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IMPORTANT: In order to view the correct calculator key stroke symbols within this PPT, IMPORTANT: In order to view the correct calculator key stroke symbols within this PPT, you will need to follow the font installation directions on this document. 9 -1 Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills • Understand how to: – Determine the relevant cash flows Key Concepts and Skills • Understand how to: – Determine the relevant cash flows for a proposed investment – Analyze a project’s projected cash flows – Evaluate an estimated NPV 9 -2

Chapter Outline 9. 1 Project Cash Flows: A First Look 9. 2 Incremental Cash Chapter Outline 9. 1 Project Cash Flows: A First Look 9. 2 Incremental Cash Flows 9. 3 Pro Forma Financial Statements and Project Cash Flows 9. 4 More on Project Cash Flows 9. 5 Evaluating NPV Estimates 9. 6 Scenario and Other What-If Analyses 9. 7 Additional Considerations in Capital Budgeting 9 -3

Relevant Cash Flows • Include only cash flows that will only occur if the Relevant Cash Flows • Include only cash flows that will only occur if the project is accepted • Incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows 9 -4

Relevant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the Relevant Cash Flows: Incremental Cash Flow for a Project Corporate cash flow with the project Minus Corporate cash flow without the project 9 -5

Relevant Cash Flows • • • “Sunk” Costs …………… N Opportunity Costs …………………. . Relevant Cash Flows • • • “Sunk” Costs …………… N Opportunity Costs …………………. . . Y Side Effects/Erosion……. . …………… Y Net Working Capital…………………. . Y Financing Costs…. …………. N Tax Effects ……………. . Y 9 -6

Pro Forma Statements and Cash Flow • Pro Forma Financial Statements – Projects future Pro Forma Statements and Cash Flow • Pro Forma Financial Statements – Projects future operations • Operating Cash Flow: OCF = EBIT + Depr – Taxes OCF = NI + Depr if no interest expense • Cash Flow From Assets: CFFA = OCF – NCS –ΔNWC NCS = Net capital spending 9 -7

Shark Attractant Project • • • Estimated sales Sales Price per can Cost per Shark Attractant Project • • • Estimated sales Sales Price per can Cost per can Estimated life Fixed costs Initial equipment cost 50, 000 cans $4. 00 $2. 50 3 years $12, 000/year $90, 000 – 100% depreciated over 3 year life • Investment in NWC • Tax rate • Cost of capital $20, 000 34% 20% 9 -8

Pro Forma Income Statement Table 9. 1 Sales (50, 000 units at $4. 00/unit) Pro Forma Income Statement Table 9. 1 Sales (50, 000 units at $4. 00/unit) $200, 00 0 Variable Costs ($2. 50/unit) 125, 000 Gross profit $ 75, 000 Fixed costs 12, 000 Depreciation ($90, 000 / 3) 30, 000 EBIT Taxes (34%) Net Income $ 33, 000 11, 220 $ 21, 780 9 -9

Projected Capital Requirements Table 9. 2 Year 0 NWC 1 2 3 $20, 000 Projected Capital Requirements Table 9. 2 Year 0 NWC 1 2 3 $20, 000 90, 000 60, 000 30, 000 0 Total $110, 000 Investment $80, 000 $50, 000 $20, 000 Net Fixed Assets NFA declines by the amount of depreciation each year Investment = book or accounting value, not market value 9 -10

Projected Total Cash Flows Table 9. 5 Year 0 OCF 1 $51, 780 NWC Projected Total Cash Flows Table 9. 5 Year 0 OCF 1 $51, 780 NWC -$110, 00 3 $51, 780 -$90, 000 CFFA $51, 780 -$20, 000 Capital Spending 2 20, 000 $51, 780 $71, 780 Note: Investment in NWC is recovered in final year Equipment cost is a cash outflow in year 0 9 -11

Shark Attractant Project OCF = EBIT + Depreciation – Taxes OCF = Net Income Shark Attractant Project OCF = EBIT + Depreciation – Taxes OCF = Net Income + Depreciation (if no interest) 9 -12

