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9-1
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
9-2
Relevant Cash Flows
• Include only cash flows that will only occur if the project is accepted
• Incremental cash flows
• The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
9-3
Relevant Cash Flows:Incremental Cash Flow for a Project
Corporate cash flow with the project
Minus
Corporate cash flow without the project
9-4
Relevant Cash Flows
• “Sunk” Costs ………………………… N
• Opportunity Costs …………………... Y
• Side Effects/Erosion……..…………… Y
• Net Working Capital………………….. Y
• Financing Costs….………..…………. N
• Tax Effects ………………………..….. Y
9-5
Sunk costs
• Costs that have already been incurred
• Won’t change if the project is accepted or rejected
• NOT relevant
9-6
Opportunity Costs
• alternatives that will be given up if the project is undertaken
• Undertaking project A means you won’t have the resources to do activity B
9-7
Side Effects/Erosion
• Positive side effects: benefits to other projects
• Negative side effects: costs to other projects– Erosion: cash flows of new project come at
the expense of an existing project– Need to adjust cash flows downward to
reflect lost profits
9-8
Net Working Capital
• Project requires investment in net working capital in addition to long term assets– Inventories and accounts receivable may be
needed for the project
– Accounts payable will be incurred to cover some of the inventory and accounts receivable, but company will need to make an investment to cover the rest
• Firm’s investment in Net Working Capital resembles a loan
9-9
Financing Costs
• The mixture of debt and equity impacts how the project cash flow is divided between owners and creditors
9-10
Tax Effects
• Consider after tax cash flow
9-11
Pro Forma Statements and Cash Flow
• Pro Forma Financial Statements – Projects future operations
• Operating Cash Flow:OCF = EBIT + Depr – Taxes
OCF = NI + Depr if no interest expense
• Cash Flow From Assets:CFFA = OCF – NCS –ΔNWC
NCS = Net capital spending
9-12
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 $12,000/year• Initial equipment cost $90,000
– 100% depreciated over 3 year life
• Investment in NWC $20,000• Tax rate 34%• Cost of capital 20%
9-13
Pro Forma Income StatementTable 9.1
Sales
Variable Costs
Gross profit
Fixed costs
Depreciation
EBIT
Taxes (34%)
Net Income
9-14
Operating Cash Flow
OCF = EBIT + Depreciation – Taxes
OCF when there is no interest expense = Net income + depreciation
9-15
Projected Total Cash FlowsTable 9.5
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
NWC -$20,000 20,000
Capital Spending
-$90,000
CFFA -$110,00 $51,780 $51,780 $71,780
Note: Investment in NWC is recovered in final year
Equipment cost is a cash outflow in year 0
9-16
Projected Total Cash FlowsTable 9.5
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
NWC -$20,000 20,000
Capital Spending
-$90,000
CFFA -$110,00 $51,780 $51,780 $71,780
Calculate PV of Cash flows
9-17
Making The Decision
• Should we accept or reject the project?
Operating Cash Flow 51,780 51,780 51,780Changes in NWC -20,000 20,000Net Capital Spending -90,000Cash Flow From Assets -110,000 51,780 51,780 71,780
Net Present Value $10,647.69IRR 25.76%
Cash Flows
9-18
The Tax Shield Approach to OCF
• OCF = (Sales – costs)(1 – T) + Deprec*T
OCF is broken down into
1- Cash flow without depreciation
2- Depreciation tax shield: tax savings resulting from the depreciation deduction
• 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
9-19
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 = D*T– D = depreciation expense– T = marginal tax rate
9-20
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
9-21
After-Tax Salvage
• If the salvage value is different from the book value of the asset,
then there is a tax effect– If book value is higher than selling price,
the fixed asset is sold at a __________– If book value is lower than selling price, the
fixed asset is sold at a __________
9-22
After-Tax Salvage
• Loss X tax rate = tax savings from loss
• Gain X tax rate = tax on gain
9-23
Cash Flow When Fixed Asset is Sold
• Fixed Asset sold at a loss:Cash flow in the year of the sale =
selling price + tax savings from loss
• Fixed Asset sold at a gain:Cash flow in the year of the sale =
selling price – tax on gain
9-24
Evaluating NPV Estimates
• NPV estimates are only estimates
• Forecasting risk: the possibility that errors in projected cash flows will lead to incorrect decisions; also called estimation risk– Sensitivity of NPV to changes in cash flow
estimates • The more sensitive, the greater the forecasting
risk
9-25
Evaluating NPV Estimates
• Sources of value • Be able to articulate why this project creates
value• A positive NPV is rare in a highly
competitive market• View a positive NPV with some suspicion
9-26
Scenario Analysis
• Examines several possible situations:
– Worst case
– Base case or most likely case
– Best case
• Provides a range of possible outcomes
9-27
Sensitivity Analysis
• Shows how changes in an input variable affect NPV
• Each variable is fixed except one– Change one variable to see the effect on
NPV • If NPV is sensitive to small changes to one
variable, then forecasting risk is high for that variable
• Can identify the variable that deserves the most attention
9-28
Sensitivity Analysis:
• Strengths– Provides indication of stand-alone risk.– Identifies dangerous variables.– Gives some breakeven information.
• Weaknesses– Says nothing about the likelihood of change
in a variable, – Ignores relationships among variables.
9-29
Making a Decision
• Beware of “paralysis of analysis”• If the majority of your scenarios have
positive NPVs, you can 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, than you may want to forgo the project
9-30
Managerial Options
• Contingency planning• Option to expand• Option to abandon• Option to wait• Strategic options
9-31
Contingency planning
What actions do we take if things don’t go as planned?
9-32
Option to expand
• if project has positive NPV, can the project be expanded or repeated to get an even larger NPV
– Can sales be increased?– Can production be increased?– Can the selling price be raised?
9-33
Option to abandon
• if project doesn’t cover expenses, then abandon it
• Discounted cash flow analysis assumes operations will continue to the end– Instead, sell or redesign
9-34
Option to wait
• Could wait for a more favorable discount rate
• Could make changes to the project
9-35
Strategic options
• Project may be undertaken in order to develop future related projects or strategies
• Hard to put value on projects that allow the company to gain experience or entrance into a new market
9-36
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
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