Chapter 9 Notes: Making Capital Investment Decisions
What do you need to begin evaluating a proposed investment?
1. A set of "pro-forma" or projected financial statements 2. From the pro-forma statements you can develop "expected cash flows" 3. From the expected cash flows you can estimate the value of the project
Why should you always be interested in "after-tax" cash flow?
1. Because taxes are definitely a cash outflow 2. "Incremental cash flows" always refer to after-tax incremental cash flows 3. After-tax cash flow and accounting profit/net income are NOT the same thing
Why does a project usually require the firm to invest in net working capital besides the cash costs for the necessary long-term assets?
1. Expenses arise 2. Initial inventory assessment 3. Accounts Receivable
What is the Earnings before interest and taxes equation?
EBIT= Sales- costs -depreciation
What is the first formula for operating cash flow?
OCF= EBIT + Depreciation -Taxes
What is the bottom-up approach?
OCF= Net Income + Depreciation The formula simply starts with the bottom line (net income) and adds back non-cash deductions such as depreciation
What is the top down approach?
OCF= Sales - Costs -Taxes Start at the top of the income statement with sales and working down to net cash flow by subtracting cash out-flow items like costs and taxes
What is the next step?
Start converting the accounting information into cash flows
True or False: A sunk cost already assumed under the guise of a previous project/investment decision cannot be changed by any decision today to accept or reject a particular object
TRUE
True or False: A sunk cost is not relevant to the decision to ultimately undertake a project
TRUE
True or false: Is it usual for a project to have "side effects" or spillover externalities?
TRUE
What is the learning objective inherent in making capital investment decisions?
To learn how to "spread the numbers" for a proposed investment or project Then, based on those numbers attempt to make and initial assessment about if the project makes financial sense for owners/shareholders
Why is the previous sentence true?
Ultimately you are interested in the cash flow generated by the assets of the project
What are other issues?
You are only interested in measuring cash flow when it actually occurs, "NOT when it accrues in an accounting sense"
What is the tax-shield approach?
OCF= [(sales-costs) x (1-tax)] + Depreciation x T 1. The first part is what the projects cash flow would be if there were no depreciation expense 2. The second part of OCF in this approach is the depreciation deduction multiplied by the tax rate (T) of 34%
What are the sources of accounting information that permit the discovery of the different roads that lead to the OCF answer that financial managers are interested in when evaluating projects?
Sales, Costs, Depreciation, Taxes
True or False
Taking on a project changes the firms overall cash flows. TRUE
Assuming that no interest is paid, what is the tax bill?
Taxes = EBIT x T which is usually 34%
When speaking of cash flow what is really being implied?
The amount of dollars IN less dollars OUT
What happens when erosion takes place?
The cash flows from the new line should be adjusted downwards to reflect lost profits on other lines
What does this "Balance" represent?
The cash investment necessary -liquidity- for an adequate amount of "Net working capital"
TRUE OR FALSE
The same net working capital number needs to finally re-appear with the opposite sign (positive) to reflect the cash in-flow TRUE
The stand-alone principle
The stand-alone principle says that the proposed project is evaluated solely on its own merits (incremental cash flows", isolated from any other projects
TRUE OR FALSE:
Whenever analyzing a proposed investment, it is NOT necessary to include interest paid or any other financing costs such as dividends or principal repaid. TRUE
What is an acceptable definition of a relevant cash flow for a project?
A relevant cash flow for a project is a change in the firm's overall future cash flow- provoked as a direct consequence of the decision to take on the project
What is an opportunity cost?
An opportunity cost requires you to give up a benefit and if it is more than one benefit only the most valuable alternative that is given up matters
Corollary
Any cash flow that exists regardless of whether or not a project is undertaken is not relevant
What is the equation for cash flow from assets?
CFA=OCF-CS-Change in NWC
What is the fundamental goal in project evaluation?
Comparing the total cash flow of a project to the cost of acquiring the project so as to best estimate NPV
Why must CFOs pay close attention to "interest paid expenses"?
Interest paid is NOT a component of Operating cash flow Interest paid is a financing expense
TRUE OR FALSE:
Interest paid is a component of cash flow to creditors NOT cash flow from assets. TRUE
What is a sunk cost?
It is a cost you have already paid or have already incurred the liability to pay It must be excluded from the project analysis
Why do you need an accounts receivable?
It is typical to have to cover credits sales until the cash payments arrives
What areas of analysis are problematic, making it difficult to correctly identify "Relevant Cash Flows"?
1. Sunk costs 2. Opportunity costs 3. Side Effects 4. Net working capital required -liquidity cash on hand necessary 5. Any financing costs
What are the three alternative ways to arrive at OCF?
1. The bottom-up approach 2. The Top down approach 3. The tax-shield approach
To correctly evaluate a proposed investment, what should the CFO consider?
1. The changes in the cash flow streams 2. Decide whether or not the new cash flows add value to the firm
What are the three components of cash flow from assets?
1. Operating cash flow 2. Capital spending 3. Changes in net working capital
To prepare the pro-forma financial statements what must you estimate as accurately as possible?
1. Quantities of unit sales 2. The unitary selling price 3. The variable cost per unit 4. Total fixed costs
Why do you deduct depreciation?
Depreciation is a non-cash expense - the only cash flow effect of deducting depreciation is to reduce taxes. At 34% rate a dollar in depreciation expense saves 34 cents in taxes
What is the term used to refer to a negative impact on the cash flows of an existing product after the introduction of a new product?
Erosion
TRUE OR FALSE
Some of the financing for these daily expenses- depending on the amounts owed to suppliers (accounts payable)- will be balanced to some degree, but the firm will have to supply the "balance" when there is more cash out-flow than cash in-flow TRUE
What does the term incremental cash flows mean?
The difference between a firm's future cash flows after incorporating the project and those without the project
TRUE OR FALSE:
The firm supplies working capital at the beginning of a project -similar to a loan and recovers it towards the end of the project's life cycle TRUE
What is the first step in analyzing cash flows?
The first step requires making a decision about which cash flows are relevant to the evaluation process and which cash flows don't affect the value of the investment
