1、Chapter 10 Making Capital Investment Decisions,Homework: 23, 24, 31, 32 & 34,Lecture Organization,Identify relevant cash flows Construct forecasted financial statements Alternative definitions of OCF CCA versus straight-line deprecation Capital budgeting examples,Fundamental Principles of Project Ev
2、aluation,Fundamental Principles of Project Evaluation:Project evaluation - the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision.Relevant cash flows - the incremental cash flows associated with the decision t
3、o invest in a project.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.Stand-alone principle - evaluation of a project based on the projects incremental cash flows.,Relevant Cash Flows,
4、Honda Corp. is considering a new car model to replace the Accord which earns 340,000 million yen a year in Accord salesEstimates it will sell 2 million units of the new model and earn 210,000 yen on each unit (420,000 million yen in revenues)Incremental cash flows = Cash Flow(With new car model)- Ca
5、sh Flows(Without new car model)420,000 - 340,000 = 80,000 million yen,Stand-Alone Principle,Evaluate project on the basis of its incremental cash flowsProject = “Mini-firm“Allows us to evaluate the investment project separately from other activities of the firmCash Flows from the Project = Cash Flow
6、s from Assets,Aspects of Incremental Cash Flows,Sunk CostsOpportunity CostsSide Effects (Erosion)Net Working CapitalFinancing Costs,All Cash Flows should be after-tax cash flows,Sunk Costs,The Limited hires The Boston Consulting Group (BCG) to evaluate whether a new product line should be launched.
7、The consulting fees are paid no matter what.,Opportunity Costs,Firm paid $300,000 land to be used for a warehouse. The current market value of the land is $450,000.,Opportunity Cost = Sunk Cost =,Side Effects and Erosion,A drop in Big Mac revenues when McDonalds introduced the Arch Deluxe.,Net Worki
8、ng Capital,Investment in inventories and receivables. This investment is recovered at the end of project.,Financing Costs,Interest, principal on debt and dividends.,Pro Forma Financial Statements and DCF Valuation,Pro forma financial statementsBest current estimate of future cash flowsExclude intere
9、st expenses and other financing costsUse statements to obtain Project cash flowIf stand-alone principle holds:Project Cash Flow = Cash Flow from Assets =Operating Cash Flow - Net Capital Spending - Additions to Net Working Capital,Depreciation,Economic and future market value are ignored. Depreciati
10、on expense uses the cost of asset.Care about depreciation because it affects tax bill Use tax accounting rules for depreciation.CCAStraight-line,Additions to Net Working Capital,Will start with a NWC number (date 0)NWC will change during project life (e.g. grow at a rate of 3% per period)NWC(year 2)
11、 = NWC(year1)*1.03Or, NWC will equal Y% of sales each period (e.g. 15%)NWC(year 2) = 0.15*Sales(year 2)All NWC is recovered at the end of the project.Inventories are run downUnpaid bills are paid.Bring NWC account to zero.,Ways to Capital Budgeting Problem,Date 0: Buy the fixed asset - Cash OutflowD
12、ate T: Sell the fixed asset - Cash Inflow If no more assets of the same class:Record after-tax gain or loss,Example: Preparing Pro Forma Statements,Suppose we want to prepare a set of pro forma financial statements for a project for Norma Desmond Enterprises. In order to do so, we must have some bac
13、kground information. In this case, assume:1. Sales of 10,000 units/year $5/unit. 2. Variable cost/unit is $3. Fixed costs are $5,000/year. Project has no salvage value. Project life is 3 years.3. Project cost is $21,000. Depreciation is $7,000/year. 4. Net working capital is $10,000. 5. The firms re
