Finance 450-Chapter 9

Sensitivity Analysis

investigation of what happens to NPV when only one variable is changed. -Basic idea is to freeze all the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable.

An investment has a positive net present value if

its market value exceeds its cost. -This investment is valuable because it creates value for its owner.

3 options on decisions for projects

option to expand option to abandon option to wait

Strategic options

options for future, related business products or strategies

Contingency Planning

taking into account the managerial options implicit in a project.

Worse-case scenario

tells us the minimum NPV of the project. -if positive we will be in good shape. -to get the worst case, we assign the least favorable value to each item. This means low values for items such as units sold and price per unit and high values for costs.

Stand-alone principle

the assumption that evaluation of a project may be based on the project's incremental cash flows. * Primarily interested in comparing the cash flows from the mini firm to the cost of acquiring it.

Erosion

the cash flows of a new project that come at the expense of a firm's existing projects *In accounting for this, it is important to recognize that any sales lost as a result of our launching a new product might be lost anyway because of future competition. -Only relevant when the sales would not other wise be lost.

Scenario Analysis

the determination of what happens to NPV estimates when we ask what-if questions

Scenario Analysis

the determination of what happens to NPV estimates when we ask what-if questions examines several possible situations -worse case -base case or most likely case -best case Provides a range of possible outcomes. Determines impact on NPV of a set of events relating to a specific scenario.

Incremental cash flows

the difference between a firm's future cash flows with a project and those without the project. *Includes all the changes in the firm's future cash flows.

Opportunity Cost

the most valuable alternative that is given up if a particular investment is undertaken

First change and most important regarding the firm's cash flows is to

decide which cash flows are relevant and which are not.

Depreciation

determines taxes owned on fixed assets when they are sold.

Pro Forma Financial Statements

financial statements projecting future years' operations -To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required including any investment in net working capital.

In analyzing a proposed investment, we will not include

interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets of the project.

financing costs

interest paid to debt holders or dividends paid to stockholders

Other Issues to watch out for.

-First, we are only interested in measuring cash flow. Moreover, we are interested in measuring it when it actually occurs, not when it accrues in an accounting sense. -Second, we are always interested in aftertax cash flow because taxes are definitely a cash outflow.

Weaknesses of sensitivity analysis

1) Does not reflect diversification 2) Says nothing about the likelihood of change in a variable 3) Ignores relationships among variables

strengths of sensitivity analysis

1) Provides indications of stand-alone risk. 2) Identifies dangerous variables. 3) Gives some breakeven information.

Cash flows from assets has three components

1. Operating cash flow 2. Capital Spending 3. Additions to net working capital Project cash flow= Project operating cash flow- Project change - Project capital spending

After-tax Salvage equation

= salvage - T(salvage - book value)

Book Value

=initial cost- accumulated depreciation

Relevant Cash Flows

A change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project. include cash flows that will ONLY occur if the project is accepted.

First line of defense against forecasting risk ?

What is it about this investment that leads to a positive NPV? -should be able to point to something specific as the source of value.

Accelerated Cost Recovery System (ACRS)

a depreciation method under U.S. tax allowing for the accelerated write-off of property under various classifications

Example of an Investment in Net Working Capital

a project will generally need some amount of cash on hand to pay any expenses that arise. In addition, a project will need an initial investment in inventories and accounts receivable (to cover credit sales). Some of this financing will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. This balance represents the investment in net working capital.

The incremental cash flows for project evaluation consist of

any and all changes in the firms future cash flows that are a direct consequence of taking the project.

Tax Effects

buyers, sellers, and the government

Sunk Costs

costs that have already been incurred and cannot be recovered and therefore should not be considered in an investment decision. * A cost we have already paid or have already incurred the liability to pay. *Such a cost cannot be changed by the decision today to accept or reject a project.

Net Working Capital

current assets - current liabilities

Cash flow From assets

CFFA= OCF - NCS- Change in NWC NCS= Net Capital Spending

Problems with Scenario Analysis

Considers only a few possible outcomes - Assumes perfectly correlated inputs - All "bad" values occur together and all "good" values occur together - Focuses on stand-alone risk, although subjective adjustments can be made

After Tax Salvage

If the salvage value is different from the book value of the asset, then there is a tax effect

Financing Costs

In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets of the project.

Because the relevant cash flows are defined in terms of changes in, or increments to, the firm's existing cash flow they are called?

Incremental cash flows

Evaluating NPV Estimates

NPV estimates are only estimates - Forecasting risk: Sensitivity of NPV to changes in cash flow estimates The more sensitive, the greater the forecasting risk - Sources of value: Be able to articulate why this project creates value

Disadvantages of Sensitivity & Scenario analysis

Neither provides a decision rule. (No indication whether a project's expected return is sufficient to compensate for its risk.) Ignores diversification. (Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting.)

Tax effect on Salvage

Net Salvage Cash Flow = SP - (SP-BV)(T) SP = selling price BV = book value T = corporate tax rate

Tax Shield Approach to OCF

OCF = (Sales - Costs)(1 - T) + Depreciation*T Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield -Ex: choosing between two different machines.

Operating Cash Flow

Operating Cash Flow= EBIT +Depreciation-Taxes OCF=Net Income + Depr if no interest expense

Managerial options

Opportunities that managers can exploit if certain things happen in the future

Changes in NWC: GAAP Requirements

Sales recorded when made, not when cash is received. Cost of goods sold recorded when the corresponding sales are made, whether suppliers paid yet or not. buy inventory/ materials to support sales before any cash collected.

Sensitivity analysis continued

Shows how changes in an input variable affect NPV or IRR Each variable is fixed except one -change one variable to see the effect on NPV or IRR -Answers what if questions.

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

When does it occur when we think a project has an NPV that is positive when it really doesn't?

This occurs if we are overly optimistic about the future, as a result our projected cash flows don't realistically reflect the possible future cash flows.

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 = DT -D = depreciation expense -T = marginal tax rate

Forecasting risk

the possibility that errors in projected cash flows will lead to incorrect decisions. -There is a danger that we will think a project has a positive NPV when it really doesn't.

Capital rationing

the situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

Hard rationing

the situation that occurs when a business cannot raise financing for a project under any circumstances

Soft rationing

the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.

Depreciation tax shield

the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate. -Non-cash expense -Will always give the same answer as our basic approach due to the fact it is sometimes simpler to use, especially in projects that involve cost-cutting.

Best-case scenario

this puts an upper bound on our NPV.