Making Capital
Investment Decisions
Project Analysis
FIN 301: Chapter 9
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
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Chapter Outline
9.1
Project Cash Flows: A First Look
9.2
Incremental Cash Flows
9.3
Pro Forma Financial Statements and Project Cash Flows
9.4
More on Project Cash Flows
9.5
Evaluating NPV Estimates
9.6
Scenario and Other What-If Analyses
9.7
Additional Considerations in Capital Budgeting
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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.
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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
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Relevant Cash Flows:
Incremental Cash Flow for a Project
Corporate cash flow with the project
Minus
Corporate cash flow without the project
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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)
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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
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• Sunk Costs
Issues Impacting Incremental Cash Flows
– 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….
9
– We must always consider the tax implications of cash flow (Tax Shield)
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Derivative Businesses
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Pro-Forma Statements
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Cash Flow Model
Cash Flow to Creditors
The cash flow identity
Cash Flow from Assets = Cash flow to creditors + Cash
flow to owners
Cash flow to creditors = Interest – net new debt
= Interest – (Ending LTD – Beg LTD)
1. Cash Flow of Assets (Firm)
Cash flow from Assets = OCF – NCS – change NWC
Cash Flow to Stockholders (owners)
OCF = EBIT + Depreciation – tax
Cash to owners = Dividends – net new equity
(includes common stock and paid in capital)
NCS = Ending NFA – Beg NFA + Depreciation
Change NWC = Ending NWC – Beg NWC
Retained Earnings
Plowback
$
OCF – change NWC
True Cash Flow
From Operations
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$
Assets
(Firm)
$
NCS
Creditors
CFFA
(Free Cash Flow)
Investments &
Other non-operating
Income
Stockholders
(Owners)
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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
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See Backup Slides
Profit = Sales – Total Costs…
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Shark Attractant Project
P-279
• Estimated sales
• Sales Price per can
• Cost per can
• Estimated life
• Fixed costs
• Initial equipment cost
50,000 cans
$4.00
$2.50
3 years
$12,000/year
$90,000
• Investment in NWC
• Tax rate
• Cost of capital
$20,000
34%
20%
– 100% depreciated over 3 year life
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Pro Forma Income Statement
Table 9.1
Sales (50,000 units at $4.00/unit)
Variable Costs ($2.50/unit)
$200,00
0
125,000
Gross profit
$ 75,000
Fixed costs
12,000
Depreciation ($90,000 / 3)
30,000
EBIT
Taxes (34%)
Net Income
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$ 33,000
11,220
$ 21,780
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Projected Capital Requirements
Table 9.2 (Book Value)
Year
0
NWC
1
2
3
$20,000
$20,000
$20,000
$20,000
90,000
60,000
30,000
0
Total
$110,000
Investment
$80,000
$50,000
$20,000
Net Fixed
Assets
NFA declines by the amount of depreciation each year
Investment = book or accounting value, not market value
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Projected Total Cash Flows
Table 9.5
Year
0
OCF
$51,780
 NWC
-$20,000
Capital
Spending
-$90,000
CFFA
-$110,00
Note:
1
2
$51,780
3
$51,780
20,000
$51,780
$51,780
$71,780
Investment in NWC is recovered in final year
Equipment cost is a cash outflow in year 0
OCF = EBIT + depreciation – taxes = 33,000 + 30,000 – 11,220 = 51,780;
OCF = NI + depreciation = 21,780 + 30,000 = 51,780
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or
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Shark Attractant Project
Year
Sales
Variable Costs
Gross Profit
Fixed Costs
Depreciation
EBIT
Taxes
Net Income
Pro Forma Income Statement
0
1
2
200,000
200,000
125,000
125,000
75,000
75,000
12,000
12,000
30,000
30,000
33,000
33,000
11,220
11,220
21,780
21,780
Operating Cash Flow
Changes in NWC
Net Capital Spending
Cash Flow From Assets
Net Present Value
IRR
Cash Flows
51,780
-20,000
-90,000
-110,000
51,780
3
200,000
125,000
75,000
12,000
30,000
33,000
11,220
21,780
51,780
51,780
20,000
51,780
71,780
$10,647.69
25.76%
OCF = EBIT + Depreciation – Taxes
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OCF = Net Income + Depreciation (if no interest)
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Computing NPV for the Project
Using the TI BAII+ CF Worksheet
Cash Flows:
CF0
= -110000
CF1
=
51780
Display
You Enter
CF, 2nd, CLR WORK
C00
-110000 Enter, Down
C01
51780 Enter, Down
CF2
=
51780
F01
2
CF3
=
71780
C02
71780 Enter, Down
F02
1
Enter, NPV
I
20
Enter, Down
NPV
CPT
10647.69
IRR, CPT
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25.76
Enter, Down
20
Making The Decision
Operating Cash Flow
Changes in NWC
Net Capital Spending
Cash Flow From Assets
Cash Flows
51,780
-20,000
-90,000
-110,000
51,780
Net Present Value
IRR
$10,647.69
25.76%
51,780
51,780
20,000
51,780
71,780
• Should we accept or reject the project?
