FINANCE Chapter 9

The Sales Forecasting Process

(Peep slide screenshot of lecture)

Capital rationing

-the situation that exists if a firm has positive NPV projects but cannot find the necessary financing -firm does not have enough money to execute project

Determining relevant cash flows example

-A company bought land six years ago for 6 million in anticipation of using it as a warehouse site, but the company decided to rent facilities elsewhere: DONT ADD, SUNK COST -The land was appraised last week at 6.8 million: DO ADD, OPPORTUNITY COST -The company now wants to build a new factory on this land; the plant will cost 10.5 million to build DO ADD, CAPITAL SPENDING What is the proper cash flow to use as the initial investment for this project? CF = $6.8M + $10.5M = $17.3M

Depreciation definition (Lecture)

-Accounting depreciation is the allocation of an asset's initial cost over time

Important managerial options

-Contingency planning -Strategic options

Projected total cash flow and value

-Create preliminary cash flow analysis -Find the NPV -Find the IRR

Side effects

-It is usual for a project to have side effects such as erosion.

stand-alone principle

-Once we have determined the incremental cash flows from undertaking a project, we can view the project as kind of a "mini firm" with its own future revenues and costs, its own assets, and its own cash flows. -Because would be too difficult to actually calculate the future total cash flows to the firm with and without a project

Strategic options

-Options for future related business moves. -Sometimes companies take on projects just to explore possibilities and evaluate potential future business strategies. -Such projects are difficult to analyze using DCF methods because their benefits are in the form of strategic options. Ex. research and development

Net Working Capital

-Projects usually require a firm to invest in net working capital in addition to long term assets such as cash to pay for expenses that arise. Net working capital changes: Projects with sales usually cause increases in NWC needed -May also need investments in things such as inventories and accounts receivable. Some forms of financing are in the amounts owed to suppliers, but the firm must supply the balance. The balance represents the investment in net working capital. -As the project winds down and bills are paid as well as cash balances, these activities free up the net working capital originally invested. -The firms investment in project net working capital closely resembles a loan, the firm supplies working capital at the beginning and recovers it towards the end.

Pitfalls of incremental cash flows

-Sunk costs, opportunity costs, side effects, net working capital, financing costs, other issues

Contingency plans: the option to abdandon

-The option to scale back or abandon a project is valuable. -If sales demands are below expectations, we might sell off the capacity or put it to another use. -We underestimate NPV if we assume that the project must last for some number of fixed years no matter what happens

Soft rationing

-occurs when different units in a business are allocated a certain amount of financing for capital budgeting -is primarily a means of controlling and keeping track of overall spending. -should try to get a larger allocation by choosing projects with the highest profitability index. -ongoing soft rationing means we are bypassing positive NPV investments

Scenario Analysis

-process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the NPV that will be realized in each case -is useful in telling us what can happen and gauge the potential for disasters but does not tell us whether or not to take the project. -compare predictions to cash flows in best (upper bound on NPV) and worst case scenarios (minimum NPV) -to get the worst case, we assign the least favorable value to each item such as low values for units sold and price per unit and high values for costs. -there are an unlimited number of scenarios we could examine, we must avoid the risk of "paralysis of analysis" which is that no matter how many scenarios we run, all we can learn is possibilities.

Opportunity costs

-the most valuable alternative that is given up if a particular investment is undertaken -Opportunity costs are RELEVANT and SHOULD be included -a requires us to give up a benefit -peep example, the FULL cost we paid for the mill does not add to the condo cost bc it is a sunken cost, we would charge the amount it's worth today to the condo project. Lecture example: Value associated with land -> current market value ex. Company owns an old rustic cotton mill and wants to turn it into condos. Using the mill for the condo complex this has an opportunity cost, we give up the valuable opportunity to do something else with it.

