Making Capital Investment
Decisions
Chapter 9
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Prepare for Capital Budgeting
Part 2: Understand financial statement & cash flow
C2-Identify cash flow from financial statement
C3-Financial statement and comparison
Part 3: Valuation of future cash flow
C4-Basic concepts
C5-More exercise
Part 4: Valuing stocks and bonds
C6-Bond
C7-Stock
Part 5: Capital budgeting
C8-NPV and other investment criteria
9.2
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Chapter Outline
1. Analyze A Project’s Projected Cash Flows
Based on Pro Forma Financial Statements
2. Relevant Cash Flows
3. Tax Shield Approach
4. Scenario and Sensitivity Analyses
5. Managerial Options
9.3
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1. Pro Forma Statements and Cash
Flow
Capitalbudgeting relies heavily on pro forma
accounting statements, particularly income
statements
Computing cash flows – refresher
Operating Cash Flow (OCF) = EBIT + depreciation
– taxes
Cash Flow From Assets (CFFA) = OCF – net
capital spending (NCS) – changes in NWC
9.4
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Cash Flow Illustration
Creditor
Company/
Asset
Owner/Stockholder
Government
EBIT+Depr. OCF CFFA
9.5
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Table 9.1 Pro Forma Income
Statement
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
9.6
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Calculating OCF
Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
OCF=33,000+30,000-11,220=51,780
9.7
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Table 9.2 Projected Capital
Requirements
Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000
Net Fixed 90,000 60,000 30,000 0
Assets
9.8
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Cash Flow Illustration
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in -$20,000 20,000
NWC
Capital -$90,000
Spending
CFFA -$110,00 $51,780 $51,780 $71,780
9.9
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Cash Flow Illustration
Now that we have the cash flows, we can apply
the techniques that we learned in chapter 8
Enter the cash flows into the calculator and
compute NPV when I/Y=20%
NPV = 10,648
Should we accept or reject the project?
9.10
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2. Relevant Cash Flows
Stand-alone principle
The cash flows that should be included in a capital
budgeting analysis are those that will only occur if
the project is accepted
These cash flows are called incremental cash
flows
The stand-alone principle, which simply
focuses on incremental cash flows, allows us to
analyze each project in isolation from the firm
simply
9.11
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Asking the Right Question
You should always ask yourself “Will this cash
flow occur ONLY if we accept the project?”
If the answer is “yes”, it should be included in the
analysis because it is incremental
If the answer is “no”, it should not be included in
the analysis because it will occur anyway
If the answer is “part of it”, then we should include
the part that occurs because of the project
9.12
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Common Types of Cash Flows
Opportunity costs – costs of lost options
Side effects
Positive side effects – benefits to other projects
Negative side effects – costs to other projects
Changes in net working capital
Taxes
Sunk costs – costs that have accrued in the past
9.13
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3. After-tax Salvage
Ifthe salvage value is different from the book
value of the asset, then there is a tax effect
Book value = initial cost – accumulated
depreciation
After-tax salvage = salvage – T*(salvage –
book value)
9.14
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Example
Consider the previous example, if the company
sells out the equipment at $10,000 when the
project is done and the company’s marginal tax
rate is 40%. What is the after-tax salvage?
After-tax salvage = salvage – T*(salvage –
book value)
After-tax salvage=10,000-.4*(10,000-0)=6,000
9.15
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Cash Flow Illustration
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in -$20,000 20,000
NWC
Capital -$90,000 6,000
Spending
CFFA -$110,00 $51,780 $51,780 $77,780
9.16
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4. Scenario Analysis
What happens to the NPV under different cash
flows scenarios?
At the very least look at:
Best case – revenues are high and costs are low
Worst case – revenues are low and costs are high
Measure of the range of possible outcomes
Best case and worst case are not necessarily
probable, they can still be possible
9.17
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Sensitivity Analysis
What happens to NPV when we vary one
variable at a time
This is a subset of scenario analysis where we
are looking at the effect of specific variables on
NPV
The greater the volatility in NPV in relation to a
specific variable, the larger the forecasting risk
associated with that variable and the more
attention we want to pay to its estimation
9.18
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New Project Example
Consider the project discussed in the text
The initial cost is $200,000 and the project has
a 5-year life. There is no salvage. Depreciation
is straight-line, the required return is 12% and
the tax rate is 34%
The base case NPV is 15,567
9.19
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Summary of Scenario Analysis
Scenario Net Cash NPV IRR
Income Flow
Base case 19,800 59,800 15,567 15.1%
Worst -15,510 24,490 -111,719 -14.4%
Case
Best Case 59,730 99,730 159,504 40.9%
9.20
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Summary of Sensitivity Analysis
Scenario Unit Sales Cash NPV IRR
Flow
Base case 6000 59,800 15,567 15.1%
Worst 5500 53,200 -8,226 10.3%
case
Best case 6500 66,400 39,357 19.7%
9.21
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5. Managerial Options
Capital budgeting projects often provide other
options that we have not yet considered
Contingency planning (“what if ” option)
Option to expand
Option to abandon
Option to wait
Strategic options (“testing” project)
9.22
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Capital Rationing
Capital rationing occurs when a firm or division
has limited resources
Soft rationing – the limited resources are temporary,
often self-imposed
Hard rationing – capital will never be available for
this project
The profitability index is a useful tool when
faced with soft rationing
9.23
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Review Questions
1. Know how to calculate OCF based on pro
forma statements to find out NPV of a project
2. How do we determine if cash flows are
relevant to the capital budgeting decision?
Is a sunk cost a relevant cash flow for project
evaluation? Is an opportunity cost a relevant
cash flow for project evaluation? Are benefits
and costs to other project, and taxes relevant
cash flows for project evaluation?
9.24
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Review Questions (cont ..)
3. Know how to calculate after-tax salvage.
4. What is scenario analysis and what is
sensitivity analysis?
5. What are the major types of typical managerial
option? What is capital rationing?
9.25
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