Chapter 9 Slides (1)

7/23/2019 Chapter 9 Slides (1)

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BU 926GA

Survey of Finance

Spring 2015Chapter 9


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Key Concepts an S!i""s

Understand how to determine the relevantcash flows for a proposed investment

Understand how to analyze a projectsprojected cash flows

Understand how to evaluate an estimatedNPV


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#e"evant Cash F"o$s

The cash flows that should be included in a capital

budgeting analysis are those that will only occur if theproject is accepted

These cash flows are called incremental cash flows

The stand-alone principleallows us to analyze eachproject in isolation from the firm simply by focusing onincremental cash flows thin! of each project as a

"minifirm#


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As!ing the #ight %uestion&

Fining 'ncre(enta" Cash F"o$s $ou should always as! yourself "%ill this cash

flow change &N'$ if we accept the project(# )f the answer is "yes*# it should be included in the

analysis because it is incremental

)f the answer is "no*# it should not be included inthe analysis because it is not affected by theproject

)f the answer is "part of it*# then we should includethe part that occurs because of the project


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Co((on )ypes of Cash F"o$s

Sun! costs costs that have accrued in the past

+hould be e,cluded from cash flows

*pportunity costs costs of lost options )nclude in the cash flows* use fair mar!et value price

Sie effects

Positive side effects benefits to other projects Negative side effects costs to other projects "erosion#

Changes in net $or!ing capita"

Financing costs

-o not include interest and dividend payments onlyinterested in .ash /lows from 0ssets

)a+es 0lways loo!ing at after ta, cash flows


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,ro For(a State(ents an Cash F"o$

.apital budgeting relies heavily on pro forma

accounting statements* particularly incomestatements

.omputing cash flows refresher &perating .ash /low 1&./2 3 45)T 6 depreciation ta,es

&./ 3 Net income 6 depreciation when there is nointerest e,pense

.ash /low /rom 0ssets 1.//02 3 &./ net capitalspending 1N.+2 changes in N%.


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-e$ ,rouct .aunch / +a(p"e

7odification to current machine

3 89:*:::* ; $ear 'ife 4,pected +ales of < a unit

0nnual fi,ed .ost of 8?>*:::

+traight 'ine -epreciation

Ta, @ate 3 ;=A

8>:! in Net %or!ing .apitalNeeded


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,ro For(a 'nco(e State(ent

+ales 1::*:::

Variable .osts 18>>:

Net )ncome 8 >?*EF:


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,roecte )ota" Cash F"o$s

$ear

: ? > ;

&./ 8


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a!ing the 3ecision

Now that we have the cash flows* we can

apply the techniHues that we learned inchapter F

Should we accept or reject the project?


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ore on -4C

%hy do we have to consider changes in

N%. separately( D00P reHuires that sales be recorded on the income

statement when made* not when cash is received

D00P also reHuires that we record cost of goods sold

when the corresponding sales are made* regardlessof when we actually pay our suppliers

+o* cash flow timing differences e,ist between thepurchase of inventory* revenue and costs from its saleon the income statement* and the actual cashcollection from its sale


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3epreciation

The depreciation e,pense used for capitalbudgeting should be the depreciationschedule reHuired by the )@+ for ta, purposes

-epreciation itself is a nonGcash e,penseI

conseHuently* it is only relevant because itaffects ta,es

-epreciation ta, shield 3 -,T

- 3 depreciation e,pense T 3 marginal ta, rate


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Co(puting 3epreciation

+traightGline depreciation - 3 1)nitial cost salvage2 C number of years Very few assets are depreciated straightGline for ta,

purposes

70.@+ Need to !now which asset class is appropriate for ta,

purposes

7ultiply percentage given in table by the initial cost

-epreciate to zero 7idGyear convention


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+a(p"e 3epreciation an After/)a+ Sa"vage

$ou purchase eHuipment for 8?::*::: and it

costs 8?:*::: to have it delivered andinstalledB 5ased on past information* youbelieve that you can sell the eHuipment for

8?E*::: when you are done with it in J yearsBThe companys marginal ta, rate is =:AB%hat is the depreciation e,pense each year*and the after ta, salvage in year J* for each

of the following situations(


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+a(p"e Straight/"ine 3epreciation

+uppose the appropriate depreciationschedule is straightGline - 3 18??:*::: ?E*:::2 C J 3 8?


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+a(p"e )hree/year AC#S

$ear 70.@+

percent

-

? B;;;; B;;;;1??:*:::2 3;J*JJ;

> B==== B====1??:*:::2 3

=F*FF=

; B?=F> B?=F>1??:*:::2 3?J*;:>

= B:E=? B:E=?1??:*:::2 3F*?


