Making Capital Investment Decisions
Created by David Moore, PhD
Reference Material: Chapter 10 of Textbook
Key Concepts
- Project Cash Flows
- Incremental Cash Flows
- Pro Forma Financial Statements
- Depreciation
- Alternative definitions of OCF
Capital Budgeting
- We learned how to evaluate projects given expected future cash flows. Where do these cash flows come from?
- Learn how to "spread the numbers"
- Work with financial statements to estimate FCF
- What info is relevant.
- Care about changes in FCF
Relevant Cash flows
The incremental cash flows for project evaluation consists of any and all changes in the firm's future cash flows that are a direct consequence of taking the project.
- 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
Stand-Alone Principle
The assumption that evaluation of a project may be based on the project's incremental cash flows.
- Can view incremental cash flows as "minifirm"
- Compare cash flows of minifirm to "cost of acquiring it"
Incremental Cash flows: Pitfalls
- Sunk Costs
- Opportunity Costs
- Side Effects
- Net Working Capital
- Financing Costs
Sunk Cost:Scenarios
- You just spent $1,000 on a ticket for a ski trip in Northern California, but soon after found a better ski trip in Colorado for $500 and bought a ticket for this trip too. You just found out the trip is the same weekend, which trip do you go on?
- Imagine you go see a movie which costs $10 for a ticket. When you open your wallet or purse you realize you've lost a $10 bill. Would you still buy a ticket?
- Now, imagine you go to see the movie and pay $10 for a ticket, but right before you hand it over to get inside you realize you've lost it. Would you go back and buy another ticket?
Sunk Cost
A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.
Sunk Cost: Examples
- The firm hires a consultant to evaluate their marketing campaign. Should you consider the cost in deciding to pursue the campaign?
- You have tickets to the Rams game on Sunday. At halftime it is 50-0 and raining and you are miserable. You are thinking of staying because "I've paid for the tickets"
- You are really hungry and order a 20 oz steak. Halfway through you are full and can't eat anymore. You try to push through because you already paid for it.
- I'm going to keep dating "Bob" because I've already invested so much time and effort into relationship.
- Basically any mobile game...
Opportunity Costs
The most valuable alternative that is given up if a particular investment is undertaken.
- Do not confuse with sunk costs
- You own an abandoned factory that you purchased for a million dollars. You are thinking of converting it into hipster heaven with lofts and shops. What is the sunk cost? Opportunity cost? Is the factory "free"?
Side Effects: Erosion
The cash flows of a new project that come at the expense of a firm's existing projects.
- Benefits can be positive or negative.
- When Apple comes out with a new iphone it cannibalizes sales from existing iphone. Need to adjust expected future cash flows for decrease in sales.
- Adding a Starbucks to Target's store front. Consider increase in Target sales due to Starbucks.
- If I own two burger restaurants and decide to open a third location. Potential side effects?
Net Working Capital
New projects often require incremental investments in current assets
- Early on you may "invest" in inventories, accounts receivable, accounts payable
- Firm supplies "the balance"
- As project winds down NWC recovered
- Resembles a loan
Financing Costs
- DO NOT include interest paid in analyzing proposed investment
- Or any other financing cost
- Financing costs are reflected in the discount rate.
