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Chapter 9

Chapter 9. Making Capital Investment Decisions. We know from Chapter 8: Capital budgeting requires calculating the NPV : Discount Future Cash Flows a t the Require Rate of R eturn But how do you determine the cash flows? And how do you know what discount rate to use?

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Chapter 9

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  1. Chapter 9 Making Capital Investment Decisions

  2. We know from Chapter 8: • Capital budgeting requires calculating the NPV: • Discount Future Cash Flows • at the Require Rate of Return But how do you determine the cash flows? And how do you know what discount rate to use? • First we’ll look at cash flows • Then we’ll look at the discount rate The General Idea: • Only use CFs associated with the project under consideration • New CFS (aka Incremental CFs) • Only these are relevant for the analysis • CFs from existing (or previous) operations are not relevant

  3. Chapter Outline: • The Stand-Alone Principle • Use only Incremental or Relevant CFs • So which CFs do you include? • Use of Pro-Forma Financial Statements • More About Net Working Capital • (Inv, A/R, A/P) • More About Depreciation • Evaluating NPV estimates • Sensitivity and Scenario Analyses • Additional Considerations

  4. 9.1 Project Cash Flows – A First Look • Don’t calculate the whole firm’s CFs • Calculate CFs withand withoutthe project • Called the Stand-Alone Principle • Calculate the Incremental CFsassociated with the project • Include any and all changes in the firm’s future CFs that are a direct consequenceof the project. • These are the Relevant CFs use to calculate NPV

  5. 9.2 Incremental CFs • Only those CFs that result from doing the project • Some Issues and Definitions associated with Identifying Incremental CFs: • Sunk Costs • A cost already paid or a liability already incurred • Opportunity Costs • The use of asset the firm already owns • How is this different from a sunk cost? • You could sell the asset • Side Effects • Cannibalization or generation of other (service?) revenues • CFs Associated with Changes in Working Capital • Inventory build-up, customer credit, supplier credit • Financing Costs • We’ll incorporate these later (see why in a minute)

  6. Sunk Costs • A Sunk Cost is cost that has already been paid • Or a liability already incurred • Any decision about the project will not affect these costs Example: • Money spent studying a project before the decision • Architectural plans, legal fees concerning zoning… • Do not include these cost! • This money is spent whether or not the project is accepted Example: • Already paying a manager to manage one factory • Do not allocate ½ the manager’s salary to the 2nd factory • The salary is a sunk cost since you are already paying it • So do not included ½ the salary in the 2nd factory CFs

  7. Two More Sunk Cost Examples: Example 1: • One more $1 slot-machine-pull after loosing $100. • Consider the lost $100 when deciding to bet the next $1? • The $100 loss is not relevant to the decision to bet the next $1 Example 2: • We tried to market a red version of our project and that didn’t work • Should we try to market a blue version? • Should we include the cost of the failed red version when deciding on the blue version? • It is often tempting to try to “turn around” a previous bad decision or bad outcome: “If we don’t continue, then past losses were in vain” • The only consideration should be changes going forward. Past costs are sunk costs.

  8. Clicker Question: A firm is deciding whether or not to build a new factory • The land will cost $1 million • Construction will cost $10 million • A road to the factory will cost $2 million • It has already spent $500,000 on a feasibility study for the project If these are all the relevant data points, what value should the company use for the initial cost (aka the initial CF)? • $10 million • $11 million • $12 million • $13 million • $13.5 million

  9. Clicker Answer: • Include costs that will be incurred if the project is approved. • Do not include costs that have already been spent. • Since money already spent are sunk costs • The land will cost $1 - Include • Construction will cost $10 - Include • Road will cost $2 - Include • Feasibility study $0.5 already spent – Sunk Cost CF0 = $1 + $10 + $2 = $13 The Answer is D.

  10. Opportunity Costs • If assets are used that the firm already owns: • Account for them at Current Market Value • Notthe original cost • Not the book value The Reason to use Current Market Value: • If the assets are not used in the project then the assets could be sold at Current Market Value

  11. Clicker Question: A Denver courier company is deciding whether or not to expand to Boulder • It owns a currently-unused truck which it could employ in the Boulder operation. • 8 years ago the company paid $100,000 for the truck • The truck has been depreciated to a book value of zero • The market value for the truck is $20,000 • What cost should the company use when calculating the CFs for the project? • $100,000 • $20,000 • Zero

  12. Clicker Answer: • Value the asset at its opportunity cost • Which is its current Market Value • If the project is not approved, the company can sell the truck for $20,000 The Answer is B.

