Because learning changes everything.

Chapter 09
Making Capital
Investment Decisions

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Key Concepts and Skills
After studying this chapter, you should be able to:
• Determine theAu
investment. In t
relevant cash flows for a proposed

• Analyze a project’s projected cash flows.

Loading…
• Evaluate an estimated NPV.

© McGraw Hill, LLC 3

 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.

© McGraw Hill, LLC 4

 Relevant Cash Flows 1

Include 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 by focusing onL
incremental cash
flows.
(
Loading… ERIM a t E

-E
Include cash Flow >
- Relevant Cash Flow > incremental cash flow

© McGraw Hill, LLC 5

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

© McGraw Hill, LLC 6

 Relevant Cash Flows 2
eX . E Uber
JEFFE (EETA)
#
“Sunk” Costs …………………………..N
FXF
Opportunity Costs …………………..Y 2:

El FLET
Side Effects/Erosion……..………….Y EX , Fi

:F
Net Working Capital…………………Y
FX
Financing Costs….………..…………..N
Tax Effects ………………………..……..Y
S17]

© McGraw Hill, LLC 7

 =R') RAFRLET
Pro Forma Statements and Cash Flow
Pro Forma Financial Statements.
• Projects future operations.
15
D Operating Cash
before
Flow: I
& interests taxes
earning
OCF = EBIT + Depreciation − Taxes.
d OCF = NI + Depreciation if no interest expense.
1 ESPE
·Cash Flow From Assets:
*I E :
ΔNWC.
CFFA = OCF − NCS − - NWC > Net working Capitals

NCS = Net capital spending.

© McGraw Hill, LLC 8

 Shark Attractant Project 1

Estimated sales YER50000

Estimated Sales 50,000cans
cans
Sales Price per can (4 $4.00
Cost per can E $2.50
Estimated life & EEAID 3 years
Fixed costs E $17,430/year
Initial equipment cost #TXSe $90,000
• 100% depreciated over 3-year life 3 H ,CH30000
Investment in NWC - NWC $20,000
Tax rate F 21%
Cost of capital E 20%

© McGraw Hill, LLC 9

 to J
Pro Forma Income Statement Table 9.1
EBET-ET Net Income
=

n & + Sales (50,000

Sales (50000 units
units at00/unit)
at $4 $4.00/unit) . $200,000
5) 200 000 ,
(50000 x 4)

-A -

Variable Costs ($2.50/unit) EXE -

125,000 (50000 x 2 5)
.

Gross profit E $ 75,000

-

Fixed costs X -

17,430
-

Depreciation (= $90,000 ÷ 3) -FE -

30,000
EBIT $ 27,570
-

Taxes (21%) 171743

-
5,790
Net Income 25 =

$ 21,780
*ETR
211780 +30000
OCF =
N2 + Depreciation =

= EBIT +
Depreciation -
Taxes =
2775% + 30000 -

5790

© McGraw Hill, LLC 10

 E ·
Total investment

Projected Capital Requirements Table 9.2

by Relevent Lash Flow

Year
Year
0 1 2 3
NWC Net
working capital $20,000 $20,000 $20,000 $20,000
Net Fixed 90,000 60,000 30,000 0
#
Loading…
>
-
>
- -
Assets F 54 3000 0 -
30008 -
30000

Total Investment $110,000 $80,000 $50,000 $20,000

NFA declines by the amount of depreciation each year

Investment = book or accounting value, not market value.

© McGraw Hill, LLC 11

ET cash inflow - cash outflow
Projected Total Cash Flows Table 9.5 : XBEE

F-F
# ↓
-

TX d ↓ ↓
* 5% Year
Year
0 1 2 3
I
OCF EX "$51,780 $51,780 $51,780
ΔNWC Y #
−$20,000 ⑰
20,000
Capital −90,000 #
&

i
Spending - 90000(3#H . E0 THULEO) ,

CFFA X-in −$110,000 $51,780 $51,780 $71,780

=2: i
Note: Investment in NWC is recovered in final year
Equipment cost is a cash outflow in Year 0.