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The Tax Shield
Approach to OCF
• OCF = (Sales – costs)(1 – T) + Deprec*TC
OCF=(200,000-137,000) 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
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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
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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
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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
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IRS Depreciation Rules
• http://www.irs.gov/publications/p946/ar02.html
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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
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Effect of depreciation or recapture Costs
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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)
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Example:
Depreciation and After-tax Salvage
• Car purchased for $12,000
• 5-year property
• Marginal tax rate = 34%.
Depreciation
Year
1
2
3
4
5
6
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$
$
$
$
$
$
5-year Asset
Beg BV
12,000.00
9,600.00
5,760.00
3,456.00
2,073.60
691.20
Depr %
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%
$
$
$
$
$
$
$
Deprec
2,400.00
3,840.00
2,304.00
1,382.40
1,382.40
691.20
12,000.00
End BV
$ 9,600.00
$ 5,760.00
$ 3,456.00
$ 2,073.60
$
691.20
$
-
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Salvage Value & Tax Effects
Depreciation
Year
1
2
3
4
5
6
$
$
$
$
$
$
5-year Asset
Beg BV
12,000.00
9,600.00
5,760.00
3,456.00
2,073.60
691.20
Depr %
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%
$
$
$
$
$
$
$
Deprec
2,400.00
3,840.00
2,304.00
1,382.40
1,382.40
691.20
12,000.00
$
$
$
$
$
$
End BV
9,600.00
5,760.00
3,456.00
2,073.60
691.20
-
Net Salvage Cash Flow = SP - (SP-BV)(T)
If sold at EOY 5 for $3,000:
NSCF = 3,000 - (3000 - 691.20)(.34) = $2,215.01
= $3,000 – 784.99 = $2,215.01
If sold at EOY 2 for $4,000:
NSCF = 4,000 - (4000 - 5,760)(.34) = $4,598.40
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= $4,000 – (-598.40) = $4,598.40
Too much
Depreciation
Too little
Depreciation
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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.
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Majestic Mulch & Compost Co
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Majestic Mulch & Compost Co
Majestic Mulch and Compost Company (MMCC)
YEAR
Background Data:
Unit Sales Estimates
Variable Cost /unit
Fixed Costs per year
Sale Price per unit
Tax Rate
Required Return on Project
Yr 0 NWC
NWC % of sales
Equipment cost - installed
Salvage Value in year 8
Depreciation Calculations:
Equipment Depreciable Base
MACRS % (Eqpt-7 yr)
Recovery Allowance
Book Value
0
$
$
$
$
$
1
3,000
60.00
25,000.00
120.00
$
120.00 $
34.0%
15.0%
20,000.00
15%
800,000
20% of equipment cost
2
5,000
120.00 $
3
6,000
120.00 $
4
6,500
110.00 $
5
6,000
110.00 $
6
5,000
110.00 $
7
4,000
8
3,000
110.00 $
110.00
800,000
After-Tax Salvage Value
Salvage Value
Book Value (Year 8)
Capital Gain/Loss
Taxes
Net SV (SV-Taxes)
20%
14.29%
114,320
685,680
24.49%
195,920
489,760
17.49%
139,920
349,840
12.49%
99,920
249,920
8.92%
71,360
178,560
8.93%
71,440
107,120
8.93%
71,440
35,680
4.46%
35,680
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
54,400
105,600
Required Net Working Capital Investment
20,000
Given Data and Projected Revenues – Table 9.9
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Majestic Mulch & Compost Co
Majestic Mulch and Compost Company (MMCC)
YEAR
Background Data:
Unit Sales Estimates
Variable Cost /unit
Fixed Costs per year
Sale Price per unit
Tax Rate
Required Return on Project
Yr 0 NWC
NWC % of sales
Equipment cost - installed
Salvage Value in year 8
0
1
3,000
60.00
25,000.00
120.00
$
120.00
34.0%
15.0%
20,000.00
15%
800,000
20% of equipment cost
$
$
$
$
$
Depreciation Calculations:
Equipment Depreciable Base
