finance units 11 & 12

Regulatory requirements:

Governments regulate economic activity to protect society from harmful effects. The most cost-effective way to handle toxic waste from a production process is to dump it into Lake Lady Bird. These projects are undertaken because they are required.

Rule 1: Include cash flows, and only cash flows, in your calculations

Project analysis is based on incremental cash flows which consist of all change in the firm's future cash flows that are a direct consequence of adopting a project. Accounting revenues and expenses are not incremental cash flows. Only the direct cash inflows and outflows created by the project are included. Overhead cannot be allocated to a project unless it is specifically integral to that project. For example, a company may have five accountants on staff. The salaries for these accountants are not allocated to the project unless an accountant is hired as a direct result of taking on the project.

Internal Rate of Return (IRR)

IRR gives the rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost. The rate of return that equates the present values of cash flows, which is the rate that makes NPV = 0. They should only accept the project if it earns (IRR) more that should be expected (RRR) given other projects of equivalent risk.

cash inflow

If a project requires a lower working capital investment, the firm should account for this as a cash inflow. With the robotic factory there will be fewer workers. The robots may also be more efficient and not produce as much scrap or fewer imperfect units. Reducing costs by outsourcing production, customer service, and other functions would also reduce the working capital investment.

cash outflow

If a project requires a working capital investment, the firm should account for this as a cash outflow. A revenue-increasing project may require additional inventory, more workers, and higher accounts receivable. The company must make these short-term investments to make the project operational. Imagine expanding the production line but not having enough workers!

initial cash flows

Projects generally require an initial investment. Projects often take several years of planning and construction before Operating Free Cash Flows appear. There are two types of capital expenditures we should include in initial cash flows: Direct expenditures are those directly connected with obtaining the capital asset. Indirect expenditures which result from our decision to purchase the asset should also be included at the project's inception.

Cost reduction projects

focus on reducing costs. Outsourcing of business functions, outsourcing production, improving supply chains, employing machine learning and other similar projects lead to lower costs and thus higher income.

capital budgeting process

should be used to guide capital expenditure decisions. Its six phases consider how the proposed project supports strategic goals, identifies the nature of the project, and how it would affect wealth. This process also guides how the project would be implemented, managed, and closed down. It ends with an audit of the project to improve the organizations approach to capital budgeting.

Calculating Project NPV. In the previous problem, suppose the required return on the project is 14 percent. What is the project's NPV?

Calculating the incremental cash flows, as we've done in the last few problems, is only part of determining the NPV. Since we have the OCF, we can find the NPV as the initial cash outlay, plus the PV of the OCFs, which are an annuity, so the NPV is: 879,100 / 1.14 + 879,100/ (1.14)^2 + 879,100 / (1.14)^3 - 1,950,000 = 90,947

major managerial decisions

Capital budgeting decision: What productive assets should the firm obtain? This decision is guided by the customers the corporation seeks to satisfy. Capital Structure decision: Productive assets are not cheap! The corporation must raise capital from investors by issuing financial securities to finance its operations. Net Working Capital decision: The corporation must be able to manage it short-term expenses.

operating cash flows

Managerial decisions affect cash flows received and the cash cost of production. The specific nature of these inflows and outflows will depend on the type of project. Revenue enhancing products will focus on cash inflows, cost reduction projects will focus on reducing cash outflows. If you cut your costs by $10, you in effect have received an inflow of $10!

deflation

an increase in the purchasing power of a currency over a given time period. Wow, you might say--my money buys more, which is great! In reality, deflation is feared by central bankers, as it lowers economic activity by encouraging consumers to delay purchases and increasing the real burden of debt.If prices are expected to drop, then consumers delay their purchases because stuff will be cheaper later. Unfortunately, as sales drop workers are laid off, lowering economic activity.Deflation also makes debt more onerous. Say that you have a monthly $1,000 mortgage payment. If your salary drops by 10%, the your mortgage payment takes up a larger share of your income and, if this trend continues, you'll loose your house.

pros and cons of AAR

accounting information is available and familiar to managers, and does represent investments revenues, and costs. The AAR does focus on profitability. However, AAR uses accounting information, not cash lows, does not use cash flows, and does not recognize time value. The AAR criteria is based on the subjective benchmarks set by managers and is thus not a market-determined opportunity cost.

payback

calculates the amount of time it takes for a project to "payback" its initial investment. The shorter the payback period the quicker the company gets its initial investment back and begins to see profit. Managers set the maximum payback period they will accept. Projects with payback periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected. Payback period = Cost of project / Annual cash inflow

cbp phase 6: audit

how can the capital budgeting process be refined? companies repeatedly make capital budgeting decisions. here practice, while not making perfect, will develop the company's capital budgeting process and make better decisions in future projects.

cbp phase 4: implement the project

how will the project begin. managers must obtain the capital needed for the investment. these managers must then translate the capital budgeting plan into action.

using the PI equation

if the PI is greater than 1, the project is acceptable. (A PI of 1.4 means that for every dollar of investment outflow, the project produces an inflow of $1.40. If PI is less than 1, then the project should be rejected. A PI of .80 means that for every $1 of investment the project would return only $.80, not a good deal. the PI equation uses the exact same variables as NPV, including the discount rate.

Revenue enhancing projects

introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign.

hard rationing

occurs when funds are not available and managers must choose the 'best' projects from among all available projects. Companies face hard rationing when: They may not have sufficiently retained earnings to finance all profitable projects. They may not be able to secure additional bank financing. They might find the capital markets are not receptive to additional security issues.

two classes of expenses

Substantial productive assets, such as a large vehicle, involve two classes of expenses: Short-term operating expenses are where the benefits are enjoyed in the same period as the expense—such as the diesel fuel to run the vehicle on a daily basis. Long-term capital expenses involve obtaining the major asset: a company will pay a substantial amount today to obtain the vehicle, but will use it its business over several years.

Rule 4: Forget sunk costs

Sunk costs are costs that have already been incurred. As such they are not incremental cash flows and are irrelevant for capital budgeting decisions. Only future inflows and outflows should be considered. Imagine that last week you put new tires on your car. This week, the transmission went out. Your previous expenditure on tires is irrelevant. The only cash flows you should consider are the costs of a new transmission compared to the current value of the vehicle.

soft rationing

occurs when limits on investments are made by a firm's managers for better control of the firm. With soft rationing companies may want to: Limit growth to a manageable level. The saying is 'growth can kill.' Some companies have had difficulties in growing too fast. They cannot manage the influx of customers, keep quality high, hire enough qualified workers, and overstretch managerial talent. Existing owners may not want to issue additional financial securities, which might dilute their control of the company.

two traditional decision rules

payback & average accounting return They were widely used before the development of economic decision rules, and do not use the elements of economic value. While companies increasingly use economic decision rules, these traditional decision rules are still used and, in some cases, may be acceptable.

operating cash flows example

revenues 950,000 costs 420,000 depreciation 180,000 The equipment has an initial cost of 2,200,000, is expected to last for 10 years, and has a residual salvage value of 400,000. The annual depreciation expense is 180,000. annual depreciation expense = 2,200,000-400,000/10 years = $180,000 net operating income 350,000 tax at 21% 73,500 which gives us a net income of 276,500 + depreciation of 180,000 gives us an operating cash flow of 456,500.

