The topic discussed in this chapter is making capital investment decisions. In this chapter, you will learn: Understand how to determine the relevant cash flows for a proposed investment, understand how to analyse a project’s projected cash flows, understand how to evaluate an estimated NPV.
Making capital investment decisions Chapter Key concepts and skills • Understand how to determine the relevant cash flows for a proposed investment • Understand how to analyse a project’s projected cash flows • Understand how to evaluate an estimated NPV Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-2 Chapter outline • Project cash flows: A first look • Incremental cash flows • Pro forma financial statements and project cash flows • More on project cash flow • Evaluating NPV estimates • Scenario and other what-if analyses • Additional considerations in capital budgeting Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-3 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 • These cash flows are called incremental cash flows • The stand-alone principle allows us to analyse each project in isolation from the firm, simply by focusing on incremental cash flows Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-4 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 ‘in part’, then we should include the part that occurs because of the project Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-5 Common types of cash flows • Sunk costs—costs that have accrued in the past – Should not be considered in investment decision • 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 • Financing costs – Not a part of investment decision ã Tax effects Copyright â2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-6 Pro forma statements and cash flow • Pro forma financial statements – Project future operations • Capital budgeting relies heavily on pro forma accounting statements, particularly income statements • Computing cash flows—refresher – Operating cash flow (OCF) = EBIT + Depreciation – Taxes – OCF = Net income + Depreciation when there is no interest expense – Cash flow from assets (CFFA) = OCF – Net capital spending (NCS) – Changes in NWC Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-7 Shark attractant project • • • • • Estimated sales Sales price per can Cost per can Estimated life Fixed costs 000/year • Initial equipment cost $90,000 50 000 cans $4.00 $2.50 years $12 – 100% depreciated over 3-year life • Investment in NWC • Tax rate Copyright â2011 McGraw-Hill Australia Pty Ltd ã Cost of capital PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh $20 000 30% 20% 9-8 Pro forma income statement Shark attractant project—Table 9.1 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 Taxes (30%) Net Income Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh $ 33 000 900 $ 23 100 9-9 Projected capital requirements —Table 9.2 Year NWC Net fixed assets Total investment $20 000 $20 000 $20 000 $20 000 90 000 60 000 30 000 $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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-10 MMCC—Pro forma income statements YEAR Initial Investment Equipment Cost Sales Variable Costs Fixed Costs Depreciation (Eqpt)) EBIT Taxes Net Operating Income Add back Depreciation CASH FLOW from Operations NWC investment & Recovery Salvage Value TOTAL PROJECTED CF -20,000 360,000 180,000 25,000 120,000 35,000 10,500 24,500 120,000 144,500 -34,000 600,000 300,000 25,000 120,000 155,000 46,500 108,500 120,000 228,500 -36,000 720,000 360,000 25,000 120,000 215,000 64,500 150,500 120,000 270,500 -18,000 715,000 390,000 25,000 120,000 180,000 54,000 126,000 120,000 246,000 750 660,000 360,000 25,000 120,000 155,000 46,500 108,500 120,000 228,500 8,250 550,000 300,000 25,000 120,000 105,000 31,500 73,500 120,000 193,500 16,500 440,000 240,000 25,000 80,000 95,000 28,500 66,500 80,000 146,500 16,500 -820,000 110,500 192,500 252,500 246,750 236,750 210,000 163,000 330,000 180,000 25,000 125,000 37,500 87,500 87,500 66,000 112,000 265,500 Discounted Cash Flows -820,000 96,087 145,558 166,023 141,080 117,707 90,789 61,278 86,792 Cumulative Cash flows -820,000 -709,500 -517,000 -264,500 -17,750 219,000 429,000 592,000 857,500 NPV IRR Payback -800,000 $85,313 17.85% 4.07 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-25 MMCC—Projected cash flows Table 9.12 YEAR Initial Investment Equipment Cost Sales Variable Costs Fixed Costs Depreciation (Eqpt)) EBIT Taxes Net Operating Income Add back Depreciation CASH FLOW from Operations NWC investment & Recovery Salvage Value TOTAL PROJECTED CF -20,000 360,000 180,000 25,000 120,000 35,000 10,500 24,500 120,000 144,500 -34,000 600,000 300,000 25,000 120,000 155,000 46,500 108,500 120,000 228,500 -36,000 720,000 360,000 25,000 120,000 215,000 64,500 150,500 120,000 270,500 -18,000 715,000 390,000 25,000 120,000 180,000 54,000 126,000 120,000 246,000 750 660,000 360,000 25,000 120,000 155,000 46,500 108,500 120,000 228,500 8,250 550,000 300,000 25,000 120,000 105,000 31,500 73,500 120,000 193,500 16,500 440,000 240,000 25,000 80,000 95,000 28,500 66,500 80,000 146,500 16,500 -820,000 110,500 192,500 252,500 246,750 236,750 210,000 163,000 330,000 180,000 25,000 125,000 37,500 87,500 87,500 66,000 112,000 265,500 Discounted Cash Flows -820,000 96,087 145,558 166,023 141,080 117,707 90,789 61,278 86,792 Cumulative Cash flows -820,000 -709,500 -517,000 -264,500 -17,750 219,000 429,000 592,000 857,500 NPV IRR Payback -800,000 $85,313 17.85% 4.07 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-26 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—how sensitive is our NPV to changes in the cash flow estimates? The more sensitive, the greater the forecasting risk – Sources of value—why does this project create value? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-27 Scenario analysis • What happens to the NPV under different cash flow 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, but they are still possible Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-28 Scenario analysis— Example Units Price/unit Variable cost/unit Fixed cost/year $ $ $ Base 6,000 80.00 $ 60.00 $ 50,000 $ BASE Lower 5,500 75.00 $ 58.00 $ 45,000 $ BEST Upper 6,500 85.00 62.00 55,000 WORST Initial investment $ 200,000 Depreciated to salvage value of over years Deprec/yr $ 40,000 Project Life years Tax rate 30% Required return 12% Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-29 Scenario analysis— Example (cont.) Units Price/unit Variable cost/unit Fixed Cost Sales Variable Cost Fixed Cost Depreciation EBIT Taxes Net Income + Deprec TOTAL CF NPV IRR $ $ $ $ BASE 6,000 80.00 $ 60.00 $ 50,000 $ WORST 5,500 75.00 $ 62.00 $ 55,000 $ BEST 6,500 85.00 58.00 45,000 480,000 $ 360,000 50,000 40,000 30,000 9,000 21,000 40,000 412,500 $ 341,000 55,000 40,000 -23,500 -7,050 -16,450 40,000 552,500 377,000 45,000 40,000 90,500 27,150 63,350 40,000 61,000 23,550 103,350 19,891 15.9% (115,108) -15.4% Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 172,554 43.0% 9-30 Sensitivity analysis • What happens to NPV when we vary one variable at a time? • This is a subset of scenario analysis, where we look at the effects 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-31 Sensitivity analysis: Unit sales Units Price/unit Variable cost/unit Fixed cost/year $ $ $ Base 6,000 80 60 50,000 Units 5,500 80 60 50,000 Units 6,500 80 60 50,000 Initial investment $ 200,000 Depreciated to salvage value of over years Deprec/yr $ 40,000 Tax rate Required Return 30% 12% Units Price/unit Variable cost/unit Fixed cost $ $ $ BASE 6,000 80 $ 60 $ 50,000 $ Sales Variable Cost Fixed Cost Depreciation EBIT Taxes Net Income + Deprec $ 480,000 $ 440,000 360,000 330,000 50,000 50,000 40,000 40,000 30,000 20,000 9,000 6,000 21,000 14,000 40,000 40,000 Unit Sales Sensitivity 50,000.00 $45,125 40,000.00 30,000.00 $19,891 V P N 20,000.00 10,000.00 0.00 5,500$(5,342) -10,000.00 6,000 Unit Sales 6,500 TOTAL CF NPV Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 61,000 $ 19,891 $ UNITS 5,500 80 $ 60 $ 50,000 $ UNITS 6,500 80 60 50,000 $ 520,000 390,000 50,000 40,000 40,000 12,000 28,000 40,000 54,000 68,000 (5,342) $ 45,125 9-32 Sensitivity analysis: Fixed costs Units Price/unit Variable cost/unit Fixed cost/year $ $ $ Base 6,000 80 60 50,000 Fixed Cost 6,000 80 60 55,000 Fixed Cost 6,000 80 60 45,000 Initial investment $ 200,000 Depreciated to salvage value of over years Deprec/yr $ 40,000 Fixed Cost Sensitivity Tax rate Required Return 30% 12% Units Price/unit Variable cost/unit Fixed cost $ $ $ BASE 6,000 80 $ 60 $ 50,000 $ Sales Variable Cost Fixed Cost Depreciation EBIT Taxes Net Income + Deprec $ 480,000 $ 480,000 360,000 360,000 50,000 55,000 40,000 40,000 30,000 25,000 9,000 7,500 21,000 17,500 40,000 40,000 35,000.00 $32,508 30,000.00 25,000.00 20,000.00 V P N $19,891 15,000.00 10,000.00 $7,275 5,000.00 0.00 $45,000 $50,000 Fixed Cost $55,000 TOTAL CF NPV Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 61,000 $ 19,891 FC 6,000 80 $ 60 $ 55,000 $ $ 480,000 360,000 45,000 40,000 35,000 10,500 24,500 40,000 57,500 $ 7,275 FC 6,000 80 60 45,000 64,500 $ 32,508 9-33 Disadvantages of sensitivity and scenario analysis • Neither provides a decision rule – No indication of 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 Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-34 Making a decision • Beware of ‘analysis paralysis’ • At some point you have to make a decision • If the majority of your scenarios have positive NPVs, you may 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, you might want to 9-35 forgo the project Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 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 ã Strategic options Copyright â2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-36 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 (this also implies an infinite cost of capital) • The profitability index is a useful tool when faced with soft rationing Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-37 Quick quiz • How we determine if cash flows are relevant to the capital budgeting decision? • What is scenario analysis and why is it important? • What is sensitivity analysis and why is it important? • What are some additional managerial options that should be considered? Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 9-38 Chapter END 9-39 ... Changes in net working capital • Financing costs – Not a part of investment decision • Tax effects Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross... $2.50 years $12 – 100% depreciated over 3-year life • Investment in NWC ã Tax rate Copyright â2011 McGraw-Hill Australia Pty Ltd • Cost of capital PPTs t/a Essentials of Corporate Finance 2e by... purposes – Multiply percentage by the written-down value at the beginning of the year – Depreciate to zero Copyright ©2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance