1. Making capital investment decisions
Chapter 9

2. 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

3. 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

4. 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.
Incremental cash flows—The difference between a firm’s future cash flows with a project and without the project.
Stand-alone principle—The assumption that evaluation of a project may be based on the project’s 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

5. 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

6. 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
With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant.
Sunk costs—our government provides ample examples of inappropriately including sunk costs in their capital allocation decisions.
Opportunity costs—the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not ‘free’. At the very least we could sell the land; consequently if we choose to use it, we cost ourselves the selling price of the asset.
A good example of a positive side effect is if you will establish a new distribution system with this project that can be used for existing or future projects. The benefit provided to those projects needs to be considered.
The most common negative side effect is erosion or cannibalism, where the introduction of a new product will reduce the sales of existing, similar products. A good real-world example is McDonald’s introduction of the Arch Deluxe sandwich. Instead of generating all new sales, it primarily reduced sales of the Big Mac and the Quarter Pounder.
It is important to consider changes in NWC. We need to remember that operating cash flow derived from the income statement assumes all sales are cash sales and that the COGS was actually paid in cash during that period. By looking at changes in NWC specifically, we can adjust for the difference in cash flow that results from accounting conventions. Most projects will require an increase in NWC initially as we build inventory and receivables.
We do not include financing costs. Students often have difficulty understanding why when it appears that we will only raise capital if we take the project. It is important to point out that because of economies of scale, companies generally do not finance individual projects. Instead, they finance an entire portfolio of projects at one time. The other reason has to do with maintaining a target capital structure over time, but not necessarily each year.
Taxes will change as the firm’s taxable income changes. Consequently, we have to consider cash flows on an after-tax basis.
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

7. 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
EBIT—Earnings before income and taxes
Note that cash flow from assets (CFFA) is referred to as project cash flow in the textbook.
Operating cash flow—students often have to go back to the income statement to see that the two definitions of operating cash flow are equivalent when there is no interest expense.
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

8. Shark attractant project
Estimated sales cans
Sales price per can $4.00
Cost per can $2.50
Estimated life 3 years
Fixed costs $12 000/year
Initial equipment cost $90,000
100% depreciated over 3-year life
Investment in NWC $20 000
Tax rate %
Cost of capital 20%
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. Pro forma income statement Shark attractant project—Table 9.1
Sales ( units at $4.00/unit) $
Variable Costs ($2.50/unit)
Gross profit $
Fixed costs
12 000
Depreciation ($ / 3)
30 000
EBIT $
Taxes (30%)
9 900
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

10. Projected capital requirements—Table 9.2
Year 1 2 3
NWC
$20 000
Net fixed assets
90 000
60 000
30 000
Total investment $
$80 000
$50 000
Ask the students why net fixed assets is decreasing each year. It is important for them to understand this when they go to compute the net capital spending in the next slide.
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

11. Projected total cash flows— Table 9.5
Year 1 2 3
OCF
$53 100
Change in NWC
-$20 000
20 000
Capital spending
-$90 000
Total project cash flow
-$110 00
$73 100
OCF = EBIT + Depreciation – Taxes = – = ; or
OCF = NI + Depreciation = =
Note that in the Table in the textbook, the negative signs have already been carried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending.
Change in NWC = We have a net investment in NWC in year 0 of ; we get the investment back at the end of the project when we sell our inventory, collect on our receivables and pay off our payables. Students often forget that we get the investment back at the end.
Capital spending—Remember that Net capital spending = Change in net fixed assets + Depreciation. So in year one NCS = ( – ) = 0; The same is true for the other years.
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

12. Shark attractant project
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

13. 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 = ; C01 = ; F01 = 2; C02 =
[NPV]; I = 20; [CPT] [NPV] =
[CPT] [IRR] = 27.3%
Do we accept or reject the project?
You can also use the formulas to compute NPV and IRR, just remember that the IRR computation is trial and error.
Click on the Excel icon to go to an embedded spreadsheet that illustrates how the pro formas and cash flows can be set up to compute the NPV and IRR.
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

14. 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.
Depreciation tax shield—The tax saving that results from the tax allowable depreciation deduction, calculated as depreciation multiplied by the 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

15. 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.
The first two items mean that our operating cash flow does not include the impact of accounts receivable and accounts payable on cash flow. The third item is very much like the purchase of fixed assets. We have to buy the assets (have the cash flow) before we can generate sales.
By looking at changes in NWC, we can incorporate the increased investment in receivables and inventory that is necessary to support additional sales. Because we look at changes in NWC, and not just current assets, we also incorporate the increase in our payable accounts that partially pays for the investment in inventory and receivables.
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

16. 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

17. 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.
The MACRS (Modified Accelerated Cost Recovery System) percentages are given in Table 9-7.
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

18. 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).
T is the 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

19. 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

20. Example: Depreciation and after-tax salvage
Car purchased for $12 000
8-year property
Marginal tax rate = 30%
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

21. Salvage value and tax effects
Net salvage cash flow = SP - (SP-BV)(T)
If sold at EOY 5 for $5100:
NSCF = (5100 – )(.3) = $
= $5100 – = $
If sold at EOY 2 for $4600:
NSCF = (4600 – )(.3) = $
= $4600 – ( ) = $
Notice in the textbook this example is solved using the prime cost method. We solve this here using the diminishing value method for illustration.
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

22. Majestic Mulch and Compost Co. (MMCC)
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

23. MMCC—Depreciation and after-tax salvage Table 9.9
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

24. MMCC—Net working capital Table 9.11
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

25. MMCC—Pro forma income statements
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

26. MMCC—Projected cash flows Table 9.12
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

27. 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

28. 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.
A good example of the worst case actually happening is the sinking of the Titanic. There were a lot of little things that went wrong, none of which were that important by themselves, but in combination they were deadly.
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

29. Scenario analysis— Example
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

30. Scenario analysis— Example (cont.)
The terms best case and worst case are very commonly used, and we will stick with them, but we should note that they are somewhat misleading.
Instead of best and worst, then, it is probably more accurate to say optimistic and pessimistic . In broad terms, if we were thinking about a reasonable range for, say, unit sales, what we call the best case would correspond to something near the upper end of that range. The worst case would simply correspond to the lower end.
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

31. 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

32. Sensitivity analysis: Unit sales
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. Sensitivity analysis: Fixed costs
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

34. 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

35. 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

36. 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

37. 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.
If you face hard rationing, you need to reevaluate your analysis. If you truly estimated the required return and expected cash flows appropriately and computed a positive NPV, then capital should be available.
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

38. 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

39. Chapter 9
END