Chapter 9: Making Capital Investment Decisions

Chapter 9: Making Capital Investment Decisions

Key Concepts and Skills

• Understand how to:

  • Determine the relevant cash flows for a proposed investment.

  • Analyze a project’s projected cash flows.

  • Evaluate an estimated NPV.

  • Use scenario and sensitivity analysis.

Chapter Outline

• 9.1 Project Cash Flows: A First Look

• 9.2 Incremental Cash Flows

• 9.3 Pro Forma Financial Statements and Project Cash Flows (excluding tax shield approach)

• 9.4 More on Project Cash Flows

• 9.5 Evaluating NPV Estimates

• 9.6 Scenario and Other What-If Analyses

• 9.7 Additional Considerations in Capital Budgeting

Relevant Cash Flows

• Estimation of Cash Flows: Understanding the relevant cash flows and conceptual issues is crucial.

  • Include only cash flows that will occur if the project is accepted.

  • Incremental cash flows only.

  • Cash Flows from Assets (CFFA): Cash flow available for distribution to investors.

  • The relevant cash flow for a project is the additional cash flow expected from assets if a project is accepted.

  • Stand-alone Principle: Analyze each project in isolation by focusing on incremental cash flows.

Incremental Cash Flow for a Project

• Calculation:

  • Corporate cash flow with the project minus corporate cash flow without the project.

Identifying the Relevant Cash Flows

• Cash Flows Associated with Fixed Assets:

  • Include cash expenses on assets, shipping, installation costs, and sales of assets at project end.

• Noncash Charges:

  • Add back depreciation (a noncash expense).

• Change in Net Working Capital (NOWC):

  • Some projects may require an increase in NOWC.

  • Required change in NOWC = Required additions to inventory + Increase in accounts receivable - Increase in accounts payable.

  • Funds invested in NOWC are recovered at the project's end through inventory sales, receivables collection.

• Interest Expenses:

  • Not included in the project's cash flows (included in discount rate/WACC).

Other Issues in Capital Budgeting

• Timing of Cash Flows:

  • Ideally deal with cash flows when they occur (e.g., daily).

  • If cash flows are predictable, they may be assessed semiannually, quarterly, etc.

• Replacement Projects:

  • More complex due to incremental cash flows being calculated by subtracting new costs from old cost numbers.

• Sunk Costs:

  • Costs that cannot be recovered and are not relevant to capital budgeting decisions.

  • Example: Investigating project costs (e.g., $1 million) are incurred regardless of going forward with the project.

• Opportunity Costs:

  • Associated with assets that the firm already owns; the best return on assets not used for the project must be considered.

• Externalities:

  • Effects on the firm/environment not reflected in project cash flows.

  • Negative Externalities: E.g., opening a new store that diverts business from an existing store.

  • Positive Externalities: E.g., when new projects are complementary.

  • Consider environmental externalities for potential costs.

Summary of Relevant Cash Flows and Their Implications

• Sunk Costs: NO

• Opportunity Costs: YES

• Side Effects/Erosion: YES

• Net Working Capital: YES

• Financing Costs: NO

• Tax Effects: YES

Analysis of an Expansion Project

• Steps to calculate:

  1. Calculate the initial investment expenditure.

  2. Calculate operating cash flow over the project life.

  3. Calculate terminal cash flows.

  4. Calculate NPV, IRR, etc.

Pro Forma Statements and Cash Flow

• Pro Forma Financial Statements: Used to project future operations.

• Operating Cash Flow (OCF): Calculated as follows:

  • $OCF = ext{EBIT} + ext{Depreciation} - ext{Taxes}$

  • Alternative: $OCF = ext{Net Income} + ext{Depreciation}$ (if no interest expense)

• Cash Flow From Assets (CFFA): Calculated as:

  • $CFFA = OCF - NCS - riangle NWC$

  • where NCS = Net capital spending.

Shark Attractant Project

• Estimated sales: 50,000 cans.

• Sales Price per can: $4.00.

• Cost per can: $2.50.

• Estimated life: 3 years.

• Fixed costs: $17,430/year.

• Initial equipment cost: $90,000 (100% depreciated over 3 years).

• Investment in NWC: $20,000.

• Tax rate: 21%.

• Cost of capital: 20%.

• Assumed market value of equipment after 3 years: $0.

Pro Forma Income Statement (Table 9.1)

• Sales: $50,000 imes 4.00 = 200,000$

• Variable Costs: $50,000 imes 2.50 = 125,000$

• Gross Profit: $200,000 - 125,000 = 75,000$

• Fixed Costs: $17,430$

• Depreciation: $rac{90,000}{3} = 30,000$

• EBIT: $75,000 - 17,430 - 30,000 = 27,570$

• Taxes: 21 ext{% of } 27,570 = 5,790

• Net Income: $27,570 - 5,790 = 21,780$

Operating Cash Flow Calculation

• OCF Calculation:

  • $OCF = 27,570 + 30,000 - 5,790 = 51,780$

Projected Capital Requirements (Table 9.2)

• Net Fixed Assets declines by the amount of depreciation annually.

