Bba 2204 fin mgt week 11 capital budget cashflow & risk

Capital Budgeting : Capital Budgeting : Cashflows & RiskCashflows & Risk

Capital Budgeting : Capital Budgeting : Cashflows & RiskCashflows & Risk

BBA 2204 FINANCIAL MANAGEMENTBBA 2204 FINANCIAL MANAGEMENT

bybyStephen OngStephen Ong

Visiting Fellow, Birmingham City Visiting Fellow, Birmingham City University Business School, UKUniversity Business School, UK

Visiting Professor, Shenzhen UniversityVisiting Professor, Shenzhen University

Today’s Overview Today’s Overview

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Learning GoalsLearning Goals1.1.Discuss the three major cash flow components. Discuss the three major cash flow components. 2.2.Discuss relevant cash flows, expansion versus Discuss relevant cash flows, expansion versus

replacement decisions, sunk costs and opportunity costs, replacement decisions, sunk costs and opportunity costs, and international capital budgeting.and international capital budgeting.

3.3.Calculate the initial investment associated with a Calculate the initial investment associated with a proposed capital expenditure.proposed capital expenditure.

4.4.Discuss the tax implications associated the sale of an old Discuss the tax implications associated the sale of an old asset.asset.

5.5.Find the relevant operating cash inflows associated with Find the relevant operating cash inflows associated with a proposed capital expenditure.a proposed capital expenditure.

6.6.Determine the terminal cash flow associated with a Determine the terminal cash flow associated with a proposed capital expenditure.proposed capital expenditure.

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Relevant Cash FlowsRelevant Cash FlowsTo evaluate investment opportunities, To evaluate investment opportunities,

financial managers must determine the financial managers must determine the relevant cash flowsrelevant cash flows——the incremental cash the incremental cash outflow (investment) and resulting outflow (investment) and resulting subsequent inflows associated with a subsequent inflows associated with a proposed capital expenditure.proposed capital expenditure.

Incremental cash flowsIncremental cash flows are the additional are the additional cash flowscash flows——outflows or inflowsoutflows or inflows——expected expected to result from a proposed capital to result from a proposed capital expenditure.expenditure.

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Focus on EthicsFocus on EthicsA Question of AccuracyA Question of Accuracy

Because estimates of the cash flows from an Because estimates of the cash flows from an investment project involve making assumptions about investment project involve making assumptions about the future, they may be subject to considerable error. the future, they may be subject to considerable error.

Taken as a whole, mergers and acquisitions in recent Taken as a whole, mergers and acquisitions in recent years have produced a disheartening years have produced a disheartening negative 12 negative 12 percent return on investment. percent return on investment.

Improvements in valuation techniques can be negated Improvements in valuation techniques can be negated when the process deteriorates into a game of when the process deteriorates into a game of tweaking the numbers to justify a deal the CEO wants tweaking the numbers to justify a deal the CEO wants to do, regardless of price. to do, regardless of price.

What would your options be when faced with the What would your options be when faced with the demands of an imperial CEO who expects you to demands of an imperial CEO who expects you to ““make it workmake it work””? Brainstorm several options.? Brainstorm several options.

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Relevant Cash Flows:Relevant Cash Flows:Major Cash Flow Major Cash Flow

ComponentsComponentsThe cash flows of any project may include The cash flows of any project may include three basic components: three basic components:

1.1. Initial investmentInitial investment: the relevant cash : the relevant cash outflow for a proposed project at time outflow for a proposed project at time zero.zero.

2.2. Operating cash inflowsOperating cash inflows: the incremental : the incremental after-tax cash inflows resulting from after-tax cash inflows resulting from implementation of a project during its life.implementation of a project during its life.

3.3. Terminal cash Terminal cash flowflow: the after-tax non-: the after-tax non-operating cash flow occurring in the final year operating cash flow occurring in the final year of a project. It is usually attributable to of a project. It is usually attributable to liquidation of the project.liquidation of the project.

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Figure 11.1 Cash Flow Figure 11.1 Cash Flow ComponentsComponents

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Relevant Cash Flows: Relevant Cash Flows: Expansion versus Expansion versus

Replacement DecisionsReplacement Decisions Developing relevant cash flow estimates is most straightforward in the case of expansion decisions.

In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflows associated with the proposed capital expenditure.

Identifying relevant cash flows for replacement decisions is more complicated, because the firm must identify the incremental cash outflow and inflows that would result from the proposed replacement.

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Figure 11.2 Relevant Cash Figure 11.2 Relevant Cash Flows for Replacement Flows for Replacement

DecisionsDecisions

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Relevant Cash Flows: Relevant Cash Flows: Sunk Costs and Sunk Costs and

Opportunity CostsOpportunity CostsSunk costs are cash outlays that have already been made (past outlays) and therefore have no effect on the cash flows relevant to a current decision.

Sunk costs should not be included in a project’s incremental cash flows.

Opportunity costs are cash flows that could be realized from the best alternative use of an owned asset.

Opportunity costs should be included as cash outflows when one is determining a project’s incremental cash flows.

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Relevant Cash Flows: Sunk Relevant Cash Flows: Sunk Costs and Opportunity Costs and Opportunity

Costs (cont.)Costs (cont.)Jankow Equipment is considering renewing its drill press X12, which it purchased 3 years earlier for $237,000, by retrofitting it with the computerized control system from an obsolete piece of equipment it owns. The obsolete equipment could be sold today for a high bid of $42,000, but without its computerized control system, it would be worth nothing.

The $237,000 cost of drill press X12 is a sunk cost because it represents an earlier cash outlay.

Although Jankow owns the obsolete piece of equipment, the proposed use of its computerized control system represents an opportunity cost of $42,000—the highest price at which it could be sold today.

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Relevant Cash Flows: Relevant Cash Flows: International Capital Budgeting International Capital Budgeting

and Long-Term Investmentsand Long-Term InvestmentsInternational capital budgeting differs from the domestic International capital budgeting differs from the domestic version because:version because:

1.1. Cash outflows and inflows occur in a foreign currencyCash outflows and inflows occur in a foreign currency Long-term currency risk can be minimized by financing the Long-term currency risk can be minimized by financing the

foreign investment at least partly in the local capital markets. foreign investment at least partly in the local capital markets. Likewise, the dollar value of short-term, local-currency cash flows Likewise, the dollar value of short-term, local-currency cash flows

can be protected by using special securities and strategies such as can be protected by using special securities and strategies such as futures, forwards, and options market instruments.futures, forwards, and options market instruments.

2.2. Foreign investments entail potentially significant political Foreign investments entail potentially significant political risk risk Political risks can be minimized by using both operating and Political risks can be minimized by using both operating and

financial strategies. financial strategies.

Foreign direct investmentForeign direct investment——the transfer of capital, the transfer of capital, managerial, and technical assets to a foreign countrymanagerial, and technical assets to a foreign country——has has surged in recent years.surged in recent years.

