Capital Budgeting P.V. Viswanath Based partly on slides from Essentials of Corporate Finance Ross, Westerfield and Jordan, 4th ed. Key Concepts and Skills Understand how to determine the relevant cash flows for a proposed investment Understand how to analyze a projects projected cash flows Understand how to evaluate an estimated NPV P.V. Viswanath 2 Chapter Outline Project Cash Flows: A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows More on Project Cash Flow Evaluating NPV Estimates Scenario and Other What-If Analyses Additional Considerations in Capital Budgeting

P.V. Viswanath 3 Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows P.V. Viswanath 4 Asking the Right Question You should always ask yourself Will this cash flow occur ONLY if we accept the project?

If the answer is yes, it should be included in the analysis because it is incremental If the answer is no, it should not be included in the analysis because it will occur anyway If the answer is part of it, then we should include the part that occurs because of the project P.V. Viswanath 5 Common Types of Cash Flows Sunk costs costs that have accrued in the past Opportunity costs costs of lost options Side effects Positive side effects benefits to other projects Negative side effects costs to other projects Changes in net working capital Financing costs Taxes P.V. Viswanath

6 Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows refresher Operating Cash Flow (OCF) = EBIT + depreciation taxes OCF = Net income + depreciation when there is no interest expense Cash Flow From Assets (CFFA) = OCF net capital spending (NCS) changes in NWC P.V. Viswanath 7 Table 9.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit)

125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (34%) 11,220 Net Income $ 21,780 P.V. Viswanath

8 Table 9.2 Projected Capital Requirements Year 0 NWC Net Fixed Assets Total Investment 1 2 3 $20,000 $20,000 $20,000 $20,000

90,000 60,000 30,000 0 $110,000 $80,000 $50,000 $20,000 P.V. Viswanath 9 Table 9.5 Projected Total Cash Flows Year 0 OCF 1 $51,780

Change in NWC -$20,000 Capital Spending -$90,000 CFFA -$110,00 2 $51,780 3 $51,780 20,000 $51,780 P.V. Viswanath $51,780

$71,780 10 Making The Decision Now that we have the cash flows, we can apply the techniques that we learned in chapter 8 Enter the cash flows into the calculator and compute NPV and IRR CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780 NPV; I = 20; CPT NPV = 10,648 CPT IRR = 25.8% Should we accept or reject the project? P.V. Viswanath 11

The Tax Shield Approach You can also find operating cash flow using the tax shield approach OCF = (Sales costs)(1 T) + Depreciation*T This form may be particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield such as when you are choosing between two different machines P.V. Viswanath 12 More on NWC Why do we have to consider changes in NWC separately? GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of

whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales although we havent collected cash yet P.V. Viswanath 13 Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes Depreciation tax shield = DT D = depreciation expense T = marginal tax rate P.V. Viswanath 14 Computing Depreciation

Straight-line depreciation D = (Initial cost salvage) / number of years Very few assets are depreciated straight-line for tax purposes MACRS Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the initial cost Depreciate to zero Mid-year convention P.V. Viswanath 15 After-tax Salvage 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

After-tax salvage = salvage T(salvage book value) P.V. Viswanath 16 Example: Depreciation and After-tax Salvage You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The companys marginal tax rate is 40%. What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following situations? P.V. Viswanath 17 Example: Straight-line Depreciation Suppose the appropriate depreciation schedule is straight-line

D = (110,000 17,000) / 6 = 15,500 every year for 6 years BV in year 6 = 110,000 6(15,500) = 17,000 After-tax salvage = 17,000 - .4(17,000 17,000) = 17,000 P.V. Viswanath 18 Example: Three-year MACRS Year MACRS percent D 1 .3333 .3333(110,000) = 36,663

2 .4444 .4444(110,000) = 48,884 3 .1482 .1482(110,000) = 16,302 4 .0741 .0741(110,000) = 8,151 P.V. Viswanath BV in year 6 = 110,000 36,663 48,884 16,302 8,151 = 0

After-tax salvage = 17,000 - .4(17,000 0) = $10,200 19 Example: Seven -Year MACRS Year MACRS Percent D 1 .1429 .1429(110,000) = 15,719 2 .2449 .2449(110,000) = 26,939

