Making Capital Investment Decisions Project Analysis FIN 301: Chapter 9

2Barton College Key Concepts and Skills Understand how to: –Determine the relevant cash flows for a proposed investment –Analyze a project’s projected cash flows –Evaluate an estimated NPV

3Barton College Chapter Outline 9.1Project Cash Flows: A First Look 9.2Incremental Cash Flows 9.3Pro Forma Financial Statements and Project Cash Flows 9.4More on Project Cash Flows 9.5Evaluating NPV Estimates 9.6Scenario and Other What-If Analyses 9.7Additional Considerations in Capital Budgeting

4Barton College Project Cash Flows Relevant Cash Flows –Are Incremental cash flows that occur only if the project is accepted –The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows Stand-Alone Principle –Projects stand alone and have their on cash flows, costs, assets –They are not part of another project (mutually exclusive) to avoid duplicated revenue streams, etc. –Allows the company to manage the projects that are accepted and or rejected, and thus manage overall risk. –“Mini Firms” or a portfolio of projects/firms as stated by the author… –Having “Mini Firms” allows the company to hedge risk by selecting a diversified portfolio of projects.

5Barton College Repeat Relevant Cash Flows are…. Cash flows that will occur only 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

6Barton College Relevant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the project Minus Corporate cash flow without the project

7Barton College Make sure the Cash Flow is Incremental….. Do not include the cash flow if it would occur without the project, i.e., it must be incremental or in addition to existing firm cash flows. –E.g., Building a new student center may increase enrollment, but how many would come otherwise? 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 incremental –If the answer is “no”, it should not be included in the analysis because it will occur anyway –If the answer is “part of it”, then we should include the part that occurs because of the project This may require a forecast or statistical estimate (i.e., forecast of the number of students when the student center is built)

8Barton College We Want to Consider Only Relevant Cash Flows “Sunk” Costs ………………………… N Opportunity Costs …………………... Y Side Effects/Erosion……..…………… Y Net Working Capital………………….. Y Financing Costs….………..…………. N Tax Effects ………………………..….. Y

9Barton College Issues Impacting Incremental Cash Flows Sunk Costs –Costs already incurred and cannot be considered in an investment decision(s). Opportunity Cost –The forgone opportunity we give up for using a resource for one thing but not another. Side Effects –Product Erosion (People buy the new Altima instead of the Maxima, etc.) –Product Tie-ins (Wilson Tennis Rackets  promotes the Wilson Tennis Balls) –Gillette Razors is a good example (dual blade  triple blade  quad blade) Shaving cream –Second Derivatives: Apple iPhone (iPhone cases), Oil (GE Locomotive Engines) Networking Capital –The short term demands of most projects require an investment in networking capital (inventories, cash, other expenses, etc.) Financing Cost –Are not considered when looking at incremental cash flow. They are looked at separately and should not be confused with the generation of cash from the asset…. It is already included in the discount rate… Others… –Always use after tax cash flows See Notes…. –We must always consider the tax implications of cash flow (Tax Shield)

10Barton College Derivative Businesses

11Barton College Pro-Forma Statements

12Barton College Cash Flow Model Cash Flow to Creditors Cash flow to creditors = Interest – net new debt = Interest – (Ending LTD – Beg LTD) Cash Flow to Stockholders (owners) Cash to owners = Dividends – net new equity (includes common stock and paid in capital) The cash flow identity Cash Flow from Assets = Cash flow to creditors + Cash flow to owners 1. Cash Flow of Assets (Firm) Cash flow from Assets = OCF – NCS – change NWC OCF = EBIT + Depreciation – tax NCS = Ending NFA – Beg NFA + Depreciation Change NWC = Ending NWC – Beg NWC Assets (Firm) OCF – change NWC NCS $ $ CFFA (Free Cash Flow) Creditors Stockholders (Owners) $ True Cash Flow From Operations Investments & Other non-operating Income Interest Dividends Retained Earnings Plowback

13Barton College 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 ΔNWC = Change in networking capital

14Barton College See Backup Slides Profit = Sales – Total Costs…

15Barton College Shark Attractant Project P-279 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%

16Barton College Pro Forma Income Statement Table 9.1 Sales (50,000 units at $4.00/unit)$200,00 0 Variable Costs ($2.50/unit)125,000 Gross profit$ 75,000 Fixed costs12,000 Depreciation ($90,000 / 3)30,000 EBIT$ 33,000 Taxes (34%)11,220 Net Income$ 21,780

17Barton College Projected Capital Requirements Table 9.2 (Book Value) Year 0123 NWC$20,000 Net Fixed Assets 90,000 60,000 30,000 0 Total Investment $110,000$80,000$50,000$20,000 NFA declines by the amount of depreciation each year Investment = book or accounting value, not market value

18Barton College 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 OCF = EBIT + depreciation – taxes = 33, ,000 – 11,220 = 51,780; or OCF = NI + depreciation = 21, ,000 = 51,780

19Barton College Shark Attractant Project OCF = EBIT + Depreciation – Taxes OCF = Net Income + Depreciation (if no interest)

20Barton College Computing NPV for the Project Using the TI BAII+ CF Worksheet DisplayYou Enter CF, 2 nd, CLR WORK C Enter, Down C Enter, Down F01 2 Enter, Down C Enter, Down F021 Enter, NPV I20 Enter, Down NPVCPT IRR, CPT Cash Flows: CF0= CF1= CF2= CF3= 71780

21Barton College Making The Decision Should we accept or reject the project?

