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Lecture 7: Capital Budgeting, part 2

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1 Lecture 7: Capital Budgeting, part 2
C. L. Mattoli

2 Last Week We finally got to apply what we have learned about valuation to the business setting, and we discussed several methods on which to base investment decisions. In this lecture, we fill out the discussion by taking a closer look at cash flows and their estimation. We also look at other ancillary considerations in the capital budgeting process. In the textbook, chapter 9.

3 What Cash Flows?

4 Intro Since the focus, in finance, as we have learned, is cash flows, we must be careful to include the proper cash flows and exclude improper ones in our evaluation. Two things should be noted, before hand. First, companies may spend some money, in the ordinary course of their business, looking at and for new business ideas (projects). What will be important is the net cash flows that a project adds to the firm.

5 Sunk Costs There are some unusual costs that are part of business project evaluation. Sunk costs are costs that a business incurs in looking at potential projects, in its regular course of business. They are liabilities that must be paid whether or not the project is actually undertaken. An example is a fee for a market analysis for a potential new product.

6 Sunk Costs R&D is done by, e.g., drug companies as part of their ordinary course of business and is not project specific. Consider another example. A company rents space for its business at $1 per square meter and has separate extra lockable space that it is not currently using. Should it rent out the space for less than $1 per SQM? Yes, because the rent that it pays is a sunk cost, and any revenue from subleasing some unused space is an additional benefit.

7 Opportunity Costs We have already seen how opportunity cost can enter economic and financial problems. The opportunity cost concept also arises in business project evaluation. Basically, opportunity costs are in terms of what you give up. For example, suppose you own a building that you paid $500,000 for, 10 years ago. Due to new zoning laws, you are now allowed to convert the building into apartments.

8 Opportunity Costs If you decide to go ahead and make the conversion, how do you treat the building cost? Since you already bought it before the project idea even arose, the $500,000 that you paid for it is a sunk cost. The opportunity cost that should be included in your evaluation of the apartment project, however, is how much you could sell it for, today, in the market.

9 Opportunity Costs Consider an other example. You buy a new piece of equipment that needs to be installed somewhere in our plant. If the space to install it has a competing possibility, such as another piece of equipment for another project, then, we should include the opportunity cost in our analysis. If there is no other potential use for the space, then, no space opportunity cost should be included.

10 Incremental Cash Flow To truly analyze the cost and benefits of adding a new business to an existing business, we have to consider all of the changes in cash flow of the whole business that are associated with the project. In other words, we consider the total net affect of the new business on cash flows. The relevant project CF’s are, therefore, incremental cash flows, the net additions or subtractions of cash flow of the whole firm.

11 Incremental Cash Flow In that regard, we do not have to actually calculate the whole of cash flows of the firm with and without the project. We only have to figure out the incremental cash flows of the project. That is known as the stand alone principle. We evaluate the project incremental cash flows, considering it as a stand alone business.

12 Incremental Example Suppose we have the following comparison of cash flows for some year in the life of a project. Project Implemented – Project Not Implemented = Increment Sales 12000 9000 3000 Cash op. cost (5000) (4000) (1000) Depreciation (2000) Pre-tax income 5000 4000 1000 Taxes (30%) (1500) (1200) (300) = Net oper. inc. 3500 2800 700 + depreciation 2000 =Operating Cash flow 5500 3800 1700

13 Why incremental? What incremental?
Consider a company that makes tooth paste. Next, assume that they want to introduce a second brand of tooth paste. One possibility is that some of the customers that used their original toothpaste might switch, so the incremental revenue from the new toothpaste will be new revenues from new toothpaste minus lost sales of old toothpaste (called erosion).

14 Why incremental? What incremental?
Alternatively, the new customers who try the new toothpaste might be so impressed with the product that they decide to try other products that the company makes, like soap. Then, the incremental revenues from the new toothpaste will be the new toothpaste sales plus the additional sales generated by new toothpaste customers who also decide to buy soap that the company makes.

15 NWC and Projects As we mentioned in an earlier lecture, startup costs for a business will involve more than just things like equipment purchase. Project startup will also involve working capital. For example, if you start a clothing boutique, you will have to buy some inventory for startup. Suppose that you estimate that your monthly sales will be $100,000, and you will be making about 25% of sales on credit.

16 NWC and Projects Then, you will also need room, in the beginning, for A/R of $25,000. If you only have $100,000 for inventor, then, when you sell the original inventory, you will only have $75,000 in cash to purchase the next month’s inventory. You needed to think ahead and also have an extra $25,000 for startup to eventually have A/R of $25,000, so WC startup will require $100,000 + $25,000 = $125,000.

17 What about Financing Costs?
We do not include interest, dividends or other financing charges of as project. As discussed in an earlier module, we are interested in CF from assets. Moreover, the motivation of the analysis is to compare the CF from assets to the cost of acquiring them. Interest and financing are part of CF to creditors and investors and the financing, not the investment, decision.

18 When CF’s? We focus on the actual cash flows, not accounting numbers.
Technically, we should focus on when those cash flows arrive, not when they accrue, since we know about time value. In practice, though, we usually assume that they all come at the end of each period under evaluation. That gives the most conservative estimate of time value, too. We should usually also be interested in after tax CF since tax is an actual outflow, although there will be cases, under Australian tax law, when we should focus on BT CF.

19 Pro forma Financial Statements and projected CF’s

20 Intro Pro forma statements can be prepared for the future for projects. We need estimates of things, like unit price, number of expected sales, VC/unit, FC/unit. We also need to collect all of the relevant costs of startup, including equipment and installation costs, as well as WC requirements of the project. We can them organize the data so it will be useful for analysis.

21 Example (Textbook) It is expected that 50,000 cans of shark attractant can be sold per year at a price of $4/can. The VC = $2.50/unit, and FC = $12,000/year for rental of space. In addition, equipment will cost $90,000 and will be depreciated over the life of the project, which will be 3 years.

22 Example (Textbook) The equipment will be worthless at the end.
An investment in WC = $20,000 will also be required for startup. The project will have a 3 year life and require an RRR of 20%. We show a pro forma income statement , in the next slide.

23 Text Table 9.1 Pro Forma Income
Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (30%) 9,900 Net Income $ 23,100

24 Example CF’s We define project CF’s as PCF = OCF – ΔNWC – CS. (Recall OCF = EBIT + Depreciation (D) – Taxes (T)). From the income statement, we can find the annual project CF’s in the future years, as PCF = $33,000 + $30,000 - $9,900 = $53,100. The initial investment is IIO = Equipment + ΔWC = $90,000 + $20,000 = $110,000.

25 Example CF’s The IIO is an negative CF since it is an outlay.
The summary of PCF’s for all years is shown, below. Year 1 2 3 OCF $53,100 ΔNWC -$20,000 20,000 CS -$90,000 TCF -$110,00 $73,100

26 WC recovery WC initial investment is normally recovered at the end of the project (unless otherwise specifically stated in a problem). For example, if we invest in inventory, in the beginning, it will have been sold and included in OCF’s, and there will be no inventory at the end of the project. Example, get $100,000 of dresses to sell. Sell them for $100,000. At the end there are none left.

27 WC recovery Thus, we have IIO = – $100,000; CF = $100,000 (sales) – $100,000 (cost) = 0. However, that would mean that we invested $100,000 and ended up with $0, which is not correct. We actually got our $100,000 back. It’s just that the accounting for CF gave us $0 OCF, so we have to reverse out the invemtory investment to make things right. After all we have no inventory because Inventory (0) = $100,000 and inventory(1) = $0.

28 PP&E We need to look more closely at PP&E, too.
First, recall that land is not depreciable but plant and equipment are. When we purchase P&E, we must consider all of the costs. If we buy an existing building, we will have to pay agent commissions, transfer and taxes plus, maybe, refurbishing.

29 PP&E When we buy equipment, it will have to be transported, insured in transport, and installed, once it arrives at the plant. There might even be training costs for operators of the new equipment. All of those costs are part of the cost of acquiring PP&E. In fact, the total cost is capitalized (put in a capital account) and depreciated.

30 Tax Shield Approach to PCF’s
Another way to get OCF is called the tax shield approach. We subtract all costs from sales = EBITD. Then, we multiply by (1 – T) to get the after tax value of EBITD. The actual value of depreciation, in finance is the tax savings that comes from deducting D from earnings before we compute taxes.

31 Tax Shield Approach to PCF’s
We can write ATI = [EBITD – D] – T [EBITD – D] = (1 – T) EBITD – D + TD. CF = ATI(1 – T) + D = (1 – T) EBITD – D + TD + D = (1 – T) EBITD + TD. +TD is the tax that was saved because D was subtracted from earnings before tax was applied to earnings. It is the tax shield provided by depreciation.

32 NWC in more detail Consider a simple business with no fixed investment and assume taxes are zero, for simplicity. Then, income for the year is Sales – costs = $500 - $310 = $190. However, the actual cash flows might be different from that number because some sales (A/R) and purchase (A/P) might be done on credit.

