Chapter 10
March 9, 2012
Ch 10 Making Capital Investment Decisions
I. Relevant & Irrelevant CFs
II. How to evaluate a project
III. Capital Budgeting Example
IV. Three special types of projects
Look at how we come up with cash flow!
I. Relevant & Irrelevant CFs
RELEVANT CFs:
Taking on a project will change future cash flows of firm. When evaluating
the project only look at “incremental cash flows” (difference between CF’ s
with and without the project!) = CF’s that can directly be attributed to a
project.
Stand alone principle: because we use incremental cash flows, we analyze
each project as if it was stand alone, i.e. in isolation from the firm.
Opportunity cost: is included; most valuable alternative given up if project
is undertaken, building could be rented out: foregone rent is an example
Side effects, positive or negative (erosion): are included; new project’s
income affects other projects/products,
erosion: new projects CFs come at the expense of another existing project
NWC: are included; certain amount of cash on hand to run day-to-day
activities, think of this as a temporary loan to the project from the firm.
Taxes: are included, directly attributed to the project
IRRELEVANT CFs:
Sunk costs are not included: costs that have already occurred, occurred in
the past
exist whether or not a project is taken! Example: marketing survey,
preliminary research
Financing costs: are not included. We are looking at CF’s from assets not
CF’s from CR or SH; how the project is financed is not important (capital
structure),
Indirectly financing (debt vs equity) is included in the discount rate
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II. How to evaluate a project?
Step 1. Set up pro-forma income statement = income statement that is
projected into future years (only using incremental numbers)
Step 2. Calculate cash flow from assets for future years=
operating CF
- additions to NWC (end. NWC - beg. NWC for each year)
- additions to capital spending (includes initial investment at t=0 and
after tax salvage value = salvage – t(salvage – book value) in last period
or salvage value x (1-t) if book = 0 for straight-line depreciation
operating CF=
EBIT
+depreciation
- taxes
note: if no interest: NI = EBIT - taxes
operating CF = NI + depreciation
draw for visualization
Step 3. Apply different investment criteria, and evaluate the project
(NPV, IRR, payback, PI)
III. Example
Capital Budgeting for Project X
if we take on project X (stereo amplifier):
sell 500 units per year at $8,000 each, unit sales grow at 10% per year
variable cost = $5,000 /unit
fixed-cost = $610,000 / year
project has a 4 year life
initial investment for equipment = $1,100,000
straight-line depreciation
Depreciation
= Year 1-4= 275,000
after year 4: book value = 0
in 4 years the market value of the equipment is $550,000
Initial investment in net working capital = $900,000
tax rate = 34%
Should we accept project using NPV criteria using 20% required return?
2
Step 1:
Pro-forma income statement:
Sales
-variable costs
-fixed costs
-depreciation
EBIT
-Taxes
NI
1
4,000,000
2,500,000
610,000
275,000
615,000
209,100
405,900
Year
2
4,400,000
2,750,000
610,000
275,000
765,000
260,100
504,900
3
4,840,000
3,025,000
610,000
275,000
930,000
316,200
613,800
4
5,324,000
3,327,500
610,000
275,000
1,111,500
377,910
733,590
765,000
275,000
260,100
779,900
930,000
275,000
316,200
888,800
1,111,500
275,000
377,910
1,008,590
Step 2: CF from assets
first CF from operations:
EBIT
+ depreciation
- taxes
= operating CF
NWC
Year –1 = 0
Year 0: $900,000
year 4: $0
615,000
275,000
209,100
680,900
Addition (Change): 900,000
Addition (Change): -900,000
Capital spending:
initial investment: $1,100,000
market value: $550,000
book value: 0
after-tax salvage value: $550,000 - [.34 x ( 550,000-0)]
550,000 – 187,000 = 363,000
the equipment was over-depreciated, firm paid too little taxes and taxes
have to be paid now.
(note: book value was = 0, market value of 550,000 is taxable!
550,000 x (1 - .34))
3
CF from assets:
year
0
operating CF
- add. to NWC -900,000
- cap. spend -1,100,000
Total CF
-2,000,000
1
680,900
0
2
779,900
0
3
888,800
0
680,900
779,900
888,800
4
1,008,590
900,000
363,000
2,271,590
Step 3:
NPV at 20%:
NPV = 718,847
IRR = .34
PI = 2,718,847/2,000,000 = 1.3594
This investment is quite profitable!
