Lecture 9 - Making Capital Investment Decisions - Chapter 10
Lecture 9 - Making Capital Investment Decisions - Chapter 10
• Part I: Valuation
• Time Value of Money, Discounted Cash Flow Valuation,
Bond and Stock Valuation.
Reading: Chapter 10
2
Key Concepts and Skills
• Understand how to determine the relevant cash flows for
various types of proposed investments
• Understand the various methods for computing
operating cash flow
• Understand how to evaluate the equivalent annual cost
of a project
Relevant Cash Flows
Example:
• In 1971 Lockheed sought a federal guarantee for a bank
loan to continue the development of the Tristar airplane.
• Lockheed argued that it would be foolish to abandon a
project on which nearly $1 billion had already been spent.
Opportunity Cost
Include opportunity costs of using existing equipment,
facilities, etc.
Example:
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid
$800,000 to purchase the building last year. The building is
worth $900,000 today.
• The store can generate $100,000 cash in perpetuity.
• Discount rate is 10%. Should the firm open the store?
Net Working Capital
Adjust for changes in net working capital
Example:
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid $800,000
to purchase the building last year. The building is worth $900,000
today.
• The store can generate $100,000 cash in perpetuity.
• Discount rate is 10%.
• Cannibalization
• e.g.
• Releasing iPhone 6s reduces the sales of iPhone 6
• Selling DVD of a movie can erode box office revenues
• Cross-selling
• e.g.
• Printer sales can increase cartridge sales
• Opening a Disney theme park can increase revenue of selling
Disney toys
Financing Costs
Do NOT include cash flows from financing activities
• Such as interest payments, dividends, or principal
repayments
• To avoid double counting
• We will adjust for financing later
Pro Forma Statements and Cash Flow
• Capital budgeting relies heavily on pro forma
accounting statements, particularly income statements
• Computing cash flows
Cash Flow From Assets (CFFA)
= OCF – net capital spending (NCS) – changes in NWC
• Operating Cash Flow (OCF) = EBIT + depreciation – taxes
• OCF = Net income + depreciation (when there is no interest
expense)
Key point: interest expense is not considered here,
because it is a financing cost, not an operating cost!
Cash Flows
Operating Cash Flow = EBIT – Taxes + Depreciation
Therefore,
Cash Flow
The fixed cost for the project is $12,000 per year. We need to
invest a total of $90,000 in manufacturing equipment, which will
be 100% depreciated over the 3-year life of the project. After 3
years, the equipment has zero market value. Assume the project
needs an initial $20,000 investment in net working capital, and the
tax rate is 34%.
Pro Forma Financial Statements and Cash Flows
New Project: Selling Shark Attractant
• IRR
51,780 51,780 71,780
• −110,000 + + 1+𝐼𝐼𝐼𝐼𝐼𝐼
1+𝐼𝐼𝐼𝐼𝐼𝐼 2 + 1+𝐼𝐼𝐼𝐼𝐼𝐼 3
IRR = 25.8%
More on NWC
• Why do we have to consider changes in NWC separately?
What are the accounting earnings? What are the cash flows?
Example of Project Cash Flows
Recall
• Use cash flows. Accounting earnings do not accurately reflect the
actual timing of cash flows
Example: Depreciation and After-tax market value
= 17,000 - .4(17,000 – 0)
= 10,200
Example: Three-year MACRS
relevant
Replacement Problem
Terminal CF = -10,000
Replacement Problem
Year 0 1 2 3 4 5
Capital -89,000
Spending
SV (New) 0
SV (Old) -10,000
∆NWC 0 0
• IRR
313,320 357,800 239,240 209,640 210,000
−1,000,000 + + + + +
1 + 𝐼𝐼𝐼𝐼𝐼𝐼 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 2 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 3 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 4 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 5
=0
IRR = 11.45%
10-41
NPV=
-100,000+43,050/(1.20)4+OCF/1.2+OCF/1.22+OCF/1.23+OCF/1.24
Sales ?
Costs $94,000
Taxes (39%) ?
The machine chosen will be replaced indefinitely and neither machine will
have a differential impact on revenue. No change in NWC is required.
Year 0 1 2 3
OCF -61.92 -61.92 -61.92
NCS -36.00 3.30
NWC 0.00 0.00
CFFA -36.00 -61.92 -61.92 -58.62
NPV -$175.21
EAC -$76.74
Long-Lasting Batteries
Initial Cost 60 Tax Rate 34%
Operating Required
Cost 88 Return 15%
Depreciation 12
After-tax
Expected market 3.3
Market Value 5 value
Year 0 1 2 3 4 5
OCF -54.00 -54.00 -54.00 -54.00 -54.00
NCS -60.00 3.30
NWC 0.00 0.00
CFFA -60.00 -54.00 -54.00 -54.00 -54.00 -50.70
NPV -$239.38
EAC -$71.41
Key Concepts and Skills
• Only incremental cash flows should be included in a capital
budgeting analysis;
• The stand-alone principle: analyze each project in isolation
from the firm
• Computing cash flows