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Matter of FactMatter of FactFDI in the United States

In 2008 the United States was the world’s largest recipient of FDI, receiving more than $325.3 billion in FDI, a 37% increase from the previous year.

The $2.1 trillion worth of FDI in the United States at the end of 2008 is the equivalent of approximately 16 percent of U.S. gross domestic product (GDP).

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Global FocusGlobal Focus Changes May Influence Future Investments in ChinaChanges May Influence Future Investments in China

Foreign direct investment in China, not including Foreign direct investment in China, not including banks, insurance, and securities, amounted to $90 banks, insurance, and securities, amounted to $90 billion in 2009.billion in 2009.

China allows three types of foreign investments: China allows three types of foreign investments: 1.1. a a wholly foreign-owned enterprisewholly foreign-owned enterprise (WFOE) in which the firm (WFOE) in which the firm

is entirely funded with foreign capitalis entirely funded with foreign capital2.2. a a joint venturejoint venture in which the foreign partner must provide at in which the foreign partner must provide at

least 25 percent of initial capitalleast 25 percent of initial capital3.3. a a representative officerepresentative office (RO), the most common and easily (RO), the most common and easily

established entity, which cannot perform business activities established entity, which cannot perform business activities that directly result in profitsthat directly result in profits

Although China has been actively campaigning for Although China has been actively campaigning for foreign investment, how do you think having a foreign investment, how do you think having a communist government affects its foreign investment?communist government affects its foreign investment?

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Table 11.1 The Basic Table 11.1 The Basic Format for Determining Format for Determining

Initial InvestmentInitial Investment

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Finding the Initial Finding the Initial Investment: Investment:

Installed Cost of New Installed Cost of New AssetAssetThe cost of new asset is the net outflow

necessary to acquire a new asset.Installation costs are any added costs that

are necessary to place an asset into operation.

The installed cost of new asset is the cost of new asset plus its installation costs; equals the asset’s depreciable value.

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Finding the Initial Finding the Initial Investment: After-Tax Investment: After-Tax

Proceeds from Sale of Old Proceeds from Sale of Old AssetAsset The after-tax proceeds from sale of old asset are

the difference between the old asset’s sale proceeds and any applicable taxes or tax refunds related to its sale.

The proceeds from sale of old asset are the cash inflows, net of any removal or cleanup costs, resulting from the sale of an existing asset.

The tax on sale of old asset is the tax that depends on the relationship between the old asset’s sale price and book value, and on existing government tax rules.

Book value is the strict accounting value of an asset, calculated by subtracting its accumulated depreciation from its installed cost.

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Finding the Initial Investment: Finding the Initial Investment: After-Tax Proceeds from Sale of After-Tax Proceeds from Sale of

Old Asset (cont.)Old Asset (cont.) Hudson Industries, a small electronics company, 2 Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed years ago acquired a machine tool with an installed cost of $100,000. cost of $100,000.

Under MACRS for a 5-year recovery period, 20% Under MACRS for a 5-year recovery period, 20% and 32% of the installed cost would be depreciated and 32% of the installed cost would be depreciated in years 1 and 2, respectively. in years 1 and 2, respectively.

In other words, 52% (20% + 32%) of the $100,000 In other words, 52% (20% + 32%) of the $100,000 cost, or $52,000 (0.52 cost, or $52,000 (0.52 $100,000), would represent $100,000), would represent the accumulated depreciation at the end of year 2.the accumulated depreciation at the end of year 2.

The book value of HudsonThe book value of Hudson’’s asset at the end of year s asset at the end of year 2 is therefore $100,000 2 is therefore $100,000 –– $52,000 = $48,000. $52,000 = $48,000.

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Table 11.2 Tax Treatment Table 11.2 Tax Treatment on Sale of Assetson Sale of Assets

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Figure 11.3 Taxable Figure 11.3 Taxable Income from Sale of AssetIncome from Sale of Asset

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Finding the Initial Investment: Finding the Initial Investment: After-Tax Proceeds from Sale of After-Tax Proceeds from Sale of

Old Asset (cont.)Old Asset (cont.) If Hudson sells the old asset for $110,000, it realizes a If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 gain of $62,000 ($110,000 –– $48,000). $48,000). This gain is made up of two partsThis gain is made up of two parts——a capital gain and a capital gain and

recaptured depreciation,recaptured depreciation, which is the portion of an asset which is the portion of an asset’’s s sale price that is above book value and below its initial sale price that is above book value and below its initial purchase price.purchase price.

The capital gain is $10,000 ($110,000 sale price The capital gain is $10,000 ($110,000 sale price –– $100,000 initial purchase price); recaptured $100,000 initial purchase price); recaptured depreciation is $52,000 (the $100,000 initial purchase depreciation is $52,000 (the $100,000 initial purchase price price –– $48,000 book value). $48,000 book value).

The total gain above book value of $62,000 is taxed as The total gain above book value of $62,000 is taxed as ordinary income at the 40% rate, resulting in taxes of ordinary income at the 40% rate, resulting in taxes of $24,800 (0.40 $24,800 (0.40 $62,000). $62,000).

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Finding the Initial Investment: Finding the Initial Investment: After-Tax Proceeds from Sale After-Tax Proceeds from Sale

of Old Asset (cont.)of Old Asset (cont.)If the asset is sold for $48,000, If the asset is sold for $48,000, its book value, the firm breaks its book value, the firm breaks even. even.

Because no tax results from Because no tax results from selling an asset for its book selling an asset for its book value, there is no tax effect on value, there is no tax effect on the initial investment in the the initial investment in the new asset.new asset.

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Finding the Initial Finding the Initial Investment: After-Tax Investment: After-Tax

Proceeds from Sale of Old Proceeds from Sale of Old AssetAsset If Hudson sells the asset for $30,000, it experiences a If Hudson sells the asset for $30,000, it experiences a

loss of $18,000 ($48,000 loss of $18,000 ($48,000 –– $30,000). $30,000). If this is a depreciable asset used in the business, the If this is a depreciable asset used in the business, the

firm may use the loss to offset ordinary operating firm may use the loss to offset ordinary operating income. income.

If the asset is not depreciable or is not used in the If the asset is not depreciable or is not used in the business, the firm can use the loss only to offset capital business, the firm can use the loss only to offset capital gains. gains.

In either case, the loss will save the firm $7,200 (0.40 In either case, the loss will save the firm $7,200 (0.40 $18,000) in taxes. $18,000) in taxes.

If current operating earnings or capital gains are not If current operating earnings or capital gains are not sufficient to offset the loss, the firm may be able to sufficient to offset the loss, the firm may be able to apply these losses to prior or future yearsapply these losses to prior or future years ’’ taxes. taxes.

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Change in Net Working Change in Net Working CapitalCapital Net working capitalcapital is the amount by which a

firm’s current assets exceed its current liabilities. The change in net working capital is the

difference between a change in current assets and a change in current liabilities. Generally, current assets increase by more than

current liabilities, resulting in an increased investment in net working capital. This increased investment is treated as an initial outflow.

