Making capital investment
decisions
Chapter 9
Key concepts and skills
• Understand how to determine the relevant
cash flows for a proposed investment
• Understand how to analyse a project’s
projected cash flows
• Understand how to evaluate an estimated
NPV
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-2
Chapter outline
• Project cash flows: A first look
• Incremental cash flows
• Pro forma financial statements and project
cash flows
• More on project cash flow
• Evaluating NPV estimates
• Scenario and other what-if analyses
• Additional considerations in capital budgeting
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-3
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.
• These cash flows are called incremental
cash flows.
• The stand-alone principle allows us to
analyse each project in isolation from the
firm, simply by focusing on incremental
cash flows.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-4
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 ‘in part’, then we should
include the part that occurs because of the
project.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-5
Common types of cash flows
• Sunk costs—costs that have accrued in the past
– Should not be considered in investment decision
• Opportunity costs—costs of lost options
• Side effects
– Positive side effects—benefits to other projects
– Negative side effects—costs to other projects
• Changes in net working capital
• Financing costs
– Not a part of investment decision
• Tax effects
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-6
Pro forma statements
and cash flow
• Pro forma financial statements
– Project future operations
• Capital budgeting relies heavily on pro forma
accounting statements, particularly income
statements.
• Computing cash flows—refresher
– Operating cash flow (OCF) = EBIT + Depreciation –
Taxes
– OCF = Net income + Depreciation when there is no
interest expense
– Cash flow from assets (CFFA) = OCF – Net capital
spending (NCS) – Changes in NWC
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-7
Shark attractant project
•
•
•
•
•
•
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
– 100% depreciated over 3-year life
• Investment in NWC
• Tax rate
• Cost of capital
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
$20 000
30%
20%
9-8
Pro forma income statement
Shark attractant project—Table 9.1
Sales (50 000 units at
$4.00/unit)
$200 000
Variable Costs ($2.50/unit)
125 000
Gross profit
$ 75 000
Fixed costs
12 000
Depreciation ($90 000 / 3)
30 000
EBIT
Taxes (30%)
Net Income
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
$ 33 000
9 900
$ 23 100
9-9
Projected capital requirements—
Table 9.2
Year
0
NWC
Net fixed
assets
Total
investment
1
2
3
$20 000
$20 000
$20 000
$20 000
90 000
60 000
30 000
0
$110 000
$80 000
$50 000
$20 000
NFA declines by the amount of depreciation each year.
Investment = book or accounting value, not market value.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-10
Projected total cash flows—
Table 9.5
Year
0
OCF
1
$53 100
Change in
NWC
-$20 000
Capital
spending
-$90 000
Total project
cash flow
-$110 00
2
$53 100
3
$53 100
20 000
$53 100
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
$53 100
$73 100
9-11
Shark attractant project
Year
Sales
Variable Costs
Gross Profit
Fixed Costs
Depreciation
EBIT
Taxes
Net Income
Pro Forma Income Statement
0
1
200,000
125,000
75,000
12,000
30,000
33,000
9,900
23,100
Operating Cash Flow
Changes in NWC
Net Capital Spending
Cash Flow From Assets
Net Present Value
IRR
Cash Flows
53,100
-20,000
-90,000
-110,000
53,100
2
200,000
125,000
75,000
12,000
30,000
33,000
9,900
23,100
3
200,000
125,000
75,000
12,000
30,000
33,000
9,900
23,100
53,100
53,100
20,000
53,100
73,100
$13,428.24
27.25%
OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation (if no interest)
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-12
Making the decision
• Now that we have the cash flows, we can apply
the techniques that we learned in Chapter 8.
• Enter the cash flows into the calculator and
compute NPV and IRR.
– CF0 = -110 000; C01 = 53 100; F01 = 2; C02 = 73 100
– [NPV]; I = 20; [CPT] [NPV] = 13 428
– [CPT] [IRR] = 27.3%
• Do we accept or reject the project?