  13. Side Effects • A new project might have spillover or side effects that must be included • Goodor Badside effects • A new product might: • Generate revenue from servicingthe product • Generate sales of replacement parts • Cause cannibalization of existing products

  14. Clicker Question: • A company that already sells $1 million of blue pens per year wants to sell red pens • It believes it can sell $700,000 of red pens • It also believes that red-pen sales will cause blue-pen sales to decrease by $100,000 per year. What Incremental or Net Sales value should the company use in it’s red-pen capital budgeting analysis? • $600,000 • $700,000 • $1,000,000 • $1,600,000 • $1,700,000

  15. Clicker Answer: • Additional red-pen sales of $700,000 • Less cannibalized blue-pen sales of $100,000 • So Incrementalsales is $700,000 - $100,000 = $600,000 The Answer is A.

  16. Correcting OCF for Changes in NWC Working Capital Accounts (on the Balance Sheet): • Inventory – Asset • Stuff you want to sell • You have already bought it, but not yet sold it • Accounts Receivable (A/R) – Asset • The value of stuff you sold on credit • So you didnot get cash yet • Accounts Payable (A/P) – Liability • This is stuff you bought or expensed on credit • So you did not pay cash yet Net Working Capital = Inv + A/R – A/P

  17. Correcting OCF for Changes in NWC (2) The Idea: • Start with the Working Capital Balance Sheet Accounts at the beginning of the year: Inventory = $60 A/R = $20 A/P = $10 Net Working Capital = Inv + A/R – A/P = $60 + $20 – $10 = $70

  18. Correcting OCF for Changes in NWC (3) Now go to the Income Statement over the year: Sales = $100 COGS = $50 SG&A = $20 • So 1st guess of CF = Sales - COGS - SG&A = $100 - $50 - $20 = $30 • This is the (almost) CF from operations (OCF)

  19. Correcting OCF for Changes in NWC (4) • So 1st guess of CF = Sales - COGS – SG&A = $100 - $50 - $20 = $30 But what if: • $20 of the $100 sales were on credit? • So $80 in cash and A/R increased by $20 • $10 of sold inventory (COGS) was not replaced? • So $50 worth sold, but only $40 in cash spent on COGS. So Inventory decreased by $10 • $5 of SG&A was on credit? • So only $15 in cash spent on SG&A and A/P increased by $5

  20. Correcting OCF for Changes in NWC (5) Sales - COGS - SG&A = $100 - $50 - $20 = $30 • $20 of sales on credit • So only $80 in cash and A/R increased by $20 • $10 of inventory (COGS) was not replaced • So only $40 in cash spent on COGS • $5 of SG&A was on credit • So only $15 in cash spent on SG&A and • So 2nd guess of CFs is: $80 - $40 - $15 = $25 Is there another way to get the $25 CF? 

  21. Correcting OCF for Changes in NWC (6) • Now back to the Balance Sheet for the End of the Year • Sales of $100, but $20 on credit • A/R = $20 + $20 = $40 • Sold $50, replaced only $40 • Inventory = $60 - $50 + $40 = $50 • SG&A Expenses of $20, but only paid $15 • A/P = $10 + $5 = $15 Net Working Capital = Inv + A/R – A/P = $50 + $40 – $15 = $75 Change in NWC = New – Old = $75 - $70 = $5

  22. Correcting OCF for Changes in NWC (7) • Recall OCF = Sales - COGS – SG&A = $100 - $50 - $20 = $30 • $20 of Sales not a cash inflow • So cash inflow is $20 less than $100 • So A/R increased by $20 • $10 of COGS expense not a cash outflow • Since only $40 of inventory was replaced • So the COGS cash outflow was $10 less than $50 • So Inventory decreased by $10 • $5 of SG&A expense not a cash outflow • Since only $15 was paid • So A/P increased by $5 Change in NWC = $20 + (-$10) -$5 = $5 Actual CF = $30 - Change in NWC = $30 – $5 = $25

  23. Review: Correcting OCF for Changes in NWC A new project might require new inventory • Pay cash for inventory? • That is a cash outflow • Borrow the money from suppliers (trade credit)? • A/P increases but there is no cash outflow • Sales in Cash or Credit (A/R)? • If credit sales, then no CF until payment received • Projected expenses in Cash or on Account (A/P)? • If on account, then no CF until payment is made • Also consider Working Cap changes at the project’s end: • Built-up Inventories sold • A/R and A/P settled • Do they return to zero? (Usually)

