FIN 301 Chapter 10 PDF

CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS  LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 How to determine the relevant cash flows for a proposed project. LO2 How to determine if a project is acceptable. LO3 How to set a bid price for a project. LO4 How to...

CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS  LEARNING OBJECTIVES After studying this chapter, you should understand: LO1 How to determine the relevant cash flows for a proposed project. LO2 How to determine if a project is acceptable. LO3 How to set a bid price for a project. LO4 How to evaluate the equivalent annual cost of a project. 10.1 Project Cash Flows: A First Look  UNDERSTANDING THE EFFECT OF A PROJECT ON FIRM’S CASH FLOWS Main Concept: Taking on a project changes the firm’s overall cash flows today and in the future. Objective: To evaluate a proposed investment, we must: Identify how it impacts future cash flows. Determine if the project adds value to the firm. Key Focus: The first and most critical step is to identify relevant cash flows. These are cash flows directly tied to the decision to take the project.  RELEVANT CASH FLOWS & INCREMENTAL CASH FLOWS Relevant Cash Flows: A relevant cash flow is a change in the firm’s overall future cash flow due to the project. Incremental Cash Flows: Definition: The difference between the firm’s future cash flows with and without the project. Key Point: Only incremental changes in cash flows matter. Important Corollary: Any cash flow that would exist regardless of the project is not relevant for evaluation. THE STAND-ALONE PRINCIPLE Definition: The stand-alone principle assumes that a project's evaluation is based on its incremental cash flows. Why It's Important: Calculating total future cash flows for the entire firm with and without the project is often impractical. The stand-alone principle simplifies the evaluation by focusing only on the project's impact on the firm’s cash flows. Applying the Stand-Alone Principle How It Works: Treat the project as a “minifirm” with its own revenues, costs, assets, and cash flows. Compare these cash flows to the cost of acquiring the project. Key Benefit: The project is evaluated in isolation, based solely on its own merits, without interference from other projects or activities. Objective: Make an objective decision by focusing solely on the incremental value the project brings to the 10.2 Incremental Cash Flows IMPORTANCE OF IDENTIFYING INCREMENTAL CASH FLOWS Key Concept: Only incremental cash flows that result from a project are relevant for decision-making. Common Pitfalls: While identifying incremental cash flows might seem straightforward, mistakes are common. In this section, we address how to avoid such errors. UNDERSTANDING SUNK COSTS Definition: A sunk cost is a cost that has already been incurred and cannot be recovered. Therefore, it should not influence an investment decision. Key Point: Sunk costs are not incremental and are irrelevant to the project decision. They are expenses that the firm will incur regardless of whether the project is accepted or rejected. Example: General Milk hires a consultant to evaluate launching chocolate milk. The consulting fee is a sunk cost, as it must be paid whether the project proceeds or not. UNDERSTANDING OPPORTUNITY COSTS Definition: Opportunity cost refers to the most valuable alternative that is given up when a particular investment is undertaken. Key Concept: Opportunity costs are not out-of- pocket expenses but represent the benefit or value that is sacrificed when choosing one investment over another. Example: If a firm converts an old cotton mill into condominiums, the opportunity cost is the value of the alternative use of the mill, such as selling it. CALCULATING OPPORTUNITY COSTS Is the Mill “Free”? No. Even though the mill was purchased years ago, its current value is still relevant for the condo project evaluation. Key Insight: The opportunity cost is what the mill could sell for today, not the original purchase price, because the $100,000 paid is a sunk cost and irrelevant. Conclusion: The condo project should be charged at least the current market value of the mill, as this reflects the opportunity cost of using the mill for the  UNDERSTANDING SIDE EFFECTS AND EROSION Side Effects: Projects can have spillover effects that impact other areas of the firm, either positively or negatively. Erosion occurs when the cash flows of a new project come