If the change in net working capital were negative, it would be shown as an initial inflow.

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Table 11.3 Calculation of Net Table 11.3 Calculation of Net Working Capital for Danson Working Capital for Danson

CompanyCompany

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Calculating the Initial Calculating the Initial InvestmentInvestmentPowell Corporation is trying to determine the initial Powell Corporation is trying to determine the initial

investment required to replace an old machine with a new, investment required to replace an old machine with a new, more sophisticated model. The proposed machinemore sophisticated model. The proposed machine ’’s purchase s purchase price is $380,000, and an additional $20,000 will be necessary price is $380,000, and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-to install it. It will be depreciated under MACRS using a 5-year recovery period. The present (old) machine was year recovery period. The present (old) machine was purchased 3 years ago at a cost of $240,000 and was being purchased 3 years ago at a cost of $240,000 and was being depreciated under MACRS using a 5-year recovery period. depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the The firm has found a buyer willing to pay $280,000 for the present machine and to remove it at the buyerpresent machine and to remove it at the buyer ’’s expense. The s expense. The firm expects that a $35,000 increase in current assets and an firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the $18,000 increase in current liabilities will accompany the replacement. The firm pays taxes at a rate of 40%.replacement. The firm pays taxes at a rate of 40%.

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Finding the Initial Investment: Finding the Initial Investment: Calculating the Initial Calculating the Initial

Investment (cont.)Investment (cont.)

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Finding the Operating Finding the Operating Cash InflowsCash Inflows

Benefits expected to result from proposed capital expenditures must be measured on an after-tax basis, because the firm will not have the use of any benefits until it has satisfied the government’s tax claims.

All benefits expected from a proposed project must be measured on a cash flow basis. Cash inflows represent dollars that can be spent, not

merely “accounting profits.” The basic calculation for converting after-tax net profits

into operating cash inflows requires adding depreciation and any other noncash charges (amortization and depletion) deducted as expenses on the firm’s income statement back to net profits after taxes.

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Finding the Operating Finding the Operating Cash Inflows (cont.)Cash Inflows (cont.)

The final step in estimating the operating cash inflows for a proposed replacement project is to calculate the incremental (relevant) cash inflows.

Incremental operating cash inflows are needed because our concern is only with the change in operating cash inflows that result from the proposed project.

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Table 11.4 Powell Corporation’s Table 11.4 Powell Corporation’s Revenue and Expenses for Proposed Revenue and Expenses for Proposed

and Present Machinesand Present Machines

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Table 11.5a Depreciation Expense Table 11.5a Depreciation Expense for Proposed and Present Machines for Proposed and Present Machines

for Powell Corporationfor Powell Corporation

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Table 11.5b Depreciation Expense Table 11.5b Depreciation Expense for Proposed and Present Machines for Proposed and Present Machines

for Powell Corporationfor Powell Corporation

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Table 11.6 Calculation of Operating Table 11.6 Calculation of Operating Cash Inflows Using the Income Cash Inflows Using the Income

Statement FormatStatement Format

Table 11.7a Calculation of Operating Cash Table 11.7a Calculation of Operating Cash Inflows for Powell Corporation’s Proposed Inflows for Powell Corporation’s Proposed


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Table 11.7b Calculation of Operating Cash Table 11.7b Calculation of Operating Cash Inflows for Powell Corporation’s Proposed Inflows for Powell Corporation’s Proposed


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Table 11.8 Incremental (Relevant) Table 11.8 Incremental (Relevant) Operating Cash Inflows for Powell Operating Cash Inflows for Powell

CorporationCorporation

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Finding the Terminal Finding the Terminal Cash FlowCash Flow

Terminal cash flow is the cash flow resulting from termination and liquidation of a project at the end of its economic life.

It represents the after-tax cash flow, exclusive of operating cash inflows, that occurs in the final year of the project.

The proceeds from sale of the new and the old asset, often called “salvage value,” represent the amount net of any removal or cleanup costs expected upon termination of the project. If the net proceeds from the sale are expected to exceed book value, a

tax payment shown as an outflow (deduction from sale proceeds) will occur.

When the net proceeds from the sale are less than book value, a tax rebate shown as a cash inflow (addition to sale proceeds) will result.

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Finding the Terminal Cash Flow (cont.)

When we calculate the terminal cash flow, the change in net working capital represents the reversion of any initial net working capital investment.

Most often, this will show up as a cash inflow due to the reduction in net working capital; with termination of the project, the need for the increased net working capital investment is assumed to end.

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Finding the Terminal Finding the Terminal Cash Flow (cont.)Cash Flow (cont.)

Powell Corporation expects to be able to liquidate the new machine at the end of its 5-year usable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. The firm pays taxes at a rate of 40%.

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Finding the Terminal Finding the Terminal Cash Flow (cont.)Cash Flow (cont.)

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Table 11.9 The Basic Table 11.9 The Basic Format for Determining Format for Determining

Terminal Cash FlowTerminal Cash Flow

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Summarizing the Summarizing the Relevant Cash FlowsRelevant Cash Flows

The initial investment, operating cash The initial investment, operating cash inflows, and terminal cash flow together inflows, and terminal cash flow together represent a projectrepresent a project’’s relevant cash flows. s relevant cash flows.

These cash flows can be viewed as the These cash flows can be viewed as the incremental incremental after-tax cash flows after-tax cash flows attributable to the proposed project. attributable to the proposed project.

They represent, in a cash flow sense, how They represent, in a cash flow sense, how much better or worse off the firm will be if much better or worse off the firm will be if it chooses to implement the proposal.it chooses to implement the proposal.

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Summarizing the Summarizing the Relevant Cash Flows Relevant Cash Flows

(cont.)(cont.)Time line for Powell Corporation’s relevant cash flows with the proposed machine

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Personal Finance Personal Finance ExampleExample

Tina Talor is contemplating the purchase of a new car. Tina Talor is contemplating the purchase of a new car. TinaTina’’s cash flow estimates for the car purchase are as s cash flow estimates for the car purchase are as follows.follows.

Negotiated price of new carNegotiated price of new car $23,500$23,500 Taxes and fees on new car purchaseTaxes and fees on new car purchase $1,650$1,650 Proceeds from trade-in of old carProceeds from trade-in of old car $9,750$9,750 Estimated value of new car in 3 yearsEstimated value of new car in 3 years

$10,500$10,500 Estimated value of old car in 3 yearsEstimated value of old car in 3 years $5,700$5,700 Estimated annual repair costs on new carEstimated annual repair costs on new car 0 (in 0 (in

warranty)warranty) Estimated annual repair costs on old carEstimated annual repair costs on old car $400$400

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Personal Finance Personal Finance Example (cont.)Example (cont.)

