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

2. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.1 Making Capital Investment Decisions Set-up the discounted cash flow analysis by working with financial and accounting information to determine the figures and make an initial assessment about whether or not the project should be undertaken Does the project add value (positive NPV) to the firm?

3. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.2 Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will occur only if the project is accepted Incremental cash flows: The difference between the firm’s future cash flows with a project and those without the project. Incremental cash flows for project evaluation consist of: any and all changes in the firm’s future cash flows that are a direct consequence of accepting a project

4. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.3 The Stand-Alone Principle In practice, it would be very cumbersome to actually calculate the future total cash flows to the firm with and without a project. Fortunately, it is not really necessary to do so. Once we identify the effect of undertaking the proposed project on the firm’s cash flows, we need only focus on the project’s resulting incremental cash flows. The evaluation of a project based solely on its incremental cash flows is the basis of the: Stand-Alone Principle. Stand-Alone Principle: allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

5. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.4 The Stand-Alone Principle We view the project as a kind of “mini-firm” with its own future: Revenues Costs Assets Cash flows We compare the cash flows from this mini- firm to the cost of acquiring it.

6. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.5 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

7. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.6 Incremental Cash Flows “Pitfalls” There are a few situations where mistakes can easily be made with regard go identifying incremental cash flows Sunk Costs Opportunity Costs Sunk cost: A cost that has already been paid, or the liability to pay has already been incurred. A cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision. The firm will have to pay this cost no matter what! Not relevant to the decision to accept or reject the project.

8. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.7 Incremental Cash Flows “Pitfalls” When we think of costs, we normally think of: out-of-pocket costs those that require the actually spending of cash An Opportunity Cost is slightly different Opportunity costs: The most valuable investment given up if an alternative investment is chosen A common situation arises where a firm already owns some of the assets a proposed project will be using.

9. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.8 Incremental Cash Flows “Pitfalls” Opportunity Cost Example: By converting a rustic cotton mill that you already own to condos, you give up: the opportunity to sell the property. The opportunity cost is: The amount for which the property could be sold (net of selling costs) this is the amount that we give up by using the property instead of selling it Not what you paid for the property – that cost is sunk

10. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.9 Side Effects Some projects have side, or spillover, effects. Both good and bad For Example: if the Innovative Motors Company (IMC) introduces a new car, some of the sales might come at the expense of other IMC cars. This is called erosion. In this case, the cash flows from the new line should be adjusted downward to reflect lost profits on other lines. The same general problem could occur for any multi-line consumer product producer or seller.

11. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.10 Side Effects Erosion: The cash flows of a new project that come at the expense of a firm’s existing projects. Note: in accounting for erosion, it’s important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition. Erosion is only relevant when sales would not otherwise be lost.

12. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.11 Net Working Capital Normally, a project will require that the firm invest in net working capital in addition to long-term assets. A project will generally need: Some amount of cash on hand to pay any expenses that arise An initial investment in inventories and accounts receivable (to cover credit sales). Some of this financing will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. The balance represents the investment in net working capital. Net Working Capital is an important feature of capital budgeting.

13. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.12 Net Working Capital As a project winds down: inventories are sold receivables are collected bills are paid and cash balances invested in the project can be drawn down. These activities free up the net working capital originally invested. The firm’s investment in project net working capital closely resembles a loan The firm supplies working capital at the beginning and recovers it towards the end.

14. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.13 Financing Costs In analyzing a proposed investment Financing Costs are not included. We do not include interest paid or any other financing costs such as dividends or principal repaid. We’re only interested in the cash flow generated by assets of the project. Interest paid is component of cash flow to creditors, not cash flow from assets. Only include the cash flow generated by the assets of the project. (Cash Flow from Assets)

15. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.14 Financing Costs Our goal in project evaluation is to compare: the cash flow from a project to the cost of acquiring that project in order to estimate NPV The particular mixture of debt and equity a firm actually chooses to use in financing a project is a managerial variable Primarily determines how project cash flow is divided between owners and creditors. Financing arrangements are important - but something to be analyzed separately covered in later chapters.

16. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.15 Other Issues With regard to project analysis (determining whether to accept or reject the project): 1. We’re only interested in measuring “cash flow” When it actually occurs Not when it accrues in an accounting sense 2. We’re always interested in aftertax cash flow Since taxes are definitely a cash outflow Remember: aftertax cash flow and accounting profit, or net income, are entirely different.

17. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.16 Pro Forma Financial Statements And Project Cash Flows The first thing we need when evaluating a proposed investment is a set of pro forma, or “projected”, financial statements. Given these, we can develop the “projected” cash flows from the project. Once we have the cash flows, we can estimate the value of the project using the techniques we described in the previous chapter. NPV IRR

18. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.17 Pro Forma Financial Statements Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Pro Forma Financial Statements: Financial Statements projecting future years’ operations Pro forma financial statements are a convenient and easily understood means of summarizing much of the relevant information for a project.

19. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.18 Pro Forma Financial Statements To prepare pro forma financial statements, we need estimates of: Quantities - such as unit sales the selling price per unit the variable cost per unit total fixed costs the total investment required including any investment in net working capital

20. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.19 Pro Forma Income Statement Example Problem stated on – Page 245 Table 9.1 – Page 246 Sales (50,000 units at $4.00/unit)$200,000 Variable Costs ($2.50/unit) cost to make 125,000 Gross profit$ 75,000 Fixed costs12,000 Depreciation ($90,000 / 3)30,000 EBIT$ 33,000 Taxes (34%)11,220 Net Income$ 21,780

21. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.20 Projected Capital Requirements Series of Abbreviated Balance Sheets Table 9.2 (Page 246) 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

22. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.21 Project Cash Flow Recall from Chapter 2 that cash flow from assets has three components: operating cash flow, capital spending, and additions to net working capital. Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC Operating Cash Flow (OCF) = EBIT + depreciation – taxes OCF = Net income + depreciation when there is no interest expense To evaluate a project, or mini-firm, we need to arrive at estimates for each of these.

23. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.22 Table 9.5: Projected Total Cash Flows CFFA = OCF - Chg in NWC - Capital Spending Year 0123 OCF$51,780 Change in NWC -$20,00020,000 Capital Spending -$90,000 CFFA-$110,00$51,780 $71,780

24. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.23 Making The Decision Enter the cash flows into the calculator and compute NPV and IRR CF 0 = -110,000 CFj = 51,780 CFj = 71,780 i = 20 NPV = 10,648 If evaluating the project based on NPV, accept the project since it has a positive NPV – otherwise reject. IRR = 25.8% If evaluating the project based on some pre-specified IRR, accept the project if the IRR is > than the required IRR – otherwise reject.

25. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.24 More on NWC (Page 248 & 249) Why do we have to consider changes in NWC separately? GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales although we haven’t collected cash yet

26. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 9.25 Project Cash Flow Example Review Project Cash Flow Example on the web site.