  24. Clicker Question: • A company expects sales of $5 million next year • $4 million in cash and $1 million on credit • Its COGS will be $3 million • But it will replace only $2 million of the inventory sold • Of the $2 million paid to replace inventory, only $1 million will be in cash, • the rest will be on credit • At the beginning of the year, its Work Cap accounts are: A/R = $1.5, Inv = $2.5 and A/P = $0.5 What are the ending values for the working capital accounts? • A/R = $1.5 Inv = $0.5 A/P = $0.5 • A/R = $2.5 Inv = $1.5 A/P = $1.5 • A/R = $1.5 Inv = $0.5 A/P = $2.5 • A/R = $2.5 Inv = $1.5 A/P = $2.5 • A/R = $3.5 Inv = $2.5 A/P = $0.5

  25. Clicker Answer: • $1 in credit sales A/R = $1.5 + $1 = $2.5 • COGS is $3 but only $2 replaced Inventory = $2.5 – $1 = $1.5 • $2 in replaced inventory, but only $1 in cash A/P = $0.5 + $1 = $1.5 The Answer is B

  26. Clicker Question: • A company expects Sales of $5 million next year • Its COGS will be $3 million • Working Cap accounts at the beginning of the year are: A/R = $1.5, Inv = $2.5 and A/P = $0.5 • Working Cap accounts at the end of the year will be: A/R = $2.5, Inv = $1.5 and A/P = $1.5 Calculate the CF for the firm • Hint: Calculate beginning NWC, ending NWC and then change in NWC • $1.5 • $2.0 • $2.5 • $3.0 • $3.5

  27. Clicker Answer: • Operating CF = Sales – COGS = $5 - $3 = $2 • Beginning NWC = A/R + Inv – A/P = $1.5 + $2.5 – $0.5 = $3.5 • Ending NWC = A/R + Inv – A/P • = $2.5 + $1.5 – $1.5 = $2.5 • Change in NWC = $2.5 – $3.5 = -$1 • CF = OCF – Change in NWC = $2 – (-$1) = $3 The Answer is D.

  28. Clicker Extra Explanation: • Operating CF = Sales – COGS = $5 - $3 = $2 Explanation: • Credit Sales means the Operating CF is too high by $1 • A/R increases $1 • Only $2 of inventory replaced means the Operating CF is too high by another $1 • Inv decreases $1 • But since only $1 of the inventory that is replaced is paid for in cash, it means the Operating CF is too low by $1 • A/P increase $1 • The net result is only $4 was collected and only $1 was paid • The easy way to calculate this is to calculate the Change in NWC (which is equal to -$1) • CF = Operating CF – DNWC = $2 – (-$1) = $3

  29. Financing Costs • We will not included Financing Costs: • Dividends Paid • Interest Paid • Why? • We are interested in CFs generated by the project’s assets • Notinterested in CFs paid to creditors (aka bond holders) • Not interested in CFs paid to stockholders • Recall from Chapter 2: • CFs from Assets = CFs to Creditors + CFs Stockholders • This equation shows the allocation of CFs from Assets: • Some to creditors, some to stockholders • We care about the CFs from Assets • How CFs from Assets is allocated is a question for later • For now: • Compare PV of the project’s CFs to the project’s costs

  30. 9.3 Pro Forma Financial Statements Pro Forma is Latin for “as a matter of form” The words “Pro Forma” have two main uses in business: • Pro Forma Earnings: • Produced by companies as an addendum to GAAP earnings • It usually shows current earnings excluding non-recurring or other extraordinary (unusual) expenses • Restructuring cost, inventory write-offs, asset write-offs… • Companies do it to show what a “regular quarter would have looked like” without the bad stuff that happened only this once • Pro Forma Financial Statements: • Created in advance of the actual project • Created as part of a business plan • ProjectedIncome Statements, Balance Sheets and Cash Flow Projections • This is what we will be doing and how we will use the term “pro forma”

  31. Pro Forma Financial Statements Used to calculate CFs for a proposed project Total CF in any period is • Operating Cash Flows (OCF) • Less the Change in Net Working Capital (DNWC) • Less Net Capital Spending (NCS) CFt = OCFt – DNWCt – NCSt • We will use Pro Form financial statements to estimate the CFs for a proposed project