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-13
The tax shield approach
• You can also find operating cash flow using the
tax shield approach.
• OCF = (Sales – Costs)(1 – T) +Depreciation*T
• This form may be particularly useful when the
major incremental cash flows are the purchase of
equipment and the associated depreciation tax
shield, such as when you are choosing between
two different machines.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-14
More on NWC
• Why do we have to consider changes in NWC
separately?
– AAS require that sales be recorded on the income
statement when made, not when cash is received.
– AAS also require 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.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-15
Depreciation and capital budgeting
• The depreciation expense used for capital
budgeting should be the depreciation
schedule required by the ATO for tax
purposes.
• Depreciation itself is a non-cash expense.
Consequently, it is only relevant because it
affects taxes.
• Depreciation tax shield = DT
– D = depreciation expense
– T = marginal tax rate
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-16
Computing depreciation
• Prime cost (straight-line) depreciation
– D = (Initial cost –Salvage)/Number of years
– Most assets are depreciated straight-line to
zero for tax purposes.
• Diminishing value depreciation
– Need to know which depreciation rate is
appropriate for tax purposes.
– Multiply percentage by the written-down
value at the beginning of the year.
– Depreciate to zero.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-17
After-tax salvage
• If the salvage value is different from the
book value of an asset, there is a tax effect.
• Book value = Initial cost – Accumulated
depreciation.
• After-tax salvage = Salvage – T(salvage –
book value).
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-18
Tax effect on salvage
• Net salvage cash flow
= SP - (SP-BV)(T)
•
Where:
– SP = selling price
– BV = book value
– T = corporate tax rate
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-19
Example:
Depreciation and after-tax salvage
• Car purchased for $12 000
• 8-year property
• Marginal tax rate = 30%
Prime Cost @12.5%
Year
0
1
2
3
4
5
6
7
8
Depreciation
1500
1500
1500
1500
1500
1500
1500
1500
End BV
12000
10500
9000
7500
6000
4500
3000
1500
0
Diminishing Value @18.75%
Beg BV
$ 12,000.00 $
$ 9,750.00 $
$ 7,921.88 $
$ 6,436.52 $
$ 5,229.68 $
$ 4,249.11 $
$ 3,452.40 $
$ 2,805.08 $
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
Deprec
2,250.00
1,828.13
1,485.35
1,206.85
980.56
796.71
647.33
525.95
$
$
$
$
$
$
$
$
End BV
$12,000
9,750.00
7,921.88
6,436.52
5,229.68
4,249.11
3,452.40
2,805.08
2,279.13
9-20
Salvage value and tax effects
Prime Cost @12.5%
Year
0
1
2
3
4
5
6
7
8
Depreciation
1500
1500
1500
1500
1500
1500
1500
1500
End BV
12000
10500
9000
7500
6000
4500
3000
1500
0
Diminishing Value @18.75%
Beg BV
$ 12,000.00
$ 9,750.00
$ 7,921.88
$ 6,436.52
$ 5,229.68
$ 4,249.11
$ 3,452.40
$ 2,805.08
$
$
$
$
$
$
$
$
Deprec
2,250.00
1,828.13
1,485.35
1,206.85
980.56
796.71
647.33
525.95
$
$
$
$
$
$
$
$
End BV
$12,000
9,750.00
7,921.88
6,436.52
5,229.68
4,249.11
3,452.40
2,805.08
2,279.13
Net salvage cash flow = SP - (SP-BV)(T)
If sold at EOY 5 for $5100:
NSCF = 5100 - (5100 – 4249.11)(.3) = $4844.733
= $5100 – 255.267= $ 4844.733
If sold at EOY 2 for $4600:
NSCF = 4600 - (4600 – 7921.88)(.3) = $ 5596.564
= $4600 – ( -996.564) = $ 5596.564
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-21
Majestic Mulch and Compost Co.
