Making Capital Investment DecisionsKey Concepts and Skills + Use basic principles of capital budgeting NPV, IRR, Payback * All use cash flows + How to estimate cash flows...incremental cash flows Understand how to determine the relevant cash flows for various types of capital investments. Be able to compute depreciation expense for tax purposes. Understand the various methods for computing operating cash flow. Evaluate special cases of discounted cash flow analysis + Incorporate inflation into capital budgeting.Cash Flows—Not Accounting Income + Finance uses cash flows + Change in cash that could be used to invest or return to investors iscount cash flows, not earnings in capital budgeting * Incremental cash flows are a direct consequence of the project * Accounting uses income or earnings * Not represent real money * Consider depreciation expense: You never write a check made out to “depreciation” + Much of the work in evaluating a project lies in taking accounting numbers and generating cash flowsIncremental Cash Flows * Sunk costs are not relevant * Just because “we have come this far” does not mean that we should continue to throw good money after bad. * Opportunity costs do matter. * Just because a project has a positive NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed,Incremental Cash Flows * Side effects matter * Erosion is a “bad” thing. + If our new product causes existing customers to demand fewer of our current products, we need to recognize the loss + Cannibalization + Synergies are a good thing + Results that create increased demand of existing products, we also need to recognize the gain + Positive spillovers + Loss-leadersEstimating Cash Flows + Cash Flows from Investments + Net Capital Spending + intial investment cash flows + Do not forget salvage value (after tax, of course) * Changes in Net Working Capital + Difference between current assets and current liabilities + Growth/new projects cause an increase in net working capital + When the project winds down, we enjoy a return of net working capitalEstimating Cash Flows * Operating Cash Flows * Different Approaches + Top-down + Bottom-up + Tax shieldAlternative Definitions of Operating Cash Flow + Top-Down Approach + OCF = Sales — Cash costs — Taxes. * Do not subtract noncash deductions (like depreciation) OCF = Sales — Cash costs — Taxes = 1800-70042 S758Alternative Definitions of Operating Cash Flow * Bottom-Up Approach + Works only when there is no interest expense * OCF = Net income + Depreciation = sa = ise esis te ne weeAlternative Definitions of Operating Cash Flow +Tax Shield Approach * OCF = (Sales — Cash costs)(1 - T,) + Depreciation x ; OCP = Sales~Cash costs Taxes Top-down Approach Takes = EBTxTe + Sales ~ Cash costs ~ Depreciation x Te = OCF = Sales ~ Cash costs ~ (Sales jon) x Te OCF = (Sales ~ Cash costs) x(1 = Te) + Depreciation x Te OCF = (81,500 — 700) x. 79 + $600 x .21 $632 + 126 S758Interest Expense + Later chapters will deal with the impact the amount of debt a firm has in its capital structure has on firm value + For now, it is enough to assume that the firm’s level of debt (and, hence, interest expense) is independent of the project at hand + No financing cash flows...yetBaldwin Company Example * Costs of test marketing (already spent): $250,000 + Sunk cost + Current market value of proposed factory site (which we own): $150,000 + Opportunity cost + Cost of bowling ball machine: $100,000 depreciated according to 5- year modified accelerated cost recovery system (MACRS) + Increase in net working capital: $10,000 due to increased inventory, cash buffer, credit sales (10% of