* FEE
9
. 1 .
9 .
2 .
9
-
.
5 te
© McGraw Hill, LLC 12
 Shark Attractant Project 2

Pro Forma Income Statement

Year
Year 001
1 22

Sales $200,000 $200,000

Variable Costs 125,000 125,000
Gross Profit $75,000 $75,000
Fixed Costs 17,430 17,430
Depreciation 30,000 30,000
EBIT $27,570 $27,570
Taxes 5,790 5,790
Net Income $21,780 $21,780
Cash Flows
Operating Cash Flows $51,780 $51,780 #
Changes in NWC −$20,000
Year OCF = EBIT + Depreciation
0 1 − Taxes 2
OCF = Net Income + Depreciation (if no interest).

© McGraw Hill, LLC 13

 Computing NPV for the Project Using the TI
BAII+ CF Worksheet
Cash Flows: Displa You Enter
y
CF, 2nd, CLR WORK
CF0 = −110,000
C00 110000 Enter, Down
CF1 = 56,070
C01 51780 Enter, Down
CF2 = 56,070 F01 2 Enter, Down
CF3 = 76,070 C02 71780 Enter, Down
F02 1 Enter, NPV
I 20 Enter, Down
NPV CPT
$19,68 IRR, CPT 30.57%
4

© McGraw Hill, LLC 14

 Making The Decision
*
Net
Net Income
income $21,780 $2178$21780
$21,780
$21780 $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
Cash Flow From −$110,000 $51,780 $51,780 $71,780
Assets

independent
Net Present $10,648.32 NPV , IRREPE
Value NPV > 0

2TTP Accept >

=

IRR 25.76% > Required Meturn

&or reject the project?

Should we accept

© McGraw Hill, LLC 15

 TC +
PM
The Tax Shield Approach to OCF PHY
SE OLFNE

In OCF =
OCF = (Sales − Costs)(1 − TC) + (Depreciation)(TC)
~

($200,000 − 142,430)(.79) + ($30,000)(.21)

OCF = $51,780.
Particularly useful when the major incremental cash flows are
the purchase of equipment and the associated depreciation
tax shield.
SE
OCF =
N2 + Depreciation >
-

/EPIYEFREE a G
EBIT Depreciation Taxes
FFEETy
= +

tHYE
-

...
,

SME =

(Sales-costs) (1-TC) + Depreciation (TC)

© McGraw Hill, LLC 16

 Changes in NWC NW2

GAAP requirements: Sales recorded when made, not when

cash is received.
ΔAR.
• Cash in = Sales − R

Cost of goods sold recorded when the corresponding sales

are made, whether suppliers paid yet or not.
ΔAP.
• Cash out = COGS − -AP
Buy inventory/materials to support sales before any cash
collected.

© McGraw Hill, LLC 17

 Depreciation & Capital Budgeting
Use the schedule required by the IRS for tax purposes.
Depreciation = Noncash expense.
• Only relevant due to tax effects.
Depreciation tax shield = DTC .
• D = Depreciation expense.
• TC = Marginal tax rate.

© McGraw Hill, LLC 18

 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.

© McGraw Hill, LLC 19

 Aftertax Salvage E
#PFE RE .

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.
Aftertax salvage = Salvage − TC(Salvage − Book value).

© McGraw Hill, LLC 20

 Tax Effect on Salvage

Net Salvage Cash Flow = SP − (SP − BV )(TC )