at the expense of a firm’s existing projects. Example: Shortened DVD release times hurt movie theater profits but boosted DVD sales. Key Insight: Cash flows for new projects should be adjusted to account for any erosion effects on existing lines. ACCOUNTING FOR EROSION AND SPILLOVER EFFECTS Erosion Relevance: Erosion is relevant only if the lost sales would not have been lost due to other factors like competition. Example: Disney was concerned that Euro Disney might drain visitors from its Florida park. However, HP embraced declining printer prices because the profit margins from consumables (ink cartridges) remained high. Conclusion: Always consider both negative and positive spillover effects when evaluating new projects to fully understand the impact on firm-wide cash flows. UNDERSTANDING NET WORKING CAPITAL IN PROJECTS Definition: Net Working Capital (NWC) is the investment a firm makes in short-term assets (e.g., cash, inventories, accounts receivable) needed to support a project. Initial Investment: Projects often require upfront NWC investment to cover expenses like: Cash on hand, Inventories, Accounts receivable, Financed partially by accounts payable, with the firm supplying the balance. Key Insight: NWC is essential for the smooth operation of a project, THE RECOVERY OF NET WORKING NWC CAPITAL as a Temporary Investment: As the project concludes: Inventories are sold, Receivables are collected, Bills are paid, and cash balances decrease Resembling a Loan: The investment in NWC is similar to a loan: NWC is invested at the start of the project. NWC is recovered toward the end as assets are liquidated. Conclusion: The recovery of NWC at the project’s end EXCLUDING FINANCING COSTS IN PROJECT EVALUATION Key Concept: When analyzing a proposed investment, financing costs (e.g., interest, dividends, principal repayment) are not included in the cash flow analysis. Why?: Financing costs are related to the cash flow to creditors, not the cash flow from assets. Focus: The goal is to assess the cash flow generated by the project’s assets in comparison to the project’s cost to determine its Net Present Value (NPV). FINANCING AS A SEPARATE CONSIDERATION Debt and Equity Choices: The mixture of debt and equity used to finance a project is a managerial decision and influences how project cash flows are distributed between owners and creditors. Why Financing Costs Are Excluded: Financing arrangements impact how the cash flow is divided, not the cash flow itself. Key Insight: Financing decisions are important but are analyzed separately from project evaluation. We'll cover these considerations in more detail in later chapters. 3 Pro Forma Financial Statemen and Project Cash Flows INTRODUCTION TO PRO FORMA FINANCIAL STATEMENTS Definition: Pro forma financial statements are projections of a project’s future operations, summarizing key information such as sales, costs, and investments. Key Elements Required: To prepare these statements, we need: Unit sales Selling price per unit Variable cost per unit Total fixed costs Total investment (including Net Working Capital) PROJECTED INCOME STATEMENT, SHARK ATTRACTANT PROJECT In this table; we organize these initial projections by first preparing the pro forma income statement. Once again, notice that we have not deducted any interest expense. This will always be so. As we described earlier, interest paid is a financing expense, not a component of operating cash flow. PROJECTED CAPITAL REQUIREMENTS, SHARK ATTRACTANT PROJECT Here we have net working capital of $20,000 in each year. Fixed assets are $90,000 at the start of the project’s life (Year 0), and they decline by the $30,000 in depreciation each year, ending up at zero. Notice that the total investment given here for future years is the total book, or accounting, value, not market value. At this point, we need to start converting this accounting information into cash flows. We consider how to do COMPONENTS OF PROJECT CASH FLOWS Definition: The cash flow from a project is derived from three key components: Operating Cash Flow (OCF) Capital Spending Changes in Net Working Capital (NWC) Formula for Project Cash Flow: Project Cash Flow=Operating Cash Flow−Change in NWC−Capital S pending Why These Components? These elements capture the total cash flow impact of the project, mimicking how an entire firm’s cash flow is calculated, but focused on the project or minifirm. CALCULATING PROJECT OPERATING CASH FLOW Formula for Operating Cash Flow Operating Cash Flow=Earnings Before Interest and Taxes (EBI T)+Depreciation−Taxes Explanation: EBIT: Earnings generated by the project before financing costs. Depreciation: Added back because it's a non-cash charge. Taxes: Deducted based on project earnings. Key Insight: Operating cash flow captures the pure cash earnings of the project, unaffected by financing costs. 