Making Capital Investment Decisions & Intro to Project Analysis

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UCD Lochlann Quinn School of Business
Making Capital Investment Decisions
& Intro to Project Analysis
© Business eLearning

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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
• Stand-alone Principle
– The assumption that evaluation of a project may be based on
the project’s incremental cash flows
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Incremental Cash Flows
The difference between a
firm’s future cash flows with a
project and those without the
project
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The incremental cash flows
for project evaluation consist
of any and all changes in the
firm’s future cash flows that
are a direct consequence of
taking the project
Dr Sha Liu, Foundations of Finance
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Incremental
Cash
Flows
Incremental Cash Flows (cont’d)
Sunk Costs
Definition
• A sunk cost is a cash
flow that has already
occurred
Rule
• Ignore all sunk costs
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Incremental Cash Flows (cont’d)
Opportunity Costs
Definition
• Opportunity costs are lost
revenues that you forego
as a result of making the
proposed investment
Rule
• Incorporate opportunity
costs into your analysis
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Incremental Cash Flows (cont’d)
Side Effects
Definition
• A side effect is classified as
either erosion or synergy.
• Erosion is when a new
product reduces the cash
flows of existing products.
• Synergy occurs when a new
project increases the cash
flows of existing projects.
Rule
• Include side effects
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Incremental Cash Flows (cont’d)
• Net working capital (NWC)
– NWC = Current Assets − Current Liabilities = Cash + Inventory
+ Receivables Payables
– The firm supplies working capital at the beginning and
recovers it towards the end.
• Financing Cost
– In analysing a proposed investment, we shall not include
interest paid or any other financing costs such as dividends or
principal repaid.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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The Capital Budgeting Process
(or Sales)
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Dr Sha Liu, Foundations of Finance
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Pro Forma Financial Statements
You think you can sell 50,000 cans of shark attractant per year at a price
of £4 per can.
It costs about £2.50 per can to make the attractant, and a new product
such as this one typically has only a 3-year life.
You require a 20 per cent return on new products.
Fixed costs for the project, including such things as rent, will run at
£12,000 per year.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Pro Forma Financial Statements (cont’d)
You will need to invest a total of £90,000 in manufacturing equipment.
Assume that this £90,000 will be 100 per cent depreciated straight-line
over the 3-year life of the project.
The cost of removing the equipment will roughly equal its actual value in 3
years, so it will be essentially worthless on a market value basis as well.
Finally, the project will require an initial £20,000 investment in net working
capital, and the tax rate is 34 per cent.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Pro Forma Financial Statements (cont’d)
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Project Cash Flows
• Project cash flow = Project operating cash flow − Pr
oject capital spending (capital expenditure)
• Operating cash flow= Net income+ Depreciation−
Increase (+Decrease) in net working capital
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Project Cash Flows (cont’d)
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Dr Sha Liu, Foundations of Finance
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Dr Sha Liu, Foundations of Finance
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A Closer Look at Net Working Capital
Suppose that during a particular year of a project we
have this simplified income statement:
Depreciation and taxes are zero and no non-current
assets are purchased during the year.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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A Closer Look at Net Working Capital (cont’d)
Assume that the only components of net working
capital are trade receivables and payables.
Based on this information, what is total cash flow for
the year?
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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A Closer Look at Net Working Capital (cont’d)
• Total cash flow = Operating cash flow – Change in NWC – Capital
spending = €190 – (- 25) – 0 = €215
• Another way to calculate total cash flow
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Depreciation
Reducing Balance
Depreciation
• A depreciation
method allowing for
the accelerated
write-off of assets
under various
classifications
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Straight-line
Depreciation
• A depreciation
method allowing for a
linear write-off of
assets over their
lifetime
Dr Sha Liu, Foundations of Finance
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Depreciation (cont’d)
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Dr Sha Liu, Foundations of Finance
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An Example: Majestic Mulch and Compost Ltd (MMC)
• MMC is investigating the
feasibility of a new line of power
mulching tools aimed at the
growing number of home
composters. Based on
exploratory conversations with
buyers for large garden shops,
MMC projects unit sales as
follows:
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
• The new power mulcher will sell for £120 per unit to start. When the
competition catches up after 3 years, however, MMC anticipates that the
price will drop to £110.
• The power mulcher project will require £20,000 in net working capital at
the start. Subsequently, total net working capital at the end of each year
will be about 15 per cent of sales for that year. The variable cost per unit is
£60, and total fixed costs are £25,000 per year.
• It will cost about £800,000 to buy the equipment necessary to begin
production. This investment is primarily in industrial equipment, which
should be depreciated using the 18 per cent reducing-balance method. The
equipment will actually be worth about 20 per cent of its cost in 8 years, or
0.20 × £800,000 = £160,000. The relevant tax rate is 23 per cent, and the
required return is 15 per cent. Based on this information, should MMC
proceed?
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
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Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
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Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
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Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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MMC Example (cont’d)
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Dr Sha Liu, Foundations of Finance
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Intro to Project Analysis
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Evaluating NPV Estimates
The Basic
Problem
What if we conclude there is positive NPV
because our estimates are wrong?
Forecasting
Risk
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Projected
versus Actual
Cash Flows
Source of Value
Why is this product better? Where
does the value come from?
Competition?
Dr Sha Liu, Foundations of Finance
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Scenario and Other What-if Analysis
Scenario Analysis
The determination of what happens to NPV estimates
when we ask what-if questions.
Sensitivity Analysis
Investigation of what happens to NPV when only one
variable is changed.
Simulation Analysis
A combination of scenario and sensitivity analysis.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Scenario and Other What-if Analysis (cont’d)
Getting Started
The following project is under consideration:
• Cost = €200,000
• 5-year life, no salvage value
• Depreciation is straight-line to zero
• Required return = 12 per cent
• Tax rate = 34 per cent.
In addition:
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Scenario and Other What-if Analysis (cont’d)
Operating cash flow =
per year.
At 12 per cent, the 5-year annuity factor is 3.6048, so the base-case
NPV =
The project looks good so far.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Scenario Analysis – Worst Case NPV
Scenario Analysis – Worst Case NPV
Unit sales
Price per unit (€)
Variable costs per unit (€)
Fixed costs per year (€)
Worst Case
5,500
75
62
55,000
Operating cash flow is
Worst-case NPV =
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Sales (€)
Variable costs (€)
Fixed costs (€)
Depreciation (€)
Profit before taxes (€)
Taxes @ 34% (€)
Net Income
412,500
341,000
55,000
40,000
-23,500
+7,990
-15,510