IV . Three special types of projects (for first two: don’t need to solve
problem only know roughly how to get CFs
a) cost-cutting project (machine that will be more efficient and reduce
costs)
Evaluate if future (after-tax) cost savings of a new equipment are larger
than the expense for the equipment
After-tax because EBIT is larger if lower costs, pay more taxes
The after-tax cost saving plus the depreciation tax shield is your operating
income
Everything else stays the same
Change in NWC if there is any and capital spending (-investment & after
tax salvage).
b) top p.320 setting the bid-price (your customer wants to by a product;
receives bids from different competitors)
firm has to put in a bid
what is lowest price it can charge and still be profitable?
Find the price that will make operating CF and therefore CF from assets so
large that the NPV is zero at a given discount rate. Then calculate the break
even price.
Calculate everything backwards
1. calculate OCF every year that will set the NPV = zero
or the PV of future CFs equal to cost.
p. 320
PV = -cost + PV of last year NWC and after tax salvage
R = rate
N= time
CPT PMT
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Example: on page 324:
Year 0
1
2
3
4
-$79,239
OCF OCF OCF OCF
-79,239 PV
20% I/Y
4N
CPT PMT: 30,609.16
Knowing the OCF and depreciation, calculate the NI
NI = OCF - Depr
Knowing NI and costs calculate the Sales
NI = (sales – cost – depr) x (1-t)
solve for sales
Knowing sales and how many units need to be produced:
Sales/units = unit price
c) evaluating projects with different economic lives.
which equipment is the most cost effective?
Using the NPV rule does not work: THIS IS THE ONLY EXCEPTION!
Comparing oranges to apples
Assumption: We need the equipment indefinitely, when it wears out we
need to buy a new one.
One piece of equipment costs less to operate than the other but is wears
out faster.
How to we compare the two? equivalent annual cost, EAC
what is amount that if paid every year would be equal to the NPV
of the equipment
what is the payment of an annuity that has a PV equal to the NPV
PMT = EAC = equivalent annual cost
chose the one with the lowest PV of cost
example P. 325:
A:
0
1
-100 -10
2
-10
0
1
2
3
ignore taxes, r = 10%
B:
-140 -8
-8
-8
NPV & PV of costs for project A: -$117.36, I/Y=10, N=2, CPT PMT = -$67.62
NPV & PV of costs for project B: -$159.89, I/Y=10, N=3, CPT PMT = -$64.29
Compare PMT: -$67.62 project A vs. -$64.29 project B
Chose the lower cost project: B
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Review:
Chapters 7, 8, 9, 10
50 multiple choice
formula sheet given on web-page, course materials, exams
Ch 7:
Bond Valuation & Interest Rates
Know the terminology for bonds
discount (price < face) vs. premium (price > face)
understand the valuation formula for bonds
semiannual vs. annual (adjust YTM & coupon by dividing by 2, multiply tx2)
interest rate risk (time to maturity (direct) coupon rate (indirect)
Reporting of bonds in the press: current yield = coupon/current price
indenture (what is covered in it), callable, protective covenants,
diff between bonds and equity
know the different types of bonds
inflation (fisher effect) & term structure, calculate the variables in the
formula
Ch 8:
Stocks & Stock Valuation
Use dividends
valuation under three scenarios
a) zero growth (perpetuity),
b) constant growth (dividend growth model) what is it comprised of?
c) non-constant growth
understand dividends and their tax deductibility
reporting of stocks in press (dividend yield), what is reported
voting procedures (cumulative and straight: # of total votes, # shares
needed to guarantee a seat)
read over the parts of how the OTC and the NYSE works, the players
primary and secondary markets
Ch. 9 Investment Criteria:
NPV (best)
Payback Rule
Not the AAR!
IRR (ranking conflict and cannot be used for non-conventional CFs)
PI
know how to calculate, advantages and disadvantages of each
crossover rate
mutually exclusive projects
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Ch. 10 Making Capital Investment Decisions
calculate CFs = cash flows from assets
which costs are/are not included?
op. cash flow - add. to NWC - add to net cap. Spending
at what time do they occur?
special situations (cost-cutting, setting bid-price, different economic lives)
know the concepts)
cost cutting: project has initial cost and then reduces cost by a certain
amount (after-tax cost savings).
what is a pro-forma statement?
Example:
Calculate the NPV given the following information:
Straight-line depreciation
OCF per year = 2000
Life = 3 years
Initial investment = 5,000
Initial investment in NWC = 3,000
Salvage value at the end of year 3 = 3500
Tax rate = 35%, interest rate = 12%
Year 0
OCF
- add in Cap sp.
- add to NWC
-5,000
-3000
-8000
1
2000
2000
2
2000
3
2000
3500(.65)=2275
3000
2000
7275
NPV = 558.30
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