Hard rationing

-the situation that occurs when a business cannot raise financing for a project under any circumstances -DCF analysis doesn't work because we don't take on the new project so the required return doesn't apply -can occur when a company experiences financial distress

Making Capital Investment Decisions (Lecture)

Step 1: Determine the relevant cash flows for a proposed investment Step 2: Analyze a projects projected cash flows: Calculate NPV

pro forma financial statements

Convenient and easily understood means of summarizing much of the relevant information for a project -To prepare these statements, we need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. Also need to know the total investment required including any investment in net working capital.

The tax shield approach

Tax shield definition of OCF: OCF = (Sales - Costs) x (1 - Tc) + Depreciation x Tc -Views OCF as having two components. The first part is what the project's cash flow would be if there was no depreciation expense -The second part is the depreciation deduction multiplied by the tax rate. -Depreciation is a non-cash expense, the only cash flow effect of deducting depreciation is to reduce our taxes, a benefit to us. -We use the tax shield approach when it is the simpler method

Basic problem

We could do our best to determine NPV, if NPV is positive there are two reasons: -the calculations are accurate -the calculations are in accurate -If our estimate is inaccurate could incur serious losses. If we estimate a negative NPV when it's actually positive we lose a valuable opportunity

contingency planning

What actions are we going to take if this huge failure actually occurs? -Amounts to an investigation of some of the managerial options implicit on a project -the process of preparing alternative courses of action that may be used if the primary plans don't achieve the organization's objectives

Chapter 9 screenshotted slide math??

When do you subtract depreciation?

Relevant cash flow

a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project -any cash flow that exists regardless of whether or not a project is undertaken is not relevant Lecture definition: Cash flow that results IF AND ONLY IF the proposed project goes forwrdn

Bonus Depreciation

accelerated deduction in the year placed in service of 50% or 100% of the cost of qualified tangible personal property

Net working capital changes

-Account for changes made in accounts receivable, payable, and on credit as reflected in cash flows Including net working capital changes in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments

Why is forecasting important?

-All businesses operate under uncertainty -Decisions must be made that affect the future -Forecasting provides an 'educated guess' about the future Lecture: Kodak ex. Kodak failed to adapt to an increasingly digital world and had to file bankruptcy in 2012.

Modified ACRS Depreciation (MACRS)

-Calculating depreciation is very mechanical -Every asset is assigned to a particular class -An asset's class establishes its life for tax purposes -Once an assets tax life is determined we compute the depreciation for each year by multiplying the cost of the asset by a fixed percentage -The expected salvage value is not explicitly considered

Sources of value

-Defense against forecasting risk -What is it about this investment that leads to a positive NPV? We should be able to point to something as the source of value. -Projects with positive NPVs will be rare in highly competitive environments -A key factor to keep in mind is that in a highly competitive market there will be few potential sources of value

managerial options

-Depending on what actually happens in the future there are always ways to modify a project known as managerial options. Not included in our previous static analysis. -Because they involve real (as opposed to financial) assets they are often called "real" options -The way a product is priced, manufactured, advertised, and produced can all be changed along with many other ways

forecasting risk

the possibility that errors in projected cash flows will lead to incorrect decisions, leading us to think a project has a positive NPV when it actually doesn't.

incremental cash flows

-The incremental cash flows for project evaluation consist of any and all changes in the FIRMS future cash flows that are a direct consequences of taking 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 the incremental cash flows associated with the project.

Evaluating NPV Estimates

NPV estimates are only estimates

Depreciation

A noncash deduction that has cash flow consequences because it influences the tax bill

Determining relevant cash flows example

A shoe store is adding a new line of winter footwear to its product lineup. Which of the following are relevant cash flows for this project? 1. Decreased revenue from products currently being offered: DO ADD, EROISON 2. Revenue from the new line of footwear: DO ADD, OCF 3. Money spent looking for new product to add: DONT ADD, SUNK COST 4. Cost of new counters to display the new line of footwear: DO ADD, NCS

Investigating a new project

Base case: We must first estimate NPV based on our projected cash flows -We then wish to investigate the impact of different assumptions about the future on our estimates. -We can do this by putting an upper and lower bound on the various components of the project ex. We forecast sales at 100 units per year. We are relatively certain our estimate will not be off by more than 10 units in either direction. We pick a lower bound of 90 and an upper bound of 110.

