Chapter 9

Making Capital Investment

Decisions
©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Key Concepts and Skills
After studying this chapter, you should be able
to:
• Determine the relevant cash flows for a proposed
investment.
• Analyze a project’s projected cash flows.
• Evaluate an estimated NPV.

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 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.
9.4 More on Project Cash Flow.
9.5 Evaluating NPV Estimates.
9.6 Scenario and Other What-If Analyses.
9.7 Additional Considerations in Capital
Budgeting.
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 Relevant Cash Flows 1

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.

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 Relevant Cash Flows:
Incremental Cash Flow for a Project
Corporate cash flow with the project
Minus
Corporate cash flow without the project.

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 Relevant Cash Flows 2

“Sunk” Costs …………………………..N

Opportunity Costs …………………..Y
Side Effects/Erosion……..………….Y
Net Working Capital…………………Y
Financing Costs….………..…………..N
Tax Effects ………………………..……..Y

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 Capital investment decision
Step 1: Pro Forma financial statements
Step 2: Estimating Project Cash flows
• Project operating cash flow
• Project net working capital (NWC) and capital
spending
Step 3: Estimating projected total cash flow and
value based on NPV
We will illustrate each step from an example of Shark
Attractant Project.
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 Shark Attractant Project 1

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-year life (straight
line depreciation over 3 years)
Investment in Net working capital (NWC) $20,000
Tax rate 21%
Cost of capital 20%

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 Step 1:
Pro forma financial statements
Establish pro forma financial statements using
relevant incremental cash flows for a project.

• Projected income statements

without considering financing costs (e.g. Interest expenses)
• Projected capital requirements

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 Pro Forma Income Statement
Each year (years 1-3) Table 9.1

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 17,430
Depreciation (= $90,000 / 3) 30,000
EBIT* $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

*EBIT: Earnings before interest and taxes

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 Projected Capital Requirements
Table 9.2
Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000
Net Fixed 90,000 60,000 30,000 0
Assets
Total $110,000 $80,000 $50,000 $20,000
Investment

NFA declines by the amount of depreciation each year

Investment = book or accounting value, not market value.

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 Step 2: Estimating project cash flows
Pro forma financial statements are accounting
information.
We need to convert them into cash flows.
Project cash flow
= Project operating cash flow (OCF)
- Project change in net working capital (∆NWC)
- Project net capital spending (NCS)

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 Project operating cash flow (OCF)
Operating Cash Flow:
• Cash flow that result from the day-to-day
activities of producing and selling:
• Does not include financing cost;
• Does not include depreciation (which is not effective
cash outflow);
• Does include taxes

OCF = EBIT + Depr – Taxes.

OCF = NI + Depr if no interest expense.
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 Project operating cash flow (OCF)
From the table 9.1
OCF = EBIT + Depr – Taxes
= 27,570 +30,000-5,790 = $51,780

Or alternatively
OCF = NI + Depr if no interest expense.
= 21,780+30,000=$51,780

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 Project NWC and Capital spending
From the table 9.2:
• At the beginning of the project’s life, the firm must
• Spend $90,000 up front for fixed assets and
• Invest an additional $20,000 in NWC
• Outflow (year 0) =$110,000
• At the end of the project’s life
• Salvage value of fixed assets =0
• Firm will recover $20,000 tied up in working capital
• Inflow (year 3) = $20,000
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 Projected Total Cash Flows
Table 9.5
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Δ NWC −$20,000 20,000
Capital −$90,000
Spending
Total -$110,000 $51,780 $51,780 $71,780
Project CF

Note: Investment in NWC is recovered in final year

Equipment cost is a cash outflow in year 0.
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 Step 3: Projected total CF and NPV
Pro Forma Income Statement
Year 0 1 2 3
Sales 200,000 200,000 200,000
Variable Costs 125,000 125,000 125,000
Gross Profit 75,000 75,000 75,000
Fixed Costs 17,430 17,430 17,430
Depreciation 30,000 30,000 30,000
EBIT 27,570 27,570 27,570
Taxes 5,790 5,790 5,790
Net Income 21,780 21,780 21,780
Cash Flows
OCF 51,780 51,780 51,780
∆NWC −20,000 20,000
NCS −90,000
Total Project CF −110,000 51,780 51,780 71,780

OCF = EBIT + Depreciation – Taxes

OCF = Net Income + Depreciation (if no interest).
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 Making The Decision
Net Income 21,780 21,780 21,780

Cash Flows
Operating Cash Flow 51,780 51,780 51,780
Changes in NWC −20,000 20,000
Net Capital Spending −90,000
Total Project Cash Flow −110,000 51,780 51,780 71,780