MACRS % (Eqpt-7 yr)
Recovery Allowance
Book Value
2
3
5,000
$
120.00
4
6,000
$
120.00
5
6,500
$
110.00
6
6,000
$
110.00
7
5,000
$
110.00
8
4,000
$
110.00
3,000
$
110.00
800,000
After-Tax Salvage Value
Salvage Value
Book Value (Year 8)
Capital Gain/Loss
Taxes
Net SV (SV-Taxes)
20%
14.29%
114,320
685,680
24.49%
195,920
489,760
17.49%
139,920
349,840
12.49%
99,920
249,920
8.92%
71,360
178,560
8.93%
71,440
107,120
8.93%
71,440
35,680
4.46%
35,680
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
54,400
105,600
Required Net Working Capital Investment
20,000
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Depreciation and After-Tax Salvage - Table 9.10
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Majestic Mulch & Compost Co
Majestic Mulch and Compost Company (MMCC)
YEAR
Background Data:
Unit Sales Estimates
Variable Cost /unit
Fixed Costs per year
Sale Price per unit
Tax Rate
Required Return on Project
Yr 0 NWC
NWC % of sales
Equipment cost - installed
Salvage Value in year 8
0
$
$
$
$
$
Depreciation Calculations:
Equipment Depreciable Base
MACRS % (Eqpt-7 yr)
Recovery Allowance
Book Value
After-Tax Salvage Value
Salvage Value
Book Value (Year 8)
Capital Gain/Loss
Taxes
Net SV (SV-Taxes)
1
3,000
60.00
25,000.00
120.00
$
120.00
34.0%
15.0%
20,000.00
15%
800,000
20% of equipment cost
2
3
5,000
$
120.00
4
6,000
$
120.00
5
6,500
$
110.00
6
6,000
$
110.00
7
5,000
$
110.00
8
4,000
$
110.00
3,000
$
110.00
800,000
20%
14.29%
114,320
685,680
24.49%
195,920
489,760
17.49%
139,920
349,840
12.49%
99,920
249,920
8.92%
71,360
178,560
8.93%
71,440
107,120
8.93%
71,440
35,680
4.46%
35,680
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
54,400
105,600
Required Net Working Capital Investment
20,000
Net Working Capital – Table 9.12
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Majestic Mulch & Compost Co
YEAR
Initial Investment
Equipment Cost
Sales
Variable Costs
Fixed Costs
Depreciation (Eqpt))
0
1
2
3
4
5
6
7
8
(800,000)
EBT
Taxes
Net Operating Income
360,000
180,000
25,000
114,320
40,680
13,831
26,849
600,000
300,000
25,000
195,920
79,080
26,887
52,193
720,000
360,000
25,000
139,920
195,080
66,327
128,753
715,000
390,000
25,000
99,920
200,080
68,027
132,053
660,000
360,000
25,000
71,360
203,640
69,238
134,402
550,000
300,000
25,000
71,440
153,560
52,210
101,350
440,000
240,000
25,000
71,440
103,560
35,210
68,350
330,000
180,000
25,000
35,680
89,320
30,369
58,951
195,920
248,113
(36,000)
139,920
268,673
(18,000)
99,920
231,973
750
71,360
205,762
8,250
71,440
172,790
16,500
71,440
139,790
16,500
Add back Depreciation
CASH FLOW from Operations
NWC investment & Recovery
Salvage Value
TOTAL PROJECTED CF
(20,000)
114,320
141,169
(34,000)
(820,000)
107,169
212,113
250,673
232,723
214,012
189,290
156,290
35,680
94,631
66,000
105,600
266,231
Discounted Cash Flows
(820,000)
93,190
160,388
164,821
133,060
106,402
81,835
58,755
87,031
Cumulative Cash flows
(820,000)
(712,831)
(500,718)
(250,046)
(17,323)
196,690
385,979
542,269
808,500
NPV
IRR
Payback
$65,483
17.24%
4.08
MMC Pro Forma Income Statements
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Majestic Mulch & Compost Co
YEAR
Initial Investment
Equipment Cost
Sales
Variable Costs
Fixed Costs
Depreciation (Eqpt))
0
1
2
3
4
5
6
7
8
(800,000)
EBT
Taxes
Net Operating Income
360,000
180,000
25,000
114,320
40,680
13,831
26,849
600,000
300,000
25,000
195,920
79,080
26,887
52,193
720,000
360,000
25,000
139,920
195,080
66,327
128,753
715,000
390,000
25,000
99,920
200,080
68,027
132,053
660,000
360,000
25,000
71,360
203,640
69,238
134,402
550,000
300,000
25,000
71,440
153,560
52,210
101,350
440,000
240,000
25,000
71,440
103,560
35,210
68,350
330,000
180,000
25,000
35,680
89,320
30,369
58,951
195,920
248,113
(36,000)
139,920
268,673
(18,000)
99,920
231,973
750
71,360
205,762
8,250
71,440
172,790
16,500
71,440
139,790
16,500
Add back Depreciation
CASH FLOW from Operations
NWC investment & Recovery
Salvage Value
TOTAL PROJECTED CF
(20,000)
114,320
141,169
(34,000)
(820,000)
107,169
212,113
250,673
232,723
214,012
189,290