Capital spending

the cash that must be invested in the project's capital assets to produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the company's security holders, so the projected capital expenditures must be subtracted from the operating cash flow.

cbp phase 2: screen investments

what is the nature of the investment? investments may expand revenue, reduce costs, renew major assets, or be required by government regulation. Each type of investment has unique features that managers must factor into their decisions, the reason you undertake the investment will be very important in classifying cash flows in the next unit.

cbp phase 5: control

what will change? during the long life of a capital asset, managers can be assured that many aspects of their economic environment will change. Technology, government fiscal and monetary policy, globalization, social changes, and smart competitors will have an effect on investment. consequently, managers will have to modify the project over its productive life or even cut the productive life short.

pros and cons of payback

- simple to use - focuses on probability shortcomings: - does not use time value - use an opportunity cost - take all cash flows into account Given these shortcomings, payback is of limited use in project analysis, except in some small scale, simple projects or where there is so much uncertainty that a useable discount rate or cash flow forecasts are not possible.

evaluating IRR: 1) Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule? 2) What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain. 3) Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.

1. IRR description: The IRR is the rate of return earned on an investment. It is the discount rate that causes the NPV of a series of cash flows to be equal to zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. For investments, the IRR decision rule is to accept projects with IRRs greater than the opportunity cost. For example, if a project has an IRR = 12%, and projects of equivalent risk earn a return of 8%, then the project is earning above what would be expected of a similar project and should be accepts. Projects earning less than the opportunity cost should be rejected. If the opportunity cost is 8%, but a project's IRR = 6%, then the project should be rejected, as the investor should be able to obtain a project earning 8%. 2. Relationship between IRR and NPV: IRR is the interest rate that a project earns, whereas the required rate of return is the opportunity cost of the project: the rate of return the project should earn given its risk. NPV directly uses the opportunity cost to evaluate the project's cash flows, and is thus is preferred in all situations to IRR. For stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques; however, IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects. 3. Appropriate uses of the IRR: IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR might provide more information about the project than would NPV.

evaluating profitability index: 1. Describe how the profitability index is calculated and describe the information this measure provides about a sequence of cash flows. What is the profitability index decision rule? 2. What is the relationship between the profitability index and the NPV? Are there any situations in which you might prefer one method over the other? Explain.

1. PI description: The profitability index is the present value of the future cash flows, discounted by the opportunity cost, divided by the initial investment. It measures the wealth created per dollar invested, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. A PI greater than one indicates that the project will return more than a dollar for each dollar invested, with this comparison using proper time value analysis. 2. Relationship between NPV and PI: Whereas NPV measures the total wealth creation of a project, PI gives the wealth creation per dollar invested. Most firms, like all organizations and most everyone other than Warren Buffet or Bill Gates, has limited capital. If capital is limited (a situation called capital rationing we'll see in Lesson 2) then the firm has more acceptable projects than investments funds available. In these situations PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project. Projects would be ranked by PI. The highest PI-project would be selected, then the next highest PI-project, until all available funds have been committed.

Calculating AAR. You're trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $12.5 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,368,000, $1,935,000, $1,738,000, and $1,310,000 over these four years, what is the project's average accounting return (AAR)?

AAR is the average return in a given period. Accounting doesn't use the concept of opportunity cost or time value, so we just determine the average net income for the project and divide it by the average periodic investment (book value in the balance sheet) of the project. Whether to accept the project depends on the hurdle rate—the rate managers set for the acceptance of the project. Average net income: The average net income is the income for each year divided by the number of periods. For this project: Average net income = ($1,368,000 + 1,935,000 + 1,738,000 + 1,310,000)/4 = $1,587,750 Average book value: The average book value the average value in the balance sheet for the assets. For this project. For straight-line depreciation with no salvage value we can just add the beginning and ending book values and divide by 2. Average book value = ($12,500,000 + 0)/2 = $6,250,000 Average accounting return: For this project: The AAR is: average net income divided by average book value =. 1,587,750/6,250,000 = .2540 or 25.4% This problem does not specific the acceptable rate for this project. Let's say that managers, based on their experience and knowledge of the company, require a 15% rate of return. In this case the project would be acceptable.

Capital Budgeting in Not-for-Profit Entities. Are the capital budgeting criteria we discussed applicable to not-for-profit corporations? How should such entities make capital budgeting decisions? What about the U.S. Government? Should it evaluate spending proposals using these techniques?

Capital budgeting is crucial for not-for-profit entities and governments. Non-profits need to allocate limited capital efficiently to accomplish their goals, just as for-profits do. Sites such as Charity Navigator, www.charitynavigator.org and Give Well, www.givewell.org exist to provide information to prospective donors. Charity Navigator had over 7 million visitors last year, so there is interest in the efficient use of donated funds. Capital budgeting techniques can help charities be more efficient and thus attract more donations! It is frequently the case that the "revenues" from not-for-profit ventures are not tangible, but rather benefits that are difficult to measure, such as quality of life for the disabled. These organizations also have no stock price or market determined discount rate to use in their decisions. However, like for-profit corporations, cost-benefit analysis is important and must be done as effectively as possible given these limitations. Finally, realistic cost/benefit analysis should definitely be used by the U.S. government and would go a long way toward balancing the budget! In fact, cost-benefit analysis is often written into the laws passed by Congress and state legislatures. The major difficulty here is that government benefits/contracts/payments for some groups are considered "fat" by others, so the allocation is often done along political, not economic or true social lines.

capital rationing

Capital rationing occurs when a company has limited capital and cannot take on all wealth-increasing projects. With capital rationing the company must rank projects and choose the best projects given the capital constraint. This is different from mutually exclusive projects, in that multiple projects can be selected; however, given there is not enough capital to invest in all of the projects, they must be ranked and the projects selected in descending order of desirability. When the money runs out, no more projects may be selected

Calculating Project OCF. H. Cochran, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $1,950,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,145,000 in annual sales, with costs of $1,205,000. If the tax rate is 21 percent, what is the OCF for this project?

Cochran's expansion project does not have economic interdependencies. Their stated costs include both variable and fixed costs. Calculate depreciation. We calculate depreciation using the straight-line method. Annual depreciation expense = (Fixed asset investment)/Project life = $1,950,000 - 0/3 = $650,000 Calculate Net Income. With these inputs we can now calculate NI. Net sales $2,145,000 Costs 1,205,000 Depreciation 650,000 EBT $290,000 Tax 21% 60,900 Net income $229,100 Calculate Operating Cash Flow. Using the methods we've developed, Cochran's OCF is OCF = NI + Depreciation = $229,100 + $650,000 = $879,100 Calculate OCF using the tax shield approach. We can also use the tax shield approach to calculating OCF Remember that the final answer will be the same no matter which of the methods you use. OCF = (Sales - Costs)(1 - TC) + Depreciation(TC) = ($2,145,000 - 1,205,000)(1 - .21) + $650,000(.21) = $879,100

Average Accounting Return. Concerning AAR: a. Describe how the average accounting return is usually calculated and describe the information this measure provides about a sequence of cash flows. What is the AAR criterion decision rule? b. What are the problems associated with using the AAR as a means of evaluating a project's cash flows? What underlying feature of AAR is most troubling to you from a financial perspective? Does the AAR have any redeeming qualities?

