1. 1 Chapter 6: Analyzing Investment Projects Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc. Objective Explain Capital Budgeting Develop Criteria

2. 2 Chapter 6 Contents  The Nature of Project Analysis  Where do Investments Ideas come from?  The NPV Investment Rule  Estimating a Project.s Cash Flows  Cost of Capital  Sensitivity Analysis  Analyzing Cost- Reducing Projects  Projects with Different Lives  Ranking Mutually Exclusive Projects  Inflation & Capital Budgeting

3. 3 Objectives  To show how to use discounted cash flow analysis to make decisions such as: Whether to enter a new line of business Whether to invest in equipment to reduce costs

4. 4 Types of Investment Projects  New Products  Cost Reduction  Replacing of Existing Assets

5. 5 Where Do Investment Ideas Come from  Surveys of Customers  R&D Department  Competition  Production Divisions

6. 6 The NPV Rule Invest if the proposed project ’ s NPV is positive

7. 7 Example: Generic Jeans Company The company is considering whether to produce a new line of jeans called Protojeans. The Cash Flow forecasts read as follows:

8. 8 Cash Flow Forecasts Year Cash Flows (in thousands of dollars) 0-$100 1 $50 2 $40 3 $30

9. 9 Protojean Projects If we discount each year ’ s cash flow at a rate of 8% per year we will have: YearCash Flows (,000) PV of CF at 8% Cumulative PV 0-100-100.00000-100.0000 150 46.29630 -53.70370 240 34.29355 -19.41015 330 23.81497 4.4082

10. 10

11. 11 Example: Compusell Corporation The PC1000 project, a new type of personal computer. The next table shows the estimated annual sales revenue, operating costs, and profit for the PC1000:

12. 12 Net Cash Inflow from Operations  Cash Flow= Revenue-Cash Expenses- Taxes  Cash Flow= Revenue-Total Expenses- Taxes+Noncash Expenses = Net Income+Noncash Expenses

13. 13

14. 14 Was 15%

15. 15 Was 40%

16. 16 Was 0%

17. 17 Was 75%

18. 18 Was $3,100,000

19. 19

20. 20 Carry-forward, Carry-back When Calculating capital gains for tax purposes, a firm nets out all capital losses in the same year. If capital losses exceed capital gains, the net capital loss may be carried back to reduce taxable capital gains in the three prior years. Under the carry-back feature, a firm files

21. 21 Carry-forward, Carry-back A revised tax return and receives a refund of prior years ’ taxes. For example, suppose Canadian Enterprises experienced a net capital loss of $1 million in 2000 and net capital gains of $300,000 in 1999, $200,000 in 1998, and $150,000 in 1997.

22. 22 Carry-forward, Carry-back Canadian could carry back a total of $650,000 to get a refund on its taxes. The remaining $350,000 can be carried forward indefinitely to reduce future taxes on capital gains.

23. 23 Carry-forward, Carry-back A similar carry-forward provision applies to operating losses. The carry-back period is three years and carry forward is allowed up to seven years.

24. 24 Table 6.4 Project Sensitivity to Sales Volume

25. 25

26. 26

27. 27

28. 28 Projects with Different Lives Example: Two labor-saving equipment 1) Costs $2 million, has an expected life of 5 years 2) Costs $4 million, lasts for 10 years Discount rate 10%

29. 29 Annualized capital Cost The annual cash payment that has a present value equal to the initial outlay

30. 30 Projects with different lives 1) n=5, i=10, PV=-2000000, FV=0 PMT=$527595 2) n=10, i=10, PV=-4000000, FV=0 PMT=$650982 So equipment 1) is the preferred one.

31. 31 Inflation and Capital Budgeting RULE: There are two correct ways of computing NPV: 1. Use the nominal cost of capital to discount nominal cash flows. 2. Use the real cost of capital to discount real cash flows.

