Capital Budgeting1 Select investments which increase value of firm Maximize wealth of shareholders Important to firm’s long-term success  Substantial cost  Cash flows over long time period Big Picture…

Capital Budgeting2 Steps in evaluating capital assets Determine cost of asset Estimate incremental cash flows  Very difficult but…  Very important… Determine decision criteria Apply decision criteria Compare actual results to projected

Capital Budgeting3 Incremental After-Tax Cash Flows Sunk costs Opportunity costs Erosion/synergy Net working capital Financing costs Taxes matter

Capital Budgeting4 Sunk costs and opportunity costs Converting a factory from making Chevy Caprices to pickup trucks… Cost of factory relevant?  Sunk costs: costs already incurred are not relevant Sales price of factory relevant?  Opportunity costs: cash flows we would receive if we reject the project.  Relevant

Capital Budgeting5 Erosion/Synergy Steak N Shake opens in Charleston… Impact on Mattoon location  Erosion: decrease in sales of existing products Relevant  Synergy: additional sales of existing products Relevant

Capital Budgeting6 Net working capital Project will initially require:  Increase in inventory (use cash)  Increase in A/R (use cash)  Increase in A/P (source) At the end of the project,  Decrease in inventory (source of cash)  Decrease in A/R (source cash)  Decrease in A/P (use cash)

Capital Budgeting7 Financing costs Not considered relevant… Presumably would require rate of return greater than cost of financing

Capital Budgeting8 Taxes After-tax cash flow is what matters Tax impact of depreciation  Reduce taxable income without requiring cash expenditure

Capital Budgeting9 Taxes Sale of asset at end of project  Factory purchased for $10 million 10 years ago. After taking $6 million of depreciation, factory is sold for $5 million. Book ValueGain Cost $10 mil Sales Price $ 5 mil Acc Depr 6 mil Book Value 4 mil Book Value 4 milGain 1 mil

Capital Budgeting10 Taxes Trade asset  No tax on “gain”  Book value + cash paid = Depreciable cost Sell asset  If market value < book value Book ValueGain Cost $10 mil Sales Price $ 1 mil Acc Depr 6 mil Book Value 4 mil Book Value 4 mil Loss 3 mil

Capital Budgeting11 Evaluating NPV Estimates Forecasting risk Scenario analysis Sensitivity analysis Managerial options

Capital Budgeting12 Forecasting Risk Make a wrong decision based on capital budgeting analysis  Accept a project which actually has a negative NPV  Reject a project which actually has a positive NPV Remember importance of required rate of return in calculating NPV

Capital Budgeting13 Scenario analysis Calculate NPV using:  Pessimistic assumptions in calculations Should this result in a negative NPV?  Optimistic assumptions in calculations Should this result in a negative NPV?

Capital Budgeting14 Sensitivity analysis What assumptions have the greatest impact on NPV?  Calculate pessimistic and optimistic NPVs while only changing one variable  Which assumption has the biggest impact on NPV? Example: apartment complex  Change monthly rents  Change vacancy rate  Change repair expense

Capital Budgeting15 Managerial Options Option to expand  If project does have large NPV Option to abandon  If NPV is less than anticipated Option to wait  If project will have positive NPV in future When should you reduce or stop expansion ? Raw land…