Concerning AAR: a. Information and procedures. The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as the average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. b. Difficulties with AAR. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals.

Cash flow and depreciation. "When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.

Depreciation is a noncash expense charged against accounting earnings to write off the cost of an asset during its estimated useful life. While you can throw these terms around to impress your friends at a bar, it's more important to understand what depreciation actually is and is not! As we saw in Unit 4, accounting deals with revenues and expenditures, not cash flow. We know that assets generally deteriorate with use and obsolescence. As the saying goes, a car depreciates by 10% when you drive it off the dealer's lot. Accountants don't want to make subjective decisions on how quickly an asset depreciates, so they generally follow a general set procedure for recognizing the decline in an asset's value over time. An amount of depreciation expense is set for each year and used as an expense in the income statement. The depreciation expense is also subtracted from gross fixed asset value in the balance sheet. Depreciation is not a cash flow and is not relevant for capital budgeting EXCEPT that depreciation is a tax-deductible expense and therefore reduces taxes, which are a cash flow. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced and thus increases the net cash flow. This is the reason that we compute net income and then add back the depreciation expense. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental after-tax cash flows.

Rule 2 (another example): Include the impact of the project on cash flows from other product lines

Economic interdependencies can also occur when the project decreases the cash flows in other parts of the company. A bricks-and-mortar store that introduces on-line shopping may suffer a loss in sales from its physical stores. This reduction in the cash flows of existing operations is called erosion.

Rule 2: Include the impact of the project on cash flows from other product lines

Economic interdependencies occur when the project would change the cash flows in other parts of the company. For example, many grocery stores are installing gas pumps. Evaluation of these pumps must include not only gas sales, but also the increased sale of groceries to people who are filling up. This positive effect where the project would increase the cash flows from existing operations is called synergy.

terminal cash flows

Given the framework of incremental analysis, at the conclusion of a project, management will restore the company to its original condition without the project. There are several types of cash flows connected with closing the project down.

To answer the next three thought questions, refer to the following example. In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. 3. Erosion. In evaluating the Cayenne, would you consider the possible damage to Porsche's reputation?

Erosion, sometimes called cannibalization, is where the sale of a product reduces sales in other parts of a business. Erosion is definitely a factor when reputation plays such a large part in demand. Looking back to 2003, there was a major risk that Porsche, clearly identified with sports cars, might suffer if a connection was made with soccer moms driving SUV. They might sell SUVs, but might also experience a substantial reduction in their sales of sports cars. The auto market is now fundamentally changing, with traditional sedans falling out of favor, and electric and hybrids now on the road.

capital budgeting problems: What are some of the difficulties that might come up in actual applications of the various criteria we discussed in this course? Do these difficulties mean that managers can ignore these economic decision techniques?

Estimating cash flows: The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Every company operates in a market environment and is subject to changes in changes to fiscal policies (taxes) and regulations not just for their government, but major governments throughout the world. Technology, consumer preferences and competitive pressures also make cash flow estimates difficult. Estimating opportunity cost: Determining an appropriate discount rate is also not a simple task. Most major governments have an active monetary and exchange-rate policy that affect interest rates. The discount rate is also subject to inflationary pressures. We have not seen inflation get out of hand in this century, but have experienced inflation shocks in the past. Do we just give up? Even with these difficulties, the economic decision rules of NPV, IRR, and PI provide a useful structure for making decisions in uncertainty. These decision rules helps managers develop their ideas of what information is useful, and provide a structure that can be adjusted as new information is obtained. Not having a decision-making structure exposes managers to ad-hoc, incomplete and uninformed decisions which are likely to produce bad results.

Rule 3: Include all opportunity costs

Even if a company already owns an asset, the asset must be included in the project evaluation. For example, imagine a company is evaluating a plant expansion that would use a vacant lot the company already owns. This lot could be sold for a considerable amount of money. Thus, the cost of the alternate use of the lot (its sale price) must be included as a project cash outflow.

Calculating IRR. What is the IRR of the following set of cash flows? Year 0: -$19,400 Year 1: $9,800 Year 2: $11,300 Year 3: $6,900

For multi-period cash flows, the IRR is the interest rate that equates the present value of the inflows and the present value of the outflows. 9800/1+ IRR + 11300/(1+IRR)^2 + 6900/(1+IRR)^3 - $19,400

more about store of value

For over two millennia, most societies used specie money: physical money made of gold, silver, copper, or other items with intrinsic value. Of its very nature specie is limited in supply and cannot be easily manipulated by a government. In the twentieth century, countries moved to fiat money, which has no intrinsic value. The word "fiat" is Latin for "order"; in essence, the US government requires its citizens to use the money it creates by declaring that "this note is legal tender for all debts public and private." Fiat money is under the control of the government and can create it without any external constraints.

Opportunity Cost. In the context of capital budgeting, what is an opportunity cost?

In general we've seen the opportunity cost as the discount rate used in valuing future cash flows. In capital budgeting, the opportunity cost is a much broader concept that helps us sort out what is relevant in our capital budgeting decision. In capital budgeting we are not evaluating the entire company. Rather, we are looking as a specific project managers are considering. We must therefore sort out what would change if the project were undertaken—how adopting the project would change the company's cash flows and wealth. This concept thus underlies the five rules for capital budgeting projects. Rule 1: Include only incremental cash flows. What cash flow would you have to give up to obtain productive assets? What cash inflows would result if you were to take on the project? Rule 2: Include economic interdependencies. A project may increase the cash flows or decrease the cash flows from your existing business operations. These synergies and erosions must be considered. Rule 3: If you're using it, it is an opportunity cost. The cost of any asset used in the project is a cost and should be included. Rule 4: Forget sunk costs. Get over it! Only future cash flows count. Rule 5: Taxes count. Taxes are a cost and if the project doesn't work on an after-tax basis don't do it.

payback example. year 1: annual cash flow 520 cumulative cash flow 520 year 2: annual cash flow 520 cumulative cash flow 1,040

In the first two years the project returns $520 + 520 = 1,040 to TMI. To completely return the projects initial investment TMI needs to earn 1200-1040 = 160 in year 3 If revenues are recieved regularly throughout the year then the remaining 160 would be received 160/520= .3 or about 1/3 of the year The projects payback is thus 2.3 years. IF the project inflows were the same, we could calculate the payback as payback = initial / annual 1,200/520 = 2.3 years

Calculating IRR. A firm evaluates all of its projects by applying the IRR rule. If the required return is 11 percent, should the firm accept the following project? Year 0 : Cash flow = -$168,500 Year 1: Cash flow = $86,000 Year 2: Cash flow = $91,000 Year 3: Cash flow = $53,000

