Making Capital

Investment Decisions
The effect of taking a project is to change the firm’s overall cash flows today and
in the future

What is a relevant cash flow for a project? The general principle is simple enough: A relevant
cash flow for a project is a change in the firm’s overall future cash flow that comes about as
a direct consequence of the decision to take that project

they are called the incremental cash flows - The difference between a firm’s future cash
flows with a project and those without the project.

The incremental cash flows for project evaluation consist of any and all changes in
the firm’s future cash flows that are a direct consequence of taking the project.

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 The Stand-Alone Principle

We need only focus on the project’s resulting incremental cash flows. This is
called the stand-alone principle .
Stand-alone principle The assumption that evaluation of a project may be based on the
project’s incremental cash flows.- kind of “minifirm”
sunk cost - A cost that has already been incurred and cannot be recouped and therefore
should not be considered in an investment decision
opportunity cost - The most valuable alternative that is given up if a particular
investment is undertaken.
Side Effects - Erosion The cash flows of a new project that come at the expense of a
firm’s existing projects.
Net Working Capital - balance represents the investment in net working capital
Financing Costs - They are just something to be analyzed separately

First, we are only interested in measuring cash flow. Moreover, we are interested in
measuring it when it actually occurs, not when it accrues in an accounting sense. Second, we
are always interested in after tax cash flow because taxes are definitely a cash outflow. In
fact, whenever we write “incremental cash flows,” we mean after tax incremental cash flows.

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 PRO FORMA FINANCIAL
STATEMENTS
AND PROJECT CASH FLOWS
The first thing we need when we begin evaluating a proposed investment is a set
of pro forma, or projected, financial statements

Pro forma financial statements are a convenient and easily understood means of
summarizing much of the relevant information for a project.

Project cash flow = Project operating cash flow− Project change in net working
capital − Project capital spending

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 PRO FORMA FINANCIAL
STATEMENTS
AND PROJECT CASH FLOWS

Operating cash flow =Earnings before interest and taxes+Depreciation−Taxes

1-4

NPV = −$110,000 + 51,780/1.2 + 51,780/1.2^2+ 71,780/1.2^3=$10,648

 EVALUATING NPV ESTIMATES

If you think about it, there are two circumstances under which a discounted cash
flow analysis could lead us to conclude that a project has a positive NPV
Notice that we could also error in the opposite way. If we conclude that a
project has a negative NPV when the true NPV is positive, then we lose a valuable
opportunity

The key inputs into a DCF analysis are projected future cash flows. If these
projections are seriously in error, then we have a classic GIGO, or garbage-in,
garbage-out, system

Forecasting Risk - The possibility that we will make a bad decision because of errors in
the projected cash flows

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 SCENARIO AND OTHER WHAT-IF
ANALYSES
scenario analysis The determination of what happens to net present value estimates when
we ask what-if questions
We are investigating a new project. Naturally, the first thing we do is estimate NPV based on
our projected cash flows. We will call this the base case

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 SCENARIO AND OTHER WHAT-IF
ANALYSES
scenario analysis

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 sensitivity analysis
sensitivity analysis - Investigation of what happens to net present value when only one
variable is changed.
The basic idea with a sensitivity analysis is - to freeze all of the variables except one
and then see how sensitive our estimate of NPV is to changes in that one variable

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 ADDITIONAL CONSIDERATIONS
IN CAPITAL BUDGETING
managerial options Opportunities that managers can exploit if certain things
happen in the future. Also known as “real” options.
 contingency planning Taking into account the managerial options
implicit in a project.
The option to expand
The option to abandon
The option to wait

strategic options Options for future, related business products or strategies.

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 Capital Rationing

capital rationing The situation that exists if a firm has positive net present
value projects but cannot obtain the necessary financing.

soft rationing The situation that occurs when units in a business are allocated a certain
amount of financing for capital budgeting.
hard rationing The situation that occurs when a business cannot raise financing for a
project under any circumstances.

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