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Review of Learning GoalsReview of Learning Goals Discuss the three major cash flow Discuss the three major cash flow

components. components. The three major cash flow components of

any project can include: (1) an initial investment, (2) operating cash inflows, and (3) terminal cash flow. The initial investment occurs at time zero, the operating cash inflows occur during the project life, and the terminal cash flow occurs at the end of the project.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Discuss relevant cash flows, expansion versus Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity replacement decisions, sunk costs and opportunity costs, and international capital budgeting. costs, and international capital budgeting. The relevant cash flows for capital budgeting decisions

are the initial investment, the operating cash inflows, and the terminal cash flow. For replacement decisions, these flows are the difference between the cash flows of the new asset and the old asset. Expansion decisions are viewed as replacement decisions in which all cash flows from the old asset are zero. When estimating relevant cash flows, ignore sunk costs and include opportunity costs as cash outflows. In international capital budgeting, currency risks and political risks can be minimized through careful planning.

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Review of Learning Goals (cont.) Calculate the initial investment associated with a Calculate the initial investment associated with a

proposed capital expenditure. proposed capital expenditure. The initial investment is the initial outflow required,

taking into account the installed cost of the new asset, the after-tax proceeds from the sale of the old asset, and any change in net working capital. The initial investment is reduced by finding the after-tax proceeds from sale of the old asset. The book value of an asset is used to determine the taxes owed as a result of its sale. The change in net working capital is the difference between the change in current assets and the change in current liabilities expected to accompany a given capital expenditure.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.) Discuss the tax implications associated the Discuss the tax implications associated the

sale of an old asset.sale of an old asset. There is typically a tax implication from the sale

of an old asset. The tax implication depends on the relationship between its sale price and book value, and on existing government tax rules. Generally, if the old asset is sold for an amount greater than its book value then the difference is subject to a capital gains tax and if the old asset is sold for an amount less than its book value then the company is entitled to tax deduction equal to the difference.

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Find the relevant operating cash inflows associated Find the relevant operating cash inflows associated with a proposed capital expenditure.with a proposed capital expenditure. The operating cash inflows are the incremental after-tax

cash inflows expected to result from a project. The income statement format involves adding depreciation back to net operating profit after taxes and gives the operating cash inflows, which are the same as operating cash flows (OCF), associated with the proposed and present projects. The relevant (incremental) cash in-flows for a replacement project are the difference between the operating cash inflows of the proposed project and those of the present project.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.) Determine the terminal cash flow Determine the terminal cash flow associatedassociated

with a proposed capital expenditure.with a proposed capital expenditure. The terminal cash flow represents the after-

tax cash flow (exclusive of operating cash inflows) that is expected from liquidation of a project. It is calculated for replacement projects by finding the difference between the after-tax proceeds from sale of the new and the old asset at termination and then adjusting this difference for any change in net working capital.

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Risk and Refinements in Risk and Refinements in Capital BudgetingCapital Budgeting

1.Understand the importance of recognizing risk in the analysis of capital budgeting projects.

2.Discuss risk and cash inflows, scenario analysis, and simulation as behavioral approaches for dealing with risk.

3.Review the unique risks that multinational companies face.4.Describe the determination and use of risk-adjusted discount

rates (RADRs), portfolio effects, and the practical aspects of RADRs.

5.Select the best of a group of unequal-lived, mutually exclusive projects using annualized net present values (ANPVs).

6.Explain the role of real options and the objective and procedures for selecting projects under capital rationing.

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Introduction to Risk in Introduction to Risk in Capital BudgetingCapital Budgeting

Thus far, we have assumed that all investment projects have the same level of risk as the firm.

In other words, we assumed that all projects are equally risky, and the acceptance of any project would not change the firm’s overall risk.

In actuality, these situations are rare—projects are not equally risky, and the acceptance of a project can affect the firm’s overall risk.

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Table 12.1 Cash Flows and Table 12.1 Cash Flows and NPVs for Bennett NPVs for Bennett

Company’s ProjectsCompany’s Projects

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Behavioural Approaches for Behavioural Approaches for Dealing with Risk: Risk and Dealing with Risk: Risk and

Cash InflowsCash Inflows Behavioural approaches can be used to get a “feel” for the level of project risk, whereas other approaches try to quantify and measure project risk.

Risk (in capital budgeting) refers to the uncertainty surrounding the cash flows that a project will generate or, more formally, the degree of variability of cash flows.

In many projects, risk stems almost entirely from the cash flows that a project will generate several years in the future, because the initial investment is generally known with relative certainty.

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Behavioural Approaches for Behavioural Approaches for Dealing with Risk: Risk and Cash Dealing with Risk: Risk and Cash

Inflows (cont.)Inflows (cont.)Treadwell Tire Company, a tire retailer with a Treadwell Tire Company, a tire retailer with a 10% cost of capital, is considering investing in 10% cost of capital, is considering investing in either of two mutually exclusive projects, A and either of two mutually exclusive projects, A and B. Each requires a $10,000 initial investment, and B. Each requires a $10,000 initial investment, and both are expected to provide constant annual cash both are expected to provide constant annual cash inflows over their 15-year lives. For either project inflows over their 15-year lives. For either project to be acceptable its NPV must be greater than to be acceptable its NPV must be greater than zero.zero.

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Behavioural Approaches for Behavioural Approaches for Dealing with Risk: Risk and Dealing with Risk: Risk and

Cash Inflows (cont.)Cash Inflows (cont.)

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Behavioural Approaches Behavioural Approaches for Dealing with Risk: for Dealing with Risk:

Scenario AnalysisScenario Analysis Scenario analysis is a behavioural approach that uses several possible alternative outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV.

In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.

The range can be determined by subtracting the pessimistic-outcome NPV from the optimistic-outcome NPV.

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Table 12.2 Scenario Table 12.2 Scenario Analysis of Treadwell’s Analysis of Treadwell’s

Projects A and BProjects A and B

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Behavioural Approaches Behavioural Approaches for Dealing with Risk: for Dealing with Risk:

SimulationSimulationSimulationSimulation is a statistics-based is a statistics-based behavioral approach that behavioral approach that applies predetermined applies predetermined probability distributions and probability distributions and random numbers to estimate random numbers to estimate risky outcomes.risky outcomes.

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Figure 12.1 NPV Figure 12.1 NPV SimulationSimulation

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Focus on PracticeFocus on PracticeThe Monte Carlo Method: The Forecast Is for Less The Monte Carlo Method: The Forecast Is for Less

UncertaintyUncertainty To combat uncertainty in the decision-making process, some To combat uncertainty in the decision-making process, some

companies use a Monte Carlo simulation program to model companies use a Monte Carlo simulation program to model possible outcomes.possible outcomes.

A Monte Carlo simulation program randomly generates values A Monte Carlo simulation program randomly generates values for uncertain variables over and over to simulate a model. for uncertain variables over and over to simulate a model.