(MMCC)
Majestic Mulch and Compost Company (MMCC)
YEAR
0
1
Background Data:
Unit Sales Estimates
3,000
Variable Cost /unit $
60.00
Fixed Costs per year$
25,000.00
Sale Price per unit $
120.00
$ 120.00
Tax Rate
30.0%
Required Return on Project 15.0%
Yr 0 NWC
$
20,000.00
NWC % of sales
15%
Equipment cost - installed
$
800,000
Salvage Value in year 8
20% of equipment cost
Depreciation Calculations:
Equipment Depreciable Base
800,000
Prime Cost % (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)
20%
2
3
4
5
6
5,000
6,000
6,500
6,000
5,000
$ 120.00
$ 120.00
$ 110.00
$ 110.00
$ 110.00
7
$
8
4,000
3,000
110.00
$ 110.00
15.00%
120,000
680,000
15.00%
120,000
560,000
15.00%
120,000
440,000
15.00%
120,000
320,000
15.00%
120,000
200,000
15.00%
120,000
80,000
15.00%
80,000
0
0
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
48,000
112,000
Required Net Working Capital Investment
20,000
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-22
MMCC—Depreciation and after-tax salvage
Table 9.9
Majestic Mulch and Compost Company (MMCC)
YEAR
0
1
Background Data:
Unit Sales Estimates
3,000
Variable Cost /unit $
60.00
Fixed Costs per year$
25,000.00
Sale Price per unit $
120.00
$ 120.00
Tax Rate
30.0%
Required Return on Project 15.0%
Yr 0 NWC
$
20,000.00
NWC % of sales
15%
Equipment cost - installed
$
800,000
Salvage Value in year 8
20% of equipment cost
Depreciation Calculations:
Equipment Depreciable Base
800,000
Prime Cost % (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)
20%
2
3
4
5
6
5,000
6,000
6,500
6,000
5,000
$ 120.00
$ 120.00
$ 110.00
$ 110.00
$ 110.00
7
$
8
4,000
3,000
110.00
$ 110.00
15.00%
120,000
680,000
15.00%
120,000
560,000
15.00%
120,000
440,000
15.00%
120,000
320,000
15.00%
120,000
200,000
15.00%
120,000
80,000
15.00%
80,000
0
0
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
48,000
112,000
Required Net Working Capital Investment
20,000
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-23
MMCC—Net working capital
Table 9.11
Majestic Mulch and Compost Company (MMCC)
YEAR
0
1
Background Data:
Unit Sales Estimates
3,000
Variable Cost /unit $
60.00
Fixed Costs per year$
25,000.00
Sale Price per unit $
120.00
$ 120.00
Tax Rate
30.0%
Required Return on Project 15.0%
Yr 0 NWC
$
20,000.00
NWC % of sales
15%
Equipment cost - installed
$
800,000
Salvage Value in year 8
20% of equipment cost
Depreciation Calculations:
Equipment Depreciable Base
800,000
Prime Cost % (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)
20%
2
3
4
5
6
5,000
6,000
6,500
6,000
5,000
$ 120.00
$ 120.00
$ 110.00
$ 110.00
$ 110.00
7
$
8
4,000
3,000
110.00
$ 110.00
15.00%
120,000
680,000
15.00%
120,000
560,000
15.00%
120,000
440,000
15.00%
120,000
320,000
15.00%
120,000
200,000
15.00%
120,000
80,000
15.00%
80,000
0
0
0
54,000
90,000
108,000
107,250
99,000
82,500
66,000
49,500
160,000
0
160,000
48,000
112,000
Required Net Working Capital Investment
20,000
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-24
MMCC—Pro forma income statements
YEAR
Initial Investment
Equipment Cost
Sales
Variable Costs
Fixed Costs
Depreciation (Eqpt))
EBIT
Taxes
Net Operating Income
Add back Depreciation
CASH FLOW from Operations
NWC investment & Recovery
Salvage Value
TOTAL PROJECTED CF