Net Present Value $10,648.32

IRR 25.76%

Should we accept or reject the project? 9-1

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 The Tax Shield Approach to OCF
OCF = (Sales – costs)(1 – T) + Deprec*TC
OCF = (200,000 − 142,430) × 79% + (30,000 × 21%)
OCF = $51,780.
• Deprec*TC : Depreciation tax shield
Particularly useful when the major incremental
cash flows are the purchase of equipment and
the associated depreciation tax shield.
• The tax shield approach will always give the same
answer as our basic approach.
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 A closer look at NWC
• NWC
= Inventory +AR (Accounts receivable) –AP (Accounts payable)
• Including ∆NWC in estimating cash flow has the effect of
adjusting discrepancy
• between accounting sales and cost
• and actual cash receipts and payments
• Simple Illustration: In a simple case without depreciation and
taxes,
Cash flow = Cash inflow – Cash outflow
= (Sales- ∆AR) – (Costs- ∆AP)
= (Sales – Costs) – (∆AR- ∆AP)
= OCF – ∆NWC
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 Depreciation & Capital Budgeting
Use the schedule required by the IRS for tax
purposes.
Depreciation = non-cash expense.
• Only relevant due to tax effects.
Depreciation tax shield = D*T.
• D = depreciation expense.
• T = marginal tax rate.

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 Computing Depreciation
Straight-line depreciation:
D = (Initial cost – salvage) / number of years.
Straight Line  Salvage Value.
Other depreciation methods exist.
(Accounting course stuff)

In this class, we use only straight-line

depreciation.
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 After-Tax Salvage
If the salvage value is different from the book
value of the asset, then there is a tax effect.
Book value = initial cost – accumulated
depreciation.
After-tax salvage = salvage – T(salvage – book
value).

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 Tax Effect on Salvage

Net Salvage Cash Flow

= SP − (SP − BV)(T)

Where:
SP = Selling Price.
BV = Book Value.
T = Corporate tax rate.

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 Example:
Depreciation and After-Tax Salvage
Equipment purchased for $35,000.
Straight-line depreciation over 5 years. (20% per year)
Marginal tax rate = 21%.

Estimate net salvage cash flow

1. If this equipment is sold for $8,750 at the end of year 4
2. If this equipment is sold for $20,000 at the end of year 2

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 Ex. Majestic Mulch & Compost Co
MMCC is investigating the feasibility of a new line of power mulching tools aimed at
the growing number of home composters. Based on exploratory conversations with
buyers for large garden shops, it projects unit sales as follows:
Year 1 2 3 4 5 6 7 8
Unit sale (in 1,000) 3 5 6 6,5 6 5 4 3

The new power mulcher will be priced to sell at $120 per unit to start. When the
competition catches up after three years, however, MMCC anticipates that the price
will drop to $110.
The power mulcher project will require $20,000 in net working capital at the start.
Subsequently, total net working capital at the end of each year will be about 15% of
sales for that year. The variable cost per unit is $60, and total fixed costs are $25,000
per year.
It will cost about $800,000 to buy the equipment necessary to begin production. This
fixed asset will be depreciated straight-line to zero over 8 years. The equipment will be
worth about 20% of its cost in eight years, or .20*$800,000=$160,000. The relevant
tax rate is 21%, and the required return is 15%. Based on this information, should
MMCC proceed?
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 Ex. Majestic Mulch & Compost Co
To answer the question, proceed the following steps:
1. Estimate Pro forma income statements and net income for
each year;
2. Estimate operating cash flow for each year;
3. Estimate changes in net working capital for each year;
4. Estimate the salvage value of the equipment at the end of
the project life (year 8)
5. Estimate NPV, IRR and the payback period.
6. Based on the above criteria, should MMCC proceed?

Use the excel sheet prepared to help you solve the question

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 Evaluating NPV Estimates
NPV estimates are only estimates.
Forecasting risk:
• Sensitivity of NPV to changes in cash flow estimates.
• The more sensitive, the greater the forecasting risk.

Sources of value.
• Be able to articulate why this project creates value.

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 Scenario Analysis
Examines several possible situations:
• Worst case.
• Base case or most likely case.
• Best case.
Provides a range of possible outcomes.

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 Scenario Analysis Example 1

Initial investment $ 200 000

Depreciation is straight-line to 0 over 5 years
Deprec/yr $ 40 000
Project Life 5years
Tax rate 21%
Required return 12%

BASE CASE LOWER BOUND UPPER BOUND

Unit sales 6,000 5,500 6,500
Price/unit $ 80.00 $ 75.00 $ 85.00
Variable cost/unit $ 60.00 $ 58.00 $ 62.00
Fixed Cost/year $ 50,000 $ 45,000 $ 55,000

Estimate NPV and IRR under the base case, the worst
scenario and the best scenario.