The simulation then requires project practitioners to develop low, The simulation then requires project practitioners to develop low, high, and most likely cost estimates along with correlation high, and most likely cost estimates along with correlation coefficients. coefficients.

One of the problems with using a Monte Carlo program is the One of the problems with using a Monte Carlo program is the difficulty of establishing the correct input ranges for the variables difficulty of establishing the correct input ranges for the variables and determining the correlation coefficients for those variables.and determining the correlation coefficients for those variables.

A Monte Carlo simulation program requires the user to first build A Monte Carlo simulation program requires the user to first build an Excel spreadsheet model that captures the input variables for an Excel spreadsheet model that captures the input variables for the proposed project. What issues and what benefits can the user the proposed project. What issues and what benefits can the user derive from this process?derive from this process?

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International Risk International Risk ConsiderationsConsiderations Exchange rate risk Exchange rate risk is the danger that an is the danger that an

unexpected change in the exchange rate unexpected change in the exchange rate between the dollar and the currency in which a between the dollar and the currency in which a projectproject’’s cash flows are denominated will s cash flows are denominated will reduce the market value of that projectreduce the market value of that project ’’s cash s cash flow.flow.

In the short term, much of this risk can be In the short term, much of this risk can be hedged by using financial instruments such as hedged by using financial instruments such as foreign currency futures and options.foreign currency futures and options.

Long-term exchange rate risk can best be Long-term exchange rate risk can best be minimized by financing the project in whole or minimized by financing the project in whole or in part in the local currency.in part in the local currency.

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Matter of FactMatter of Fact

A 2001 survey of Chief Financial A 2001 survey of Chief Financial Officers (CFOs) found that more Officers (CFOs) found that more than than 40%40% of the CFOs felt that it of the CFOs felt that it was important to adjust an was important to adjust an investment projectinvestment project’’s cash flows or s cash flows or discount rates to account for discount rates to account for foreign exchange risk.foreign exchange risk.

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International Risk International Risk Considerations (cont.)Considerations (cont.)

Political risk Political risk is much harder to protect against. Firms is much harder to protect against. Firms that make investments abroad may find that the host-that make investments abroad may find that the host-country government can limit the firmcountry government can limit the firm ’’s ability to return s ability to return profits back home. Governments can seize the firmprofits back home. Governments can seize the firm ’’s s assets, or otherwise interfere with a projectassets, or otherwise interfere with a project ’’s operation. s operation.

The difficulties of managing political risk after the fact The difficulties of managing political risk after the fact make it even more important that managers account for make it even more important that managers account for political risks before making an investment. political risks before making an investment.

They can do so either by adjusting a projectThey can do so either by adjusting a project ’’s expected s expected cash inflows to account for the probability of political cash inflows to account for the probability of political interference or by using risk-adjusted discount rates in interference or by using risk-adjusted discount rates in capital budgeting formulas.capital budgeting formulas.

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International Risk International Risk Considerations (cont.)Considerations (cont.)

Other special issues relevant for Other special issues relevant for international capital budgeting international capital budgeting include:include:TaxesTaxesTransfer pricingTransfer pricingStrategic, rather than financial, Strategic, rather than financial,

considerationsconsiderations

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Risk-Adjusted Discount Risk-Adjusted Discount RatesRates

Risk-adjusted discount rates (RADR) are rates of return that must be earned on a given project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s share price.

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Personal Finance Personal Finance ExampleExample

Talor Namtig is considering investing $1,000 in Talor Namtig is considering investing $1,000 in either of two stockseither of two stocks——A or B. She plans to hold A or B. She plans to hold the stock for exactly 5 years and expects both the stock for exactly 5 years and expects both stocks to pay $80 in annual end-of-year cash stocks to pay $80 in annual end-of-year cash dividends. At the end of the year 5 she estimates dividends. At the end of the year 5 she estimates that stock A can be sold to net $1,200 and stock B that stock A can be sold to net $1,200 and stock B can be sold to net $1,500. Her research indicates can be sold to net $1,500. Her research indicates that she should earn an annual return on an that she should earn an annual return on an average risk stock of 11%. Because stock B is average risk stock of 11%. Because stock B is considerably riskier, she will require a 14% return considerably riskier, she will require a 14% return from it. Talor makes the following calculations to from it. Talor makes the following calculations to find the risk-adjusted net present values (NPVs) find the risk-adjusted net present values (NPVs) for the two stocks:for the two stocks:

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Although TalorAlthough Talor’’s calculations indicate that both s calculations indicate that both stock investments are acceptable (NPVs > $0), stock investments are acceptable (NPVs > $0), on a risk-adjusted basis, she should invest in on a risk-adjusted basis, she should invest in Stock B because it has a higher NPV.Stock B because it has a higher NPV.

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Risk-Adjusted Discount Risk-Adjusted Discount Rates: Rates:

Review of CAPMReview of CAPMUsing beta, Using beta, bbjj,, to measure the relevant risk of any to measure the relevant risk of any

asset asset j,j, the CAPM is the CAPM is

rrjj = = RRFF + [ + [bbjj ( (rrmm –– RRFF)])]

wherewhere

rrjj == required return on asset required return on asset jj

RRFF == risk-free rate of returnrisk-free rate of return

bbjj == beta coefficient for asset beta coefficient for asset jj

rrmm == return on the market portfolio of return on the market portfolio of assetsassets

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Figure 12.2 CAPM and Figure 12.2 CAPM and SMLSML

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Using CAPM to Find RADRs Using CAPM to Find RADRs (cont.)(cont.)Figure 12.2 shows two projects, L and R. Figure 12.2 shows two projects, L and R.

Project L has a beta, Project L has a beta, bbLL,, and generates an internal rate of and generates an internal rate of return, IRRreturn, IRRLL.. The required return for a project with risk The required return for a project with risk bbLL is is rrLL.. Because project L generates a return greater than that required Because project L generates a return greater than that required

(IRR(IRRLL > > rrLL), project L is acceptable. ), project L is acceptable. Project L will have a positive NPV when its cash inflows are Project L will have a positive NPV when its cash inflows are

discounted at its required return, discounted at its required return, rrLL.. Project R, on the other hand, generates an IRR below Project R, on the other hand, generates an IRR below

that required for its risk, that required for its risk, bbRR (IRR (IRRRR < < rrRR). ). This project will have a negative NPV when its cash inflows This project will have a negative NPV when its cash inflows

are discounted at its required return, are discounted at its required return, rrRR.. Project R should be rejected.Project R should be rejected.

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Focus on EthicsFocus on EthicsEthics and the Cost of CapitalEthics and the Cost of Capital

On April 20, 2010 the Deepwater Horizon, an offshore On April 20, 2010 the Deepwater Horizon, an offshore drilling rig operated by Transocean Ltd. on behalf of BP, drilling rig operated by Transocean Ltd. on behalf of BP, exploded and eventually sank in the Gulf of Mexico, exploded and eventually sank in the Gulf of Mexico, killing 11 people.killing 11 people.