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

© McGraw Hill, LLC 21

 Example: Depreciation and Aftertax
Salvage
Car purchased for $35,000.
5-year property.
Marginal tax rate = 21%.
Depreciatio 5-year Asset
n
Year Beg BV Deprivation % Depreciation End BV
1 $ 35,000.00 20.00% $ 7,000.00 $ 28,000.00
2 $ 28,000.00 32.00% $ 11,200.00 $ 16,800.00
3 $ 16,800.00 19.20% $ 6,720.00 $ 10,080.00
4 $ 10,080.00 11.52% $ 4,032.00 $ 6,048.00
5 $ 6,048.00 11.52% $ 4,032.00 $ 2,016.00
6 $ 2,016.00 5.76% $ 2,016.00 $ -
100.00% $ 35,000.00
© McGraw Hill, LLC 22
 Salvage Value & Tax Effects
Depreciation 5-year Asset
Year Beg BV Depriation % Depreciation End BV
1 $ 35,000.00 20.00% $ 7,000.00 $ 28,000.00
2 $ 28,000.00 32.00% $ 11,200.00 $ 16,800.00
3 $ 16,800.00 19.20% $ 6,720.00 $ 10,080.00
4 $ 10,080.00 11.52% $ 4,032.00 $ 6,048.00
5 $ 6,048.00 11.52% $ 4,032.00 $ 2,016.00
6 $ 2,016.00 5.76% $ 2,016.00 $ -
Net Salvage Cash Flow = SP − (SP − BV
100.00% )(TC ).
$ 35,000.00

If sold at EOY 5 for $8,750:

NSCF = 8,750 − ($8,750 − 2,016)(.21) = $7,335.86
= $8,750 − 1,1414.14 = $7,335.86
If sold at EOY 2 for $15,000:
NSCF = $15,000 − ($15,000 − 16,800)(.21) = $15,378
= $15,000 − (−378) = $15,378
© McGraw Hill, LLC 23
 Majestic Mulch & Compost Co 1

Majestic Mulch and Compost Company (MMCC)

YEAR 0 1 2 3 4

Background Data:

Unit Sales Estimates 3,000 5,000 6,000 6,500

Variable Cost /unit $ 60.00

Fixed Costs per year $ 25,000.00

Sale Price per unit $ 120.00 $ 120.00 $ 120.00 $ 120.00 $ 110.00

Tax Rate 21.0%

Required Return on Project 15.0%

Yr 0 NWC $ 20,000.00

NWC % of sales 15%

Equipment cost - installed $ 800,000

Salvage Value in year 8 20%

of equipment cost

Depreciation Calculations:

Equipment Depreciable Base 800,000

MACRS %Given Data

(Eqpt-7 yr) and Projected Revenues – Table 9.9
14.29% 24.49% 17.49% 12.49%

Recovery Allowance 114,320 195,920 139,920 99,920

© McGraw Hill, LLC 24
 Book Value 685,680 489,760 349,840 249,920

Majestic Mulch & Compost Co 2

20,000 54,000 90,000 108,000 107,250 99,000 82,500 66,000 49,50

YEAR 0 1 2 3 4 5 6 7

Initial Investment

Equipment Cost (800,000)

Sales 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,00

Variable Costs 180,000 300,000 360,000 390,000 360,000 300,000 240,000 180,00

Fixed Costs 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,00

Depreciation (Eqpt) 114,320 195,920 139,920 99,920 71,360 71,440 71,440 35,68

EBT 40,680 79,080 195,080 200,080 203,640 153,560 103,560 89,32

Taxes 8,543 16,607 40,967 42,017 42,764 32,248 21,748 18,75

Net Operating Income 32,137 62,473 154,113 158,063 160,876 121,312 81,812 70,56

Add back Depreciation 114,320 195,920 139,920 99,920 71,360 71,440 71,440 35,68

CASH FLOW from

146,457 258,393 294,033 257,983 232,236 192,752 153,252 106,24
Operations

NWC investment &

(20,000) (34,000) (36,000) (18,000) 750 8,250 16,500 16,500 66,00
Recovery

Salvage Value 126,40

Depreciation and Aftertax Salvage - Table 9.10
TOTAL PROJECTED CF (820,000) 112,457 222,393 276,033 258,733 240,486 209,252 169,752 298,64

Discounted Cash Flows (820,000) 97,789 168,161 181,496 147,932 119,564 90,466 63,816 97,62

Cumulative
© McGraw Hill, LLC Cash flows (820,000) (707,543) (485,150) (209,116) 49,617 290,102 499,355 669,107 967,75
25
 Majestic Mulch & Compost Co 3

