Making Capital Investment Decision

1. Making Capital Investment Decision RWJ-Chapter 10

2. Project Cash Flows: A First Look • A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project. • The relevant cash flows are called “incremental cash flows”. • Incremental cash flow: The difference between a firm’s future cash flows with a project and those without a project.

3. Incremental Cash Flows • Cash flows matter—not accounting earnings. • Sunk costs don’t matter. • Incremental cash flows matter. • Opportunity costs matter. • Side effects like cannibalism and erosion matter. • Taxes matter: we want incremental after-tax cash flows. Incremental CFs are changes in firm’s cash flows that occur as a direct consequence of accepting the project.

4. Cash Flows—Not Accounting Earnings. • Consider depreciation expense. • You never write a check made out to “depreciation”. • Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows. • Example: A company just paid $1 million for a building, as part of a new capital budgeting project. $1 million is a cash outflow. Assuming straight line depreciation for 20 years, only $50,000 is considered as accounting expense in the current year. Current earnings are reduced by $50,000; remaining 950,000 will be expensed over the following 19 years. For capital budgeting purposes, the relevant cash flow at date 0 is the full $1 million, not the reduction in earnings of $50,000.

5. Incremental Cash Flows • Sunk costs are not relevant • Costs that we have already paid or have already incurred the liability to pay. Such costs cannot be changed by the decision today to accept or reject the project. • Example: General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation the company had paid a consulting firm $100,000 to perform a test-marketing analysis. This expenditure was made last year. Is this cost relevant for capital budgeting decision? • No!! Once the company incurred the expense, the cost became irrelevant for any future decision (the consulting fee must be paid whether or not the company launches the new line).

6. Incremental Cash Flows • Opportunity costs do matter. If we are giving up a valuable alternative when we take a particular investment, we have to take that into consideration. • Example: Weinstein Company has an empty warehouse in Philadelphia that can be used to store a new line of electronic pinball machines. The company hopes to sell these machines to northeastern customers. Should the warehouse be considered a cost in the decision to sell the machines? • Yes!! The company could have sold the warehouse or rented it to an other company.

7. Incremental Cash Flows • Side effects matter. • Erosion or cannibalism is a bad thing. If our new product causes existing customers to demand less of current products, we need to recognize that. • Example: A car company, IMC, is determining the NPV of a new convertible sports car. Some of the customers who would purchase the car are the owners IMC’s compact sedan. Are all sales and profits from the new convertible incremental? What if the competitor launches a convertible car? • IMC is also contemplating the formation of a racing team. The team is forecasted to lose money but it is likely to generate publicity and increase cash flows elsewhere in the firm. Should the firm consider those cash flows in their decision?

8. Allocated Costs • Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects. • For example, project to open a Home Depot store might have total advertising expense allocated to it. • If the allocated cost is an incremental cost of the project, then it should be considered as cash outflow. So, one must ask the question: What is the difference between the cash flows of the entire firm with the project and the cash flows of the entire firm without the project? • If Home Depot’s advertising expenses will increase when the new store opens, then this is an incremental cash flow. Otherwise it is not.

9. Financing Costs • In analyzing a proposed investment, we will NOT include interest paid or any other financing costs such as dividends. • Firms are interested in the cash flow generated by the assets of the project. Therefore they typically calculate a project’s cash flows under the assumption that the project is financed only with equity. • Any adjustments for debt financing are reflected in the discount rate, not the cash flows.

10. Pro-Forma Financial Statements and Project Cash Flows • Cash Flows from Operations • Recall that: Operating Cash Flow = EBIT – Taxes + Depreciation • Net Capital Spending • Don’t forget salvage value (after tax, of course). • Changes in Net Working Capital • Increases in net working capital are viewed as cash outflows. • Decreases in net working capital are viewed as cash inflows.

11. Example- Pristine Urban-Tech Zither, Inc. (PUTZ) • Calculating Project NPV

12. Some Special Cases of Discounted Cash Flow Analysis • Evaluating cost-cutting proposals • Evaluating equipment options with different lives

13. Evaluating Cost-Cutting Proposals (1) • We are considering automating some part of an existing production process. The necessary equipment costs $80,000. • The automation will save $22,000 (before taxes). The equipment has 5 year life and is depreciated straight-line to zero over five years. The machine will be worth $20,000 in five years. Should we automate? • Relevant cash flows • Cost of the machine ($80,000) • After-tax salvage value (20,000 x (1-0.34) = $13,200) • Additional depreciation deduction

14. Evaluating Cost-Cutting Proposals (2) • Operating Cash Flow = EBIT – Taxes + Depreciation • EBIT= Sales- Costs-Depreciation • EBIT = $22,000 – $16,000 = $6,000 • Taxes = EBIT x Tax rate = $6,000 x 0.34 = $2,040 • OCF = $6,000 - $2,040 + $16,000 = $19,960 • Cost savings increase our pretax income by $22,000. We have to pay taxes on this amount , so our tax bill also increases.