To make matters worse, oil began spewing into the Gulf. To make matters worse, oil began spewing into the Gulf. By June 2010, BPBy June 2010, BP’’s stock price was 50% below pre-crisis s stock price was 50% below pre-crisis

levels and the companylevels and the company’’s bonds traded at levels s bonds traded at levels comparable to junk rated companies. comparable to junk rated companies.

Is the ultimate goal of the firm, to maximize the wealth of Is the ultimate goal of the firm, to maximize the wealth of the owners for whom the firm is being operated, ethical?the owners for whom the firm is being operated, ethical?

Why might ethical companies benefit from a lower cost Why might ethical companies benefit from a lower cost of capital than less ethical companies?of capital than less ethical companies?

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Applying RADRsApplying RADRsBennett Company wishes to apply the Risk-Bennett Company wishes to apply the Risk-Adjusted Discount Rate (RADR) approach to Adjusted Discount Rate (RADR) approach to determine whether to implement Project A or B. determine whether to implement Project A or B. In addition to the data presented earlier, In addition to the data presented earlier, BennettBennett’’s management assigned a s management assigned a ““risk indexrisk index”” of of 1.6 to project A and 1.0 to project B as indicated 1.6 to project A and 1.0 to project B as indicated in the following table. The required rates of in the following table. The required rates of return associated with these indexes are then return associated with these indexes are then applied as the discount rates to the two projects applied as the discount rates to the two projects to determine NPV.to determine NPV.

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Applying RADRs (cont.)Applying RADRs (cont.)

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Figure 12.3a Calculation of NPVs for Figure 12.3a Calculation of NPVs for Bennett Company’s Capital Expenditure Bennett Company’s Capital Expenditure

Alternatives Using RADRsAlternatives Using RADRs

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Figure 12.3b Calculation of NPVs for Figure 12.3b Calculation of NPVs for Bennett Company’s Capital Expenditure Bennett Company’s Capital Expenditure

Alternatives Using RADRsAlternatives Using RADRs

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Project A Project B

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Portfolio EffectsPortfolio Effects As noted earlier, individual investors must hold diversified portfolios because they are not rewarded for assuming diversifiable risk.

Because business firms can be viewed as portfolios of assets, it would seem that it is also important that they too hold diversified portfolios.

Surprisingly, however, empirical evidence suggests that firm value is not affected by diversification.

In other words, diversification is not normally rewarded and therefore is generally not necessary.

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Portfolio Effects (cont.)Portfolio Effects (cont.)It turns out that firms are not rewarded for diversification because investors can do so themselves.

An investor can diversify more readily, easily, and costlessly simply by holding portfolios of stocks.

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Table 12.3 Bennett Table 12.3 Bennett Company’s Risk Classes Company’s Risk Classes

and RADRsand RADRs

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RADRs in Practice (cont.)RADRs in Practice (cont.)Assume that the management of Bennett Company decided Assume that the management of Bennett Company decided to use risk classes to analyze projects and so placed each to use risk classes to analyze projects and so placed each project in one of four risk classes according to its perceived project in one of four risk classes according to its perceived risk. The classes ranged from I for the lowest-risk projects risk. The classes ranged from I for the lowest-risk projects to IV for the highest-risk projects. to IV for the highest-risk projects.

The financial manager of Bennett has assigned project A to class III and project B to class II. The cash flows for project A would be evaluated using a 14% RADR, and project B’s would be evaluated using a 10% RADR. The NPV of project A at 14% was calculated in Figure 12.3 to be $6,063, and the NPV for project B at a 10% RADR was shown in Table 12.1 to be $10,924.

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Capital Budgeting Capital Budgeting Refinements: Comparing Refinements: Comparing

Projects With Unequal LivesProjects With Unequal LivesThe financial manager must often select the

best of a group of unequal-lived projects. If the projects are independent, the length

of the project lives is not critical. But when unequal-lived projects are

mutually exclusive, the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

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Capital Budgeting Refinements: Capital Budgeting Refinements: Comparing Projects With Unequal Comparing Projects With Unequal

Lives (cont.)Lives (cont.)The AT Company, a regional cable-TV firm, is evaluating two projects, X and Y. The projects’ cash flows and resulting NPVs at a cost of capital of 10% is given below.

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Capital Budgeting Refinements: Capital Budgeting Refinements: Comparing Projects With Comparing Projects With

Unequal Lives (cont.)Unequal Lives (cont.)Project X Project Y

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Unequal Lives (cont.)Unequal Lives (cont.)

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Lives (cont.)Lives (cont.)Ignoring the difference in their useful lives, both projects are acceptable (have positive NPVs). Furthermore, if the projects were mutually exclusive, project Y would be preferred over project X. However, it is important to recognize that at the end of its 3 year life, project Y must be replaced, or renewed.

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Unequal Lives (cont.)Unequal Lives (cont.)The annualized net present value (ANPV) approach is an approach to evaluating unequal-lived projects that converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount (in NPV terms).

Step 1 Calculate the net present value of each project j, NPVj, over its life, nj, using the appropriate cost of capital, r.

Step 2 Convert the NPVj into an annuity having life nj. That is, find an annuity that has the same life and the same NPV as the project.

Step 3 Select the project that has the highest ANPV.

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Unequal Lives (cont.)Unequal Lives (cont.)By using the AT Company data presented By using the AT Company data presented earlier for projects X and Y, we can apply the earlier for projects X and Y, we can apply the three-step ANPV approach as follows:three-step ANPV approach as follows:

Step 1Step 1 The net present values of projects X and Y The net present values of projects X and Y discounted at 10%discounted at 10%——as calculated in the as calculated in the preceding example for a single purchase of preceding example for a single purchase of each asseteach asset——areare

NPVNPVXX = $11,277.24 (table value = $11,248) = $11,277.24 (table value = $11,248)

NPVNPVYY = $19,013.27 (table value = $18,985) = $19,013.27 (table value = $18,985)

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Unequal Lives (cont.)Unequal Lives (cont.)Step 2 Step 2 In this step, we want to convert the In this step, we want to convert the NPVs from Step 1 into annuities. For NPVs from Step 1 into annuities. For project X, we are trying to find the project X, we are trying to find the answer to the question, what 3-year answer to the question, what 3-year annuity (equal to the life of project X) annuity (equal to the life of project X) has a present value of $11,248 (the has a present value of $11,248 (the NPV of project X)? Likewise, for NPV of project X)? Likewise, for project Y we want to know what 6-year project Y we want to know what 6-year annuity has a present value of $18,985. annuity has a present value of $18,985. Once we have these values, we can Once we have these values, we can determine which project, X or Y, determine which project, X or Y, delivers a higher annual cash flow on a delivers a higher annual cash flow on a present value basis.present value basis.

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Lives (cont.)Lives (cont.)

Project XProject X Project YProject Y

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Unequal Lives (cont.)Unequal Lives (cont.)