156,290
35,680
94,631
66,000
105,600
266,231
Discounted Cash Flows
(820,000)
93,190
160,388
164,821
133,060
106,402
81,835
58,755
87,031
Cumulative Cash flows
(820,000)
(712,831)
(500,718)
(250,046)
(17,323)
196,690
385,979
542,269
808,500
NPV
IRR
Payback
$65,483
17.24%
4.08
MMC Projected Cash Flows – Table 9.14
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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
•
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Be able to articulate why this project creates
value
38
Scenario Analysis
• Examines several possible situations:
–Worst case
–Base case or most likely case
–Best case
• Provides a range of possible outcomes
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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 0 over 5 years
Deprec/yr
$
40,000
Project Life
5 years
Tax rate
34%
Required return
12%
Note: “Lower” ≠ Worst
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“Upper” ≠ Best
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Scenario Analysis Example
Units
Price/unit
Variable cost/unit
Fixed Cost
Sales
Variable Cost
Fixed Cost
Depreciation
EBIT
Taxes
Net Income
+ Deprec
$
480,000
360,000
50,000
40,000
30,000
10,200
19,800
40,000
$
WORST
5,500
75.00 $
62.00 $
55,000 $
412,500 $
341,000
55,000
40,000
(23,500)
(7,990)
(15,510)
40,000
BEST
6,500
85.00
58.00
45,000
552,500
377,000
45,000
40,000
90,500
30,770
59,730
40,000
TOTAL CF
59,800
24,490
99,730
NPV
15,566
(111,719)
159,504
IRR
Barton College
$
$
$
BASE
6,000
80.00 $
60.00 $
50,000 $
15.1%
-14.4%
40.9%
41
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
Barton College
42
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
Barton College
43
Sensitivity
Analysis:
Units
Price/unit
Variable cost/unit
Fixed cost/year
Unit Sales
$
$
$
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 0 over 5 years
Deprec/yr
$
40,000
Unit Sales Sensitivity
50,000.00
40,000.00
34%
12%
Units
Price/unit
Variable cost/unit
Fixed cost
BASE
6,000
80 $
60 $
50,000 $
$39,357
30,000.00
NPV
20,000.00
$15,566
10,000.00
0.00
5,500
-10,000.00
Tax rate
Required Return
6,000
$(8,226)
-20,000.00
Unit Sales
6,500
Sales
Variable Cost
Fixed Cost
Depreciation
EBIT
Taxes
Net Income
+ Deprec
$
$
$
$
TOTAL CF
NPV
Barton College
480,000
360,000
50,000
40,000
30,000
10,200
19,800
40,000
$
59,800
$
15,566
$
UNITS
5,500
80 $
60 $
50,000 $
440,000
330,000
50,000
40,000
20,000
6,800
13,200
40,000
$
UNITS
6,500
80
60
50,000
520,000
390,000
50,000
40,000
40,000
13,600
26,400
40,000
53,200
66,400
(8,226) $
39,357
44
Sensitivity
Analysis:
Units
Price/unit
Variable cost/unit
Fixed cost/year
Fixed Costs
Initial investment
$ 200,000
Depreciated to salvage value of 0 over 5 years
Deprec/yr $ 40,000
Fixed Cost Sensitivity
$
$
$
Base Fixed Cost Fixed Cost
6,000
6,000
6,000
80
80
80
60
60
60
50,000
55,000
45,000
Tax rate
Required Return
34%
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
360,000
50,000
40,000
30,000
10,200
19,800
40,000
$ 480,000
360,000
55,000
40,000
25,000
8,500
16,500
40,000
$ 480,000
360,000
45,000
40,000
35,000
11,900
23,100
40,000
59,800
56,500
63,100
30,000.00
$27,461
25,000.00
NPV
20,000.00
FC
6,000
80
60
45,000
$15,566
15,000.00
10,000.00
5,000.00
$3,670
0.00
$45,000
$50,000
Fixed Cost
$55,000
TOTAL CF
NPV
Barton College
FC
6,000
80 $
60 $
55,000 $
$
15,566
$
3,670
$
45
27,461
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.
Barton College
46
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.
Barton College
47
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
Barton College
48
Capital Rationing
• Capital rationing occurs when a firm or division has limited
resources
– Soft rationing – the limited resources are temporary, often selfimposed
– 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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END
9-50
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
Barton College
Marketing & Sales
Manufacturing,
Control & Supply
Chain
51
2nd Version of Majestic Mulch
Barton College
52
More Complex
Barton College
53