15. Evaluating Cost-Cutting Proposals (3) NPV = $3,860 (so automate!!)

16. Investments of Unequal Lives: The Equivalent Annual Cost Method • There are times when application of the NPV rule can lead to the wrong decision. Consider a factory which must have an air cleaner. The equipment is mandated by law, so there is no “doing without”. • There are two choices: • The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years. • The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years. • Which one should we choose?

17. Cadillac Air Cleaner Cheapskate Air Cleaner CF0 CF0 CF1 CF1 F1 F1 I I NPV NPV EAC with a Calculator At first glance, the Cheapskate cleaner has a lower NPV –4,000 –1,000 –100 –500 10 5 10 10 –2,895.39 –4,614.46

18. Investments of Unequal Lives: The Equivalent Annual Cost Method • This overlooks the fact that the Cadillac cleaner lasts twice as long. • When we incorporate that, the Cadillac cleaner is actually cheaper.

19. -$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100 0 1 2 3 4 5 6 7 8 9 10 -$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500 0 1 2 3 4 5 6 7 8 9 10 Investments of Unequal Lives: The Equivalent Annual Cost Method The Cadillac cleaner time line of cash flows The Cheapskate cleaner time line of cash flows over ten years:

20. Cadillac Air Cleaner Cheapskate Air Cleaner CF0 CF1 F1 I NPV The Equivalent Annual Cost Method When we make a fair comparison, the Cadillac is cheaper: –4,000 CF0 –1,000 CF1 –500 –100 F1 4 10 CF2 –1,500 F1 1 10 I 10 CF3 –500 –4,614.46 NPV –4,693 F1 5

21. Investments of Unequal Lives • Replacement Chain (Common Life) Method • Repeat projects until they begin and end at the same time—like we just did with the air cleaners. • Compute NPV for the “repeated projects”. • The Equivalent Annual Cost Method

22. Investments of Unequal Lives: EAC The Equivalent Annual Cost Method • The Equivalent Annual Cost is the value of the level payment annuity that has the same PV as our original set of cash flows. • Costs should be stated in real terms. • NPV = EAC × ArT • Where ArTis the present value of $1 per period for T periods when the discount rate is r. • For example, the EAC for the Cadillac air cleaner is $750.98 • The EAC for the cheapstake air cleaner is $763.80 which confirms our earlier decision to reject it.

23. CF0 N CF1 I/Y F1 PV PV I PMT NPV FV Cadillac EAC with a Calculator Use the cash flow menu to find the PV of the “lumpy” cash flows. Then use the time value of money keys to find a payment with that present value. –4,000 10 –100 10 –4,614.46 10 10 750.98 –4,614.46

24. Summary and Conclusions • Capital budgeting must be placed on an incremental basis. • Sunk costs are ignored • Opportunity costs and side effects matter • When a firm must choose between two machines of unequal lives: • the firm can apply either the replacement chain (common life) approach or the equivalent annual cost approach.

25. The Human Factor in Capital Budgeting • Every project has a champion behind it. This creates a potential for an optimistic bias in estimating the numbers. Small adjustments to cash flow projections and the discount rates can sway a project’s NPV from negative to positive. • One way to control for this bias is to put the responsibility for analyzing an investment proposal under an authority independent from the individual or group proposing the investment. • Best financial analysts can not only provide the numbers to highlight the value of a good investment but can also explain why the investment makes sense.

26. How Do We Estimate Project Revenues And Expenses? • Experience and history • The process of estimating project revenues and expenses is simplest for firms that consider the same kind of projects repeatedly. (e.g. Home Depot has many stores and a rich database of how these stores did in the past). • Market testing • If the products and services being considered by the firm is catering to a different market, the company might not be able to use the experience from previous projects. Market surveys and market testing can be useful tools in these cases. (e.g. Home Depot opened 8 Expo stores in different parts of the country to test the concept) • Scenario analysis • There is considerable uncertainty introduced by external factors. A firm can consider different scenarios and revenues and expenses under each scenario. If probabilities are attached to each scenario, then they can be used to find the expected values of the project.