33 NWC in more detail Assume that the accounts are as shown, below.
Begin year End year Change A/R 880 910 +30 A/P 550 605 +55 NWC = A/R – A/P 330 305 – 25

34 Actual CF’s adjusted for ΔNWC
The book income has to be modified to account for increased A/R, which means the cash we got from sales was actually less than book sales, and some costs were not paid by cash since A/P increased. So, real CF was OCF –ΔA/R + ΔA/P = OCF – ΔNWC (since there was also no capital spending on the project during the year). For the example Actual revenues = Sales – ΔA/R; real costs = costs – ΔA/P; and CF = $190 – (– $25) = $215.

35 The logic of ΔNWC & CF’s If we invest in CA, it will be a cash outflow. Thus, increased inventory or A/R will subtract from actual cash flow. Notice, also, that, if we divided up CA, like in the above example, and group change in inventory with costs, we will ad change in inventory to costs because cost are subtracted from revenues, and positive change in inventory is an investment and adds to cost.

36 The logic of ΔNWC & CF’s For CL, if we reduce a CL, that is an investment, so, we will have to add change in CL to CF. In that manner, a reduction in CL will subtract from CF. Again, for example, if A/P increases, then, we are getting positive CF. So, we add change in CL to CF. If, however, we group A/P, for example with costs, then, it will subtract from costs. We can look at some more examples.

37 Example Initial Investment
CM wants to modernise the welding section of their production line. A new high tech system will cost $ to purchase, $5 000 to insure and transport to the plant and $3 000 to install. The existing equipment cost $ years ago and could be sold for $ as is. The new system would result in a significant annual sales increase and higher production levels. To support these, management have estimated that accounts receivable would increase by $30 000, accounts payable would increase by $ and inventory would increase by $ What is the initial outlay for the new welding system?

38 Example Solution Installed cost Purchase price -250 000
Insurance and transport -5 000 Installation -3 000 Sale of existing equipment 10 000 – Change in net working capital Add increase in accounts receivable 30 000 Less increase in accounts payable Add increase in inventory 20 000 = Initial outlay

39 Text Example A company reports revenue=$998 and cost= $734, plus the following WC entries. Since A/R increased, we subtract that from revenues. Inventories decreased, so we subtract that from costs. Begin End Change A/R 100 110 +10 Inventory 80 - 20 A/P 70 - 30 NWC 120 +20

40 Text Example Also we add the decrease in A/P to costs.
Adjusted Sales, are then, 998 – 10 = 988. Adjusted costs are 734 – 20 – (– 30) = 744. The affect on CF is adj rev – adj costs = 988 – 744 = 244. Alternatively, we have rev – costs – ΔNWC = 998 – 734 – 20 = 244.

41 Depreciation As we mentioned, earlier, the real value of depreciation, in finance, is the tax savings. Thus, in finance, we always use tax depreciation, which is different from accounting depreciation. The tax office tells us how we can depreciate things, and we use that. For example, if an asset costs $100,000, can be depreciated over 5 years and has an estimated terminal value of $20,000 and useful life of 8 years, we depreciate as $100,000/5 = $20,000, straight line (prime cost).

42 Depreciation The alternative way at looking at depreciation is in %/year instead of tax years. The two ways are just inverses of each other. D in years = 1/[D in %/year]. Thus, a 5 year tax life has depreciation of 1/5 = 20%/year. An asset with 15%/year depreciation has a 1/15%/year = 6 2/3 years. It will have BV = 0 at the end of the 5 years.

43 Diminishing balance depreciation
In addition to prime cost, the ATO also allows an accelerated depreciation method, diminishing balance. First you compute the Prime cost 1 year D, then, multiply by 150% the BV and divided by tax years = year 1 D. Subtract to get end year BV. For the next year, you divided BV by the straight line years, multiply by 150%, get year 2 D, subtract, get the BV, etc.

44 Example Asset’s installed cost = $1 160 000 effective life = 10 years
what is the annual straight line depreciation? what amount can be claimed for the first 2 years if the diminishing value method is chosen?

45 Prime cost depreciation

46 Diminishing value depreciation

47 What is the real difference in the two methods of depreciation
We know that money has a time value. The farther out in time that we get money, the less valuable it is to us now. Thus, if we deduct more in future years that are closer to the present, we pay less tax in those closer future years, and we pay more tax in years that are more distant into the future. So the present value of our tax payments is reduced compared to paying the same tax in all years because of straight line, even depreciation deductions. In turn, the PV of net CF is increased.

48 BV vs. MV, taxes on sale of P&E
Suppose that you sell the asset of the second last example, in year 4, for $25,000. The BV = $100,000 – 4x$20,000 = $20,000. Then, the tax law says that you must pay tax on the gain (or loss, which is a tax savings) on sale price over BV. Gain = 25,000 – 20,000 = $5,000.