In this example we'll introduce the cash flow functions of the calculator. This will allow us to enter differing cash flows and access the calculator's IRR function directly. The IRR is the rate of return earned on an investment. Here we have irregular cash flows: the operating cash flows differ in each period. For multi-period cash flows, the IRR is the interest rate that equates the present value of the inflows and the present value of the outflows. 86000/1+IRR + 91000/(1+IRR)^2 + 53000/(1+IRR)^3 = $168,500

deadly combination of inflation and tax rates

Inflation does affect the value of a currency over time, with future nominal cash flows increasing to take the drop in purchasing power, as we saw in the previous example. However, marginal tax rates are stated in nominal terms and are generally not adjusted for inflation! This produces a very unpleasant affect, as Dianne learns in the next example. you think you're paying a tax of 20% on your investment, when adjusted for inflation youre paying 50% long-term investment face a major problem. Your cash flows reflect inflation. The taxes you pay are not adjusted for inflation, so your effective tax rate will increase with no overt action on the part of the government. inflation is a silent tax

Payback Period. Concerning payback: a. Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule? b. What are the problems associated with using the payback period as a means of evaluating cash flows? c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

Information and procedures. Payback period is simply the break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. For example, while you may be paid at the end of the month, you actually earn income for each day worked. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. b. Difficulties with payback. The worst problem associated with payback period is that it ignores the time value of money. In not using time value, it also does not use an opportunity cost which would reflect the uncertainty of the cash flows. Additionally, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method, such as the market-based opportunity cost. The payback period is biased towards short-term projects as it ignores any cash flows that occur after the cutoff point. c. Advantages of payback. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. Payback may be sufficient for some small projects that are not of great consequence. Also, projects concerned with maintenance are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. It may also be used when opportunity cost would be difficult to estimate, such as risky investments in an unstable country,

Calculating NPV. For the cash flows in the previous problem, what is the NPV at a discount rate of 0 percent? What if the discount rate is 10 percent? If it is 20 percent? If it is 30 percent?

Managers may often include sensitivity analysis in their capital budgeting decision, which consists of changing a variables to see how a change in a variable might impact their decision. In this problem the managers think that there may be several possible discount rates. We can use the power of our financial calculator to see how much the NPV of our project would change if the discount rate changes. The NPV of a project is the PV of the outflows plus by the PV of the inflows. Zero discount rates can exist—The Federal Reserve for a time in the earlier part of this decade held short-term interest rates near zero. Throughout the world there are about 11 trillion dollar equivalent government interest rates that are actually negative At a zero discount rate (and only at a zero discount rate), the cash flows can be added together across time. Exact same thing as above problem except you divide it by 1 because there is no %. we end up at $8,600. than you would put in the percent for all the others and it would be 1.10, 1.20, and 1.30. Notice that as the required return increases, the NPV of the project decreases. This will always be true for projects with conventional cash flows. Conventional cash flows are negative at the beginning of the project and positive throughout the rest of the project.

Capital budgeting and survivor bias. Porsche was one of the last manufacturers to enter the sports-utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?

Market timing: Companies may enter a market at different times based on several factors. One company may have an existing advantage in that they might have a well-developed supply chain and able to produce a new product at lower incremental cost. Others may have a strong market presence that may attract customers to something new. Some companies also seem to have a better feel for the movements in consumer interests, or be willing to try a new concept and see how it develops. We may be subject to survivor bias, where we look at the performance of existing companies to gauge the historical performance of all companies. When we look at, say, five very innovative and successful auto companies we may not recall that perhaps ten or fifteen years ago there were a dozen companies with bright prospects. We see the five survivors, but do not see the seven companies that just didn't make it. Innovators may made mistakes! Yes, the Cayenne might be a mistake. But what about the Edsel, or New Coke? One of the difficulties in studying Finance, or Business, or even politics, is that organizations that make mistakes often disappear from public view, along with the cautionary lessons that could be learned from their managers' mistakes. How many of you could discuss Kodak or Enron? We can always look back in the history of successful companies and think we identify the event that made it assured that they would succeed However, we cannot today look at companies and be assured that we know who will win. Studying failures helps as much as studying successes. The potential mistakes made by these companies are still out there, ready to be made by new managers and seasoned managers who forget! It's for this reason that we go back to historic decisions. As George Santana famously stated: "Those who cannot remember the past are condemned to repeat it." And, of course, there's just dumb luck.

net present value (NPV)

NPV is a dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable. essentially a cost/benefit analysis

Calculating Profitability Index. What is the profitability index for the following set of cash flows if the relevant discount rate is 10 percent? What if the discount rate is 15 percent? If it is 22 percent? Year 0: -$27,500 Year 1: 15,800 Year 2: 13,600 Year 3: 8300

NPV is cost/benefit analysis. All cash flows are identified, placed on the project's time line and discounted to time = 0. As they are stated at the same point in time we can subtract the outflows from the inflows. A positive NPV signifies that the inflows exceed the outflows and the project is wealth creating. If its wealth creating then this increase in wealth accrues to the shareholders, as we showed in Unit 10. The profitability index is similar to NPV in that it measures the increase in wealth; however it measures wealth relative to a dollar of investment. The decision rule for PI is to accept a project if the PI is 1 or greater, and reject if the PI is less than 1. As always, we begin with our time line. PI = 15800/1+ RRR + 13600/(1+RRR)^2 + 8300 / (1 + RRR) ^3 ALL divided by 27500 rrr is 1.10 by the way At a 10% discount rate, the project's PI is 1.158. Every dollar invested in the project is expected to produce $1.158 in wealth increase. At a 15% discount rate the PI is 1.072. Still an acceptable project At a 22% discount rate the PI is 0.969. At the 22% discount rate we would not accept the project. For every dollar invested we'd get back only 97 cents—not a good deal. Again with the calculator. For PI we would use the calculator to calculate the present value of the inflows and then divide that result by the initial investment.

evaluating net present value: Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule? Why is NPV considered to be a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

NPV is the sum of the present values of a project's cash flows. It's a way of doing cost-benefit analysis. For most projects their cash flows occur at different points in time. A valid comparison is possible only if these cash flows can be restated as of a single point in time. This involves using the opportunity cost, which reflects the basic time value of money (risk free interest rate) and an appropriate risk premium. Again drawing on the concept of cost-benefit analysis, NPV measures whether or not the project increases wealth. Wealth is command over economic assets. Wealth is increased if cash inflows stated as of today exceed the cash outflows also stated as of today: the cash available—wealth—has increased. NPV takes into account all aspects of economic value: cash flows, the timing of these cash flows, and the risk-adjusted opportunity cost. The NPV decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. NPV is superior to the other methods of analysis presented in our course because it directly measures a decision's impact on wealth. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted. This does not mean the shareholders get a check for that amount: it is a statement of the expected increase in wealth given the project, which should be reflected by an increase in the stock price.

