Ch. 9: Making Capital Investment Decisions • NPV of a Project • Relevant Cash Flows • Pro Forma Financial Statements • Evaluating NPV Estimates • Real Options • Capital Rationing
NPV of a Project • See Table 9.14 on p. 256 • Calculate relevant net cash flow for each period • Discount by WACC, if project’s risk is similar to firm’s (Ch. 12) • Adjust WACC up or down if project’s risk is significantly higher or lower (Ch. 12)
Relevant Project Cash Flows • Use aftertax incremental cash flows: any change in the firm’s future cash flows because of the project, including side effects. • Exclude sunk costs. • Use opportunity cost: the most valuable alternative given up if the project is undertaken. • Since WACC includes inflation, so should projected cash flows (i.e., they should be nominal). • Project’s cash flow = + project’s operating cash flow - project’s change in net working capital - project’s capital spending
Relevant CFs (cont.) • Exclude financing costs from cash flows (interest expense, principal payments, dividends) because they are already in WACC • Ex.: One-year project, initial cost = $100. Borrow $100 at 10% (WACC) for a year; ignoring taxes, need to make $110 to break even (NPV=0): NPV = -$100 + $110/1.10 -CORRECT • If we incorrectly deduct financing cost from Year 1 cash flow, we would be double-counting: NPV = -$100 + $(110-10)/1.10 = -$9.09 -WRONG
Pro Forma Financial Statements • See Tables 9.9 - 9.14 on pp. 253-6 • Project’s cash flow = + project’s operating cash flow - project’s change in net working capital - project’s capital spending • Project’s operating cash flow = EBIT + depreciation - taxes • Depreciation: see next slide • Subtract project’s change in net working capital • Subtract project’s capital spending
Net Salvage Value • net salvage value = salvage (market) value - taxes • taxes = tax rate * gain on sale • gain on sale = salvage (market) value - book value • book value = original depreciable basis - accumulated depreciation • MACRS Tables 9.6 & 9.7, p. 250 Book Value versus Market Value The Half-year convention implies 7-year asset depreciated over 8 years, etc.
Evaluating NPV Estimates • Cash flows are estimates into the future • Forecasting (estimation) risk: the possibility that errors in projected cash flows will lead to incorrect decisions • Analyze sources of project’s value • Scenario analysis: base case, optimistic case, pessimistic case • Sensitivity analysis: see how sensitive the NPV conclusion to one variable by varying it while using base case for all other inputs.
Real Options, Capital Rationing • Real (a.k.a. managerial, embedded) options • option to expand, option to abandon, option to wait, strategic options • Capital rationing: funds are not available for a project with positive NPV
Recommended Practice • Self-Test Problems 9.1 & 9.2 on pp. 266-7 • Questions 2, 3, 7-9 (starts after 6), 12 on pp. 267-8 • Problems on pp. 268-71: 1, 7, 9-12, 19, 21 (most answers are on p. 548)