49 BV vs. MV, taxes on sale of P&E
Tax is then, 30%x$5,000 = $15,00. We must include the after tax CF of the sale of equipment in winding up the project. The general formula is ATCF(terminal value, salvage) = Sale Price – Tx[Sale – BV]. Sale price, net of removal, sales commissions, and clean up, is a real cash inflow. The taxes paid are an outflow.

50 Text example MMCC MMCC is considering a project.
It has estimates for unit sales and prices for 8 years. It estimates that it will need to purchase equipment for $800,000, which is will deprecate 15%/year (note: 15%x6 = 90%, so there will be 6 years of 15%, the 7th year a remainder, and none in the 8th year).

51 Text example MMCC It believes the equipment can be sold for 15% of purchase in 8 years from now. It will need 20,000 in WC to begin and will maintain WC at 15% of sales. FC = $25,000; and VC/unit = $60. We show the Pro Forma income statement and analysis in the next 2 slides.

52 Example PF IS plus year 1 2 3 4 5 6 7 8 IIO -800,000 WC 20,000 54,000
1 2 3 4 5 6 7 8 IIO -800,000 WC 20,000 54,000 90,000 108,000 107,250 99,000 82,500 66,000 49,500 ΔWC -20,000 -34,000 -36,000 -18,000 750 8,250 16,500 units 3,000 5,000 6,000 6,500 4,000 unit price 120 110 Revs. 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000 VC ($60/unit) 180,000 300,000 390,000 240,000 FC 25,000 D (15%/yr) 120,000 80,000 EBIT 35,000 155,000 215,000 105,000 95,000 125,000 Tax 10,500 46,500 64,500 31,500 28,500 37,500 ATI 24,500 108,500 150,500 126,000 73,500 66,500 87,500 ATCF 144,500 228,500 270,500 246,000 193,500 146,500

53 Analysis ATCF 144,500 228,500 270,500 246,000 193,500 146,500 87,500 WC recovery 49,500 AT salvage 112,000 Total CFs -820,000 110,500 192,500 252,500 246,750 236,750 210,000 163,000 265,500 Cumm CF -709,500 -517,000 -264,500 -17,750 219,000 429,000 592,000 857,500 DCF (k=15%) 96,087 145,558 166,023 141,080 117,707 90,789 61,278 86,792 PBP 4.07 NPV 85,313 IRR 17.85% PI 1.10

54 Notes The CFs are OCF + change in WC for intermediate years.
Change in WC = last year’s minus this years = net investment/divestment of WC. To get salvage AT, we take 15%x800,000 = sale price, then, we subtract BV, which is $0, and finally multiply by 70% (=1 –T) to get ATCF Salvage. We add back the leftover WC (recover) to the final year’s CF.

55 Notes We have computed cumulative CF’s and used them to find PBP.
We have also computed PV’s to find NPV and PI. Finally, the analysis also includes IRR. NPV is positive, so we can accept the project.

56 Evaluating the Evaluation

57 Intro As we said, last lecture, one of the biggest problems with our whole evaluation program is the accuracy of our estimates of future events. Can we really know how much revenues we will have? Are our estimates of both unit sales and prices, several years into the future, reasonable? In truth, the estimates will ultimately depend on the unfolding of other economic events.

58 Intro Will there be cost-push or demand-pull inflation in materials prices and labor? Will the general economy grow or contract. Certainly, the way that things actually play out, could be the difference between positive and negative NPV, in some cases. In thinking about all that our estimates depend on, and how that can affect our project outlook, it might be better to consider the problem, further.

59 Forecasting Risk Thus, we are naturally led to consider our forecasting risk, i.e., the risk that our forecast is way wrong. Projects are usually expensive and not easily reversed. Our valuation system and companies’ investments cover a much broader ground than business expansion or replacement projects.

60 Forecasting Risk Companies can buy (take over, merge, buy out, acquire the stock of, tender for the shares of, and a few other terms) whole other companies. That can be even more expensive and more difficult to reverse (see the textbook for an example, p.272). Especially with a low RRR or a case of small but positive NPV, reality could turn an expected winner into a loser.

61 The Root of Value Based on economics and assuming business is pretty completive at this point in world history, we would not expect to find an abundance of positive NPV projects. Of course, new things can be invented, including more efficient technologies to help existing producers produce more efficiently an cost-effectively. However, what other opportunities are there that other people have not already taken advantage of?