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+a(p"e Seven/ear AC#S

$ear 70.@+

Percent

-

? B?=>9 B?=>91??:*:::2 3? B>==9 B>==91??:*:::2 3>J*9;9

; B?E=9 B?E=91??:*:::2 3?9*>;9

= B?>=9 B?>=91??:*:::2 3?;*E;9

< B:F9; B:F9;1??:*:::2 3 9*F>;

J B:F9; B:F9;1??:*:::2 3 9*F>;

5V in year J 3??:*::: ?J*9;9 ?9*>;9 ?;*E;9 9*F>; 9*F>; 3 ?=*E?F

0fterGta, salvage 3?E*::: G B=1?E*:::

?=*E?F2 3

?J*:FEB>:


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After )a+ Sa"vage

)f the salvage value is different from the boo!

value of the asset* then there is a ta, effect

5oo! value 3 initial cost accumulated

depreciation

0fter ta, salvage 3 salvage T1salvage boo!value2


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+a(p"e #ep"ace(ent ,ro7"e(

&riginal 7achine )nitial cost 3 ?::*::: 0nnual depreciation 3

9*:::

Purchased < years ago

5oo! Value 3


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#ep"ace(ent ,ro7"e( 8 Co(puting Cash F"o$s

@emember that we are interested in incremental

cash flows

)f we buy the new machine* then we will sell the

old machine

%hat are the cash flow conseHuences of sellingthe old machine today instead of in < years(


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#ep"ace(ent ,ro7"e( 8 ,ro For(a 'nco(e State(ents

$ear ? > ; = F*E;? ;


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#ep"ace(ent ,ro7"e( 8 'ncre(enta" -et Capita"

Spening

$ear :

.ost of new machine 3 8?


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#ep"ace(ent ,ro7"e( 8 Cash F"o$ Fro( Assets

$ear : ? > ; = J*=::

N.+ GF9*::: G?:*:::

)nN%.

: :

.//0 GF9*::: =J*;9F ;:*F=J ?J*=::


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#ep"ace(ent ,ro7"e( 8 Ana"ying the Cash F"o$s

Now that we have the cash flows* we can

compute the NPV and )@@ 4nter the cash flows

.ompute NPV 3 89

.ompute )@@ 3 ;JB>EA

Should the company replace theequipment?


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va"uating -,: sti(ates

The NPV estimates are just that

estimates

0 positive NPV is a good start now weneed to ta!e a closer loo!

/orecasting ris! how sensitive is our NPVto changes in the cash flow estimatesI themore sensitive* the greater the forecasting

ris! +ources of value why does this project

create value(


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Scenario Ana"ysis

%hat happens to the NPV under differentcash flows scenarios(

0t the very least* loo! atK 5est case revenues are high and costs are low

%orst case revenues are low and costs are high 7easure of the range of possible outcomes

5est case and worst case are not

necessarily probableI they can still bepossible


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Sensitivity Ana"ysis

%hat happens to NPV when we vary onevariable at a time

This is a subset of scenario analysis where weare loo!ing at the effect of specific variableson NPV

The greater the volatility in NPV in relation toa specific variable* the larger the forecastingris! associated with that variable and the

more attention we want to pay to itsestimation


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-e$ ,roect +a(p"e

.onsider the project discussed in thete,t

The initial cost is 8>::*::: and theproject has a A* and the ta,rate is ;=A

The base case NPV is 8?


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Su((ary of Scenario Ana"ysis

+cenario Net)ncome

.ash/low

NPV )@@

5ase case 8?9*F:: 8


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Su((ary of Sensitivity Ana"ysis

+cenario Unit

+ales

.ash /low NPV )@@

5ase case J*::: 8


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a!ing A 3ecision

5eware "Paralysis of 0nalysis#

0t some point* you have to ma!e a decision

)f the majority of your scenarios have positiveNPVs* then you can feel reasonably

comfortable about accepting the project )f you have a crucial variable that leads to anegative NPV with a small change in theestimates* then you may want to forgo the

project


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anageria" *ptions

.apital budgeting projects often provide

other options that we have not yetconsidered

.ontingency planning

&ption to e,pand &ption to abandon

&ption to wait

+trategic options


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Capita" #ationing

.apital rationing occurs when a firm or

division has limited resources +oft rationing the limited resources are

temporary* often selfGimposed

Lard rationing capital will never be availablefor this project

The profitability inde, is a useful tool when

faced with soft rationing


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;o(e$or!

ProblemsK ?* >* =* J* E* 9* M ?:

The 70.@+ table is on pgB >EE table 9BE

Landout Problem

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Chapter 9 Slides (1)