14、quired return is 20%. The tax rate is 34%.,Example: Preparing Pro Forma Statements (continued),Pro Forma Financial Statements Projected Income StatementsSales $_Var. costs _$20,000Fixed costs 5,000Depreciation 7,000“EBIT” $_Taxes (34%) 2,720Net income $_,Example: Preparing Pro Forma Statements (conc
15、luded),Projected Balance Sheets0 1 2 3 NWC $_ $10,000 $10,000 $10,000 NFA 21,000 _ _ 0 Total $31,000,Example: Using Pro Formas for Project Evaluation,Lets use the information from the previous example to do a capital budgetingProject operating cash flow (OCF):EBIT Depreciation Taxes OCF $_,Example:
16、Using Pro Formas for Project Evaluation (continued),Project Cash Flows0 1 2 3 OCF NWC Sp. _ _ Cap. Sp. -21,000 Total _ _,Example: Using Pro Formas for Project Evaluation (concluded),Capital Budgeting Evaluation:NPV = PB = AAR = Should the firm invest in this project? Why or why not?,Alternative Defi
17、nitions of OCF,Let: OCF = operating cash flow S = sales C = operating costs D = depreciation Tc = corporate tax rate,Alternative Definitions of OCF (concluded),The Tax-Shield ApproachOCF = (S - C - D) + D - (S - C - D) x Tc= (S - C) x ( 1 - Tc) + (D x Tc) = (S - C) x (1 - Tc) + depreciation tax shie
18、ld The Bottom-Up ApproachOCF = (S - C - D) + D - (S - C - D) x Tc= (S - C - D) x (1 - Tc) + D= Net income + depreciation The Top-Down ApproachOCF = (S - C - D) + D - (S - C - D) x Tc= (S - C) - (S - C - D) x Tc= Sales - costs - taxes,Chapter 10 Quick Quiz,Assume we have the following background info
19、rmation for a project being considered by Gillis, Inc. Calculate the projects NPV and payback period.1. Required NWC investment = $40; initial capital spending = $60; 3 year life2. Annual sales = $100; annual costs = 50; straight line depreciation to $03. Salvage value = $10; tax rate = 34%, require
20、d return = 12% The after-tax salvage is $10 - ($_ - _ )(.34) = $6.6OCF = (100 - 50 - 20) + 20 - (100 - 50 - 20)(.34) = $_,Chapter 10 Quick Quiz (concluded),Project cash flows are thus:0 1 2 3OCF $39.8 $39.8 $39.8Add. NWC _ _Cap. Sp. -60 _ $39.8 $39.8 $86.4NPV = $ _Payback period = 2.24 years,Example
21、: Fairways Equipment and Operating Costs,Equipment requirements:Ball dispensing machine $ 2,000Ball pick-up vehicle 7,000Tractor and accessories 9,000$18,000 all depreciable equipment is Class 10, 30% all equipment is expected to have a salvage value of 10% of cost after 6 years. Assume there are no
22、 more class 10 assets after the project ends.Balls and buckets $ 3,000 expenditures for balls and baskets are expected to grow to 5% per year Corporate tax rate is 15%,Example: Fairways Equipment and Operating Costs (concluded),Operating Costs (annual)Land lease $ 12,000Water 1,500Electricity 3,000L
23、abor 30,000Seed & fertilizer 2,000Gasoline 1,500Maintenance 1,000Insurance 1,000Misc. 1,000$53,000,Working Capital Initial requirement = $3,000 Working capital requirements are expected to grow at 5% per year for the life of the project,Example: Fairways Revenues, Depreciation, and Other Costs,Proje
24、cted RevenuesYear Buckets Revenues1 20,000 $60,0002 20,750 62,2503 21,500 64,5004 22,250 66,7505 23,000 69,0006 23,750 71,250,Example: Fairways Revenues, Depreciation, and Other Costs (continued),Cost of balls and bucketsYear Cost1 $3,0002 3,1503 3,3084 3,4735 3,6476 3,829,Example: Fairways Revenues
25、, Depreciation, and Other Costs (concluded),CCA for the six year life of the project Year Beg. UCC CCA Ending UCC 1 9000 2700 6300 2 15300 4590 10710 3 10710 3213 7497 4 7497 2249 5248 5 5248 1574 3674 6 3674 1102 2572,Example: Fairways Pro Forma Income Statement,Year1 2 3 4 5 6 Revenues $60,000 62,