Other Issues
- Use cash flows NOT accounting numbers. Occurs not accrues
- Always use after tax cash flows
Pro Forma Financial Statements
Pro Forma
Financial statements projecting future years' operations
- Latin for "for the sake of form"
- Complex in real life
- Many ways to construct
- Most important and difficult part of capital budgeting
Steps
- Treat Project as mini-firm
- Determine project costs and returns: sales projections, fixed/variable costs, capital requirements
- Create Pro-forma balance sheet and income statement (NO INTEREST)
- Calculate project (mini-firm) cash flows (Bring back Chapter 2 skills)
- Tabulate total cash flows and value(Chapter 9 skills)
Example (from book)
- Sales: 50,000 cans of shark attractant per year, 4 dollars per can
- $2.50 per can to produce
- Product has a three year life
- Require 20% return
- FC 12,000/year
- 90,000 initial investment in manufacturing
- 100% depreciated over three-years (equal)
- 20,000 initial investment in NWC
- 34% tax rate
Projected Income Statement
Sales (50,000 units at 4/unit) |
200,000 |
Variable Costs (2.50/unit) |
125,000 |
Fixed Costs |
12,000 |
Depreciation (90,000/3) |
30,000 |
EBIT |
33,000 |
Taxes (34%) |
11,220 |
Net Income |
21,780 |
Projected Capital Requirements (Balance Sheet)
|
Year |
|
0 |
1 |
2 |
3 |
Net Working Capital |
20,000 |
20,000 |
20,000 |
20,000 |
Net Fixed Assets |
90,000 |
60,000 |
30,000 |
0 |
Total Investment |
110,000 |
80,000 |
50,000 |
20,000 |
Notice: Book/Accounting Values NOT Cash Flows (Remember Chapter 2)
Projected Cash Flows
$OCF=EBIT+Depreciation$
$OCF= 33,000+30,000-11,220$
|
Year |
|
0 |
1 |
2 |
3 |
Operating Cash Flow |
|
51,780 |
51,780 |
51,780 |
Changes in NWC |
-20,000 |
|
|
+20,000 |
Capital Spending |
90,000 |
|
|
|
Total Cash Flow |
-110,000 |
51,780 |
51,780 |
71,780 |
NPV @ 20% = 10,648 IRR =25.8%
More about Project Cash Flows
- Net Working Capital
- Depreciation (under old tax law)
Net Working Capital
General idea: Need to consider cash flows that aren't reflected on income statement.
- Sales might be on credit
- Costs may not have been paid yet
- Cash flows have not yet occurred
- Important to consider in CF calculations
NWC: Example
Sales |
500 |
Costs |
310 |
Net Income |
190 |
|
Beginning of Year |
End of Year |
Change |
Accounts Receivable |
880 |
910 |
+30 |
Accounts Payable |
550 |
605 |
55 |
Net Working Capital |
330 |
305 |
-25 |
Total cash flow = 190-(-25)-0
Total cash flow = 215
NWC: Alternative View
What were cash revenues and costs for the year?
Change in Accounts Receivable shows 30 of sales have not been received yet |
Sales |
500 |
-30 |
=470 |
Change in Accounts Payable shows 55 of costs have not been paid yet |
Costs |
310 |
-55 |
255 |
Cash flow = Inflow - Outflow
Cash flow = 470 - 255 = 215
Depreciation
- MARCS: Modified Accelerated cost recovery system
- Asset class establishes"tax life"
- Table determined depreciation allowance by year
MARCS Table
Depreciation: Example
What is the annual depreciation for a 12,000 asset in the five-year class.
Asset Sales
Tax considerations to selling assets. Account for book vs market value.
What if I sold the asset in the previous example for 3,000 in year 5?
3,000-691.21=2,308.80
2,308.80*0.34=784.99
After-tax Salvage value = Salvage value +/- Taxes from Salvage Value
After-tax Salvage value (cash flow) = 3,000-784.99
What if I sold the asset in the previous example for 500 in year 5?
500-691.21=-191.21
-191.21*0.34=-65.01
After-tax Salvage value = 500+65.01
Adjust for paying too much or too little in taxes.
Alternative OCF Definitions
- Bottom-up: OCF=Net Income+Depreciation
- Top-down: OCF=Sales-Costs-Taxes
- Tax Shield: OCF=(Sales-Costs)(1-T)+Depreciation*T
All measures are dollars in - dollars out.
Alternative OCF: Example
Sales 1500;Costs 700; Depreciation 600
EBIT=200; Taxes=68
OCF= 200+600-68=732
BU=132+600=732
TD=1500-700-68=732
TS=(1500-700)*(1-.34)+600*.34=732
Mega Example
Your company is thinking about a new product line. The product will sell for $120 per unit for the first 3 years and $110 per unit afterwards. Upfront NWC is $20,000, yearly NWC is 15% of sales. Variable costs are $60/unit and fixed costs are $25,000/year. New equipment will cost $800,000 and depreciate over seven-years following MACRS. Salvage value is 20% of cost. The tax rate is 34% and required return is 15 percent. Should you pursue this new product?
Projected Unit Sales |
Year |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
Unit Sales |
3,000 |
5,000 |
6,000 |
6,500 |
6,000 |
5,000 |
4,000 |
3,000 |
Key Learning Outcomes
- Identify relevant/incremental cash flows and understand:
- Sunk costs
- Opportunity costs
- Side Effects
- NWC
- Financing Costs
- Calculate Pro Forma Financial Statements
- Estimate expected future cash flows
- Role of NWC
- Depreciation
- Alternative ways to calculate OCF