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Lecture 2 Finance

Making Capital Investment Decisions

2003 The McGraw-Hill Companies, Inc. All rights reserved.


Relevant Cash Flows

 The effect of taking a project is to change the firms overall cash flows today and in the future. To evaluate a proposed investment, we must consider these changes in the firms cash flows and then decide whether they add value to the firm. The first step, therefore, is to decide which cash flows are relevant. What is a relevant cash flow for a project? a change in the firms overall future cash flow that comes about as a direct consequence of the decision to take that project. Because the relevant cash flows are defined in terms of changes in, or increments to, the firms existing cash flow, they are called the incremental cash flows associated with the project. The stand-alone principle: In practice, we need to identify the effect of undertaking the proposed project on the firms cash flows, so we need to focus only on the projects resulting incremental cash flows, NOT the total cash flows of the firm with and without a project. This allows us to analyse each project in isolation from the firm simply by focusing on incremental cash flows.




Incremental cash flows

 Incremental cash flows for project evaluation consist of any and all changes in the firms future cash flows that are a direct consequence of taking the project.  Example: When a firm decides whether to replace an old machine with a new, more efficient one.

The relevant cash flows in this case will consist of those generated by the new machine less those that would have been retained by replacing the old machine. The decision should centre on the differences in cash flows between the two machines.


Asking the Right Question

 You should always ask yourself Will this cash flow occur (or not occur) ONLY if we accept the project?  If the answer is yes, it should be included in the analysis because it is incremental.  If the answer is no, it should not be included in the analysis because it will occur anyway.  If the answer is part of it, then we should include the part that occurs (or does not occur) because of the project.


Other Cash Flow Considerations

     Sunk costs: Costs that have been incurred in the past. Such costs can not be changed by the decision today to accept or reject a project. Such costs are not relevant to the decision, so should be excluded from the analyses. Example: Alba Limited is considering an investment in a new piece of machinery. The machinery would require an initial outlay of 160,000. Alba has already spent 15,000 on market research looking at the benefits of the new machinery. The machinery should have a life of 5 years with no scrap value. The project should generate 65,000 additional cash flow each year. However, this does not yet take into account the cost of 15,000 per annum for the employment of a new machine operator. REQUIRED: Detail the relevant cash flows which should be used in this investment appraisal.


Other Cash Flow Considerations

 Relevant cash flows are:  Cash outflow: Investment 160,000  Cash inflow: Profit 65,000 less salary 15,000 = 50,000 per year  Market research (15,000 ) is sunk costs and should be excluded from capital budgeting decisions.


Other Cash Flow Considerations

 Opportunity costs:

 cost of foregone opportunities.  or the most valuable alternative use of a resource or an asset that the firm gives up by accepting a project. Example: - A firm is considering a project proposal that requires storing additional products/goods. - The firm now has excess storage capacity suitable for the new proposal. - If the firm does not use the storage capacity for the new project, it could rent the space for 25,000 a year. Required: Should the business attach a cost to this storage space if corporate managers decided to go ahead with the new project?


Other Cash Flow Considerations

 YES, corporate managers should charge the loss of revenue against the new project because it entails an opportunity cost or a loss of alternative income for using the storage space instead of renting it.  HOWEVER; if the firm cannot rent the unused storage space to outsiders or put it to another productive use; the opportunity cost of using the excess storage capacity is ZERO. In this case, corporate managers should not assign a storage cost to the new project.


Other Cash Flow Considerations

 Side effects: Implementing new project may have important side effects because they affect the cash flows of other projects or products.  Corporate managers should consider these potential side effects in capital budgeting analyses.  Positive side effects benefits to other projects or products  Negative side effects costs to other projects or products


Other Cash Flow Considerations

 Example:  A company currently sells 30,000 motor homes per year at $45,000 each and 12,000 motor coaches per year at 95,000 each.  The company wants to introduce a new portable camper, it hopes to sell 20,000 units at 12,000 each.  An independent consultant determinates that if the company introduces the new campers, it should increase the sales of its existing motor homes by 5,000 units per year and reduce the sales of its motor coaches by 1,300 units per year.  What is the amount to use as the annual sales figure when evaluating this project? Why?