  32. Pro Forma Financial Statements: Example: Sell Cans of Shark Attractant (page 279) Need to estimate: • Units sold: 50,000 cans per year for 3 years • Selling Price: $4.00 per can • Variable Costs: $2.50 per can • Fixed Costs: $12,000 per year • Costs of Machinery: $90,000 • Depreciated at Straight-line to zero over three years • Any residual value will equal disposal costs • These are simplifying assumptions • Investment in Net Working Capital: $20,000 • New inventory, short term borrowing,… • The tax rate is 34% • Required Return is 20% Produce a Pro Forma Income Statement for this Project

  33. Pro Forma Income Statement: Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Fixed costs 12,000 Depreciation Exp ($90,000/3) 30,000 Taxable Income 33,000 Taxes (34%) 11,220 Net Income $21,780 OCF = NI + Dep $51,780 (Note: No interest expense. Deal with that later.) Pro Forma Statement of Projected Capital Requirements 

  34. Really looks like this: Since estimates are the same each year: Year 1 Year 2 Year 3 Sales $200,000 $200,000 $200,000 VC125,000 125,000 125,000 Fixed costs 12,000 12,000 12,000 Depreciation 30,00030,00030,000 Taxable Income33,000 33,000 33,000 Tax Exp 11,22011,220 11,220 NI $21,780 $21,780 $21,780 OCF = NI + Dep$51,780 $51,780 $51,780 OCF1 = $51,780 OCF2 = $51,780 OCF3 = $51,780 (Later we will have different OCF estimates for each year)

  35. Projected NWC and NCS: • Spend $20,000 at time zero on Working Capital (inventory…) DNWC0= $20,000 • Spend $90,000 at time zero on Fixed Assets (Machines) Net Capital Spending = NCS0= $90,000 • Get $20,000 in working capital back at time 3 when the project ends DNWC3= -$20,000 (Sell all the inventory, collect all the A/R, pay all A/P) This is a simple example: • Sales are the same in each year • Should they increase over time? • Inventory (part of working capital) is constant • Usually increase gradually and sell it off as project nears end • Will company collect all A/R? Now Create a Pro Form CF Statement

  36. Pro Forma Cash Flow Statement: CFs at each period = OCF - DNWC - Net Capital Spending • Why do we add $20,000 to Year 3 OCF to get CF? • We subtracted $20,000 in COGs when we calculated OCF • But since the inventory was not replaced, the cash was not spent • When was that cash spent on Inventory? • Time zero. And we reduced CF0 by $20k

  37. Calculate NPV using Pro-Form IS: Calculate the NPV using the CFs and R = 20% • CF0 = -110,000 • CF1= 51,780 • CF2= 51,780 • CF3= 71,780 NPV = $10,684 > 0 so accept the project

  38. Another Method of Computing OCF The Tax Shield Approach to OCF • A slightly different way to calculate OCF • The idea is to see how much of OCF can be attributed to the depreciation method • Depreciation is an expense that “shields the firm from taxes” • So come up with a formula to calculate OCF that isolates the tax savings from Depreciation OCF = (Sales – VC – FC)(1 – T) + Dep x T • We’ll also use this as an opportunity to talk about Depreciation and Net Salvage Value

  39. The Tax Shield Approach to OCF Before: We calculated OCF = NI + Dep: NI = Sales – VC – FC – Dep – Tax Exp Tax Exp = (Sales – VC – FC – Dep)T So Sub for Tax Exp and simplify: NI = (Sales – VC – FC – Dep) – (Sales – VC – FC – Dep)T NI = (Sales – VC – FC – Dep)(1 – T) NI = ($200 – $125 – $12 – $30)(1 – 0.34) = $21.78 Same as NI on slide #33

  40. The Tax Shield Approach to OCF Now: OCF = (Sales – VC – FC)(1 – T) + Dep x T Dep x T is the tax savings for the amount of depreciation expense OCF = ($200 – $125 – $12)(1 – 0.34) + $30(0.34) OCF = ($63)(0.66) + $30(0.34) OCF = $41.58 + $10.20 = $51.78 Same as OCF on slide #34

  41. The Tax Shield Approach to OCF • Same value but we can break OCF in to 2 components: • The OCF with no depreciation ($41.58) • This year’s tax savings from this years depreciation ($10.20) • The tax savings is the “tax shield” • So separate depreciation to see how different depreciation schedules change OCF • Using the Tax Shield Approach: • Calculate OCF if this years depreciation is $40 instead of $30: OCF = (Sales – VC – FC)(1 – T)+ Dep x T OCF = ($63)(0.66) + $40(0.34) = $55.18 • Why a bigger OCF? ($55.18 > $51.78) • Larger Deprecation means lower taxes

