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Making Capital Investment Decisions

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9

Making Capital Investment Decisions

Prepared by Ernest Biktimirov, Brock University

9.1Project Cash Flows: A First Look

9.2Incremental Cash Flows

9.3Pro Forma Financial Statements and Project Cash Flows

9.4More on Project Cash Flows

9.5Evaluating NPV Estimates

9.6Scenario and Other What-If Analyses

9.7Additional Considerations in Capital Budgeting

- Understand how to determine the relevant cash flows for a proposed investment
- Understand how to analyze a project’s projected cash flows
- Be able to compute the CCA tax shield
- Understand how to evaluate an estimated NPV
- Understand different managerial options and capital rationing

- Relevant cash flows - the incremental cash flows associated with the decision to invest in a project.
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.

- Stand-alone principle - evaluation of a project based on the project’s incremental cash flows.

- You should always ask yourself “Will this cash flow occur (or not 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 (or does not occur) because of the project

- Sunk costs – costs that have been incurred and cannot be recouped
- 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
- Financing costs
- Inflation
- Taxes

Treat a project as a mini-firm:

- Start with pro forma income statement (don’t include interest) and balance sheet
- Determine the sales projection, variable costs, fixed costs, and capital requirements

Project cash flow = Project operating cash flow – Project change in net working capital

– Project capital spending

Operating Cash Flow (OCF)

= Earnings before interest and taxes

+ Depreciation

– Taxes

- Now that we have the cash flows, we can apply the techniques that we learned in chapter 8
- Assume the required return is 20%
- Compute NPV and IRR
- NPV = -$110,000 + 51,780/1.2 + 51,780/(1.2)2 + 71,780/(1.2)3
- NPV = $10,648
- IRR = 25.8%

- Should we accept or reject the project?

- You can also find operating cash flows using the tax shield approach:
OCF = (Sales – Costs) × (1 – Tc) + Depreciation × Tc

where Depreciation × Tc = depreciation tax shield

- Why do we have to consider changes in NWC separately?
- GAAP requires that sales be recorded on the income statement when made, not when cash is received
- GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet
- Finally, we have to buy inventory to support sales although we haven’t collected cash yet

- Depreciation is a non-cash expense, but it has cash flow consequences because it affects taxes
- CCA is depreciation for tax purposes
- Each asset falls into a particular class, which has an assigned CCA rate
- Straight-line depreciation:
- D = (Initial cost – salvage) / number of years
- Very few assets are depreciated straight-line for tax purposes

- Declining Balance:
- Multiply CCA rate by the undepreciated capital cost (UCC)
- Half-year rule

Compute the CCA for $22,000 furniture (CCA Class 8) for the first six years

YearBeginning UCCCCAEnding UCC

1 $22,000 $2,200 $19,800

219,800 3,960 15,840

315,840 3,168 12,672

412,672 2,534 10,138

510,138 2,028 8,110

68,110 1,622 6,488

- When asset is sold, the UCC is reduced by the Adjusted Cost of Disposal
- Adjusted Cost of Disposal = Asset’s sale price or its original cost, whichever is less.

- An asset is sold but the asset class continues:
- If Adjusted Cost of Disposal > UCC, future CCA deductions will be reduced as the class continues.
- If Adjusted Cost of Disposal < UCC, future CCA deductions will be increased as the class continues

- An asset is sold and the asset class is terminated:
- If Adjusted Cost of Disposal > UCC, the company must pay tax on this difference, which is called a recapture
- If Adjusted Cost of Disposal < UCC, a terminal loss, which is equal to the remaining UCC, is deducted from income for that year.

- An asset used in a three-year project falls in CCA Class 10 for tax purposes. The asset has an acquisitions cost of $450,000 and will be sold for $120,000 at the end of the project. The tax rate is 34 percent. What is the aftertax cash flow for the sale if the asset class is terminated?

- First, we need to calculate the asset’s undepreciated capital cost (UCC) at the time of the sale:
YearBeginning UCCCCAEnding UCC

1 $450,000 $ 67,500 $382,500

2 382,500 114,750 267,750

3 267,750 80,325 187,425

- Terminal loss = $187,425 – 120,000 = $67,425
- Tax savings = $67,425 × .34 = $22,924.50
- Aftertax cash flow = $120,000 + 22,924.50 = $142,924.50

MMCC is considering a new line of power mulching tools. The new power mulcher will be priced at $120 per unit to start, and at $110 after three years. This project will last for 8 years and will require $20,000 investment in NWC at the start. Subsequently, total net working capital at the end of each year will be 15 percent of sales for that year. The variable cost per unit is $60, and fixed costs are $25,000 per year. The equipment, which falls in Class 8 with a CCA rate of 20%, will cost $800,000 and will be sold at 20% of its cost in eight years. The tax rate is 40% and the required return is 15%. Should MMCC proceed?