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 Scenario Analysis Example 2

• Lower bound is not necessarily worst and upper bound is not

necessarily best case.
• Best scenario (in green) : with the highest sales and price +
with the lowest costs.
• Worst scenario (in beige): with the lowest sales and price +
with the highest costs.
BASE CASE LOWER BOUND UPPER BOUND
Unit sales 6,000 5,500 6,500
Price/unit $ 80.00 $ 75.00 $ 85.00
Variable cost/unit $ 60.00 $ 58.00 $ 62.00
Fixed Cost/year $ 50,000 $ 45,000 $ 55,000

Best Scenario Worst Scenario

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 Scenario Analysis Example 3

    BASE Worst Best

Unit sales

Price/unit
6 000 5 500 6 500 NPV for base case
$ 80,00 $ 75,00 $ 85,00
Variable
cost/unit
$ 60,00 $ 62,00 $ 58,00
Fixed
Cost/year $ 50 000 $ 55 000 $ 45 000
      Note in worst case:
Sales $ 480 000 $ 412 500 $ 552 500
Variable Cost
360 000 341 000 377 000 • Tax credit for negative
Fixed Cost

Depreciation
50 000 55 000 45 000
earnings
40 000 40 000 40 000
EBIT 30 000 -23 500 90 500
Taxes 6 300 -4 935 19 005
Net Income
23 700 -18 565 71 495
+ Deprec
40 000 40 000 40 000
         
TOTAL CF
63 700 21 435 111 495
NPV 29 624 (122 732) 201 915
IRR 17,8% -17,7% 47,9%
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 Problems with Scenario Analysis
Considers only a few possible outcomes.
Assumes perfectly correlated inputs.
• All “bad” values occur together and all “good”
values occur together.
Focuses on stand-alone risk, although subjective
adjustments can be made.

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 Sensitivity Analysis 1

Shows how changes in an input variable affect

NPV or IRR.
Each variable is fixed except one.
• Change one variable to see the effect on NPV or IRR.
Answers “what if” questions.

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 Sensitivity Analysis Example
    Base
Units   6 000
Price/unit $ 80
Variable cost/unit $ 60
Fixed cost/year $ 50 000
             
             
Initial investment $ 200 000        
  Depreciated to salvage value of 0 over 5 years    
  Deprec/yr $ 40 000        

Estimate
1. Sensitivity of NPV to changes in the sales
2. Sensitivity of NPV to changes in fixed cost
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 Sensitivity of NPV to changes in sales
    BASE UNITS UNITS
Units   6 000 5 500 6 500
Price/unit
$ 80 $ 80 $ 80
Variable cost/unit
$ 60 $ 60 $ 60
Fixed cost
$ 50 000 $50 000 $ 50 000
         
Sales   $ 480 000 $ 440 000 $ 520 000
Variable Cost
360 000 330 000 390 000
Fixed Cost
50 000 50 000 50 000
Depreciation
40 000 40 000 40 000
EBIT   30 000 20 000 40 000
Taxes   6 300 4 200 8 400
Net Income
23 700 15 800 31 600
+ Deprec
40 000 40 000 40 000
         
TOTAL CF
63 700 55 800 71 600
         
NPV   $ 29 624 $ 1 147 $ 58 102
% change in NPV -96,13% 96,13%
% change in variable -8,33% 8,33%
Sensitivity ratio 11,54 11,54

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 Sensitivity of NPV to ∆ Fixed cost
    BASE FC FC
Units  6 000 6 000 6 000
Price/unit $ 80 $ 80 $ 80
Variable
$ 60 $ 60 $ 60
cost/unit
Fixed cost $ 50 000 $ 55 000 $ 45 000
       
Sale
$ 480 000 $ 480 000 $ 480 000
s  
Variable
360 000 360 000 360 000
Cost
Fixed Cost 50 000 55 000 45 000
Depreciati
40 000 40 000 40 000
on
EBIT   30 000 25 000 35 000
Taxe
6 300 5 250 7 350
s  
Net
23 700 19 750 27 650
Income
+ Deprec 40 000 40 000 40 000
         
TOTAL CF 63 700 59 750 67 650
         
NPV   $ 29 624 $ 15 385 $ 43 863
         
% change in NPV -48,06% 48,06%
% change in variable 10,00% -10,00%
Sensitivity ratio -4,81 -4,81

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 Sensitivity Analysis 2

Strengths.
• Provides indication of stand-alone risk.
• Identifies dangerous variables.
• Gives some breakeven information.

Weaknesses.
• Does not reflect diversification.
• Says nothing about the likelihood of change in a
variable.
• Ignores relationships among variables.
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 Disadvantages of Sensitivity and
Scenario Analysis
Neither provides a decision rule.
• No indication whether a project’s expected return is
sufficient to compensate for its risk.
Ignores diversification.
• Measures only stand-alone risk, which may not be
the most relevant risk in capital budgeting.

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 Managerial Options
Contingency planning.
Option to expand.
• Expansion of existing product line.
• New products.
• New geographic markets.
Option to abandon.
• Contraction.
• Temporary suspension.
Option to wait.
Strategic options.
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 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.
The profitability index is a useful tool when
faced with soft rationing.

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 Mini Data Case
Work on the mini data case of IBM.
Goals:
• Read and extract information from financial statements
• Estimate cash flows for capital budgeting problems
• Apply decision rules
• Use Excel for capital budgeting problems

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 Chapter 9

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©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.