Ch 10 Making Capital Investment Decisions

relevant cash flows

-the cash flows tht shud be included in a capital budgeting analysis are those tht will only occur (or not 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 frm the firm simply by focusing on incremental cash flows

Types of Costs: Side Effects

Cannibalization (erosion): a new product (or plant) takes sales away from the firm's existing products (or plants) Sales creation (opposite of erosion): an investment creates or is expected to create additional sales for existing products Include them: they are costs/benefits that would not have happened wer.. They are crucial in estimating the incremental cash flows generated by the project

Operating Cash Flow

EBIT + Depreciation - Taxes

u shud always ask urself "will this cash flow occur ONLY if we accept the project?"

if yes, it shud be included in the analysis bc it's incremental if no, it shudnt be included bc it will occur anyway if the answer is "part of it," then we shud include the part tht occurs bc o the project

how to identify relevant cash flows?

incremental cash flow = cash flow w project - cash flow w/o project Ask the right question: Will this cash flow occur ONLY if we accept the project? ¤If the answer is "yes", it should be included because it is incremental ¤If the answer is "no", it should not be included because it will occur anyway ¤If the answer is "part of it", then we should include the part that occurs because of the project

Project Cash Flow

project operating cash flow - project change in net working capital - project capital spending

Erosion will ____ the sales of existing products.

reduce

opportunity costs are classified as ___ costs in project analysis

relevant

any cash flows that exists regardless of whether or not a project is undertaken is not relevant. t or f?

t

which of the following is an example of a sunk cost? salvage value of equipment test marketing expenses

test marketing expenses

stand-alone principle

the assumption that evaluation of a project may be based on the project's incremental cash flows

erosion

the cash flows of a new project that come at the expense of a firm's existing projects

incremental cash flows

the difference between a firm's future cash flows with a project and those without the project

Step 3: Pro Forma Statements and Cash Flow

¨Capital budgeting relies heavily on pro forma accounting statements, particularly income statements ¨Computing cash flows: a refresher Operating Cash Flow (OCF) = EBIT + depreciation - taxes Or (OCF = Net Income + depreciation) ¤Cash Flow From Assets (CFFA): CFFA = OCF - Net Capital Spending (NCS) - ΔNWC

Sunk costs

¨Costs that have already been incurred in the past and cannot be removed ¨These costs will not change regardless if the project happen. ¨ ØIgnore them: you have already paid for them

Financing Costs

¨Financing costs are any payment stemming from the specific financial arrangement used to make the investment necessary to the project ¨Dividend, interest, or principal expenses ¨ ØIgnore them: they are not cash flows from assets, but a component of cash flows to creditors / owners ØThey don't determine whether the project 'generates cash flows', they only determine how the cash flows of the project are divided among owners and creditors ØIn a sense, financing costs are already accounted when discount

Summary of Step 1: Estimating Relevant Cash Flows

¨Include all incidental effects ¨Include all opportunity costs ¨Ignore sunk costs ¨Ignore financing costs ¨Ignore allocated overhead expenses ¨Include investment in working capital ¨Include the effect of taxes and depreciation

Finally making the decision: 20% required return

¨We now have all the information needed to decide whether to produce shark attractants ¤With the techniques we learned in Sessions 9 & 10 ¨Use the calculator for NPV & IRR Rules: ¤CF0 = -110,000 ¤CF1 = 51,780 N1 = 2 ¤CF2 = 71,780 N2 = 1 ¤I/YR = 20 ¤Then click NPV = $10,648 > 0 ¤Then click IRR = 25.8% > 20% ¨Do we accept or reject the project? Yes! NPV > 0 and IRR > discount rate

Step 2: Estimating the Net Initial Investment (NII)

•Net Initial investment: project's net cash outlay -It includes any opportunity costs associated with undertaking the project •3 components of initial investment: -Cost of acquiring and placing into service the necessary assets -Cost of changing working capital -Net proceeds from the sale of existing assets (replacement decision) If tax is involved, apply taxes associated with all these operations

Net Working Capital (NWC)

current assets - current liabilities

Side effects from investing in a project refer to cash flows from:

erosion effects beneficial spillover effects

pro forma financial statements

financial statements projecting future years' operations

financing costs

Funding a business activity or project through debt, equity, or venture capital

∆Net Working Capital (NWC)

Initially, a project will need some amount of cash on hand to pay unexpected expenses, or inventories. -This translates into an investment in NWC -This investment closely resembles a loan At beginning of project: you need to build up NWC ¤Cash outflow: ΔNWC > 0 At end of project: you can wind down NWC ¤Cash inflow: ΔNWC < 0 Include changes in net working capital

opportunity costs

Opportunity costs (of an asset): is the cash the asset could generate for the firm should it be sold or put to some other productive use Include them: they are costs that would not have happened because of the project. They are crucial in estimating the incremental cash flows generated by the project Example: A firm decides to build a new plant on land purchased 5 years ago. The cost of land must be included in evaluating the project Land Value 5 Years Ago = $1,000,000 Market Value Today = $2,500,000 Which land value should be used in determining the cost of the project? Money from selling it = $2,500,000

Incremental Cash Flows

The stand-alone principle: ¤You can analyze each project in isolation from the firm by focusing on the project's incremental cash flows ¤You do not need to analyze all firm's cash flows with or without the project only the cash flows that are affected by ur choice of project are relevant

Home Builder Supply® currently operates seven retail outlets. Management is contemplating building an eighth retail store in the town next to its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Which of the following should be included as incremental cash flows? a)The original purchase price of the land where the new store would be located b)The cost of demolishing the abandoned warehouse and cleaning the lot c)The loss of sales in the existing retail outlet, from some costumers who previously drove across town d)Construction costs for the new store e)The value of the land if sold f)Interest expense on the debt borrowed to pay the construction costs

a) ignore - sunk cost b) include - operating cost c) include - cannibalism/erosion (side effect), also an opportunity cost d) include - operating cost e) include - opportunity cost f) ignore - financing cost

Cash flows should always be considered on a(n) _______________ basis.

after-tax