YearUnit PriceUnit SalesRevenues

1 $120 3,000 $360,000

2 120 5,000 600,000

- 3 120 6,000 720,000
- 4 110 6,500 715,000
- 5 110 6,000 660,000
- 6 110 5,000 550,000
- 7 110 4,000 440,000
- 8 110 3,000 330,000

YearBeginning UCCCCAEnding UCC

1 $800,000 $ 80,000 $720,000

2 720,000 144,000 576,000

- 3 576,000 115,200 460,800
- 4 460,800 92,160 368,640
- 5 368,640 73,728 294,912
- 6 294,912 58,982 235,930
- 7 235,930 47,186 188,744
- 8 188,744 37,749 150,995

Operating

YearEBIT + Depreciation – Taxes = Cash flow 0 $ 0 $ 0 $ 0 $ 0

175,00080,00030,000125,000

2131,000144,00052,400222,600

3219,800115,20087,920247,080

4207,84092,16083,136216,864

5201,27273,72880,509194,491

6166,01858,98266,407158,593

7127,81447,18651,126123,874

887,25137,74934,90190,099

YearRevenuesNWCCash Flow

- 0 $ 20,000 –$20,000
- 1 $360,000 54,000 – 34,000
- 2 600,000 90,000 – 36,000
- 3 720,000 108,000 – 18,000
- 4 715,000 107,250 750
- 5 660,000 99,000 8,250
- 6 550,000 82,500 16,500
- 7 440,000 66,000 16,500
- 8 330,000 49,500 66,000

OperatingProject

Year Cash flow– Ch. in NWC – Cap. Sp. = Cash flow 0 $ 0 –$ 20,000 –$800,000 –$820,000

1 125,000 – 34,000 91,000

2 222,600 – 36,000186,600

3 247,080 – 18,000229,080

4 216,864 750217,614

5 194,491 8,250202,741

6 158,593 16,500175,093

7 123,874 16,500140,374

8 90,099 66,000 160,000316,099

- Now that we have the cash flows, we can compute the NPV and IRR
- NPV = –$820,000 + 91,000/1.151 + 186,600/1.152 + 229,080/1.153 + 217,614/1.154 + 202,741/1.155 + 175,093/1.156 + 140,374/1.157 + 316,099/1.158 = $7,873
- IRR = 15.26%
- Should the company proceed with the project?

- OCF = (Sales – Costs) × (1 – Tc) + Depreciation × Tc
- where:
C = Cost of the asset

d= CCA rate

Tc = Corporate tax rate

k = Discount rate

S= Salvage value of the asset

n = number of years until the asset will be sold

= $158,976

- How do we determine if cash flows are relevant to the capital budgeting decision?
- How do we prepare pro forma financial statements and estimate project cash flows?
- Why is it important to consider changes in net working capital?
- What is the CCA tax shield?
- What are the two parts of the present value of the CCA tax shield equation?

- The NPV estimates are just that – estimates
- A positive NPV is a good start – now we need to take a closer look
- Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates? The more sensitive, the greater the forecasting risk
- Sources of value – why does this project create value?

- What happens to the NPV under different cash flow 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

- While best case and worst case are not necessarily probable, they can still be possible

- 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

- 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

- Beware “Paralysis of Analysis”
- At some point you have to make a decision
- If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project
- If 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 project

- Capital budgeting projects often provide other options that we have not yet considered
- Contingency planning
- Option to expand
- Option to abandon
- Option to wait
- Strategic options

- 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

- 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?
- What is the difference between hard rationing and soft rationing?

- The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project
- The project cash flows can be calculated as:
Project CF = OCF – Change in NWC – Cap. Spending

where OCF = EBIT + Depreciation – Taxes

- Change in NWC is important part of project cash flows because it adjusts for the discrepancy between accounting revenues and costs and cash revenues and costs.

- CCA is depreciation for tax purposes. The present value of CCA tax shield can be computed as:
- Forecasting risk arises from the possibility of errors in the projected cash flows
- Scenario and sensitivity analyses are useful tools for evaluating the impact of assumptions made about future cash flows and NPV estimates

- Projects frequently have future managerial options
- Capital rationing happens when a firm has profitable projects but cannot obtain the necessary financing