32. 32 Inflation and Capital Budgeting  Example: An investment with an initial outlay of $2 million, produces an annual after-tax real CF of $600000 for 5 years, the cost of capital is 10%. Inflation rate is 6% per year. We can summarize the information in the following table:

33. 33 Investment under 6% inflation YearReal Cash Flow Nominal CF (6% inflation) 1600,000636,000 2600,000647,160 3600,000714,610 4600,000757,486 5600,000802,935

34. 34 Inflation and … 1) By discounting the annual 600,000 by 10% we come to PV=$2,274,472. So that NPV=$2,274,472-2,000,000=$274,472 2) By discounting the third column by 16.6% nominal rate we get the same PV and NPV=$247,472

35. 35 Analyzing Cost-Reducing Projects A firm is considering an investment proposal to automate its production process to save labor costs. It can invest $2 million now in equipment and save $700,000 per year in pretax labor costs. If the equipment has an expected life of 5 years and if the tax rate is (33+1/3)%, is this investment worthwhile?

36. 36 Cost-Reducing Projects We must compute the incremental cash flows due to the investment

37. 37 Incremental Cash flows Without Investment With Investment Difference Due to Inv. Revenue$5,000,000 0 Labor Costs 1,000,000 300,000-$700,000 Other cash expenses 2,000,000 0 Depreciation 1,000,000 1,400,000 $400,000 Pretax profit 1,000,000 1,300,000 $300,000 Income tax 333,333 433,333 $100,000 After-tax pr. 666,667 866,667 $200,000 Net CF$1,666,667$2,266,667 $600,000

38. 38 Time Line NPV =$2,274,472-$2,000,000 =$274,472

39. 39 Cost-reducing Projects (2) Steiness Danish Ham, Inc., is contemplating buying a new machine that has an economic life of five years. The cost of machine is 1,242,000 krone and will be fully depreciated using the straight line method. At the end of five years it will have a market value of 138,000 krone.

40. 40 It is estimated that the new machine will save the company 345,000 krone per year due to reduced labor costs. Moreover, it will lead to a reduction in net working capital of 172,500 krone because of the higher yield from raw materials inventory. The net working

41. 41 Capital will be recovered by the end of the five years. If the corporate tax is 34% and the discount rate is 12%, what is the NPV of the project?

42. Working Capital Working Capital=Current Assets – Current Liabilities Current Assets: Inventories, Accounts Receivable Current Liabilities: Accrued Expenses, Accounts Payable 42

43. The Cash Flow Cycle Ordered Arrives Finished Goods Sold Cash Received Inventory Period Receivable Period Payable Period Time Cash Cycle Time Invoice Received Cash Paid 43

44. 44 Solution: Incremental cash flows Years 1 to 4 (in thousands krone) Revenue 0 Labor costs -345 Other cash expenses 0 Depreciation 248.4 Pretax profit 96.6 Income taxes 32.844 After-tax pr. 63.756 NCF 312.156

45. 45 Year 5 Labor costs -345 Depreciation 248.4 Pretax profit 96.6 Income taxes 32.844 After-tax pr. 63.756 OCF 312.156 Chg. in Working Cap. -172.5 Salvage value 138 Tax on Capital Gain.34*138 Terminal Value 91.08 NCF 230.736

46. 46 Year 0 Working Capital -172.5 Investment in P&E 1,242 Investment CF 1,069.5 NCF 1,069.5

47. 47 Time Line

48. 48

49. Comparing 2 projects with different lifetimes  You are evaluating two different pollution control options 1. A filtration System: Installation Cost $1.1 million Pretax AOC $60,000 Lifetime 5 years 49

50. Comparing 2 projects with different lifetimes 2. A Precipitation System Installation Cost $1.9 million Pretax AOC $10,000 Lifetime 8 years Discount rate: 12% Tax rate: 40% 50

51. Incremental Cash Flow of two Projects NCF=(1-t)(R-C-D)+D =(1-t)(R-C)+tD As about Cost: Cost=-(1-t)C+tD 51

52. Incremental Cash Flow of two Projects Filtration SystemPrecipitation System After tax operating cost -$36,000-$6,000 Depreciation tax shield $ 88,000 $95,000 Operating CF $ 52,000 $89,000 PV of operating CF $ 187,450 $ 442,116 Capital spending-$1,100,000-$1,900,000 Total PV of costs-$912,550-$1,457,884 52

53. Incremental Cash Flow of two Projects  ACC: Annualized Capital Cost -912,550=ACC(F)*3.6048 ACC(F)=-$253,149 -1,457,884=ACC(P)*4.9676 ACC(P)=-$293,479 53