3 .1749 .1749(110,000) = 19,239 4 .1249 .1249(110,000) = 13,739 5 .0893 .0893(110,000) = 9,823 6 .0893 .0893(110,000) = 9,823 P.V. Viswanath BV in year 6 =

110,000 15,719 26,939 19,239 13,739 9,823 9,823 = 14,718 After-tax salvage = 17,000 - .4(17,000 14,718) = 16,087.20 20 Example: Replacement Problem Original Machine New Machine Initial cost = 100,000 Annual depreciation = 9000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000

Salvage in 5 years = 10,000 Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation Required return = 10% Tax rate = 40% P.V. Viswanath 21 Replacement Problem Computing Cash Flows Remember that we are interested in incremental cash flows

If we buy the new machine, then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years? P.V. Viswanath 22 Replacement Problem Pro Forma Income Statements Year 1 2 3 4 5 50,000 50,000

50,000 50,000 50,000 New 49,500 67,500 22,500 10,500 0 Old 9,000 9,000 9,000 9,000

9,000 Increm. 40,500 58,500 13,500 1,500 (9,000) EBIT 9,500 (8,500) 36,500 48,500 59,000

Taxes 3,800 (3,400) 14,600 19,400 23,600 NI 5,700 (5,100) 21,900 29,100 35,400 Cost Savings Depr.

P.V. Viswanath 23 Replacement Problem Incremental Net Capital Spending Year 0 Cost of new machine = 150,000 (outflow) After-tax salvage on old machine = 65,000 - .4(65,000 55,000) = 61,000 (inflow) Incremental net capital spending = 150,000 61,000 = 89,000 (outflow) Year 5 After-tax salvage on old machine = 10,000 - .4(10,000 10,000) = 10,000 (outflow because we no longer receive this) P.V. Viswanath

24 Replacement Problem Cash Flow From Assets Year 0 OCF 1 2 3 4 5 46,200 53,400 35,400

30,600 26,400 NCS -89,000 -10,000 In NWC 0 0 CFFA -89,000 46,200 53,400 P.V. Viswanath

35,400 30,600 16,400 25 Replacement Problem Analyzing the Cash Flows Now that we have the cash flows, we can compute the NPV and IRR Enter the cash flows Compute NPV = 54,812.10 Compute IRR = 36.28% Should the company replace the equipment? P.V. Viswanath 26 Evaluating NPV Estimates

The NPV estimates are just that estimates A positive NPV is a good start now we need to take a closer look Forecasting risk how sensitive is our NPV to changes in the cash flow estimates, the more sensitive, the greater the forecasting risk Sources of value why does this project create value? P.V. Viswanath 27 Scenario Analysis What happens to the NPV under different cash flows scenarios? At the very least look at: Best case revenues are high and costs are low Worst case revenues are low and costs are high Measure of the range of possible outcomes

Best case and worst case are not necessarily probable, they can still be possible P.V. Viswanath 28 Sensitivity Analysis What happens to NPV when we vary one variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable and the more attention we want to pay to its estimation P.V. Viswanath 29 New Project Example Consider the project discussed in the text The initial cost is $200,000 and the project has a 5year life. There is no salvage. Depreciation is straight-line, the required return is 12% and the tax rate is 34%

The base case NPV is 15,567 P.V. Viswanath 30 Summary of Scenario Analysis Scenario Net Income Cash Flow NPV IRR Base case 19,800 59,800 15,567 15.1% Worst

Case -15,510 24,490 -111,719 -14.4% Best Case 59,730 99,730 159,504 40.9% P.V. Viswanath 31 Summary of Sensitivity Analysis Scenario

Unit Sales Cash Flow NPV IRR Base case 6000 59,800 15,567 15.1% Worst case 5500 53,200 -8,226 10.3% Best case 66,400

39,357 19.7% 6500 P.V. Viswanath 32 Making A Decision Beware Paralysis of Analysis At some point you have to make a decision If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project P.V. Viswanath 33 Managerial Options Capital budgeting projects often provide other

options that we have not yet considered Contingency planning Option to expand Option to abandon Option to wait Strategic options P.V. Viswanath 34 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 P.V. Viswanath 35 Quick Quiz How do we determine if cash flows are relevant to the capital budgeting decision? What is scenario analysis and why is it important? What is sensitivity analysis and why is it important? What are some additional managerial options that should be considered? P.V. Viswanath 36