Chapter 6: Analyzing
Investment Projects
Objective
Explain Capital Budgeting
Develop Criteria
Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.
1
Chapter 6 Contents






The Nature of Project
Analysis
Where do Investments
Ideas come from?
The NPV Investment
Rule
Estimating a Project.s
Cash Flows
Cost of Capital
Sensitivity Analysis




Analyzing CostReducing Projects
Projects with Different
Lives
Ranking Mutually
Exclusive Projects
Inflation & Capital
Budgeting
2
Objectives

To show how to use discounted
cash flow analysis to make
decisions such as:


Whether to enter a new line of
business
Whether to invest in equipment to
reduce costs
3
Types of Investment Projects



New Products
Cost Reduction
Replacing of Existing Assets
4
Where Do Investment Ideas Come
from




Surveys of Customers
R&D Department
Competition
Production Divisions
5
The NPV Rule
Invest if the proposed project’s NPV
is positive
6
Example: Generic Jeans Company
The company is considering
whether to produce a new line of
jeans called Protojeans. The Cash
Flow forecasts read as follows:
7
Cash Flow Forecasts
Year
Cash Flows
(in thousands of dollars)
0
-$100
1
2
$50
$40
3
$30
8
Protojean Projects
If we discount each year’s cash flow
at a rate of 8% per year we will
have:
Year
Cash Flows
(,000)
PV of CF
at 8%
Cumulative
PV
0
-100
-100.00000
-100.0000
1
50
46.29630
-53.70370
2
40
34.29355
-19.41015
3
30
23.81497
4.4082
9
NPV as a Function of Discount Rate
250
200
150
NPV
100
50
0
-50
0%
5%
10%
15%
20%
-100
-150
-200
Discount Rate
10
Example: Compusell Corporation
The PC1000 project, a new type of
personal computer.
The next table shows the estimated
annual sales revenue, operating
costs, and profit for the PC1000:
11
Net Cash Inflow from Operations