mutually exclusive

Nathan Burris has already analyzed the Cerebral Stimulator project. His life is now a bit more complex, as he has been handed another possible project for TMI. The company may want to produce knee joint replacement devices in what has been designated the Meniscus Project. Unfortunately, given limited production space, TMI can undertake the Cerebral Stimulator project or the Meniscus Project, but not both: They are mutually exclusive. These two projects must therefore be economically ranked and only the best project chosen. In this next example Nathan calculates the NPV, IRR and PI for the Meniscus Project. He sees that all three projects are, individually, ranked acceptable and, if they were independent TMI would accept both of them. Cerebral simulator project: NPV 522,306, IRR 26.31, and PI 1.44 Meniscus project has NPV 197,455, IRR 47.23%, and PI 1.99 Nathan would rank the cerebral simulator project first because it would lead to the greatest increase in wealth. IRR and PI would rank the meniscus project first. It has the highest IRR and offers the best rate of return. IT also has the greatest inflow per dollar invested. Nathan will recommend the cerebral stimulator project as it will increase TMI's wealth more and provide the maximum benefit to TMI's shareholders.

terminal cash flows example

Nathan has competed much of the analysis. The net investment of 2.5 million is expected to product annual incremental operating cash flows of 456,500 for each of the ten years of the project. Nathan is pondering terminal value. H e thinks that 10 years is an appropriate planning horizon for the project. There are three cash flows that occur at the end of the tenth year. The las annual operating cash flow of $456,500. Separately, some cash flows are involved with closing the project. The project's salvage value of $400,000 return of the working capital investment of 300,000 total terminal cash flows are 700,000 discount rate is 12%. initial cash flows 2,500,000 PV operating cash flows 2,579,328 pv terminal cash flows 225,381 NPV = 2,579,328 + 225,381 - ( 2,500,00) = $304,709 given this positive npv the project is a go

Capital budgeting considerations. A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to produce an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play?

Our publisher should be concerned for two reasons. The first is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? Text purchasers would just switch from the existing text to the new text. Sales would not increase as much as if an entirely new text, with new customers, were on the offering. This would be of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? This is very much an issue as publishers are competing more and more with eBooks, such as the one used in our course. A particular concern to book publishers (and producers of a variety of other similar products) is that the publisher only makes money from the sale of new books. Used book dealers capture the revenue streams from the sale of used books: a major reason why new books are so expensive! Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher's perspective) or new books (not good). The concern arises any time that there is an active market for a used product. Our own course is a major example of this. McGraw-Hill is increasingly offering online content. In a few years publishers may cease to offer standard texts and instead go to eBooks. One of the motives is to sell information (the eBook and Connect) in a controlled, time-limited environment. You can't sell an eBook in the used text market. Publishers thus capture the full revenue of the book from each student over the eBook's life and don't lose value to dealers in the secondary market. While this might not look good to you as a student, accepting a job in publishing or media may change your future opinion of this issue. As you go through your day, try to envision the many ways that you experience/see the results of capital budgeting decisions.

Profitability Index (PI)

PI is a ratio that calculates the relative wealth created per dollar invested. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications. PV (inflows) / PV (outflows) = profitability index

Summarizing the traditional capital budgeting methods.

Payback focuses on the amount of time a project takes to pay back its initial investment. This is a logical decision rule in that the sooner the initial investment is payed back, the sooner the project is profitable. It is also simple to understand and use. Payback does not use time value or a risk-adjusted opportunity cost as a discount rate. It also ignores all cash flows beyond the payback period. Average accounting return logically focuses on the rate of return earned on a project. It uses accounting information which is available to the managers and which they are familiar with. Like payback, accounting does not use time value or a risk-adjusted discount rate. It also uses accounting revenues and expenses, not cash flows. Also, the AAR is set by managers, not based on a market-determined opportunity cost. For some decisions these may be used; however for most decisions that affect the future of the firm, the economic decision rules should be used.

Capital Budgeting and competition. In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely they will be maintained as the market becomes more competitive, or will Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne?

Porsche should recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense. This has occurred previously in the auto market. The luxury car in the 1960s through the 1980s was the Mercedes-Benz. I know, as I had one! This was a very popular brand, despite its being expensive. In fact, the price increased spectacularly in the 1970s as the drop in the U.S. dollar made German products quite expensive in the U.S. The more expensive it was, the more people lusted after the M-B Star! Toyota developed as a fuel-efficient, well-made import. However there was substantial competition in the mid-range auto market, and Toyota management looked at the envious M-B profit margins. In 1989 they introduced the Lexus. Honda saw this and introduced the Acura. Nissan saw the party getting started and introduced the Infiniti. These new competitors fundamentally changed the luxury auto market and dethroned M-B as the car to own. This basic short example on Porsche's SUV decision thus brings up some major issues. A positive NPV project is quite valuable. If a company is doing something neat other companies will muscle in on that lucrative market, such as the iPhone being squeezed by producers such as Samsung and other Android-based smartphones. Companies must thus constantly innovate, and seek to reduce costs, to stay up with the competition!

ranking decision

Regardless of the reason for capital rationing, managers are faced with a special selection process. Managers must rank the projects in order of desirability, pick the best projects, and stop when out of capital. This ranking decision is fundamentally different from that used with mutually exclusive projects. Remember these two points: The ranking decision with mutually exclusive projects was caused by the nature of the projects themselves. The ranking decision with capital rationing is not due to the nature of the projects, but due to limits on available investment capital.

five rules for capital budgeting

Rule 1: Include cash flows, and only cash flows, in your calculations Rule 2: Include the impact of the project on cash flows from other product lines Rule 3: Include all opportunity costs Rule 4: Forget sunk costs Rule 5: Include only after-tax cash flows in the cash flow calculation

accounting rate of return example.

The AAR uses accounting numbers. Instead of cash inflow AAR uses net income. Instead of cash outflows, AAr uses the average book value, which reflects the cost of the project, adjusted depreciation. AAR = average net income / average book value Managers determine the minimal acceptable AAR. A project that earns more than the minimum is acceptable. TMI requires a 10% AAR. initial investment is 1200 with a 340 annual income average net income = 340+340+340+340/4 =340 Some notes: these amounts differ from the project's previous time line, as thy are accounting net income developed in accordance with GAAP. They do not represent the incremental cash flow after tax of the project There is not time value of money. The amounts are simply averaged. Next, Nathan estimates the average investment. Accounting will recognize the initial cost of the project, $1,200,000 and record that amount on TMI's balance sheet. This amount will then be reduced each year by the depreciation expense using straight line depreciation. Annual deprecation = (1200-0)/4 = 300 Assuming a zero salvage value, the annual depreciation expense would be 300. The relevent book values of the investment would be 1200-300 depreciation = 900 for year one, 900-300 = 600 for year 2, 600-300=300 for year 3, 300-300=0 for year 4. Once the book values for each year are determined, Nathan calculates the average investment. Average investment (000) = 1200 + 900 + 600 + 300 + 0 / 5 = 600 NATHAN CAN JUST NOW COMPUTE THE AAR AAR = average net income / average book value = 340 / 600 = 56/67 average investment = 600 = average book value in the formula this rate is crazy cus we only needed 10% so well take it :)

Corporate Social Responsibility:

The ExxonMobil project is an example of corporations contributing to society. While the corporation's function in society is to efficiently produce goods and services, corporations are expected to be good citizens. These projects do help society, and also enhance the reputation of the company.

decision rules

The decision rule is to maximize total NPV while staying within the capital budget. While this can be quite complex in practice, in this course we will examine only indivisible projects , where managers must take all or nothing. If you are building a bridge, then you'll build the entire bridge, not just go half way across the river.

