Tài chính doanh nghiệp - Chapter 9: Making capital investment decisions

Making Capital Investment DecisionsChapter 90Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerKey Concepts and SkillsUnderstand how to determine the relevant cash flows for a proposed investmentUnderstand how to analyse a project’s projected cash flowsUnderstand how to evaluate an estimated NPV1Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChapter OutlineProject Cash Flows: A First LookIncremental Cash FlowsPro Forma Financial Statements and Project Cash FlowsMore on Project Cash FlowEvaluating NPV EstimatesScenario and Other What-If AnalysesAdditional Considerations in Capital Budgeting2Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerRelevant Cash FlowsThe cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is acceptedThese cash flows are called incremental cash flowsThe stand-alone principle allows us to analyse each project in isolation from the firm simply by focusing on incremental cash flows3Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAsking the Right QuestionYou 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 incrementalIf the answer is “no”, it should not be included in the analysis because it will occur anywayIf the answer is “part of it”, then we should include the part that occurs because of the project4Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCommon Types of Cash FlowsSunk costs – costs that have accrued in the pastOpportunity costs – costs of lost optionsSide effectsPositive side effects – benefits to other projectsNegative side effects – costs to other projectsChanges in net working capitalFinancing costsTaxes5Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPro Forma Statements and Cash FlowCapital budgeting relies heavily on pro forma accounting statements, particularly income statementsComputing cash flows – refresherOperating Cash Flow (OCF) = EBIT + depreciation – taxesOCF = Net income + depreciation when there is no interest expenseCash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC6Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 9.1 Pro Forma Income StatementSales (50,000 units at $4.00/unit)$200,000Variable Costs ($2.50/unit)125,000Gross profit$ 75,000Fixed costs12,000Depreciation ($90,000 / 3)30,000EBIT$ 33,000Taxes (30%)9,900Net Income$ 23,1007Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 9.2 Projected Capital RequirementsYear0123NWC$20,000$20,000$20,000$20,000Net Fixed Assets 90,000 60,000 30,000 0Total Investment$110,000$80,000$50,000$20,0008Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 9.5 Projected Total Cash FlowsYear0123OCF$53,100$53,100$53,100Change in NWC-$20,00020,000Capital Spending-$90,000 CFFA-$110,00$53,100$53,100$73,1009Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMaking the DecisionNow that we have the cash flows, we can apply the techniques that we learned in Chapter 8Enter the cash flows into the calculator and compute NPV and IRRCF0 = -110,000; C01 = 53,100; F01 = 2; C02 = 73,100NPV; I = 20; CPT NPV = 13,428CPT IRR = 27.3%Do we accept or reject the project?10Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Tax Shield ApproachYou can also find operating cash flow using the tax shield approachOCF = (Sales – costs)(1 – T) + Depreciation*TThis form may be particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield – such as when you are choosing between two different machines11Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMore on NWCWhy do we have to consider changes in NWC separately?AAS requires that sales be recorded on the income statement when made, not when cash is receivedAAS also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yetFinally, we have to buy inventory to support sales although we haven’t collected cash yet12Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDepreciationThe depreciation expense used for capital budgeting should be the depreciation schedule required by the Tax Office for tax purposesDepreciation itself is a non-cash expense. Consequently, it is only relevant because it affects taxesDepreciation tax shield = DTD = depreciation expenseT = marginal tax rate13Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerComputing DepreciationPrime cost (Straight-line) depreciationD = (Initial cost – salvage)/number of yearsMost assets are depreciated straight-line to zero for tax purposesDiminishing value depreciationNeed to know which deprecation rate is appropriate for tax purposesMultiply percentage by the written down value at beginning of the yearDepreciate to zero14Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAfter-tax SalvageIf the salvage value is different from the book value of the asset, then there is a tax effectBook value = initial cost – accumulated depreciationAfter-tax salvage = salvage – T(salvage – book value)15Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Depreciation and After-tax SalvageYou purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following