annual sales estimated) + Production (in units) by year during 5-year life of the machine: + 5,000, 8,000, 12,000, 10,000, 6,000Baldwin Company Example Year 0] Year] Year2] Year3] Yeora] Years 0) Bowing aor tom es ‘machine (@haccumuiated s2000| s5200] s7i20] sez72| onze Ty aeted basis of 2000] 48.00] 2000] 1728 machine ater a depreciation tend ot {@) Opportunity cost 350.00 (5) Net working capital nd (6) Change In net working “i008 <6] 065] 375] 2122 capltal 2 (0) Total cash flow of 60 =] 06s] 275] ae8a3 $ thousands ahd }YFEaSA Hows Bdcurat the thd of tHe yebBaldwin Company Example + Production (in units) by year during 5-year life of the machine: + 5,000, 8,000, 12,000, 10,000, 6,000 + Price during first year is $20; price increases 2% per year thereafter + Operating costs of production during first year are $10 per unit and increase 10% per year thereafter + Annual inflation rate: 5 percentBaldwin Company Example YearO] Year| Year2] Years| veara] vears (@) Sales Revenues gyn0.00| $263.| $289.70] s2i224] $1298 20 9 + Production (in fits) by year during 5-year life of the machine: + 5,006-6-80012,000, 10,000, 6,000 * Price during the first year is $20 and increases 2 percent per year thereafter *Year2 sales reven' , 08 21 28" mes 20.0 163,00 § thousands and all cash flows occur at the end of the yearBaldwin Company Example YearO] Year| Year2] Years| veara] vears (@) Sales Revenues s10000| $1632) $2497| s2i22| $1298 o o Abeer (9) Operating costs [7 —s0.| -e8.) 145. —133.] 07. oo} oo} ¢ 20] iol os “Production tiryntts} by year during S-yeartife of the machine: + 5.0vere:086-42,000-10,000, 6.000 + Production costs during the first year (per unit) are $10, and they increase 10 percent per year thereafter. *Year 2 production co, 0S 104 Ds 88,00 § thousands and all cash flows occur at the end of the yearBaldwin Company Example Yearo] veari] vear2] vear3| veara] Years (@) Sales Revenues 70000] 16320) 2aa70| P22] 12589 10) Operating cone “so00| e800] —aasz0] —139,] 2785 10, OBEBFEC Eon is calcllatee? | ~*? i singthe Madted Accelerated Cost Reco ia System (shown at ri Paces | coy fe) eet ee a) =e + Our cost basis is $100,000 ie * Depreciation charge in Year> SS 4 = $100 000 x 1152 =Baldwin Company Example Years (@) Sales Revenues ls163.20 | $249.70 $1298 3 (9) Operating costs =50.[ a8] —245. maT, oo} 00 20 55, (10) Depreciation =a “20, az] aa (1) income berore taxes (8) - (9) 10) (12) Tax 2-ebamninigsBaldwin Company Example Years (@) Sales Revenues ls163.20 | $249.70 $1298 3 (9) Operating costs =50.[ a8] —245. maT, oo} 00 20 55, (10) Depreciation 32) 2! abe 32, (1) income berore $305) taxes (8) - (9) 3 10) (12) Tax 2-ebamninigs (13) Net incomeBaldwin Company Example + Add depreciation back to NI to get OCF Yeor] Yeort] veor2] veor3[ Years] Years Sales Revenues sioeoo]| sieaz0 | s2a70| sizza] siz9—0 (2) Operating costs =30.| 688.00] 14520] —13520 (Or Tares =o] -aar | -un | aan (ocr G++ $03.7] $06.) 500.59] sone 3 o 3 (6) Total OF of “5260, Ten] ees] a7] 19003 (6) Total cro Project {4} + (31,Baldwin Company Example + Add investment cash flows to OCF Year | _Yeorl] Yeor2] _vear3| Years] _vears (sales Revenues ‘sioooo) sissz0| s21070] sziaze] siz0es (2) Operating oats =s0.[ -s6800[ 14520] 23310] 2705 Orie ~aao| sar] zn] -agan [oan ocr + ae sex70] 96615] 50659] soaoe| sas.6e B) otal cror | $260. 5. 