Cash Flow= Revenue-Cash ExpensesTaxes
Cash Flow= Revenue-Total ExpensesTaxes+Noncash Expenses
= Net Income+Noncash
Expenses
12
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
40.00%
4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
NPV =
1236
1
2
3
4
5
6
7
20,000
20,000
20,000
20,000
20,000
20,000
20,000
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
0
1,300
1130
0
0
1,300
983
0
0
1,300
855
0
0
1,300
743
0
0
1,300
646
0
0
1,300
562
3,100
15,000
400
1,500
600
900
1,300
-2,200
0
-2,200
3,500
1316
13
(Table in $'000)
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
25.00%
40.00%
4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
Was 15%
-429
NPV =
1
2
3
4
5
6
7
20,000
20,000
20,000
20,000
20,000
20,000
20,000
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
3,100
15,000
400
1,500
600
900
1,300
0
1,300
1040
0
0
1,300
832
0
0
1,300
666
0
0
1,300
532
0
0
1,300
426
0
0
1,300
341
3,100
15,000
400
1,500
600
900
1,300
-2,200
0
-2,200
3,500
734
14
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
30.00%
4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
Was 40%
NPV =
1860
1
2
3
4
5
6
7
20,000
20,000
20,000
20,000
20,000
20,000
20,000
3,100
15,000
400
1,500
450
1,050
1,450
3,100
15,000
400
1,500
450
1,050
1,450
3,100
15,000
400
1,500
450
1,050
1,450
3,100
15,000
400
1,500
450
1,050
1,450
3,100
15,000
400
1,500
450
1,050
1,450
3,100
15,000
400
1,500
450
1,050
1,450
0
1,450
1261
0
0
1,450
1096
0
0
1,450
953
0
0
1,450
829
0
0
1,450
721
0
0
1,450
627
3,100
15,000
400
1,500
450
1,050
1,450
-2,200
0
-2,200
3,650
1372
15
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
40.00%
4,000
5.00%
$5,000
0.00%
3,100,000
0.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
Was 0%
NPV =
2885
1
2
3
4
5
6
7
20,000
21,000
22,050
23,153
24,310
25,526
26,802
3,100
15,000
400
1,500
600
900
1,300
3,100
15,750
400
1,750
700
1,050
1,450
3,100
16,538
400
2,013
805
1,208
1,608
3,100
17,364
400
2,288
915
1,373
1,773
3,100
18,233
400
2,578
1,031
1,547
1,947
3,100
19,144
400
2,881
1,153
1,729
2,129
0
1,300
1130
0
0
1,450
1096
0
0
1,608
1057
0
0
1,773
1014
0
0
1,947
968
0
0
2,129
920
3,100
20,101
400
3,200
1,280
1,920
2,320
-2,200
0
-2,200
4,520
1699
16
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
40.00%
4,000
0.00%
$5,000
0.00%
3,100,000
0.00%
85.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
Was 75%
NPV =
-3757
1
2
3
4
5
6
7
20,000
20,000
20,000
20,000
20,000
20,000
20,000
3,100
17,000
400
-500
-200
-300
100
3,100
17,000
400
-500
-200
-300
100
3,100
17,000
400
-500
-200
-300
100
3,100
17,000
400
-500
-200
-300
100
3,100
17,000
400
-500
-200
-300
100
3,100
17,000
400
-500
-200
-300
100
0
100
87
0
0
100
76
0
0
100
66
0
0
100
57
0
0
100
50
0
0
100
43
3,100
17,000
400
-500
-200
-300
100
-2,200
0
-2,200
2,300
865
17
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
40.00%
4,000
0.00%
$5,000
0.00%
3,500,000
0.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
Was $3,100,000
NPV =
237
1
2
3
4
5
6
7
20,000
20,000
20,000
20,000
20,000
20,000
20,000
3,500
15,000
400
1,100
440
660
1,060
3,500
15,000
400
1,100
440
660
1,060
3,500
15,000
400
1,100
440
660
1,060
3,500
15,000
400
1,100
440
660
1,060
3,500
15,000
400
1,100
440
660
1,060
3,500
15,000
400
1,100
440
660
1,060
0
1,060
922
0
0
1,060
802
0
0
1,060
697
0
0
1,060
606
0
0
1,060
527
0
0
1,060
458
3,500
15,000
400
1,100
440
660
1,060
-2,200
0
-2,200
3,260
1226
18
Assumptions
Cost of capital
Tax rate
Unit sales in year 1
Sales growth rate
Unit price
Unit Price Growth
Fixed Start
Fixed Growth
Variable pcent
Depreciation schedule
Start working capt
Investment schedule
Working Cap Sch
Year
CF Forecast
Sales revenue
Expenses
Fixed Costs (cash)
Variable costs
Depreciation
Operating Profit
Taxes
Net Profit
Operating CF
Working cap move
Investment in P&E
Invest CF
Net CF
PV(NCF)
(Table in $'000)
15.00%
40.00%
4,000
2.00%
$5,000
-3.00%
3,100,000
8.00%
75.00%
400,000
2,200,000
2,800,000
2,200,000
0
2200
2,800
5,000
-5,000
-5000
NPV =
-797
1
2
3
4
5
6
7
20,000
19,788
19,578
19,371
19,165
18,962
18,761
3,100
15,000
400
1,500
600
900
1,300
3,348
14,841
400
1,199
480
719
1,119
3,616
14,684
400
879
351
527
927
3,905
14,528
400
538
215
323
723
4,218
14,374
400
174
70
104
504
4,555
14,222
400
-214
-86
-129
271
0
1,300
1130
0
0
1,119
846
0
0
927
610
0
0
723
413
0
0
504
251
0
0
271
117
4,919
14,071
400
-629
-252
-377
23
-2,200
0
-2,200
2,223
836
19
Carry-forward, Carry-back
When Calculating capital gains for
tax purposes, a firm nets out all
capital losses in the same year. If
capital losses exceed capital gains,
the net capital loss may be carried
back to reduce taxable capital gains
in the three prior years. Under the
carry-back feature, a firm files
20
Carry-forward, Carry-back
A revised tax return and receives a
refund of prior years’ taxes. For
example, suppose Canadian
Enterprises experienced a net
capital loss of $1 million in 2000
and net capital gains of $300,000 in
1999, $200,000 in 1998, and
$150,000 in 1997.
21
Carry-forward, Carry-back
Canadian could carry back a total of
$650,000 to get a refund on its
taxes. The remaining $350,000 can
be carried forward indefinitely to
reduce future taxes on capital
gains.
22
Carry-forward, Carry-back
A similar carry-forward provision
applies to operating losses. The
carry-back period is three years and
carry forward is allowed up to seven
years.
23
Table 6.4 Project Sensitivity to Sales Volume
Sales Units
2000
3000
3604
4000
5000
6000
Net CF Operations
200000
550000
1003009
1300000
2050000
2800000
NPV Project
5005022
1884708
0
1235607
4355922
7476237
24
Sensitivity of Project to Sale Volume
$3,000,000
Net CF from Operations
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
$2,000
$2,500
$3,000
$3,500
$4,000
$4,500
$5,000
$5,500
$6,000
$500,000
Sales (Units)
25
NPV Project
$10,000,000
$8,000,000
$6,000,000
NPV
$4,000,000
$2,000,000
$0
2000
2500
3000
3500
4000
4500
5000
5500
6000
$2,000,000
$4,000,000
$6,000,000
Sales (Units)
26
NPV v. Discount Rate
$7,000
$6,000
$5,000
NPV $000
$4,000
$3,000
$2,000
$1,000
$0
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
$1,000
$2,000
$3,000
Rate
27
Projects with Different Lives
Example: Two labor-saving
equipment
1) Costs $2 million, has an expected
life of 5 years
2) Costs $4 million, lasts for 10 years
Discount rate 10%
28
Annualized capital Cost
The annual cash payment that has a
present value equal to the initial
outlay
29
Projects with different lives
1)
2)
n=5, i=10, PV=-2000000, FV=0
PMT=$527595
n=10, i=10, PV=-4000000,
FV=0
PMT=$650982
So equipment 1) is the preferred one.
30
Inflation and Capital Budgeting
RULE: There are two correct ways of
computing NPV:
1. Use the nominal cost of capital to
discount nominal cash flows.
2. Use the real cost of capital to
discount real cash flows.
31
Inflation and Capital Budgeting

