budgeting Capital budgeting projects often provide other options that we have not yet considered Contingency planning - what action are we going to take if a certain situation occurs? Option to expand –if we truly find a positive NPV project, this is an obvious consideration. Can we expand the project or repeat it to get an even larger NPV? Option to abandon – the option to scale back or even abandon a project if it doesn’t cover expenses. We might be better off if we abandon it.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.13 Managerial Options and Capital Budgeting Option to wait – the project could be postponed in hopes of more favorable conditions. Market interest rates could change. Strategic options – options for future, related business products or strategies. stick a toe in before diving: i.e. open a retail outlet as a pilot study to gain market insight, evaluate whether or not to open more outlets, or change the product mix, etc.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.14 Capital Rationing Capital Rationing: The situation that exists if a firm has positive NPV projects but cannot obtain the necessary financing to undertake them. Soft Rationing: The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. Occurs when, different units in a business are allocated some fixed amount of money each year for capital spending. The corporation as a whole isn’t short of capital

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.15 Capital Rationing Hard Rationing: The situation that occurs when a business can’t raise financing for a project under any circumstances. Can occur when a company experiences financial distress – bankruptcy is a possibility.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.16 Suggested Homework: Know chapter theories, concepts and definitions Review “Project Cash Flow Example” on the web-site Self-Test Problem: 9.1 and Page Critical Thinking and Concepts Review: Questions 1, and 10 - Page Questions and Problems: Problem 3, 4, 9, 10, and 20 - Page