Ch. 9: Making Capital Investment Decisions NPV of a Project Relevant Cash Flows Pro Forma Financial Statements Evaluating NPV Estimates Real Options Capital Rationing

NPV of a Project See Table 9.14 on p. 256 Calculate relevant net cash flow for each period Discount by WACC, if project’s risk is similar to firm’s (Ch. 12) Adjust WACC up or down if project’s risk is significantly higher or lower (Ch. 12)

Relevant Project Cash Flows Use aftertax incremental cash flows: any change in the firm’s future cash flows because of the project, including side effects. Exclude sunk costs. Use opportunity cost: the most valuable alternative given up if the project is undertaken. Since WACC includes inflation, so should projected cash flows (i.e., they should be nominal). Project’s cash flow = + project’s operating cash flow - project’s change in net working capital - project’s capital spending

Relevant CFs (cont.) Exclude financing costs from cash flows (interest expense, principal payments, dividends) because they are already in WACC Ex.: One-year project, initial cost = $100. Borrow $100 at 10% (WACC) for a year; ignoring taxes, need to make $110 to break even (NPV=0): NPV = -$100 + $110/1.10 -CORRECT If we incorrectly deduct financing cost from Year 1 cash flow, we would be double-counting: NPV = -$100 + $(110-10)/1.10 = -$9.09 -WRONG

Pro Forma Financial Statements See Tables 9.9 - 9.14 on pp. 253-6 Project’s cash flow = + project’s operating cash flow - project’s change in net working capital - project’s capital spending Project’s operating cash flow = EBIT + depreciation - taxes Depreciation: see next slide Subtract project’s change in net working capital Subtract project’s capital spending

Net Salvage Value net salvage value = salvage (market) value - taxes taxes = tax rate * gain on sale gain on sale = salvage (market) value - book value book value = original depreciable basis - accumulated depreciation MACRS Tables 9.6 & 9.7, p. 250 Book Value versus Market Value The Half-year convention implies 7-year asset depreciated over 8 years, etc.

Evaluating NPV Estimates Cash flows are estimates into the future Forecasting (estimation) risk: the possibility that errors in projected cash flows will lead to incorrect decisions Analyze sources of project’s value Scenario analysis: base case, optimistic case, pessimistic case Sensitivity analysis: see how sensitive the NPV conclusion to one variable by varying it while using base case for all other inputs.

Real Options, Capital Rationing Real (a.k.a. managerial, embedded) options option to expand, option to abandon, option to wait, strategic options Capital rationing: funds are not available for a project with positive NPV

Recommended Practice Self-Test Problems 9.1 & 9.2 on pp. 266-7 Questions 2, 3, 7-9 (starts after 6), 12 on pp. 267-8 Problems on pp. 268-71: 1, 7, 9-12, 19, 21 (most answers are on p. 548)