3.75] 196.13 Jnvestment 32 (6) Total cF e260.) sesvo] sami] _s77os] sesso] 25177, Project a) F131, BHBEDS “INAS “NBS B.S _ 281.77Some Special Cases of Discounted Cash Flow Analysis *Cost-Cutting Proposals *Investments of Unequal LivesCost-Cutting Proposals * Cost savings from investment will increase pretax income * But we have to pay taxes on this amount * Depreciation will reduce our tax liability * Does the present value of the cash flow associated with the cost savings exceed the cost? $80,000 to autoh¥@su EREDPSACRRAny over 5 Equipment sold tor $20,000 n 5 years Depreciation straight line $80,000/5 = $16,000 annually over afonetezen tne wseOdrwrdteatedation deduction increases by $16 000, therefore BIT increases by Ser crease of $6,000.21 = $1,260 in increased tones Equipment sold for $20,000 in 5 vears must pay taxes on sale: $20,000 x (1.21) = $15,800 = equalsCost-Cutting Proposals + $80,000 to automate and save $22,000 annually over 5 years + Equipment sold for $20,000 in 5 years + Depreciation straight ine $80,000/: years + Taxes at 21% and discount rate at 109% GCF increase By $22,000 and depreciation deduction increases by $16,000, therefore EBIT increases by $6,000 OCF increase of $6,000 x 21 {$16,000 annually over 5 oct N+ Depreciation amount returnes = [At 10% discount rate, NPV = $8431Investments of Unequal Lives = There are times when application of the NPV rule can lead to the wrong decision, Consider a factory that must have an air cleaner that is mandated by law. Assume a 10% discount rate. There are ‘A -$500 -$120 -$120 -$120 B___-$600 -$100 -s100 $100 ~$100] Machine B= 991699 1 $109 _ sido _sioo _ s100Time Value of Money Present Value Interest F rear von tomato Sst Pvate ‘Progen Ar $9169 CXPVIEEs PY = 289.28 Or use the Excel PMT function to get EAC: enter rate,Equivalent Annual Cost ‘Cash outfiows ofMachine A $500 $120 -$120——$120 EAC of Machine A “32106-32106 321.06 (Cash cutows of Machine B $600 -S100 $100 $100 -$100 EAC of Machine B 269.28 25928 299.28 299.28 ‘The EAC is the value of the level payment annuity that has the same PV as our original set of cash flowsInflation and Capital Budgeting + Inflation is an important fact of economic life and must be considered in capital budgeting. + Consider the relationship between interest rates and inflation, often referred to as the Fisher equation: Rea intent te 2 Nominees te —lafaton ae In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.Inflation and Capital Budgeting +In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates. ie nominaeiscount rats 4 percent an the inflaton rates foreast to be 5 poet > 4 2 gin ect EE ad 31.000 $000 $650Risk Analysis and Capital BudgetingSensitivity Analysis Scenario Analysis Break-Even Analysis + Each allows us to look behind the NPV number to see how stable our estimates are + When working with spreadsheets, try to build your model so that you can adjust variables in a single cell and have the NPV calculations update accordinglyRevenue Costs: = 3a en S540mithon = S3NOmion + 1.940 on ‘Vuntiecom rene) $1.2 atin ‘ss.uton Fuadeot paryery $2070. 1240 mation vest 1,900 mition 00 ton[NPV alelstons (a mshon fr the Soar Jet Engine Using Senet Anny Pessinisc Optimistic ‘Markt size “$2434 sui8 $9463 Manet share = 0" sis oats Price mm isis 07 Variable cost - 4 isis 3106 Fae cost Lass sis 2048 Investment us Asi 1948 ‘Under sensitivity ana ne input is varied while al ote inputs ave assumed to meet their expectation, For example an NPV of ~$2.454ocears whe the pessimistic forecast o 5.00 is se fo market sie, wil al ote varabes re set at their expected forecasts Scanerto ana Anat oft tect on polo erent scene tn ete scant lohng many valleBreak-Even Analysis + Common tool for analyzing the relationship between sales volume and profitability. + Accounting break-even: sales volume at which net income = 0. + Financial break-even: sales volume at which net present value = 0.