0.4 More about Project Cash Flo NET WORKING CAPITAL (NWC) Net Working Capital is crucial for accurate cash flow analysis. When calculating operating cash flow, changes in NWC must be included to reflect the actual cash impact of sales and costs. Example Calculation: Operating Cash Flow: Given as EBIT in the absence of taxes and depreciation, which is $190. Change in NWC: Declined by $25, meaning $25 was freed up. Total Cash Flow: CASH REVENUES AND COSTS: Cash Revenues: Sales minus increase in accounts receivable. Example: Sales of $500 with a $30 increase in receivables gives cash revenues of 500−30=470. Cash Costs: Costs minus increase in accounts payable. Example: Costs of $310 with a $55 increase in payables gives cash costs of 310−55=255 DEPRECIATION Depreciation impacts cash flows primarily through its effect on taxes. Under U.S. tax law, depreciation is calculated using Modified Accelerated Cost Recovery System (MACRS), which allows for accelerated depreciation. MACRS DEPRECIATION: Assets are assigned to specific classes with fixed percentages for depreciation. Example: For a $12,000 automobile classified as a five-year property: Year 1: 20% of $12,000 = $2,400 Year 2: 32% of $12,000 = $3,840 BOOK VALUE VS. MARKET VALUE: Depreciation is computed without considering salvage value or economic life. Example: A car with a purchase price of $12,000 might have a market value of $3,000 after five years. Selling the car for this amount results in a taxable recapture of excess depreciation. Tax Impact: If the sale price exceeds the book value, the difference is taxed as excess depreciation. If the sale price is below the book value, it results in a tax saving. CAPITAL INVESTMENT DECISION: MMCC EXAMPLE Project Details: Initial Investment: $800,000 in equipment NWC Requirements: $20,000 initially, adjusting to 15% of annual sales Depreciation: Seven-year MACRS Expected Salvage Value: 20% of initial cost after eight years Tax Rate: 34% Required Return: 15% Steps: 1.Calculate Operating Cash Flows: Based on sales projections, costs, and depreciation. 2.Determine Changes in NWC: Adjustments for changes in sales. 3.Assess Capital Spending: Account for initial investment and salvage value. 4.Compute Total Cash Flows: Sum of operating cash flows, changes in NWC, and capital spending. Result: Net Present Value (NPV): $65,485 (positive, indicating the project is acceptable) Internal Rate of Return (IRR): 17.24% (greater than the required return) Payback Period: 4.08 years Conclusion: MMCC should proceed with the project based on the positive NPV and acceptable IRR, although further sensitivity analysis and evaluation of estimates are recommended. 10.5 Alternative Definitions of Operating Cash Flow OPERATING CASH FLOW (OCF) DEFINITIONS: 1. General Definition: 2. Bottom-Up Approach: Start with net income and add back noncash deductions such as depreciation. Top-Down Approach: Start with sales and subtract costs, taxes, and other expenses, excluding noncash items like depreciation. Tax Shield Approach: OCF is split into two parts: cash flow before depreciation and the tax shield from depreciation.  10.6 Some Special Cases of Discounted Cash Flow Analysis 1. Evaluating Cost-Cutting Proposals: Calculate incremental cash flows including capital spending, operating cash flows, and tax effects. Example: Automating production involves initial capital costs, tax effects from depreciation, and savings from reduced labor and materials. Compute NPV to decide if the investment is worthwhile. 2. Setting the Bid Price: Determine the lowest price that allows a desired return on investment, using NPV as a benchmark. This involves calculating required operating cash flow and determining the appropriate sales price. 3. Evaluating Equipment Options with Different Lives: Equivalent Annual Cost (EAC): Converts the present value of costs into an annual amount, allowing for comparison of options with different service lives. Example: Compare machines with different purchase prices and operating costs by calculating the EAC to determine the most cost-effective choice.