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Making Capital Investing Decisions

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  1. Making Capital Investing Decisions Chapter 8

  2. Cash Flows • Relevant • Cash flows (not accounting earnings) • Depreciation • Incremental cash flows • Opportunity costs • Side effects (externalities) • E.g. cannibalism or synergy • Taxes • Inflation • Irrelevant • Sunk costs

  3. Estimating Cash Flows • Cash Flows from Operations • Operating Cash Flow = EBIT – Taxes + Depreciation • Net Capital Spending • Usually up front and at the end • Remember salvage value (after tax) • Changes in Net Working Capital

  4. Working Capital • What is working capital? • Current assets – current liabilities • Net investment in s-t assets • Usually inventory, accounts receivable, and accounts payable • Usually, working capital = Inv + AR – AP • Why does it increase? • Essentially, you are making an investment in working capital (negative CF) • At end of project – usually assumed to be completely recovered • Increases then decreases

  5. Interest Expense • For CF estimation, ignore how the project is financed • Ignore debt payments • Why? • Ask the following: Is the project’s existence dependent on financing? • If no, you must separate financing and investment decisions • More later!

  6. Example: Speedo LZR-2 • After the success of Michael Phelps in the 2008 Beijing Olympics and the upcoming 2012 Olympics, Speedo has decided to introduce the LZR-2. An improved version of the LZR that Phelps and others wore. • Speedo spent 250k developing an improved “Pulse” fabric • Speedo spent 100k test marketing it with Olympic hopeful swimmers • Test market was successful

  7. Example: Speedo LZR-2 • Details • Speedo is assuming three years for the project. They assume that at the end of three years the technology will be essentially obsolete. • Cost of equipment to support the new swimsuit: $200,000 (depreciated according to MACRS 3-year life) • Increase in net working capital (mainly fabric materials): $20,000. This will be recovered at the end of the project. • Inflation has been built into financial statements already. • Operating costs are about 90% of revenues. • The equipment can be sold at the end of the project for an estimated $20,000. • Speedo has estimated the appropriate discount rate to be 10%.

  8. Example: Speedo LZR-2 • Relevant or not? • 250k developing fabric? • 100k test marketing swimsuits? • Do you think this project will have externalities?

  9. Example: Speedo LZR-2 • Starting point: Year 0 outflowsEquipment -200NWC -20Total -220

  10. Example: Speedo LZR-2 • Depreciation • Why do we care about depreciation? • Taxes • Tax shield = depreciation * tax rate • Now, do you want tax shields sooner or later? • Tax law allows accelerated depreciation (Modified Accelerated Cost Recovery System or MACRS)

  11. Example: Speedo LZR-2

  12. Example: Speedo LZR-2 • Notice that MACRS uses a half-year convention • To use: Take investment * rate • Since it accelerates tax shield, what should happen to NPV? • Speedo (rounded):

  13. Example: Speedo LZR-2

  14. Example: LZR-2 • Equipment can be sold at end of year 3 for 20,000. • So, additional CF:Book value: 14Capital gain: 20 – 14 = 6Taxes: 6 * .4 = 2.4CF: 20 – 2.4 = 17.6 Note: Taxes on Salvage = (Salvage – Book)*TCand CF from Salvage = Salvage – Taxes • Put it all together! • Capital investment • Change in NWC • Operating CFs (need depreciation) • CF from Salvage • Evaluate!

  15. Example: LZR-2 • Find NPV, IRR.

  16. Example: LZR-2 • What if I sell the equipment after Year 2? • Book value: 14+30=44 OR200-66-90=44 • Capital gain or loss: 20 – 44 = -24Taxes: -24 * .4 = -9.6CF: 20 – (-9.6) = 29.6 • Suppose, selling price is 50 after Year 2. • Capital gain or loss: 50 – 44 = 6Taxes: 6 * .4 = 2.4CF: 50 – 2.4 = 47.6

  17. Example: LZR-2 What if working capital changed over the life of the project?

  18. Inflation and Capital Budgeting • Be consistent! • Nominal with nominal • Real with real

  19. Inflation and Capital Budgeting • Example: Shields Electric has the following nominal CFs. Nominal rate is 14% and inflation is 5%. Find NPV. • Year 0: -1000 • Year 1: +600 • Year 2: +650

  20. Unequal Lives: Equivalent Annual Cost Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

  21. Unequal Lives: Equivalent Annual Cost Example • Consider a factory that must have an air cleaner that is mandated by law. There are two choices: • The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100, and lasts 10 years. • The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500, and lasts 5 years. • Assuming a 10% discount rate, which one should we choose?

  22. Unequal Lives: Equivalent Annual Cost First, what does NPV tell you? What is wrong with this? Now, find EAC.

  23. Unequal Lives: Equivalent Annual Cost • Think of it like rental payments • If different economic lives, select the one with the lowest rental charge (lowest EAC) • Remember: Only if both machines can be replaced!