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

2. 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)

3. 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

4. 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/ CORRECT
If we incorrectly deduct financing cost from Year 1 cash flow, we would be double-counting:
NPV = -$100 + $(110-10)/1.10 = -$ WRONG

5. Pro Forma Financial Statements
See Tables on pp
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

6. 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.

7. 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.

8. 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

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