NPV versus IRR. Zayas, LLC, has identified the following two mutually exclusive projects a. What is the IRR for each of these projects? If you apply the IRR decision rule, which project should the company accept? Is this decision necessarily correct? b. If the required return is 11 percent, what is the NPV for each of these projects? Which project will you choose if you apply the NPV decision rule? c. Which project should you accept? Year 0 cash flow -78,500 (a) and 78,500 (b) then 43,000 and 21,000 29,000 and 28,000 23,000 and 34,000 21,000 and 41,000

The key characteristic of this decision is that these projects are mutually exclusive. The manager must rank them and chose the best one. The two methods used will be NPV which measures the wealth creation of the projects and IRR which measures the rate of return given the timing and placement of the projects cash flows. a. Determine which project should be selected using IRR. The IRR is the interest rate that makes the NPV of the project equal to zero. Using our financial calculator we determine that IRRB = 18.73% Examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so the IRR decision rule implies accepting Project A. This may not be a correct decision, however, because the IRR criterion may have a ranking problem for mutually exclusive projects. To see if the IRR decision rule is correct or not, we need to evaluate the project NPVs. b. Determine which project should be selected using NPV NPV is cost-benefit analysis. Given the comparison of all cash flows discounted to time zero using the risk-adjusted discount rate of 11%, which project has the greatest impact on wealth: the highest NPV? The NPV of Project B is NPVB = $15,012.82 The NPVB is greater than the NPVA, so we should accept Project B. While the initial investment is the same, Project B has higher cash flows and produces a higher NPV. If you can invest in only one project, B is the better—wealth increasing—investment. c. Which project should you accept? Both projects are, on their own, acceptable, as each has an IRR greater than the discount rate of 11%, and each also has a positive NPV, again calculated at the discount rate of 11%. Where there is a conflict between the recommendations between NPV and IRR, choose NPV. IRR is a relative measure of performance, whereas NPV provides a dollar measure of the wealth created. As we saw in Unit 10, a positive NPV would increase the stock price. As project B has the greatest increase in wealth for the shareholders, it's the best choice.

inflation adjusted cash flows and NPV example

There are no indirect cash flows, so the direct cash flow of 320,000 is the only cash flow at a time = 0. The operating cash flows are 90,000 per year. While each nominal cash flow is 90,000, a dollar received in future years will be worth less than a dollar today. Deflating the third year's cash flow is not taking a present value, but rather restating it with the same purchasing power as the initial investment at t=0. real value = nominal value / (1 + inflation rate)^t = 90,000 / (1.04)^3 - 80,010 Using the inflation rate, we can develop a project time line in real, inflation adjusted terms. We can also find the present value of the project salvage value. which is 30,000 in four years. 30,000/(1.04)^4 = 25,644 25644/ (1.0577)^4 is 20,490 In 4 years the nominal salvage value 30,000 has a real purchasing power of 25,644 in today's dollar, and a present value, using the real discount rate, of 20,490. Now lets look at NPV initial cash flows : 320,000 pv operating cash flows in 285,283 Pv terminal cash flows: 20,490 NPV = 285,283 + 20,490) -320,000 = -14,277 given the negative NPV we would not adopt this project

Economically Independent Projects

These are the types of decisions we've examined thus far. Economically independent projects are ones when making one choice is independent of other choices. For example, this month you purchase a refrigerator and a car. Your purchase of a refrigerator is independent of your auto purchase. Independent projects involves an accept/reject decision for each project.

Relevant cash flows; Sunk, Book, and Market. Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $5.3 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $7.4 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $26.5 million to build, and the site requires $1.32 million for an access road to a major highway. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?

This first question involves the direct and indirect cash flows connected with obtaining the manufacturing plant. The $5.3 million acquisition cost of the land six years ago is a sunk cost. This amount would occur in Kenny, Inc.'s Balance Sheet, but it does not reflect what the land is worth today. The $7.4 million current net (after-tax) value of the land is an opportunity cost if the land is used rather than sold off. As you could get $7.4 million for the land, you should include the use of the land as part of the incremental cash flows for the project. The $26.5 million cash outlay is a direct cost of the project. The $1,320,000 for the access road is a necessary cost and part of the project expenses as it is needed to get the plant ready for use. No road, no operating cash flows from the plant! Therefore, the proper year zero cash flow to use in evaluating this project is: Cash flow = $7,400,000 + 26,500,000 + 1,320,000 Cash flow = $35,220,000

Calculating NPV and IRR. A project that provides annual cash flows of $2,145 for eight years costs $8,450 today. Is this a good project if the required return is 8 percent? What if it's 24 percent? At what discount rate would you be indifferent between accepting the project and rejecting it?

This problem integrates NPV and IRR and thus reinforces the elements of the previous two problems. The NPV of a project is the PV of the outflows plus the PV of the inflows. Since the cash inflows in this problem are an annuity, the equation for the NPV of this project at an 8 percent is fairly easy to calculate using the calculator's cash flow and NPV functions, as we'll demonstrate at the end of this solution. At an 8 percent required return, the NPV is positive, so we would accept the project. The NPV of the project at a 24 percent required return is negative and we would reject the project. remember, NPV is PV inflows - PV outflows. While the cash flows have not changed, something has happened to the discount rate. Inflation could have spiked and caused an increase in the risk-free rate, or the project's risk might have increased. Our decision changes with this change in information. We would be indifferent to the project if the required return was equal to the IRR of the project, since at that required return the NPV is zero. The IRR of the project is: 19.13% By now we know that if the project cash flows are already in our calculator, we need only punch the IRR button to get this answer! The IRR rule agrees with the NPV rule.

Project Evaluation. Your firm is contemplating the purchase of a new $410,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. You will save $125,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $35,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 21 percent, what is the IRR for this project?

This project is also a cost-reduction project. Your firm already processes orders. You want to improve your order processing system by purchasing a new computer-based system. This new system will save your company cash in two ways. $125,000 will be saved each year in processing costs. $35,000 will also be saved in that your need for working capital will be reduced for the life of the project As this is a cost-reduction project, not one that increases revenues, the tax shield approach is the most efficient one to use, and we'll not involve NI. Initial cash flows: There is a capital cost of $410,000 at time zero. The reduction in working capital causes an inflow of $35,000, making your initial cash flows ($410,000) + $35,000 = ($375,000). Operating cash flows: We can use NI to get OCF. Net sales No change Costs +$125,000 Note: Cost reduction Depreciation 82,000 $410,000/5 = $82,000 EBT $43,000 Tax @ 21% 9,030 Net income $33,970 + Depreciation $82,000 OCF $115,970 Terminal cash flows: As the assed is fully depreciated, the only terminal cash flow is the $35,000 return of working capital. Calculating the IRR; Our project time line is: 115,970 /1.08 with the squared shit 5 times - 375,000 = 64,214 The IRR is 14.57%. If the opportunity cost/discount rate is 8% we should adopt the project.