Example: An investment with an
initial outlay of $2 million, produces
an annual after-tax real CF of
$600000 for 5 years, the cost of
capital is 10%. Inflation rate is 6%
per year. We can summarize the
information in the following table:
32
Investment under 6% inflation
Year
Real
Cash Flow
1
600,000
Nominal CF
(6%
inflation)
636,000
2
600,000
647,160
3
600,000
714,610
4
600,000
757,486
5
600,000
802,935
33
Inflation and …
1)
By discounting the annual 600,000 by
10% we come to PV=$2,274,472. So
that
NPV=$2,274,472-2,000,000=$274,472
2)
By discounting the third column by
16.6% nominal rate we get the same PV
and
NPV=$247,472
34
Analyzing Cost-Reducing Projects
A firm is considering an investment
proposal to automate its production
process to save labor costs. It can
invest $2 million now in equipment
and save $700,000 per year in
pretax labor costs. If the equipment
has an expected life of 5 years and
if the tax rate is (33+1/3)%, is this
investment worthwhile?
35
Cost-Reducing Projects
We must compute the incremental
cash flows due to the investment
36
Incremental Cash flows
Without
Investment
Revenue
$5,000,000
Labor Costs
1,000,000
Other cash expenses 2,000,000
With
Investment
$5,000,000
300,000
2,000,000
Difference
Due to Inv.
0
-$700,000
0
Depreciation
Pretax profit
Income tax
1,000,000
1,000,000
333,333
1,400,000
1,300,000
433,333
$400,000
$300,000
$100,000
After-tax pr.
Net CF
666,667
$1,666,667
866,667
$2,266,667
$200,000
$600,000
37
Time Line
NPV
=$2,274,472-$2,000,000
=$274,472
38
Cost-reducing Projects (2)
Steiness Danish Ham, Inc., is
contemplating buying a new
machine that has an economic life
of five years. The cost of machine is
1,242,000 krone and will be fully
depreciated using the straight line
method. At the end of five years it
will have a market value of 138,000
krone.
39
It is estimated that the new
machine will save the company
345,000 krone per year due to
reduced labor costs. Moreover, it
will lead to a reduction in net
working capital of 172,500 krone
because of the higher yield from
raw materials inventory. The net
working
40
Capital will be recovered by the end
of the five years. If the corporate
tax is 34% and the discount rate is
12%, what is the NPV of the
project?
41
Working Capital
Working Capital=Current Assets –
Current Liabilities
Current Assets: Inventories, Accounts
Receivable
Current Liabilities: Accrued Expenses,
Accounts Payable
42
The Cash Flow Cycle
Ordered
Arrives
Finished Goods Sold
Inventory Period
Cash Received
Receivable Period
Payable Period
Time
Cash Cycle Time
Invoice Received
Cash Paid
43
Solution: Incremental cash flows
Years 1 to 4 (in thousands krone)
Revenue
Labor costs
Other cash expenses
Depreciation
Pretax profit
Income taxes
After-tax pr.
NCF
0
-345
0
248.4
96.6
32.844
63.756
312.156
44
Year 5
Labor costs
Depreciation
Pretax profit
Income taxes
After-tax pr.
OCF
Chg. in Working Cap.
Salvage value
Tax on Capital Gain
Terminal Value
NCF
-345
248.4
96.6
32.844
63.756
312.156
-172.5
138
.34*138
91.08
230.736
45
Year 0
Working Capital
Investment in P&E
Investment CF
NCF
-172.5
1,242
1,069.5
1,069.5
46
Time Line
47
312.156 312.156 312.156 312.156 277.656