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Lives (cont.)Lives (cont.)Step 3Step 3 Reviewing the ANPVs calculated Reviewing the ANPVs calculated

in Step 2, we can see that project X in Step 2, we can see that project X would be preferred over project Y. would be preferred over project Y. Given that projects X and Y are Given that projects X and Y are mutually exclusive, project X mutually exclusive, project X would be the recommended project would be the recommended project because it provides the higher because it provides the higher annualized net present value.annualized net present value.

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Recognizing Real Recognizing Real OptionsOptions

Real options Real options are opportunities that are embedded in are opportunities that are embedded in capital projects that enable managers to alter their cash capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability flows and risk in a way that affects project acceptability (NPV). (NPV).

Also called strategic options.Also called strategic options.

By explicitly recognizing these options when making By explicitly recognizing these options when making capital budgeting decisions, managers can make capital budgeting decisions, managers can make improved, more strategic decisions that consider in improved, more strategic decisions that consider in advance the economic impact of certain contingent actions advance the economic impact of certain contingent actions on project cash flow and risk. on project cash flow and risk.

NPVNPVstrategicstrategic = NPV = NPVtraditionaltraditional + Value of real options + Value of real options

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Table 12.4 Major Types of Table 12.4 Major Types of Real OptionsReal Options

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Recognizing Real Recognizing Real Options (cont.)Options (cont.)

Assume that a strategic analysis of Bennett Assume that a strategic analysis of Bennett CompanyCompany’’s projects A and B finds no real s projects A and B finds no real options embedded in Project A but two real options embedded in Project A but two real options embedded in B: options embedded in B:

1.1. During itDuring it’’s first two years, B would have s first two years, B would have downtime that results in unused production downtime that results in unused production capacity that could be used to perform capacity that could be used to perform contract manufacturing;contract manufacturing;

2.2. Project BProject B’’s computerized control system s computerized control system could control two other machines, thereby could control two other machines, thereby reducing labor costs.reducing labor costs.

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BennettBennett’’s management estimated the NPV of the contract s management estimated the NPV of the contract manufacturing over the two years following manufacturing over the two years following implementation of project B to be $1,500 and the NPV of implementation of project B to be $1,500 and the NPV of the computer control sharing to be $2,000. Management the computer control sharing to be $2,000. Management felt there was a 60% chance that the contract felt there was a 60% chance that the contract manufacturing option would be exercised and only a 30% manufacturing option would be exercised and only a 30% chance that the computer control sharing option would be chance that the computer control sharing option would be exercised. The combined value of these two real options exercised. The combined value of these two real options would be the sum of their expected values.would be the sum of their expected values.

Value of real options for project B Value of real options for project B = (0.60 = (0.60 $1,500) + (0.30 $1,500) + (0.30 $2,000) $2,000)= $900 + $600 = $1,500= $900 + $600 = $1,500

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Adding the $1,500 real options value to the traditional Adding the $1,500 real options value to the traditional NPV of $10,924 for project B, we get the strategic NPV NPV of $10,924 for project B, we get the strategic NPV for project B.for project B.

NPVNPVstrategicstrategic = $10,924 + $1,500 = = $10,924 + $1,500 = $12,424$12,424

Bennett CompanyBennett Company’’s project B therefore has a strategic s project B therefore has a strategic NPV of $12,424, which is above its traditional NPV and NPV of $12,424, which is above its traditional NPV and now exceeds project Anow exceeds project A’’s NPV of $11,071. Clearly, s NPV of $11,071. Clearly, recognition of project Brecognition of project B’’s real options improved its NPV s real options improved its NPV (from $10,924 to $12,424) and causes it to be preferred (from $10,924 to $12,424) and causes it to be preferred over project A (NPV of $12,424 for B > NPV of $11,071 over project A (NPV of $12,424 for B > NPV of $11,071 for A), which has no real options embedded in it.for A), which has no real options embedded in it.

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Capital Rationing Firm’s often operate under conditions of capital

rationing—they have more acceptable independent projects than they can fund.

In theory, capital rationing should not exist—firms should accept all projects that have positive NPVs.

However, in practice, most firms operate under capital rationing.

Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management.

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Capital Rationing (cont.)Capital Rationing (cont.)The internal rate of return approach is an

approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects.

The graph that plots project IRRs in descending order against the total dollar investment is called the investment opportunities schedule (IOS).

The problem with this technique is that it does not guarantee the maximum dollar return to the firm.

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Capital Rationing (cont.)Capital Rationing (cont.)Tate Company, a fast growing plastics company Tate Company, a fast growing plastics company with a cost of capital of 10%, is confronted with six with a cost of capital of 10%, is confronted with six projects competing for its fixed budget of $250,000.projects competing for its fixed budget of $250,000.

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Figure 12.4 Investment Figure 12.4 Investment Opportunities ScheduleOpportunities Schedule

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Capital Rationing (cont.)Capital Rationing (cont.)

The net present value approach is an approach to capital rationing that is based on the use of present values to determine the group of projects that will maximize owners’ wealth.

It is implemented by ranking projects on the basis of IRRs and then evaluating the present value of the benefits from each potential project to determine the combination of projects with the highest overall present value.

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Table 12.5 Rankings for Table 12.5 Rankings for Tate Company ProjectsTate Company Projects

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Review of Learning GoalsReview of Learning Goals Understand the importance of Understand the importance of

recognizing risk in the analysis of recognizing risk in the analysis of capital budgeting projects. capital budgeting projects. The cash flows associated with capital

budgeting projects typically have different levels of risk, and the acceptance of a project generally affects the firm’s overall risk. Thus it is important to incorporate risk considerations in capital budgeting.

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Discuss risk and cash inflows, scenario analysis, and Discuss risk and cash inflows, scenario analysis, and simulation as behavioral approaches for dealing with simulation as behavioral approaches for dealing with risk. risk. Risk in capital budgeting is the degree of variability of

cash flows, which for conventional capital budgeting projects stems almost entirely from net cash flows. Finding the breakeven cash inflow and estimating the probability that it will be realized make up one behavioral approach for assessing capital budgeting risk. Scenario analysis is another behavioral approach for capturing the variability of cash inflows and NPVs. Simulation is a statistically based approach that results in a probability distribution of project returns.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.) Review the unique risks that Review the unique risks that

multinational companies face. multinational companies face. Although the basic capital budgeting

techniques are the same for multinational and purely domestic companies, firms that operate in several countries must also deal with exchange rate and political risks, tax law differences, transfer pricing, and strategic issues.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.) Describe the determination and use of risk-Describe the determination and use of risk-

adjusted discount rates (RADRs), portfolio adjusted discount rates (RADRs), portfolio effects, and the practical aspects of RADRs.effects, and the practical aspects of RADRs. The risk of a project whose initial investment is

known with certainty is embodied in the present value of its cash inflows, using NPV. Two opportunities to adjust the present value of cash inflows for risk exist—adjust the cash inflows or adjust the discount rate. Because adjusting the cash inflows is highly subjective, adjusting discount rates is more popular. RADRs use a market-based adjustment of the discount rate to calculate NPV.