Calculating Payback. Global Toys Inc. imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should it accept either of them? Year0 cash flow = -60,000(a) and 105000(b) then 23,000 and 21,000 28,000 and 26,000 19,000 and 29,000 9,000 and 260,000

This project requires an investment of $60,000 today. The first two years have inflows totaling $51,000. Cash flows = $23,000 + 28,000 = $51,000 The cash flows are still short by $9,000 ($60,000 - $51,000) of recapturing the initial investment, and we need 47% of the third year to get this last $9,000. $9,000 / $19,000 = .47 The payback for Project A is: Payback = 2.47 years This project requires an initial investment of $105,000. The first three years have inflows totaling $76,000. Cash flows = $21,000 + 26,000 + 29,000 = $76,000 The cash flows are still short by $29,000 ($105,000 - $76,000) of recapturing the initial investment, and we need 11% of the third year to get this last $29,000. $29,000 / $260,000 = .11 The payback for Project B is: Payback = 3.11 years Payback analysis We have determined the payback periods, but the problem did not state the maximum payback acceptable. If the maximum payback period was set at 3 years, we would accept Project and reject Project B. The maximum payback period is set by the company managers based on their experience and knowledge of the company. While interesting, this method does not use a measure of risk nor recognize time value. Another factor to consider is the last cash flow for Project B. The $260,000 is largely ignored in this decision rule.

Relevant cash flows: Economic interdependencies. Winnebagel Corp. currently sells 1,800 motor homes per year at $77,000 each and 600 luxury motor coaches per year at $120,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 800 of these campers per year at $23,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 90 units per year and reduce the sales of its motor coaches by 10 units per year. What is the amount to use as the annual sales figure when evaluating this project? Why?

This second problem involves estimating a project's annual cash flows from sales. New product line: Sales due solely to the new portable campers are: 800 x $23,500 = $18,800,000 The company should take economic interdependencies into account: how would the introduction of this new product affect their existing sales? Synergy: The new portable campers are expected to attract additional new customers to its existing motor home line, producing an increase in sales of: 90 x $77,000 = $6,930,000 increase in sales Erosion: As with many new products, existing customers may switch from existing lines to the new product. The introduction of the portable camper is expected to decrease Wommebagels sales of luxury motor coach sales. 10 x $120,000 = $1,200,000 loss in sales The net sales figure to use in evaluating the new line is thus: Net sales = Sales of portable camper + increase in sales of motor homes - loss of sales of motor coaches Net sales = $18,800,000 + $6,930,000 - $1,200,000 Net sales = $24,530,000 NPV for a new product should include the project's impact on all cash flows of the company, not just the project's narrowly defined cash flows. The hit is lost sales is far less than the increase resulting from the proposed portable campers and the synergistic impact on motor home sales.

Calculating OCF. Consider the following income statement: Sales $558,400Costs 346,800 Depreciation 94,500EBIT ? Taxes @ 21% ?Net Income ? Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?

To find the OCF, we need to complete the income statement as follows: Sales $ 558,400 Costs 346,800 Depreciation 94,500 EBIT $ 117,100 Taxes@21% 24,591 Net income $ 92,509 NI reflects the taxes paid to our nice government. The taxes paid are calculated after all the expenses of the company, including depreciation, which is not a cash flow are subtracted from revenues. Once taxes are computed we need only add back depreciation to get the operating cash flow. OCF = NI + Depreciation OCF = $92,509 + $94,500 OCF = $187,009 The depreciation tax shield is the increase in operating cash flows created by the tax deductibility of depreciation. Let's say that depreciation was not allowed. Our NI would be Sales $ 558,400 Costs 346,800 EBIT $ 211,600 Taxes@21% 44,436 Net income $ 167,164 You might celebrate, as your NI went from $92,509 with depreciation to $167,164 without depreciation. However, without the depreciation expense your taxes went from $24,591 to $44,436. Your taxes increased by $44,436 - $24,591 = $19,845 As your taxes increase, your operating cash flows decrease. Without the depreciation tax shield, your OCF becomes: OCF = NI + Depreciation OCF = $167,164 + squat OCF = $167,164 Your operating cash flows with depreciation are $19,854 higher than without depreciation Value of depreciation tax shield = OCF with - OCF without $19,854 = $187,009 - $167,164 The depreciation tax shield is the depreciation times the tax rate.: Depreciation tax shield = Depreciation x (TC) Depreciation tax shield = $94,500 x .21 Depreciation tax shield = $19,845 $187,009 - $167,164 = $19,845 While this looks complex, it is a logical system that gets far less complex as you understand basic relationships. Many of you state in Introduce Yourself that your careers will involve business decisions. Business decisions involve inflows and outflows. Understanding the basic accounting relationships, and then expanding them to consider incremental cash flow analysis will greatly enhance our career effectiveness.

Calculating projected net income. A proposed new investment has projected sales of $645,000. Variable costs are 40 percent of sales, and fixed costs are $168,000; depreciation is $83,000. Prepare a pro forma income statement assuming a tax rate of 21 percent. What is the projected net income?

We need to construct an income statement, which we studied in Unit 4. This is a pro forma statement in that it is not recording what has happened, but rather a forecast of what the future would look like if the project were adopted. This statement lists the inflows (revenues) less the costs of producing those revenues. In this question, as in our general treatment of capital budgeting we look at the operating characteristics of the project and not the impact of financing. We therefore have no interest expense to consider. Interest is certainly not irrelevant to the company, but we'd like to determine whether the project makes sense from an operating viewpoint, and examine the capital structure (financing) decision separately. The income statement Sales $ 645,000 Variable costs 258,000 40% of the sales of $645,000 Fixed costs 168,000 Depreciation 83,000 EBIT $ 136,000 Taxes@21% 28,560 Net income $ 107,440 Note that thus far we've calculated the Net Income, and not the operating cash flows. To calculate the operating cash flows, we would add back depreciation. Depreciation served its purpose to reduce taxes, but once taxes have been calculated, we add deprecation to net income to get net cash flow. Net cash flow = Net Income + Deprecation. $190,440 = $107,440 + $83,000 Quite a difference!

Calculating NPV. For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 9 percent, should the firm accept this project? What if the required return was 21 percent?