1
2
3
4
5
6
7
8
-20,000
360,000
180,000
25,000
120,000
35,000
10,500
24,500
120,000
144,500
-34,000
600,000
300,000
25,000
120,000
155,000
46,500
108,500
120,000
228,500
-36,000
720,000
360,000
25,000
120,000
215,000
64,500
150,500
120,000
270,500
-18,000
715,000
390,000
25,000
120,000
180,000
54,000
126,000
120,000
246,000
750
660,000
360,000
25,000
120,000
155,000
46,500
108,500
120,000
228,500
8,250
550,000
300,000
25,000
120,000
105,000
31,500
73,500
120,000
193,500
16,500
440,000
240,000
25,000
80,000
95,000
28,500
66,500
80,000
146,500
16,500
-820,000
110,500
192,500
252,500
246,750
236,750
210,000
163,000
330,000
180,000
25,000
0
125,000
37,500
87,500
0
87,500
66,000
112,000
265,500
Discounted Cash Flows
-820,000
96,087
145,558
166,023
141,080
117,707
90,789
61,278
86,792
Cumulative Cash flows
-820,000 -709,500
-517,000
-264,500
-17,750
219,000
429,000
592,000
857,500
NPV
IRR
Payback
0
-800,000
$85,313
17.85%
4.07
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-25
MMCC—Projected cash flows
Table 9.12
YEAR
Initial Investment
Equipment Cost
Sales
Variable Costs
Fixed Costs
Depreciation (Eqpt))
EBIT
Taxes
Net Operating Income
Add back Depreciation
CASH FLOW from Operations
NWC investment & Recovery
Salvage Value
TOTAL PROJECTED CF
0
1
2
3
4
5
6
7
8
-20,000
360,000
180,000
25,000
120,000
35,000
10,500
24,500
120,000
144,500
-34,000
600,000
300,000
25,000
120,000
155,000
46,500
108,500
120,000
228,500
-36,000
720,000
360,000
25,000
120,000
215,000
64,500
150,500
120,000
270,500
-18,000
715,000
390,000
25,000
120,000
180,000
54,000
126,000
120,000
246,000
750
660,000
360,000
25,000
120,000
155,000
46,500
108,500
120,000
228,500
8,250
550,000
300,000
25,000
120,000
105,000
31,500
73,500
120,000
193,500
16,500
440,000
240,000
25,000
80,000
95,000
28,500
66,500
80,000
146,500
16,500
-820,000
110,500
192,500
252,500
246,750
236,750
210,000
163,000
330,000
180,000
25,000
0
125,000
37,500
87,500
0
87,500
66,000
112,000
265,500
Discounted Cash Flows
-820,000
96,087
145,558
166,023
141,080
117,707
90,789
61,278
86,792
Cumulative Cash flows
-820,000 -709,500
-517,000
-264,500
-17,750
219,000
429,000
592,000
857,500
NPV
IRR
Payback
-800,000
$85,313
17.85%
4.07
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-26
Evaluating NPV estimates
• The NPV estimates are just that—
estimates.
• A positive NPV is a good start—now we
need to take a closer look.
– Forecasting risk—how sensitive is our NPV to
changes in the cash flow estimates? The more
sensitive, the greater the forecasting risk.
– Sources of value—why does this project create
value?
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-27
Scenario analysis
• What happens to the NPV under different
cash flow scenarios?
• At the very least, look at:
– Best case—revenues are high and costs are low
– Worst case—revenues are low and costs are high
– Measure of the range of possible outcomes
• Best case and worst case are not necessarily
probable, but they are still possible.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-28
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
30%
Required return
12%
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-29
Scenario analysis—
Example (cont.)
