Making Capital Investment Decisions
and Project Analysis and Evaluation
Projecting Cash Flows
PV 
CFt

t
t  0 (1  r )
or
N
CFt
NPV  - CF0  
t
t 1 (1  r )
N
What Cash Flows (CFt ) are Relevant?
Only those cash flows that occur with the project but
not without the project are relevant, i.e., only
incremental cash flows are relevant.
– Sunk Costs?
– Opportunity Costs?
– Externalities, e.g., erosion
Projecting Cash Flows
• Projecting Cash Flows
– Pro Forma Operating Cash Flow (Cash Flow from Operations)
– Pro Forma Changes in Net Working Capital (Cash Flow from
Operations)
– Pro Forma Changes in Fixed Assets (Cash Flow from Investment)
• Question: Why aren’t cash flows from financing part of
the cash flow projections?
How are Cash Flows Defined?
Total Cash Flows = OCF -  NWC - Fixed Assets
OCF =
Bottom Up:
Net Income + Depreciation
Top-Down:
Sales - Costs - Taxes
Tax Shield:
(Sales-Costs)*(1-T) + T*Depreciation
Forecasting Risk: What Can Go Wrong?
• Sales = p*q
= price per unit sold*quantity sold
• Variable Costs = v*q
= variable cost per unit*quantity
• Fixed Costs = FC
= create operating leverage
• Costs of New Equipment, Salvage Value, and NWC
requirements are all subject to estimation error.
Ways of Dealing With Forecasting Error
• Scenario Analysis - the determination of what happens to
NPV when we ask what-if questions
• Sensitivity Analysis - the determination of what happens to
NPV when we change only one variable at a time.
• Simulation Analysis - the determination of a distribution of
NPVs that depends on the distribution of outcomes for
individual variables that are inputs for the NPV
calculation.
Problems 25 through 28 (Base Case)
Time
0
Sales
Variable Costs
Fixed Costs
Depreciation
EBIT
Taxes
Net Income
Depreciation
OCF
Changes in NWC
$ (450,000)
Cost of Equipment $ (750,000)
Salvage Value
Tax Adjustment
Total Cash Flow
$ (1,200,000)
1
$ 6,300,000
$ (5,400,000)
$ (150,000)
$ (150,000)
$ 600,000
$ (228,000)
$ 372,000
$ 150,000
$ 522,000
2
$ 6,300,000
$ (5,400,000)
$ (150,000)
$ (150,000)
$ 600,000
$ (228,000)
$ 372,000
$ 150,000
$ 522,000
3
$ 6,300,000
$ (5,400,000)
$ (150,000)
$ (150,000)
$ 600,000
$ (228,000)
$ 372,000
$ 150,000
$ 522,000
4
$ 6,300,000
$ (5,400,000)
$ (150,000)
$ (150,000)
$ 600,000
$ (228,000)
$ 372,000
$ 150,000
$ 522,000
5
$ 6,300,000
$ (5,400,000)
$ (150,000)
$ (150,000)
$ 600,000
$ (228,000)
$ 372,000
$ 150,000
$ 522,000
$ 450,000
$
$
522,000 $
522,000 $
522,000 $
500,000
(190,000)
522,000 $ 1,282,000
Problems 25 through 28 (Worst Case)
Time
0
1
Sales
$ 5,670,000
Variable Costs
$ (5,400,000)
Fixed Costs
$ (150,000)
Depreciation
$ (172,500)
EBIT
$ (52,500)
Taxes
$ (19,950)
Net Income
$ (32,550)
Depreciation
$ 172,500
OCF
$ 139,950
Changes in NWC $ (472,500)
Cost of Equipment $ (862,500)
Salvage Value
Tax Adjustment
Total Cash Flow
$ (1,335,000) $ 139,950
2
$ 5,670,000
$ (5,400,000)
$ (150,000)
$ (172,500)
$ (52,500)
$ (19,950)
$ (32,550)
$ 172,500
$ 139,950
3
$ 5,670,000
$ (5,400,000)
$ (150,000)
$ (172,500)
$ (52,500)
$ (19,950)
$ (32,550)
$ 172,500
$ 139,950
4
$ 5,670,000
$ (5,400,000)
$ (150,000)
$ (172,500)
$ (52,500)
$ (19,950)
$ (32,550)
$ 172,500
$ 139,950
5
$ 5,670,000
$ (5,400,000)
$ (150,000)
$ (172,500)
$ (52,500)
$ (19,950)
$ (32,550)
$ 172,500
$ 139,950
$ 472,500
$
$
139,950 $
139,950 $
425,000
(161,500)
139,950 $ 875,950
Problems 25 through 28 (Best Case)
Time
0
Sales
Variable Costs
Fixed Costs
Depreciation
EBIT
Taxes
Net Income
Depreciation
OCF
Changes in NWC
$ (427,500)
Cost of Equipment $ (637,500)
Salvage Value
Tax Adjustment
Total Cash Flow
$ (1,065,000)
1
$ 6,930,000
$ (5,400,000)
$ (150,000)
$ (127,500)
$ 1,252,500
$ 475,950
$ 776,550
$ 127,500
$ 904,050
2
$ 6,930,000
$ (5,400,000)
$ (150,000)
$ (127,500)
$ 1,252,500
$ 475,950
$ 776,550
$ 127,500
$ 904,050
3
$ 6,930,000
$ (5,400,000)
$ (150,000)
$ (127,500)
$ 1,252,500
$ 475,950
$ 776,550
$ 127,500
$ 904,050
4
$ 6,930,000
$ (5,400,000)
$ (150,000)
$ (127,500)
$ 1,252,500
$ 475,950
$ 776,550
$ 127,500
$ 904,050
5
$ 6,930,000
$ (5,400,000)
$ (150,000)
$ (127,500)
$ 1,252,500
$ 475,950
$ 776,550
$ 127,500
$ 904,050
$ 427,500
$
$
904,050 $
904,050 $
904,050 $
575,000
(218,500)
904,050 $ 1,688,050