situations?16Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Straight-line DepreciationSuppose the appropriate depreciation schedule is straight-lineD = (110,000 – 17,000) / 6 = $15,500 every year for 6 yearsBV in year 6 = 110,000 – 6(15,500) = $17,000After-tax salvage = 17,000 - .4(17,000 – 17,000) = $17,00017Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Replacement ProblemOriginal MachineInitial cost = $100,000Annual depreciation = $9000Purchased 5 years agoBook Value = $55,000Salvage today = $65,000Salvage in 5 years = $10,000New MachineInitial cost = $150,0005-year lifeSalvage in 5 years = $0Cost savings = $50,000 per year3-year MACRS depreciationRequired return = 10%Tax rate = 40%18Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReplacement Problem – Computing Cash FlowsRemember that we are interested in incremental cash flowsIf we buy the new machine, then we will sell the old machineWhat are the cash flow consequences of selling the old machine today instead of in 5 years?19Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReplacement Problem – Pro Forma Income StatementsYear12345Cost Savings50,00050,00050,00050,00050,000Depr: New49,50067,50022,50010,5000 Old9,0009,0009,0009,0009,000Increm.40,50058,50013,5001,500(9,000)EBIT9,500(8,500)36,50048,50059,000Taxes3,800(3,400)14,60019,40023,600NI5,700(5,100)21,90029,10035,40020Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReplacement Problem – Incremental Net Capital SpendingYear 0Cost of new machine = $150,000 (outflow)After-tax salvage on old machine = 65,000 - .4(65,000 – 55,000) = $61,000 (inflow)Incremental net capital spending = 150,000 – 61,000 = $89,000 (outflow)Year 5After-tax salvage on old machine = 10,000 - .4(10,000 – 10,000) = $10,000 (outflow because we no longer receive this)21Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReplacement Problem – Cash Flow From AssetsYear012345OCF46,20053,40035,40030,60026,400NCS-89,000-10,000 In NWC00CFFA-89,00046,20053,40035,40030,60016,40022Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReplacement Problem – Analysing the Cash FlowsNow that we have the cash flows, we can compute the NPV and IRREnter the cash flowsCompute NPV = $54,812.10Compute IRR = 36.28%Should the company replace the equipment?23Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerEvaluating NPV EstimatesThe NPV estimates are just that – estimatesA positive NPV is a good start – now we need to take a closer lookForecasting risk – how sensitive is our NPV to changes in the cash flow estimates? The more sensitive, the greater the forecasting riskSources of value – why does this project create value?24Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerScenario AnalysisWhat happens to the NPV under different cash flows scenarios?At the very least look at:Best case – revenues are high and costs are lowWorst case – revenues are low and costs are highMeasure of the range of possible outcomesBest case and worst case are not necessarily probable, they can still be possible25Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSensitivity AnalysisWhat 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 NPVThe 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 estimation26Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerNew Project ExampleConsider the project discussed in the textThe 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 $15,56727Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSummary of Scenario AnalysisScenarioNet IncomeCash FlowNPVIRRBase case19,80059,80015,56715.1%Worst Case-15,51024,490-111,719-14.4%Best Case59,73099,730159,50440.9%28Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSummary of Sensitivity AnalysisScenarioUnit SalesCash FlowNPVIRRBase case600059,80015,56715.1%Worst case550053,200-8,22610.3%Best case650066,40039,35719.7%29Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMaking a DecisionBeware “Paralysis of Analysis”At some point you have to make a decisionIf the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the projectIf you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project30Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerManagerial OptionsCapital budgeting projects often provide other options that we have not yet consideredContingency planningOption to expandOption to abandonOption to waitStrategic options31Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital RationingCapital rationing occurs when a firm or division has limited resourcesSoft rationing – the limited resources are temporary, often self-imposedHard rationing – capital will never be available for this projectThe profitability index is a useful tool when faced with soft rationing32Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerQuick QuizHow do we determine if cash flows are relevant to the capital budgeting decision?What is scenario analysis and why is it important?What is sensitivity analysis and why is it important?What are some additional managerial options that should be considered?33Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan Trayler