Units
Price/unit
Variable cost/unit
Fixed Cost
Sales
Variable Cost
Fixed Cost
Depreciation
EBIT
Taxes
Net Income
+ Deprec
TOTAL CF
NPV
IRR
$
$
$
$
BASE
6,000
80.00 $
60.00 $
50,000 $
WORST
5,500
75.00 $
62.00 $
55,000 $
BEST
6,500
85.00
58.00
45,000
480,000 $
360,000
50,000
40,000
30,000
9,000
21,000
40,000
412,500 $
341,000
55,000
40,000
-23,500
-7,050
-16,450
40,000
552,500
377,000
45,000
40,000
90,500
27,150
63,350
40,000
61,000
23,550
103,350
19,891
15.9%
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
(115,108)
-15.4%
172,554
43.0%
9-30
Sensitivity analysis
• What happens to NPV when we vary one
variable at a time?
• This is a subset of scenario analysis, where
we look at the effects of specific variables
on NPV.
• The greater the volatility in NPV in relation
to a specific variable, the larger the
forecasting risk associated with that
variable and the more attention we want
to pay to its estimation.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-31
Sensitivity analysis:
Unit sales
Units
Price/unit
Variable cost/unit
Fixed cost/year
$
$
$
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
Tax rate
Required Return
30%
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 $ 440,000
360,000
330,000
50,000
50,000
40,000
40,000
30,000
20,000
9,000
6,000
21,000
14,000
40,000
40,000
Unit Sales Sensitivity
50,000.00
$45,125
40,000.00
NPV
30,000.00
$19,891
20,000.00
10,000.00
0.00
5,500$(5,342)
-10,000.00
6,000
Unit Sales
6,500
TOTAL CF
NPV
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
61,000
$
19,891
$
UNITS
5,500
80 $
60 $
50,000 $
UNITS
6,500
80
60
50,000
$ 520,000
390,000
50,000
40,000
40,000
12,000
28,000
40,000
54,000
68,000
(5,342) $
45,125
9-32
Sensitivity analysis:
Fixed costs
Units
Price/unit
Variable cost/unit
Fixed cost/year
$
$
$
Base
6,000
80
60
50,000
Fixed Cost
6,000
80
60
55,000
Fixed Cost
6,000
80
60
45,000
Initial investment
$ 200,000
Depreciated to salvage value of 0 over 5 years
Deprec/yr
$ 40,000
Fixed Cost Sensitivity
Tax rate
Required Return
30%
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 $ 480,000
360,000
360,000
50,000
55,000
40,000
40,000
30,000
25,000
9,000
7,500
21,000
17,500
40,000
40,000
35,000.00
$32,508
30,000.00
25,000.00
20,000.00
FC
6,000
80 $
60 $
55,000 $
FC
6,000
80
60
45,000
NPV
$19,891
15,000.00
10,000.00
$7,275
5,000.00
0.00
$45,000
$50,000
$55,000
Fixed Cost
TOTAL CF
NPV
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
61,000
$
19,891
$ 480,000
360,000
45,000
40,000
35,000
10,500
24,500
40,000
57,500
$
7,275
64,500
$
32,508
9-33
Disadvantages of sensitivity and
scenario analysis
• Neither provides a decision rule.
– No indication of 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.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-34
Making a decision
• Beware of ‘analysis paralysis’.
• At some point you have to make a decision.
• If the majority of your scenarios have
positive NPVs, you may feel reasonably
comfortable about accepting the project.
• If you have a crucial variable that leads to a
negative NPV with a small change in the
estimates, you might want to forgo the
project.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-35
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
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-36
Capital rationing
• Capital rationing occurs when a firm or
division has limited resources.
– Soft rationing—the limited resources are
temporary, often self-imposed.
– Hard rationing—capital will never be available
for this project (this also implies an infinite
cost of capital).
• The profitability index is a useful tool when
faced with soft rationing.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-37
Quick quiz
• How do we determine if cash flows are
relevant to the capital budgeting decision?
• What is scenario analysis and why is it
important?
• What is sensitivity analysis and why is it
important?
• What are some additional managerial
options that should be considered?
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh
9-38
Chapter 9
END
9-39