  42. Clicker Question: • For a new project, a firm expects annual sales of $15, VC of $3 and FC of $8 • The Depreciation Expense will be $3 per year • The Marginal tax rate is 35% • Calculate the annual Depreciation Tax Shield and the annual OCF for the project. • Dep Tax Shield = $1.05, OCF = $2.45 • Dep Tax Shield = $1.05, OCF = $3.65 • Dep Tax Shield = $1.95, OCF = $3.35 • Dep Tax Shield = $1.95, OCF = $4.45 • Dep Tax Shield = $3.00, OCF = $4.00

  43. Clicker Answer: • For a new project, a firm expects annual sales of $15, VC of $3 and FC of $8 • The Depreciation Expense will be $3 per year • The Marginal tax rate is 35% • Depreciation Tax Shield = Dep x T = $3 x 0.35 = $1.05 • OCF = (Sales – VC – FC)(1 – T) + Dep x T = ($15 – $3 – $8)(1 – 0.35) + ($3 x 0.35) = $2.6 + $1.05 = $3.65 The Answer is B.

  44. 9.4 More about CFs More About Depreciation: Depreciation as a Tax Shield: • You buy a $100k truck today that will last 4 years • The ONLY cash outflow is right now (CF0 = -$100k) • But GAAPallows charging a portion of the cost against sales over each of the next four years • This lowers taxes in each of the next four years • So when calculating the CFs for each of the next four years, calculate depreciation expense • We can think about the Depreciation Expense as a Tax Shield • Note: Although I am using a truck for this example, trucks generally do not qualify for the depreciation schedule used in this example.

  45. Depreciation as a Tax Shield (2): Previous example OCF = (Sales – VC – FC)(1 – T) + Dep x T • Sales = $200, VC = $125, FC = $12, Dep = $30 and T = 34% • Sales – VC – FC = $200 - $125 - $12 = $63 • We only keep 66% of $63. The rest is paid in taxes: • $63(1 - 0.34) = $41.58 • Tax Shield from Dep = $30 x 0.34 = $10.2 • We keep this extra $10.2 since taxable income was $30k lower • So the cost of the truck is an outflow only at time 0 (CF0) • But depreciation lowers taxes in the following years

  46. Depreciation as a Tax Shield (3): • Assume we buy a $100k truck (CF0 =-$100) • We use it 4 years • Sales = $75, Costs = $30, T = 34% • All sales are cash, all costs are cash so no DNWC • Assume Straight-Line Dep: $25 per year • CF = OCF = (Sales – Costs)(1 – T) + Dep x T • CF = ($75 - $30)(1 – 0.34) + ($25)(0.34) = $29.70 + $8.50 = $38.20 • So CF0 = -$100, CF1 through CF4 = $38.20 • If R = 20% then NPV = -$1.11 reject

  47. Depreciation as a Tax Shield (4): • Now assume we can depreciate a little quicker • Use the MACRS schedule • Still expense the $100 over 4 years: • What is the effect in years 1 & 2? • Higher depreciation expense - higher than $25 • So Lower Taxable Income means Lower Taxes • So Higher CF

  48. Depreciation as a Tax Shield (5): CF = OCF = (Sales – Costs)(1 – T) + Dep x T (Sales – Costs)(1 – T) = ($75 - $30)(1 – 0.34) = $29.70 (in all yrs) Dep1x T = $33.33(0.34) = $11.3322  CF1 = $41.0322 Dep2 x T = $44.44(0.34) = $15.1096  CF2 = $44.8096 Dep3 x T = $14.82(0.34) = $5.0388  CF3 = $34.7388 Dep4 x T = $7.41(0.34) = $2.5194  CF4 = $32.2194 NPV @ 20% = $0.953 > 0 The accelerated depreciation increased the NPV

  49. Here is the Same Example:

  50. Notice Under Either Depreciation Schedule: • Total Taxable income over the 4 years is $80 • Total Tax Expense over the 4 years is $27.20 34% of $80 = $27.20 • Total CFs over the 4 years is $152.80 • The depreciation schedule just changes the timing of the CFs: • Higher CFs sooner, Lower CFs later So CF timing changes the NPV

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