EBT 40,680 79,080 195,080 200,080

Taxes (21%) 8,543 16,607 40,967 42,017

Net Income 32,137 62,473 154,113 158,063

Add back Depreciation 114,320 195,920 139,920 99,920

CASH FLOW from Operations 146,457 258,393 294,033 257,983

NWC investment & Recovery –20,000 –34,000 –36,000 –18,000 750

Salvage Value

TOTAL PROJECTED CF –820,000 112,457 222,393 276,033 258,733

Cumulative Cash Flow –820,000 –707,543 –485,150 –209,116 49,617

Depreciation and Aftertax Salvage - Table 9.10

© McGraw Hill, LLC 26

 Majestic Mulch & Compost Co 4

Pro Forma Income Statements

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
Operating Cash Flow 51,780 51,780 51,780
MMC
Changes in NWC Pro Forma Income Statements
–20,000 20,000

© McGraw Hill, LLC 27

 Majestic Mulch & Compost Co 5

EBT 40,680 79,080 195,080 200,080

Taxes (21%) 8,543 16,607 40,967 42,017
Net Income 32,137 62,473 154,113 158,063
Add back Depreciation 114,320 195,920 139,920 99,920
CASH FLOW from
146,457 258,393 294,033 257,983
Operations
NWC investment & Recovery –20,000 –34,000 –36,000 –18,000 750
Salvage Value
TOTAL PROJECTED CF –820,000 112,457 222,393 276,033 258,733
Cumulative Cash Flow –820,000 –707,543 –485,150 –209,116 49,617

MMC Projected Cash Flows – Table 9.14

© McGraw Hill, LLC 28

 Evaluating NPV Estimates
NPV estimates are only estimates.
Forecasting risk: i) /
Sensitivity of NPV to changes in cash flow estimates.
• The more sensitive, the greater the forecasting risk.
Sources of value. Loading…
• Be able to articulate why this project creates value.

© McGraw Hill, LLC 29

 Scenario Analysis H5 #ST

Examines several possible situations:

• Worst case. FPG

• Base case or most likely case. ⑧

• Best case. A PE
Provides a range of possible outcomes.

© McGraw Hill, LLC 30

 Scenario Analysis Example 1

Deprec/yr $$40000
Deprec/yr 40,000 15 * 40000)
Project Life 5 years
Tax rate 21%
Required return O 12% FP ITE
Base Case Lower Bound Upper Bound
Units 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 $ 50,000 $ 45,000 $ 55,000
Sales $ 480,000 $ 412,500 $552,500
Variable cost 360,000 319,000 403,000
Fixed cost Note: 50,000 45,000
“Lower” ≠ Worst “Upper” ≠ Best 55,000
© McGraw Hill, LLC 31
 Scenario Analysis Example 2

Base Case Lower Bound Upper Bound

Units 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 $ 50,000 $ 45,000 $ 55,000
Sales $ 480,000 $ 412,500 $ 552,500
Variable cost 360,000 319,000 403,000
Fixed cost 50,000 45,000 55,000
Depreciation 40,000 40,000 40,000
EBIT 30,000 8,500 54,500
Taxes 6,300 1,785 11,445
OCF Net income 23,700 6,715 43,055

© McGraw Hill, LLC

+Deprec 40,000 40,000 40,000 32
 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.

© McGraw Hill, LLC 33

 Sensitivity Analysis 1
IEEE*ST

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.

© McGraw Hill, LLC 34

 Sensitivity Analysis Example

NPV $29624$1147$5802
$ 29,624 $ 1,147 $ 58,102
IRR
% Change in NPV −96.1% 96.1%
% Change in Variable −8.3% −10.0%
SENSITIVITY RATIO 11.54 −9.61
DIRECT INVERSE

© McGraw Hill, LLC 35

 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.

© McGraw Hill, LLC 36

 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.

© McGraw Hill, LLC 37

 Managerial Options F

Contingency planning.
D Option to expand. Fr x

• Expansion of existing product line.

• New products.
• New geographic markets.
② Option to abandon. F
• Contraction. *

• Temporary suspension.
&
Option to wait. EFE Fr ,

⑪ Strategic options. EFFE

© McGraw Hill, LLC 38
 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.

© McGraw Hill, LLC 39

 End of Main Content

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