2
3
4
1.12
(1.12)
(1.12)
(1.12)
(1.12)5
312.156
230.736
 1069.5 
(1  1.12 4 ) 
.12
1.125
230.736
 1069.5  (2601.3)(0.3645) 
1.125
230.736
 1069.5  948.0645 
1.125
 9.553
NPV  1069.5 
48
Comparing 2 projects with different
lifetimes
You are evaluating two different
pollution control options
1. A filtration System:
Installation Cost $1.1 million
Pretax AOC
$60,000
Lifetime
5 years

49
Comparing 2 projects with different
lifetimes
2. A Precipitation
Installation Cost
Pretax AOC
Lifetime
System
$1.9 million
$10,000
8 years
Discount rate: 12%
Tax rate: 40%
50
Incremental Cash Flow of two
Projects
NCF=(1-t)(R-C-D)+D
=(1-t)(R-C)+tD
As about Cost:
Cost=-(1-t)C+tD
51
Incremental Cash Flow of two
Projects
After tax operating
cost
Filtration System
Precipitation
System
-$36,000
-$6,000
Depreciation tax
shield
$ 88,000
$95,000
Operating CF
$ 52,000
$89,000
PV of operating CF
$ 187,450
$ 442,116
Capital spending
-$1,100,000
-$1,900,000
Total PV of costs
-$912,550
-$1,457,884
52
Incremental Cash Flow of two
Projects
ACC: Annualized Capital Cost
-912,550=ACC(F)*3.6048
ACC(F)=-$253,149

-1,457,884=ACC(P)*4.9676
ACC(P)=-$293,479
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