Book Value vs. Market Value

Book Value (historical cost) •Assets listed on balance sheet at purchase price •Market value •Assets listed at value if sold in today's market -The difference between market value and book value is "excess" depreciation and must be "recaptured" when the asset is sold -Capital gain can only occur if the market price exceeds the original cost -If the book value exceeds the market value, the difference is treated as a loss for tax purposes

Project net working capital and capital spending

Ex. The firm must spend $90,000 on fixed assets and $20,000 in NWC. The immediate outflow is $110,000. At the end of the projects life The fixed assets will be 0, but the firm will recover the $20,000 in working capital leasing to a $20,000 cash inflow in the next year. This is because when we have an investment in net working capital that same investment must be recovered. The same number needs to appear at some time in the future with the opposite sign.

Contingency plan: The option to expand

If we find a truly positive NPV project, can we expand the project or repeat it to get an even larger NPV? -If the sales demand greatly exceeds expectations we may investigate increasing production or raising the price. -If we ignore the option to expand, we underestimate NPV

Typical capital budgeting format (Lecture)

Initial investment cash flows: -Project costs (NCS, Capital spending) -Working capital investment (NWC) Annual after-tax operating cash flow: -OCF = (EBIT + Dep - Tax) (OCF) End of project cash flows: -After tax salvage value (add) -Return of working capital (add) CUMULATIVE CASH FLOW

Project operating cash flow

Operating Cash Flow = EBIT + Depreciation - Taxes

Sunk cost

-A cost that we have already paid or have already incurred in the liability to pay that cannot be changed by the decision to accept or reject a project. -If a fee has to be paid no matter what for the creation of the project, it is a sunken cost. (ex. consulting something) -Are IRRELEVANT and NOT included Lecture definition: costs that won't change regardless of project decision ex. You buy equipment for full price, you keep it unused for 5 years. You want to take on a new project involving the equipment but do not add the full price you paid 5 years ago because it is a sunken cost. You only add the value of the equipment today.

Contingency plans: The option to wait

-A third option is that the project can always be postponed in the hope of more favorable conditions. -As long as there is some possible future scenario under which a project has a positive NPV, the option to wait is valuable.

Sensitivity Analysis (figure 9.1)

-A variation on scenario analysts that is useful in pinpointing the areas where forecasting risk is especially severe. -The basic idea is to freeze all of the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. -Pinpoints which variable needs the most attention and possible additional market research. -If our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some component of project cash flow, the forecasting risk for that variable is very high.

Erosion or cannibalization

-The cash flows of a new project that come at the expense of a firm's existing project. -Can happen for any multi line producer or seller. -Cash flows from the new line should be adjusted downward to reflect lost profits on other lines. -If the new project AFFECTS OTHER CASH FLOWS of the firm, they SHOULD be included ex. IMC introduces a new car, and some of the sales come at the expense of other IMC cars in the same line.

Project cash flows

-To develop cash flows from a project, we need to recall that cash flows from assets have three components: -operating cash flow -capital spending -additions to net working capital. Once we have these estimates of the components of cash flow we calculate cash flow this way: Project cash flow = Project operating cash flow - project change in NWC - project capital spending

Other issues

-We are only interest in measuring cash flow when it actually occurs, not when it accrues in an accounting sense. -We are always interested in aftertax cash flow because taxes are a cash outflow. -When we write "incremental cash flows" we mean aftertax incremental cash flows because aftertax cash flow and net income are two different things.

Financing costs

-When analyzing a proposed investment, we do not include interest paid, dividends, or any other financing costs. -This is because our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project in order to estimate NPV. -The mixture of debt and equity is a managerial variable, financing arrangements are important but analyzed separately.