1. Chapter 9 - Making Capital Investment Decisions

2. Estimating the Projects Cash Flows
Include only cash flows that will only occur if the project is accepted.
What is the incremental Concept
An incremental cash flow is the change in a firm’s cash flow attributable to an investment project. Use incremental cash flows.
Corporate cash flow with the project minus corporate cash flow without the project.

3. Estimating the Projects Cash Flows
Relevant Cash Flows
Sunk Cost
Opportunity Cost
Externalities

4. Estimating the Projects Cash Flows
Relevant Cash Flows - Continued
Inflation
Net Working Capital
Financing costs
Use After-Tax Cash Flows!

5. Estimating the Projects Cash Flows
Identify incremental cash flows for all phases of the project:
Initial Investment Outlay: The incremental cash flow that will occur only at the start of the project.
Initial Operating Cash Flow: The changes in day to day cash flows that result from the project and continue until the project ends.
Terminal Cash Flow: The net cash flow that occurs at the end of the project

6. Investment Project Estimated sales 50,000 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%

7. Pro Forma Income Statement
Sales (50,000 units at $4.00/unit)
$200,000
Variable Costs ($2.50/unit)
125,000
Gross profit
$ 75,000
Fixed costs
12,000
Depreciation ($90,000 / 3)
30,000
EBIT
$ 33,000
Taxes (34%)
11,220
Net Income
$ 21,780

8. Investment Project OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation (if no interest)

9. Making the decision
Should we accept or reject the project?

10. The Tax Shield Approach to OCF
OCF = (Gross Profit)(1 – T) + Deprec*TC
OCF=(200, ,000) x 66% + (30,000 x .34)
OCF = 51,780
Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield
i.e., choosing between two different machines

11. Depreciation & Capital Budgeting
Use the schedule required by the IRS for tax purposes
Depreciation = non-cash expense
Only relevant due to tax affects
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate

12. Computing Depreciation
Straight-line depreciation
D = (Initial cost – salvage) / number of years
Straight Line  Salvage Value
MACRS
Depreciate  0
Recovery Period = Class Life
1/2 Year Convention
Multiply percentage in table by the initial cost
The MACRS percentages are given in Table 9-7

13. Salvage Value, Book Value, and Depreciation
Salvage Value versus Book Value: Tax Implication
If (Salvage Value) > (Book Value), then taxes are due on
(Salvage Value – Book Value).
Reason: Excess depreciation must be recaptured!
If (Salvage Value) < (Book Value), then taxes savings are credited on (Book Value – Salvage Value).
Reason: Assets were under-depreciated!
Bottom Line:
After-tax Salvage Value = Salvage Value – Taxes
= SV – (SV – BV) (T).
Example:

15. Example: Depreciation and After-tax Salvage
Car purchased for $12,000
5-year property
Marginal tax rate = 34%.

16. Salvage Value & Tax Effects
Net Salvage Cash Flow = SP - (SP-BV)(T)
If sold at EOY 5 for $3,000:
NSCF = 3,000 - ( )(.34) = $2,215.01
= $3,000 – = $2,215.01
If sold at EOY 2 for $4,000:
NSCF = 4,000 - ( ,760)(.34) = $4,598.40
= $4,000 – ( ) = $4,598.40

17. Evaluating NPV Estimates
NPV estimates are only estimates
Forecasting risk:
Sensitivity of NPV to changes in cash flow estimates
The more sensitive, the greater the forecasting risk
Sources of value
Be able to articulate why this project creates value

18. Scenario Analysis Examines several possible situations:
Worst case
Base case or most likely case
Best case
Provides a range of possible outcomes

19. Problems with Scenario Analysis
Considers only a few possible out-comes
Assumes perfectly correlated inputs
All “bad” values occur together and all “good” values occur together
Focuses on stand-alone risk, although subjective adjustments can be made

20. Sensitivity Analysis
Shows how changes in an input variable affect NPV or IRR
Each variable is fixed except one
Change one variable to see the effect on NPV or IRR
Answers “what if” questions

21. Sensitivity Analysis:
Strengths
Provides indication of stand-alone risk.
Identifies dangerous variables.
Gives some breakeven information.
Weaknesses
Does not reflect diversification.
Says nothing about the likelihood of change in a variable.
Ignores relationships among variables.

22. Disadvantages of Sensitivity and Scenario Analysis
Neither provides a decision rule.
No indication 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.

23. 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

24. 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
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.

25. Example:
You have been asked by the president of your company to evaluate the proposed acquisition of a spectrometer for the firm’s R&D department. The equipment’s base price is $140,000, and it would cost another $30,000 to modify it. The spectrometer falls into the MACRS 3-year class, and would be sold after 3 years for $60,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $8,000. The spectrometer would have no effect on revenues, but is expected to save the firm $50,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 40%.
What’s the initial investment outlay associated with this project? (That is, what is the Year 0 net cash flow?)

26. Example:
What are the incremental operating cash flows in Years 1, 2, and 3?

27. Example:
What is the terminal cash flow in Year 3?

28. Example:
If the project’s required rate of return is 12%, should the spectrometer be purchased? (Calculate the project’s NPV and make a recommendation.)

29. Project Risk and Estimating the Project’s Required Rate of Return
Risk-adjusted discount rate approach:
Increase the discount rate for projects that are riskier than the firm’s average projects, and
Decrease the discount rate for projects that are less risky than the firm’s average projects.

30. Project Risk and Estimating the Project’s Required Rate of Return
Many firms use this approach.
Chevron Example:
Examples Opportunity Cost Rate*
“High Risk” Projects
“Medium Risk” Projects
“Low Risk” Projects
* This is the rate used for
The discount rate in NPV Calculations, and
The cutoff rate for IRR analysis

31. Analyzing the project:
Break even
Sensitivity Analysis
Scenario Analysis

32. Replacement analysis Example
The Gehr Company is considering the purchase of a new machine tool to replace an obsolete one. The machine being used for the operation has both a tax book value and market value of 0. It is in good working order, however, and will physically last at least another 10 years. The proposed replacement machine will perform the operation more efficiently with estimated after-tax cash flows of $ 9,000 per year in labor savings and depreciation. The new machine will cost $40,000 delivered and installed and is expected to last 10 years. It will have zero salvage value. Should the firm purchase the new machine? (Assume the firm’s required rate of return is 10%.)