9-1

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

9-2

Relevant Cash Flows

• Include only cash flows that will only occur if the project is accepted

• 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

9-3

Relevant Cash Flows:Incremental Cash Flow for a Project

Corporate cash flow with the project

Minus

Corporate cash flow without the project

9-4

Relevant Cash Flows

• “Sunk” Costs ………………………… N

• Opportunity Costs …………………... Y

• Side Effects/Erosion……..…………… Y

• Net Working Capital………………….. Y

• Financing Costs….………..…………. N

• Tax Effects ………………………..….. Y

9-5

Sunk costs

• Costs that have already been incurred

• Won’t change if the project is accepted or rejected

• NOT relevant

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Opportunity Costs

• alternatives that will be given up if the project is undertaken

• Undertaking project A means you won’t have the resources to do activity B

9-7

Side Effects/Erosion

• Positive side effects: benefits to other projects

• Negative side effects: costs to other projects– Erosion: cash flows of new project come at

the expense of an existing project– Need to adjust cash flows downward to

reflect lost profits

9-8

Net Working Capital

• Project requires investment in net working capital in addition to long term assets– Inventories and accounts receivable may be

needed for the project

– Accounts payable will be incurred to cover some of the inventory and accounts receivable, but company will need to make an investment to cover the rest

• Firm’s investment in Net Working Capital resembles a loan

9-9

Financing Costs

• The mixture of debt and equity impacts how the project cash flow is divided between owners and creditors

9-10

Tax Effects

• Consider after tax cash flow

9-11

Pro Forma Statements and Cash Flow

• Pro Forma Financial Statements – Projects future operations

• Operating Cash Flow:OCF = EBIT + Depr – Taxes

OCF = NI + Depr if no interest expense

• Cash Flow From Assets:CFFA = OCF – NCS –ΔNWC

NCS = Net capital spending

9-12

Shark Attractant Project• Estimated sales 50,000 cans• Sales Price per can $4.00• Cost per can $2.50• Estimated life 3 years• Fixed costs $12,000/year• Initial equipment cost $90,000

– 100% depreciated over 3 year life

• Investment in NWC $20,000• Tax rate 34%• Cost of capital 20%

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Pro Forma Income StatementTable 9.1

Sales

Variable Costs

Gross profit

Fixed costs

Depreciation

EBIT

Taxes (34%)

Net Income

9-14

Operating Cash Flow

OCF = EBIT + Depreciation – Taxes

OCF when there is no interest expense = Net income + depreciation

9-15

Projected Total Cash FlowsTable 9.5

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

NWC -$20,000 20,000

Capital Spending

-$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

Note: Investment in NWC is recovered in final year

Equipment cost is a cash outflow in year 0

9-16

Projected Total Cash FlowsTable 9.5

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

NWC -$20,000 20,000

Capital Spending

-$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

Calculate PV of Cash flows

9-17

Making The Decision

• Should we accept or reject the project?

Operating Cash Flow 51,780 51,780 51,780Changes in NWC -20,000 20,000Net Capital Spending -90,000Cash Flow From Assets -110,000 51,780 51,780 71,780

Net Present Value $10,647.69IRR 25.76%

Cash Flows

9-18

The Tax Shield Approach to OCF

• OCF = (Sales – costs)(1 – T) + Deprec*T

OCF is broken down into

1- Cash flow without depreciation

2- Depreciation tax shield: tax savings resulting from the depreciation deduction

• Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield – i.e., choosing between two different machines

9-19

Depreciation & Capital Budgeting

• Use the schedule required by the IRS for tax purposes

• Depreciation = non-cash expense– Only relevant due to tax affects

• Depreciation tax shield = D*T– D = depreciation expense– T = marginal tax rate

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Computing Depreciation• Straight-line depreciation

D = (Initial cost – salvage) / number of years

Straight Line Salvage Value

• MACRS Depreciate 0

Recovery Period = Class Life

1/2 Year Convention

Multiply percentage in table by the initial cost

9-21

After-Tax Salvage

• If the salvage value is different from the book value of the asset,

then there is a tax effect– If book value is higher than selling price,

the fixed asset is sold at a __________– If book value is lower than selling price, the

fixed asset is sold at a __________

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After-Tax Salvage

• Loss X tax rate = tax savings from loss

• Gain X tax rate = tax on gain

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Cash Flow When Fixed Asset is Sold

• Fixed Asset sold at a loss:Cash flow in the year of the sale =

selling price + tax savings from loss

• Fixed Asset sold at a gain:Cash flow in the year of the sale =

selling price – tax on gain

9-24

Evaluating NPV Estimates

• NPV estimates are only estimates

• Forecasting risk: the possibility that errors in projected cash flows will lead to incorrect decisions; also called estimation risk– Sensitivity of NPV to changes in cash flow

estimates • The more sensitive, the greater the forecasting

risk

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Evaluating NPV Estimates

• Sources of value • Be able to articulate why this project creates

value• A positive NPV is rare in a highly

competitive market• View a positive NPV with some suspicion

9-26

Scenario Analysis

• Examines several possible situations:

– Worst case

– Base case or most likely case

– Best case

• Provides a range of possible outcomes

9-27

Sensitivity Analysis

• Shows how changes in an input variable affect NPV

• Each variable is fixed except one– Change one variable to see the effect on

NPV • If NPV is sensitive to small changes to one

variable, then forecasting risk is high for that variable

• Can identify the variable that deserves the most attention

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Sensitivity Analysis:

• Strengths– Provides indication of stand-alone risk.– Identifies dangerous variables.– Gives some breakeven information.

• Weaknesses– Says nothing about the likelihood of change

in a variable, – Ignores relationships among variables.

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Making a Decision

• Beware of “paralysis of analysis”• If the majority of your scenarios have

positive NPVs, 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, than you may want to forgo the project

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Managerial Options

• Contingency planning• Option to expand• Option to abandon• Option to wait• Strategic options

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Contingency planning

What actions do we take if things don’t go as planned?

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Option to expand

• if project has positive NPV, can the project be expanded or repeated to get an even larger NPV

– Can sales be increased?– Can production be increased?– Can the selling price be raised?

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Option to abandon

• if project doesn’t cover expenses, then abandon it

• Discounted cash flow analysis assumes operations will continue to the end– Instead, sell or redesign

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Option to wait

• Could wait for a more favorable discount rate

• Could make changes to the project

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Strategic options

• Project may be undertaken in order to develop future related projects or strategies

• Hard to put value on projects that allow the company to gain experience or entrance into a new market

9-36

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