9.0
Chapter
9
McGraw-Hill/Irwin
Making
Capital
Investment
Decisions
©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?
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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

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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
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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.
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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

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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.

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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.

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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

The amount for which the property could be sold
(net of selling costs)


opportunity cost is:
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
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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.
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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.

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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
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budgeting.

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.




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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)

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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.
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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.
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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
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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.
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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
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Pro Forma Income Statement Example
9.19
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 costs
12,000
Depreciation ($90,000 / 3)
30,000
EBIT
Taxes (34%)
$ 33,000
11,220
Net Income
$ 21,780
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Projected Capital Requirements
9.20
Series of Abbreviated Balance Sheets
Table 9.2 (Page 246)
Year
0
NWC
Net Fixed
Assets
Total
Investment
McGraw-Hill/Irwin
1
$20,000
$20,000
90,000
60,000
$110,000
$80,000
2
3
$20,000 $20,000
30,000
0
$50,000 $20,000
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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.
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9.22
Table 9.5: Projected Total Cash Flows
CFFA = OCF - Chg in NWC - Capital Spending
Year
0
OCF
Change in
NWC
Capital
Spending
CFFA
McGraw-Hill/Irwin
1
$51,780
2
$51,780
-$20,000
3
$51,780
20,000
-$90,000
-$110,00
$51,780
$51,780
$71,780
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9.23
Making The Decision

Enter the cash flows into the calculator and compute NPV
and IRR
 CF0 = -110,000
 CFj =
51,780
 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.
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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

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9.25
Project Cash Flow Example
 Review
Project Cash Flow Example on the
web site.
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