62 The Root of Value Can we really produce a product, new for us, that is better than an existing one? Will we have better luck finding and exploiting new markets than our established competitors? Even if we really do hit on a good idea, how fast and how furiously will other people follow us into the new frontier. How will those things and the economy, in general, affect our forecasts and our conclusion about NPV?

63 Scenarios: Splitting the Future

64 Intro Since we know that the future is uncertain, we are admitting that it could turn out a number of different ways. Given that, wouldn’t it be smart to actually make a number of forecast? It could be as simple as making a good, neutral (base case), and bad set of pro forma’s . We could define the scenarios. Based on other forecast of markets or the entire economy.

65 Intro We could go even further, assign probabilities to each scenario, and find a probability-weighted average forecast and NPV. It all depends on how much time and money you want to put into it versus the benefit you get out of the more elaborate analysis. We continue with a simple exampls, defining upper and lower bounds on some of the input variables.

66 3 Scenario Example Consider a project with a cost of $200,000, depreciated over 5 years straight-line with zero salvage value and no ΔWC; T = 34%. We show three scenarios for the inputs, in the table, below, the same for all years. 3 Input Scenarios Base Lower Upper Units 6,000 5,500 6,500 Unit price 80 75 85 VC/unit 60 58 62 FC/unit 50,000 45,000 55,000

67 Pro Forma Income Statements
3 Scenario Example From those numbers we can construct pro forma’s. Pro Forma Income Statements Base Case Best Case Worst Case Sales 480,000 552,500 412,500 VC 360,000 377,000 341,000 FC 50,000 45,000 55,000 Depreciation 40,000 EBIT 30,000 90,500 -23,500 Taxes 10,200 30,770 -7,990 ATI 19,800 59,730 -15,510

68 3 Scenario Example From those numbers, we can compute annual ATCF’s and the resulting analytical numbers, summarized, below. Cash Flows & NPV Year 1 59800 99730 24490 2 3 4 5 NPV $15,565.62 $159,504.33 ($111,719.03) IRR 15.10% 40.88% -14.40%

69 Sensitivity Analysis In the foregoing scenario analysis, we varied all of the variables. In sensitivity analysis, we vary one variable at a time to see what happens to the results. For example, we could vary unit sales, fixed costs, or prices. In the end we will be able to construct a graph of NPV vs. the variable. The higher the slope of the line, the more sensitive is the NPV to that variable. We show an example of unit variation, below.

70 Sensitivity Analysis NPV vs. Units

71 Further Considerations

72 Managerial Options So far, we have assumed that once a project is begun, it will not be changed. This is a static view of projects. In practice, after a project is started, it can be changed in a number of ways. This dynamic view of projects considers management options, also called real options since they deal with real assets. These include things like pricing, method of manufacture, and advertising.

73 Some general options We can use the prior analysis to think about what might happen, and we can also try to plan adjustments, if things happen. That is contingency planning. Options include, expansion, if things are looking up, downsizing, even abandoning, or waiting to see how investment rates change and make an undesirable project desirable.

74 Some general options Another possibility is to take on an otherwise unacceptable project, now, as part of a longer-term strategic plan. For example, you might start a computer repair operation to gain experience in computer repair service as part of a bigger plan to eventually produce computers.

75 Capital Rationing Companies, instead of taking on all positive NPV project, might limit capital spending at the corporate or divisional levels. (soft rationing) This could lead to accepting some inferior projects that fit into the budget and not taking on other because they would put us over budget. We show an example, in the next slide.

76 The Inconsistency Cap Budget R WACC 95 120 150 170 195 Choose the set of projects that give the highest total NPV while keeping within the budget constraint. Vertical axis – IRR. Horizontal line at 10% is firm’s unconstrained hurdle rate or the return that would be required on all projects without capital rationing. Vertical line ($120,000) is the size of capital budget under capital rationing.

77 Inconsistency solution
We might take D, which would put us under budget, instead of C, which would put us over budget. We might pick E, which will take us up to capacity in the budget but is below our COC. Thus, when dealing with the supply-of-funds constraint on how much we can spend, and with the possible projects that we have to choose from, we might end up with not quite maximum use of our funds.

78 Hard Rationing In hard rationing, the firm cannot raise capital for new projects for any reason. This is known as hard rationing. It could occur, for example, for a company in financial distress. Another reason might be restrictive covenants in other obligations. Then, it is like we face an infinite RRR, and no projects can be taken on.

79 Learning activity In chapter nine of the text (page 282), attempt
critical thinking questions 9.1 – 9.6, 9.10, 9.11, 9.13 & 9.14 problems 1 – 10, 13, 14, 16, 21, 24 & 25

80 End

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