26、250 64,500 66,750 69,000 71,250 Variable costs 3,000 3,150 3,308 3,473 3,647 3,829 Fixed costs 53,000 53,000 53,000 53,000 53,000 53,000 Depreciation 2,700 4,590 3,213 2,249 1,574 EBIT 1,300 1,510 4,979 8,028 10,779 Taxes 195 227 747 1,204 1,617 Net income $ 1105 1,283 4,232 6,824 9,162,Example: Fai
27、rways Projected Increases in NWC,Projected increases in net working capitalYear Net working capital Increase in NWC0 3,000 _1 3,150 1502 3,308 1583 3,473 1654 3,647 1745 3,829 1826 4,020 _,Example: Fairways Cash Flows,Operating cash flows:Operating Year EBIT + Depreciation - Taxes = cash flow0 $ 0 $
28、 0 $ 0 $ 01 1,300 2,700 195 3,8052 1,510 4,590 227 5,8733 4,979 3,213 747 7,4454 8,028 2,249 1,204 9,0735 10,779 1,574 1,617 10,7366 _ _ _ _,Example: Fairways Cash Flows (concluded),Total cash flow from assets:Operating - Increases Capital Total Year cash flow in NWC - spending = cash flow0 $ 0 $ _
29、$18,000 -$_1 3,805 150 0 3,6552 5,873 158 0 5,7153 7,445 165 0 7,2804 9,073 174 0 8,8995 10,736 182 0 10,5546 _ _ _ _,Present Value of the Tax Shield on CCA,Let: C = total capital cost added to the pool (initial UCC) d = CCA rate for the asset class k = discount rate S = salvage value of asset Tc =
30、corporate tax rate n = asset life in years,Notes for Present Value of CCA Tax Shield (CCATS),Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal,Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital
31、 and a scrap value of $1,000 after five years. The equipment is in class 8 with a CCA rate of 20%. The marginal tax rate is 34% and the appropriate discount rate is 10%. (Assume there are other class 8 assets in use after 5 years.),Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal (conclude
32、d),Example 2: Straight-line Depreciation and Cost-Cutting Proposal,Redo the previous example with straight-one deprecation. Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a scrap value of $1,000
33、 after five years. For simplicity, assume straight-line depreciation. The marginal tax rate is 34% and the appropriate discount rate is 10%.,Example 2: Straight-line Depreciation and Cost-Cutting Proposal (concluded),Example: Setting the Bid Price,Operating Increases Capital Total Year cash flow in
34、NWC spending = cash flow0 $ 0 _ _ _1 OCF 0 0 OCF2 OCF 0 0 OCF3 OCF _ _ OCF + _,The Army is seeking bids on Multiple Use Digitizing Devices (MUDDs). The contract calls for 4 units per year for 3 years. Labour and material costs are estimated at $10,000 per MUDD. Production space can be leased for $12
35、,000 per year. The project will require $50,000 in new equipment which is expected to have a salvage value of $10,000 after 3 years. Making MUDDs will require a $10,000 increase in net working capital. Assume a 34% tax rate and a required return of 15%. Use straight-line depreciation.,Example: Setti
36、ng the Bid Price (concluded),Machine A,Machine B,Costs Annual Operating Costs Replace,$100,$140,$10,$8,Every 2 years,Every 3 years,Evaluating equipment with different economic lives,Equivalent Annul Cost (EAC),PV(Costs) = EAC*(Annuity Factor),EAC = PV(Costs)/Annuity Factor,Example: Equivalent Annual
37、 Cost Analysis,Two types of batteries are being considered for use in electric golf carts at City Country Club. Burnout brand batteries cost $36, have a useful life of 3 years, will cost $100 per year to keep charged, and have a salvage value of $5. Longlasting brand batteries cost $60 each, have a life of 5 years, will cost $88 per year to keep charged, and have a salvage value of $5. Assume straight-line depreciation.,Example: Equivalent Annual Cost Analysis (concluded),