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Scenario and Other What-if Analysis (cont’d)
Scenario Analysis
*We assume a tax credit is created in our worst-case scenario.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Sensitivity Analysis
Freeze all variables except one and see what happens our NPV estimates.
Freeze Everything
except Fixed
Costs
Sales (€)
Variable costs (€)
Fixed costs (€)
Depreciation (€)
Profit before taxes (€)
Taxes (€)
Net Income
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480,000
360,000
55,000
40,000
25,000
8,500
16,500
Dr Sha Liu, Foundations of Finance
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Sensitivity Analysis (cont’d)
Sensitivity analysis for unit sales
Sensitivity analysis shows that the project is
more sensitive to changes in
projected sales than it is to changes in
projected fixed costs.
Useful for pinpointing which forecasting error
will do most damage.
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Sensitivity Analysis and Scenario Analysis
Sensitivity Analysis (cont’d)
What Does Sensitivity Analysis Tell Us?
Backup
• If there are many negative NPVs in the
sensitivity analysis, more investigation
is needed
Influential
Variables
• Sensitivity analysis identifies influential
variables
• These variables must be estimated
with more accuracy
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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Sensitivity Analysis and Scenario Analysis
Sensitivity Analysis (cont’d)
Weaknesses of Sensitivity Analysis
Weaknesses
It does not tell us
what to do about
possible errors
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Each variable is
treated in
isolation
Dr Sha Liu, Foundations of Finance
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Readings
• Corporate Finance and selected chapters from
Investments for University College Dublin. David Hillier,
Zvi Bodie.
– Week 8 readings
• OR:
• Hillier, D., I. Clacher, S. Ross, R. Westerfield, J. Jaffe, and
B. Jordan. "Fundamentals of Corporate Finance", 3rd
edition, Mcgraw-Hill, 2017.
– Chapter 9 (section 9.1-9.5)
– Chapter 10 (section 10.1-10.2)
UCD Lochlann Quinn School of Business
Dr Sha Liu, Foundations of Finance
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