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Select the best of a group of unequal-Select the best of a group of unequal-lived, mutually exclusive projects using lived, mutually exclusive projects using annualized net present values annualized net present values (ANPVs). (ANPVs). The ANPV approach is the most efficient

method of comparing ongoing, mutually exclusive projects that have unequal usable lives. It converts the NPV of each unequal-lived project into an equivalent annual amount—its ANPV.

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Explain the role of real options and the objective Explain the role of real options and the objective and procedures for selecting projects under capital and procedures for selecting projects under capital rationing. rationing. Real options are opportunities that are embedded in capital

projects and that allow managers to alter their cash flow and risk in a way that affects project acceptability (NPV). By explicitly recognizing real options, the financial manager can find a project’s strategic NPV.

Capital rationing exists when firms have more acceptable independent projects than they can fund. The two basic approaches for choosing projects under capital rationing are the internal rate of return approach and the net present value approach. The NPV approach better achieves the objective of using the budget to generate the highest present value of inflows.

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Integrative Case: Integrative Case: Lasting Impressions Lasting Impressions

CompanyCompanyLasting Impressions (LI) CompanyLasting Impressions (LI) Company’’s general s general manager has proposed the purchase of one of manager has proposed the purchase of one of two large, six-colour presses designed for two large, six-colour presses designed for long, high-quality runs. The purchase of a long, high-quality runs. The purchase of a new press would enable LI to reduce its cost new press would enable LI to reduce its cost of labour and therefore the price to the client, of labour and therefore the price to the client, putting the firm in a more competitive putting the firm in a more competitive position. The key financial characteristics of position. The key financial characteristics of the old press and of the two proposed presses the old press and of the two proposed presses are summarized in what follows.are summarized in what follows.

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Integrative Case: Lasting Integrative Case: Lasting Impressions Company Impressions Company

(cont.)(cont.)Press APress A This highly automated press can be This highly automated press can be purchased for $830,000 and will require $40,000 in purchased for $830,000 and will require $40,000 in installation costs. It will be depreciated under installation costs. It will be depreciated under MACRS using a 5-year recovery period. At the end MACRS using a 5-year recovery period. At the end of the 5 years, the machine could be sold to net of the 5 years, the machine could be sold to net $400,000 before taxes. If this machine is acquired, $400,000 before taxes. If this machine is acquired, it is anticipated that the following current account it is anticipated that the following current account changes would result:changes would result:

Cash: +$25,400Cash: +$25,400 Accounts receivable: +$120,000Accounts receivable: +$120,000 Inventories: Inventories: –– $20,000 $20,000 Accounts payable: +$35,000Accounts payable: +$35,000

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(cont.)(cont.)Press BPress B This press is not as sophisticated This press is not as sophisticated as press A. It costs $640,000 and requires as press A. It costs $640,000 and requires $20,000 in installation costs. It will be $20,000 in installation costs. It will be depreciated under MACRS using a 5-year depreciated under MACRS using a 5-year recovery period. At the end of 5 years, it recovery period. At the end of 5 years, it can be sold to net $330,000 before taxes. can be sold to net $330,000 before taxes. Acquisition of this press will have no Acquisition of this press will have no effect on the firmeffect on the firm’’s net working capital s net working capital investment.investment.

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(cont.)(cont.)The firm estimates that its earnings The firm estimates that its earnings before depreciation, interest, and taxes before depreciation, interest, and taxes with the old press and with press A or with the old press and with press A or press B for each of the 5 years would press B for each of the 5 years would be as shown in Table 1. The firm is be as shown in Table 1. The firm is subject to a 40% tax rate. The firmsubject to a 40% tax rate. The firm ’’s s cost of capital, cost of capital, r,r, applicable to the applicable to the proposed replacement is 14%.proposed replacement is 14%.

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Table 1. Earnings Before Depreciation, Table 1. Earnings Before Depreciation, Interest, and Taxes for Lasting Interest, and Taxes for Lasting

Impressions Company’s PressesImpressions Company’s Presses

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(cont.)(cont.)a.a. For each of the two proposed replacement For each of the two proposed replacement presses, determine:presses, determine:

1.1. Initial investment.Initial investment.2.2. Operating cash inflows. (Operating cash inflows. (Note:Note: Be sure to Be sure to

consider the depreciation in year 6.)consider the depreciation in year 6.)3.3. Terminal cash flow. (Terminal cash flow. (Note:Note: This is at the end of This is at the end of

year 5.)year 5.)

b.b. Using the data developed in part Using the data developed in part a,a, find and find and depict on a time line the relevant cash flow depict on a time line the relevant cash flow stream associated with each of the two stream associated with each of the two proposed replacement presses, assuming that proposed replacement presses, assuming that each is terminated at the end of 5 years.each is terminated at the end of 5 years.

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(cont.)(cont.)c.c. Using the data developed in part Using the data developed in part b,b, apply each apply each of the following decision techniques:of the following decision techniques:

1.1. Payback period. (Payback period. (Note:Note: For year 5, use only the For year 5, use only the operating cash inflowsoperating cash inflows——that is, exclude terminal that is, exclude terminal cash flowcash flow——when making this calculation.)when making this calculation.)

2.2. Net present value (NPV).Net present value (NPV).3.3. Internal rate of return (IRR).Internal rate of return (IRR).

d.d. Draw net present value profiles for the two Draw net present value profiles for the two replacement presses on the same set of axes, and replacement presses on the same set of axes, and discuss conflicting rankings of the two presses, discuss conflicting rankings of the two presses, if any, resulting from use of NPV and IRR if any, resulting from use of NPV and IRR decision techniques.decision techniques.

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(cont.)(cont.)e.e. Recommend which, if either, of the presses Recommend which, if either, of the presses

the firm should acquire if the firm has (1) the firm should acquire if the firm has (1) unlimited funds or (2) capital rationing.unlimited funds or (2) capital rationing.

f.f. What is the impact on your What is the impact on your recommendation of the fact that the recommendation of the fact that the operating cash inflows associated with operating cash inflows associated with press A are characterized as very risky in press A are characterized as very risky in contrast to the low-risk operating cash contrast to the low-risk operating cash inflows of press B?inflows of press B?

Gitman, Lawrence J. and Gitman, Lawrence J. and Zutter ,Chad J.(2013) Zutter ,Chad J.(2013) Principles of Managerial Principles of Managerial Finance, Pearson,13Finance, Pearson,13thth Edition Edition

Brooks,Raymond (2013) Brooks,Raymond (2013) Financial Management: Core Financial Management: Core Concepts , Pearson, 2Concepts , Pearson, 2thth edition edition

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Further ReadingFurther Reading

Questions?Questions?