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Making Capital Investing Decisions

Making Capital Investing Decisions. Chapter 8. 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. Estimating Cash Flows.

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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!

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