• Yearly investment data:

  • Year 0: NWC = 20,000, NFA = 90,000, Total Investment = 110,000.

  • Year 1: NWC = 20,000, NFA = 60,000, Total Investment = 80,000.

  • Year 2: NWC = 20,000, NFA = 30,000, Total Investment = 50,000.

  • Year 3: NWC = 20,000, NFA = 0, Total Investment = 20,000.

Projected Total Cash Flows (Table 9.5)

• Year-wise Cash Flows:

  • Year 0: OCF = 51,780, NWC change = -20,000, CFFA = -110,000.

  • Year 3: Cash flowing from recovery of NWC = 20,000.

Final Project Cash Flows Summary

• Cash Flow From Assets calculation:

  • $CFFA = OCF - ext{Change in NWC} - ext{Capital Spending}$

  • Yearly totals result in cash flows of -110,000 (Year 0), 51,780 (Year 1 and 2) and 71,780 (Year 3).

Computing NPV for the Project

• Calculator inputs:

  • CFO = -110000

  • Cash Flows for Years 1-3 as respectively 51,780, 51,780, and 71,780.

• Terminal NPV Calculation Outputs:

  • NPV = 10,647.69, IRR = 25.76%.

Terminal Cash Flows

• Calculation of terminal cash flows at project end:

  • Terminal Cash Flow = after-tax salvage value + recovery of NOWC.

  • Formula: Terminal Cash Flow = [Sale of Old Equipment - ((Sale Price - Book Value) * Tax Rate)] + Change in NOWC.

Net Salvage Cash Flow Formula

• $ext{Net Salvage Cash Flow} = SP - (SP - BV)(Tc)$

  • Where:

  • SP = Selling Price

  • BV = Book Value

  • Tc = Corporate tax rate.

Evaluating NPV Estimates

• NPV Estimates: Only estimates hence involve forecasting risk.

• Sensitivity of NPV: Changes in cash flow estimates affect NPV.

• Sources of Value: Articulate how the project generates value.

Types of Project Risk

1. Stand-alone Risk: Total risk of the project as if it operates independently, measured by standard deviation.

2. Corporate Risk: Risk considering firm's other projects, can be diversified away within the firm.

3. Market Risk: Risk to the well-diversified investor considering the project's impact on firm's overall beta.

Relevance of Risk Types

• Most Relevant: Market risk for capital projects due to the goal of shareholder wealth maximization.

• Easiest to Measure: Stand-alone risk.

Risk-Adjusted Cost of Capital

• Projects are categorized, each assigned a risk-adjusted WACC:

  • Average risk projects use corporate WACC.

  • Higher-risk projects may have a premium added.

  • Lower-risk projects may have a discount applied.

Sensitivity Analysis

• Definition: Measures changes in NPV due to varying project parameters.

• Variables like equipment price, unit sales, tax rate, etc. can be tested.

Advantages and Disadvantages of Sensitivity Analysis

• Advantages:

  • Identifies key variables impacting profitability.

• Disadvantages:

  • Does not consider diversification, only measures stand-alone risk.

  • Lacks magnitude information about forecast errors.

Scenario Analysis

• Definition: Compares sets of financial circumstances against a base-case scenario.

  • Base-case: Most likely values.

  • Worst-case: All variables at their worst forecasts.

  • Best-case: All variables at their best forecasts.

Probability Distributions and Expected Returns

• Definitions:

  • Lists of possible outcomes and associated probabilities.

• Calculating expected returns:

  • $E(R) = ext{sum of } (p_i imes R_i)$

Variance & Standard Deviation

• Variance: Weighted average of squared deviations.

• Standard Deviation: Square root of variance; measures the volatility of returns.

Computing Expected NPV and Standard Deviation from Scenario Analysis

• Calculations reflect different NPVs across scenarios, demonstrating the stochastic nature of cash flows.

Correlation with the Firm's Business Risk

• Project's correlation with aggregate cash flows can indicate overall risk contributions to the firm.

Issues with Scenario Analysis

• Limited outcomes considered and assumes correlations that may not exist.

Subjective Risk Factors

• Additional risks affecting projects include potential lawsuits or ability to redeploy/sell assets easily.

Managerial Options

• Contingency Planning: Prepare for uncertain outcomes.

• Expansion Options: Chance to expand product lines, geographical reach, etc.

• Abandonment Options: Temporarily or permanently exit projects.

• Waiting Options: Delay project initiation to gather more information.

Example of Proposed Project

• Overview of cost structure, projected operational performance, depreciation over time, terminal cash flows, and operational challenges.

Conclusion: Evaluating Project Viability

• Based on all calculated cash flows and metrics (NPV, IRR, Payback) to make a sound investment decision.