Other Cash Flow Considerations

Relevant Cash Flows  Sales due solely to the new product line are: 20,000 units x $12,000 = $240,000,000  Increased sales of the motor home line occur because of the introduction of the new product line; thus: 5,000 units x $45,000 = $225,000,000 in new sales is relevant  Reduction of motor coach sales is also due to the new product line; thus: 1,300 units x $95,000 = $123,500,000 loss in sales is relevant.  The net sales figure to use in evaluating the new line = $240,000,000 + 225,000,000 123,500,000 = $341,500,000


Other Cash Flow Considerations

        Net working capital (NWC) Normally, a project will require investment in net working capital (NWC) in addition to long-term assets. NWC is the change in current assets (inventory, account receivables) less the change in all current liabilities (wages payable, tax payable, trade payable). Increases in NWC are a cost of the project. Decreases in NWC are a benefit of the project. NWC often increases initially and then decreases at the end of the projects life. At the end of a project, the firm recovers the net working capital by selling inventory, collecting outstanding accounts receivablesetc. This recovery represents a one-time cash inflow in the final year of the project's life.


Other Cash Flow Considerations

 Financing costs:  In analysing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets for a project.  Our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project to estimate NPV.  As a general principle, capital budgeting analyses require separating investment and financing decisions.  In other words, corporate managers evaluate a capital budgeting project independently of the source of funds used to finance the project.  Therefore, corporate managers include operating cash flows and investment cash flows in their estimations, but not financing cash flows.


Other Cash Flow Considerations

Other issues: Corporate managers are interested only in:

1. Measuring cash flow when it actually occurs, not when it accrues in an accounting sense (i.e. accounting profit). 2. After-tax cash flow because taxes are definitely a cash outflow.


Pro Forma Statements and Cash Flow

 Capital budgeting relies heavily on pro forma accounting statements, particularly income statements  Computing cash flows: Total project cash flow = Project operating cash flow Project change in net working capital Project capital spending  Operating Cash Flow (OCF) = EBIT + Depreciation Taxes  Change in NWC = NWCEnd of Period NWCStart of Period  Net Capital Spending = Net Fixed AssetsEnd of Period Net Fixed AssetsStart of Period + Depreciation


Example (page 306)

We sell 50,000 units ($4 per unit) Costs ($2.5 per unit) Required return 20% Fixed costs $12,000 Fixed asset Equipment $90,000 ( will be depreciated over the three-year life of the project, scrap value = zero)  20,000 investment in net working capital in each year  Tax rate 34%

Requirement:  Calculate total project cash flow.


Example: Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) Variable Costs ($2.50/unit) Gross profit Fixed costs Depreciation ($90,000 / 3) EBIT Taxes (34%) Net Income

$200,000 125,000 $ 75,000 12,000 30,000 $ 33,000 11,220 $ 21,780


Total project cash flow = Project operating cash flow Project change in net working capital Project capital spending
 Operating Cash Flow (OCF) = EBIT + Depreciation Taxes = $33,000+$30,000 $11,220 =$51,780


Example: Total Project Cash Flows

Year 0
Op Cash Flow Change in NWC Capital Spending Total



$51,780 +$20,000 0

$20,000 $90,000 $110,000

$51,780 $51,780



Making The Decision

 Given the cash flows, we can apply the techniques from Chapter 9  Assume the required return is 20%  Compute NPV  NPV =  NPV = PV benefits PV costs

[FV / (1 + r)t] Cost

 NPV = 51,780/1.2 + 51,780/(1.2)2+71,780/(1.2)3 110,000 = $10,648  Based on these projections, the project creates over $10,000 in value and should be accepted.


