1. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Making Capital Investment Decisions Chapter 9

2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.1 Prepare for Capital Budgeting Part 2: Understand financial statement & cash flow C2-Identify cash flow from financial statement C3-Financial statement and comparison Part 3: Valuation of future cash flow C4-Basic concepts C5-More exercise Part 4: Valuing stocks and bonds C6-Bond C7-Stock Part 5: Capital budgeting C8-NPV and other investment criteria

3. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.2 Chapter Outline 1. Analyze A Project’s Projected Cash Flows Based on Pro Forma Financial Statements 2. Relevant Cash Flows 3. Tax Shield Approach 4. Scenario and Sensitivity Analyses 5. Managerial Options

4. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.3 1. Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows – refresher Operating Cash Flow (OCF) = EBIT + depreciation – taxes Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

5. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.4 Cash Flow Illustration

6. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.5 Table 9.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit)$200,000 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

7. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.6 Calculating OCF Operating Cash Flow (OCF) = EBIT + depreciation – taxes OCF=33,000+30,000-11,220=51,780

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.7 Table 9.2 Projected Capital Requirements Year 0123 NWC$20,000 Net Fixed Assets 90,000 60,000 30,000 0

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.8 Cash Flow Illustration Year 0123 OCF$51,780 Change in NWC -$20,00020,000 Capital Spending -$90,000 CFFA-$110,00$51,780 $71,780

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.9 Cash Flow Illustration Now that we have the cash flows, we can apply the techniques that we learned in chapter 8 Enter the cash flows into the calculator and compute NPV when I/Y=20% NPV = 10,648 Should we accept or reject the project?

11. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.10 2. Relevant Cash Flows Stand-alone principle The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle, which simply focuses on incremental cash flows, allows us to analyze each project in isolation from the firm simply

12. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.11 Asking the Right Question 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

13. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.12 Common Types of Cash Flows Opportunity costs – costs of lost options Side effects Positive side effects – benefits to other projects Negative side effects – costs to other projects Changes in net working capital Taxes Sunk costs – costs that have accrued in the past

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.13 3. 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)

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.14 Example Consider the previous example, if the company sells out the equipment at $10,000 when the project is done and the company’s marginal tax rate is 40%. What is the after-tax salvage? After-tax salvage = salvage – T*(salvage – book value) After-tax salvage=10,000-.4*(10,000-0)=6,000

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.15 Cash Flow Illustration Year 0123 OCF$51,780 Change in NWC -$20,00020,000 Capital Spending -$90,000 6,000 CFFA-$110,00$51,780 $77,780

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.16 4. Scenario Analysis What happens to the NPV under different cash flows scenarios? At the very least look at: Best case – revenues are high and costs are low Worst case – revenues are low and costs are high Measure of the range of possible outcomes Best case and worst case are not necessarily probable, they can still be possible

18. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.17 Sensitivity Analysis What happens to NPV when we vary one variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV 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

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.18 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

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.19 Summary of Scenario Analysis ScenarioNet Income Cash Flow NPVIRR Base case19,80059,80015,56715.1% Worst Case -15,51024,490-111,719-14.4% Best Case59,73099,730159,50440.9%

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.20 Summary of Sensitivity Analysis ScenarioUnit SalesCash Flow NPVIRR Base case600059,80015,56715.1% Worst case 550053,200-8,22610.3% Best case650066,40039,35719.7%

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.21 5. Managerial Options Capital budgeting projects often provide other options that we have not yet considered Contingency planning (“what if ” option) Option to expand Option to abandon Option to wait Strategic options (“testing” project)

23. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.22 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 is a useful tool when faced with soft rationing

24. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.23 Review Questions 1. Know how to calculate OCF based on pro forma statements to find out NPV of a project 2. How do we determine if cash flows are relevant to the capital budgeting decision? Is a sunk cost a relevant cash flow for project evaluation? Is an opportunity cost a relevant cash flow for project evaluation? Are benefits and costs to other project, and taxes relevant cash flows for project evaluation?

25. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 9.24 Review Questions (cont..) 3. Know how to calculate after-tax salvage. 4. What is scenario analysis and what is sensitivity analysis? 5. What are the major types of typical managerial option? What is capital rationing?