22Barton College The Tax Shield Approach to OCF OCF = (Sales – costs)(1 – T) + Deprec*T C OCF=(200, ,000) x 66% + (30,000 x.34) OCF = 51,780 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

23Barton College Changes in NWC GAAP requirements: –Sales recorded when made, not when cash is received Cash in = Sales – ΔAR –Cost of goods sold recorded when the corresponding sales are made, whether suppliers paid yet or not Cash out = COGS – ΔAP Buy inventory/materials to support sales before any cash collected

24Barton College 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 = DT –D = depreciation expense –T = marginal tax rate

25Barton College Computing Depreciation Straight-line depreciation D = (Initial cost – salvage) / number of years Straight Line  Salvage Value MACRS (Modified accelerated cost recovery system) Depreciate  0 Recovery Period = Class Life 1/2 Year Convention Multiply percentage in table by the initial cost

26Barton College IRS Depreciation Rules

27Barton College After-Tax Salvage If the salvage value is different from the book value of the asset, then there is a tax effect Book value = initial cost – accumulated depreciation After-tax salvage = salvage – T(salvage – book value) Market Value Effect of depreciation or recapture Costs

28Barton College Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate Book = Salvage Net Salvage Value = SP(1-T)

29Barton College Example: Depreciation and After-tax Salvage Car purchased for $12,000 5-year property Marginal tax rate = 34%.

30Barton College Salvage Value & Tax Effects Net Salvage Cash Flow = SP - (SP-BV)(T) If sold at EOY 5 for $3,000: NSCF = 3,000 - ( )(.34) = $2, = $3,000 – = $2, If sold at EOY 2 for $4,000: NSCF = 4,000 - ( ,760)(.34) = $4, = $4,000 – ( ) = $4, Too much Depreciation Too little Depreciation

31Barton College Some Modeling Rules 1. Don’t make your model too complex…….GIGO…… 2. Create a common location for making input assumptions a.- Variable Costs, Price, Units Sold, Discount Rate, etc. 3. Create a common location for showing outputs of the model a.NPV, IRR, PI, Payback, ROI, etc. 4. As numbers 1-3 become more expansive, numbers 1-3 become even more important; (use relative and absolute referencing between pages and within sheets to compartmentalize your work 5. Remember, others may need to understand your “numbers” and how you derived the assumptions.

32Barton College Majestic Mulch & Compost Co

33Barton College Majestic Mulch & Compost Co Given Data and Projected Revenues – Table 9.9

34Barton College Majestic Mulch & Compost Co Depreciation and After-Tax Salvage - Table 9.10

35Barton College Majestic Mulch & Compost Co Net Working Capital – Table 9.12

36Barton College Majestic Mulch & Compost Co MMC Pro Forma Income Statements

37Barton College Majestic Mulch & Compost Co MMC Projected Cash Flows – Table 9.14

38Barton College Evaluating NPV Estimates NPV estimates are only estimates Forecasting risk: –Sensitivity of NPV to changes in cash flow estimates The more sensitive, the greater the forecasting risk Sources of value Be able to articulate why this project creates value

39Barton College Scenario Analysis Examines several possible situations: –Worst case –Base case or most likely case –Best case Provides a range of possible outcomes

40Barton College Scenario Analysis Example Note: “Lower” ≠ Worst “Upper” ≠ Best

41Barton College Scenario Analysis Example

42Barton College Problems with Scenario Analysis Considers only a few possible out-comes Assumes perfectly correlated inputs –All “bad” values occur together and all “good” values occur together Focuses on stand-alone risk, although subjective adjustments can be made

43Barton College Sensitivity Analysis Shows how changes in an input variable affect NPV or IRR Each variable is fixed except one – Change one variable to see the effect on NPV or IRR Answers “what if” questions

44Barton College Sensitivity Analysis: Unit Sales

45Barton College Sensitivity Analysis: Fixed Costs

46Barton College Sensitivity Analysis: Strengths –Provides indication of stand-alone risk. –Identifies dangerous variables. –Gives some breakeven information. Weaknesses –Does not reflect diversification. –Says nothing about the likelihood of change in a variable. –Ignores relationships among variables.

47Barton College Disadvantages of Sensitivity and Scenario Analysis Neither provides a decision rule. –No indication whether a project’s expected return is sufficient to compensate for its risk. Ignores diversification. –Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting.

48Barton College Managerial Options Contingency planning Option to expand –Expansion of existing product line –New products –New geographic markets Option to abandon –Contraction –Temporary suspension Option to wait Strategic options

49Barton College 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 The profitability index (PI) is a useful tool when faced with soft rationing

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51Barton College Review A few Relationships Variable Cost = VC = Q * V –V = cost per unit –Q = number of units FC = Fixed Cost Total Cost = TC = FC + VC Sales (S) = Revenue = P * Q –P = Price per unit Operating Profit = Sales – TC Depreciation = D Operating Profit = EBIT Operational Cash Flow = OCF = EBIT + D - Taxes We know that: –OCF = EBIT + D – Tax –OCF = (S - VC - FC) - D) + D – Tax –OCF = S – VC – FC – Tax –OCF = (PxQ) – (VxQ) – FC - Tax Marketing & Sales Manufacturing, Control & Supply Chain

52Barton College 2 nd Version of Majestic Mulch

53Barton College More Complex