Project Analysis and Evaluation

 Now, we carefully identify the relevant cash flows, avoiding sunk costs; considering working capital requirements, paying attention to opportunity costs.etc.  If we find the estimated NPV is positive, this is definitely a good sign, HOWEVER  This is possibly because the project really have a positive NPV. This is good news.  The bad news is the second possibility A project may appear to have a positive NPV because our estimates are inaccurate!!!  Note that: we also might conclude that a project has a negative NPV when the true NPV is positive, so we lose a valuable opportunity.


Evaluating NPV Estimates

 NPV estimates are just that estimates  A positive NPV is a good start now we need to take a closer look  Estimated future cash flows our estimate of future cash flow is an expected value.
ECash Flow ! CF1 Probabilit y1  CF2 Probabilit y2  . . .

 Forecasting risk how sensitive is NPV to changes in the cash flow estimates?
 The more sensitive, the greater the forecasting risk  Need to understand the assumptions that underlie the cash flow forecasts


Scenario Analysis
 What happens to NPV under different cash flows scenarios?  At the very least look at:  Base case based on forecasted future cash flows  Best case revenues are high and costs are low  Worst case revenues are low and costs are high  Measures the range of possible outcomes  While best case and worst case are not necessarily probable, they can still be possible


New Project Example

 The initial cost of a project is $200,000 and the project has a 5-year life. There is no salvage value. Depreciation is straight-line, the required return is 12% and the tax rate is 34%

Base Case Unit Sales Price per unit Var cost/unit Fixed cost/year 6,000 $80 $60 $50,000

Lower Bound 5,500 $75 $58 $45,000

Upper Bound 6,500 $85 $62 $55,000

10.24  Calculate Net Income for the base case Sales Variable costs Fixed costs Depreciation EBIT Taxes (34%) Net Income $480,000 360,000 50,000 40,000 30,000 10,200 19,800

 Calculate cash flow for the base case:

Base ase

! 30,000  40,000  10,200 ! $59,800

ash Flo

! EBIT  Depreciation  Taxes


New Project Example

 Calculate the NPV for the base case

1  .12  5 1 ! 200,000  59,800 .12 ! $15,567

 Now want to recalculate the NPV using a variety of different scenarios. Establish the best & worst cases by using the upper & lower bounds for each variable. Worst case Best case Unit sales Price per unit Variable cost Fixed costs 5,500 $75 $62 $55,000 6,500 $85 $58 $45,000

NPV Base

1   r  t 1 !  Investment  ash Flo r


Summary of Scenario Analysis

Net Income
$19,800 -15,510 59,730


Cash Flow



Base Case Worst Case Best Case

$59,800 24,490 99,730

$15,567 -111,719 159,504

15.1% -14.4% 40.9%

What conclusions can we draw from this? Should we undertake the project? Scenario analysis is useful in telling us what can happen and helping us estimate the potential for disaster, but it does not tell us whether to take a project.


Sensitivity Analysis
 What happens to NPV when we vary one variable at a time.  This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV.  The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable and the more attention we want to pay to its estimation  In the first table on the next page, we calculate cash flow, NPV and IRR assuming all variables are fixed at the level of the base case, other than sales volume.  Sales volume is allowed to vary between the best (6,500 units) & worst (5,500 units) cases  In the second table, we assume all variables are fixed other than fixed costs.


Summary of Sensitivity Analysis for New Project

Sensitivity to Unit Sales
Scenario Unit Sales Cash Flow
$59,800 $53,200 $66,400

$15,567 -$8,226 $39,357

15.1% 10.3% 19.7%

Base case 6,000 Worst case Best case

5,500 6,500

Sensitivity to Fixed Costs

Scenario Base case Worst case Best case Fixed Costs
50,000 55,000 45,000

Cash Flow
$59,800 $56,500 $63,100

$15,567 $3,670 $27,461

15.1% 12.7% 17.4%


Making A Decision
 Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage, but it does not tell us what to do about possible errors.  However, at some point you have to make a decision  If the majority of your scenarios have positive NPVs, then 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, then you may want to forego the project