We'll calculate NPV for the same time line used in Problem 6. The NPV is the cost/benefit analysis of the project, using the opportunity cost to determine the present values. NPV = 86000/1 + IRR + 91000/(1.09)^2 + 53000/(1.09)^3 - $168,500 NPV = $27,918 As the NPV is positive at 9%, the project's benefits exceed the costs and we should adopt the project. An increase in the discount rate to 21% lowers the PVinflows but does not affect the PVoutflows thus reducing the NPV. (you would change 1.09 to 1.21 and end up with a -5,354 NPV)

Problems with Profitability Index. The Matterhorn Corporation is trying to choose between the following two mutually exclusive design projects: a. If the required return is 11 percent and the company applies the profitability index decision rule, which project should the firm accept? b. If the company applies the NPV decision rule, which project should it take? c. Explain why your answers in parts (a) and (b) are different. Year 0 cashflow -78,500 (I) and 28,800 (II) then 28,300 and 9,600 34,800 and 17,400 43,700 and 15,600

While NPV and PI use the same building blocks, PI is a relative measure that may conflict with NPV when evaluating mutually exclusive projects. As always, we begin with the project time lines. The profitability index is defined as the PV of the future cash flows divided by the initial investment. The equation for the profitability index for each project at the discount rate of 11% is: for project I 28300/1.11 + 34,800(1.11)^2 + 43,700/(1.11)^3 all divided by 78,000 = 1.099 As these projects are mutually exclusive, the profitability index decision rule implies that we accept Project II, since PIII is greater than the PII. im not calculating the PI for project II c. Explain the difference in project acceptance Profitability Index, like IRR, is a relative measure. For standard independent projects NPV, IRR and PI should give the same accept/reject decision. For mutually exclusive projects the relative rankings of IRR and PI may differ from the ranking given by NPV. Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitudes of the cash flows for the two projects are of different scale. In this problem, Project I is roughly 2.5 times as large as Project II and produces a larger NPV, yet the profitability index criterion implies that Project II is more acceptable. As always, NPV measures the increase in wealth resulting from the project decision and in the event of a conflict between NPV, IRR and NPV should guide your decisions.

mutually exclusive projects

With mutually exclusive projects you are choosing from among alternatives and can pick only the best one. In shopping for the refrigerator, you may visit several stores and look at a dozen refrigerators, but you will end up purchasing only one refrigerator--the one you think is best! Capital budgeting for mutually exclusive projects involves a ranking process. Managers rank the projects in order of their desirability and will choose only the top-ranked project.

Project Evaluation. Kolby's Korndogs is looking at a new sausage system with an installed cost of $655,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which it will have a zero market value. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 21 percent and the discount rate is 8 percent, what is the NPV of this project?

With our practice in the previous problems, we're now prepared to do an entire cash flow NPV evaluation for Kolby's Korndogs. This problem is a bit different from our other problems in that it is a cost-reduction problem where the benefit comes from reduced costs and not an increase in revenues. Revenues are thus not incremental cash flows and are not included in our calculations. We'll develop the time line in sequence: Initial cash flows, operating cash flows, and terminal cash flows. Initial cash flows: To begin the project Korndogs must invest $655,000 in the new sausage equipment and $35,000 in increased working capital. Operating cash flows: We can use NI to get OCF. Net sales No change Costs +$183,000 Note: Cost reduction Depreciation 131,000 EBT $52,000 Tax @ 21% 10,920 Net income $41,080 + Depreciation $131,000 OCF $172,080 Where annual depreciation = $655,000/5 = $131,000 We could also use the tax shield approach: OCF = $183,000(1 - .21) + .21($131,000) = $172,080 Terminal cash flows: As the project is over, the investment of $35,000 in net working capital is returned to the company. Finally, NPV. Fourth: However we get it, OCF now goes into our project NPV calculation. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the after-tax salvage value.

Rule 5: Include only after-tax cash flows in the cash flow calculation

You can only spend what you keep. As the project being evaluated is in addition to the other activities of a company, each project should be evaluated using marginal tax rates.

inflation

a decrease in the purchasing power of a currency over a given time period. Inflation is more common in modern societies. Central banks, fearing deflation, usually aim for a low, steady rate of inflation, often about 2%. While this doesn't sound like a large rate, over time it can have a major impact on real purchasing power. prices rise with inflation. the purchasing power of money declines over time.

the fisher effect

describes how the nominal interest rate is made up of two components, the real interest rate and the rate of inflation. The nominal interest rate is the rate we see reported in business news, is used in contracts and valuing securities, and generally used in capital budgeting projects. This is the rate we use in this course. The real interest rate measures the real increase in the purchasing power of amount over time: how much actual purchasing power of money is expected to increase. The inflation rate is the rate by which prices are expected to increase due to a loss of purchasing power of money. (1 + Nominal rate ) = (1 + real rate)(1 + inflation rate) The Fisher Effect posits that investors who feel that their purchasing power will decrease will demand an increase in the nominal interest rate earned--an inflation risk premium--in order to give them their required real rate of return.

cbp phase 1: develop long-term goals

does the investment fit the company? is the investment economically profitable?

three functions of money

exchange, prices, value An exchange is where economic assets are traded among buyers and sellers. Money facilitates economic activity in that the price of each economic asset is specified in terms of money. Without money exchange would consist of barter, where the buyer and seller must negotiate a swap of physical goods and services. For example, if you want a bike you would have to negotiate what you would swap for it, like two goats. Life would be difficult for you, especially if you're short goats. It would be impossible for our sophisticated economy to function without money. Money allows prices to be set for tangible and intangible assets. While we often complain about high prices, we use prices constantly and would not be capable of making comparisons and purchases without a general system of prices. Prices set in terms of money extend to the labor market. Money traditionally has been a store of value. where wealth (purchasing power) can be stored until needed. If you don't need the purchasing power immediately, then you can just put money in your wallet or purse and spend it later. Storing your wealth in the form of bananas would not be nearly as efficient.

additions to net working capital

investments in the project's short-term assets. A project may require investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders. To summarize, the project may produce positive cash flow from its operations, but these cash flows would occur only if the company made the necessary investments in the short- and long-term assets required. The investors get what is left over--the free cash flow.

Operating cash flow

is earnings before interest plus depreciation minus taxes. And, its important to remember that these cash flows have not yet occurred--we estimate what they would be if the project were to be adopted. Operating cash flow = EBIT + Depreciation - Taxes

Free Cash Flow (FCF)

is the amount of cash generated by a company that is available to distribute to the firm's creditors and owners. This type of cash flow is not needed for short-term (working capital) or long-term (fixed asset) investments and can thus be distributed to the investors—creditors and stockholders—of the firm. In our course Free Cash Flow is interchangeable with cash flow from assets, which is also used. Free cash flow is composed of three parts: operating cash flow, capital spending, and additions to Net Working Capital.

cbp phase 3: evaluate investments

is the investment economically desirable? managers must determine the economic profitability of the investment. this is a two-step process: 1. estimate the cash flows involved 2. evaluate cash flows using a chosen evaluation method

initial cash flows example

the new equipment for this project will cost 2,200,000, have a useful life of 10 years, and a salvage value of 400,000. We'll also need 300,000 in additional working capital for the project. I expect the system to increase revenues by 950,000. Our operating costs will increase by 420,000. Our corporate tax rate is 21% and our discount rate is 12%. The net initial cash flows consist of: direct cost 2,200,000 and investment of 300,000 in additional working capital . The total initial investment is thus 2,500,000

Incremental Cash Flows After Taxes (ICFAT)

the periodic cash outflows and inflows that occur if, and only if, an investment project is accepted. We are focused on the project, not the company as a whole.

average accounting return

the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR. If the project earns more than this specified rate, it is accepted. If the ARR is less, the project will be rejected. While useful for some purposes the ARR is not based on future cash flows, and does not use the opportunity cost. It is thus of limited use in making decisions about the future. AAR = Average net income / Average book value