Computing NPV for the Project Using the TI BAII+ CF Worksheet Cash Flows: CF Computing NPV for the Project Using the TI BAII+ CF Worksheet Cash Flows: CF 0 = -110000 CF 1 = 51780 CF 2 = 51780 CF 3 = 71780 Display You Enter ‘' C 00 C 01 F 01 C 02 F 02 I NPV 110000 S!# 51780 !# 2 !# 71780 !# 1 !#( 20 !# % ) % 10647. 69 25. 76 9 -13

Making The Decision • Should we accept or reject the project? 9 -14 Making The Decision • Should we accept or reject the project? 9 -14

The Tax Shield Approach to OCF • OCF = (Sales – costs)(1 – T) The Tax Shield Approach to OCF • OCF = (Sales – costs)(1 – T) + Deprec*T OCF=(200, 000 -137, 000) x 66% + (30, 000 x. 34) OCF = 51, 780 • Particularly useful when the major incremental cash flows are the purchase of equipment and the associated depreciation tax shield – i. e. , choosing between two different machines 9 -15

Changes in NWC • GAAP requirements: – Sales recorded when made, not when cash Changes in NWC • GAAP requirements: – Sales recorded when made, not when cash is received • Cash in = Sales - ΔAR – Cost of goods sold recorded when the corresponding sales are made, whether suppliers paid yet or not • Cash out = COGS - ΔAP • Buy inventory/materials to support sales before any cash collected 9 -16

Depreciation & Capital Budgeting • Use the schedule required by the IRS for tax Depreciation & Capital Budgeting • Use the schedule required by the IRS for tax purposes • Depreciation = non-cash expense – Only relevant due to tax affects • Depreciation tax shield = DT – D = depreciation expense – T = marginal tax rate 9 -17

Computing Depreciation • Straight-line depreciation D = (Initial cost – salvage) / number of Computing Depreciation • Straight-line depreciation D = (Initial cost – salvage) / number of years Straight Line Salvage Value • MACRS Depreciate 0 Recovery Period = Class Life 1/2 Year Convention Multiply percentage in table by the initial cost 9 -18

After-Tax Salvage • If the salvage value is different from the book value of After-Tax Salvage • If the salvage value is different from the book value of the asset, then there is a tax effect • Book value = initial cost – accumulated depreciation • After-tax salvage = salvage – T(salvage – book value) 9 -19

Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP Tax Effect on Salvage Net Salvage Cash Flow = SP - (SP-BV)(T) Where: SP = Selling Price BV = Book Value T = Corporate tax rate 9 -20

Example: Depreciation and After-tax Salvage • Car purchased for $12, 000 • 5 -year Example: Depreciation and After-tax Salvage • Car purchased for $12, 000 • 5 -year property • Marginal tax rate = 34%. 9 -21

Salvage Value & Tax Effects Net Salvage Cash Flow = SP - (SP-BV)(T) If Salvage Value & Tax Effects Net Salvage Cash Flow = SP - (SP-BV)(T) If sold at EOY 5 for $3, 000: NSCF = 3, 000 - (3000 - 691. 20)(. 34) = $2, 215. 01 = $3, 000 – 784. 99 = $2, 215. 01 If sold at EOY 2 for $4, 000: NSCF = 4, 000 - (4000 - 5, 760)(. 34) = $4, 598. 40 = $4, 000 – (-598. 40) = $4, 598. 40 9 -22

Majestic Mulch & Compost Co Given Data and Projected Revenues – Table 9. 9 Majestic Mulch & Compost Co Given Data and Projected Revenues – Table 9. 9 9 -23

Majestic Mulch & Compost Co Depreciation and After-Tax Salvage - Table 9. 10 9 Majestic Mulch & Compost Co Depreciation and After-Tax Salvage - Table 9. 10 9 -24

Majestic Mulch & Compost Co Net Working Capital – Table 9. 12 9 -25 Majestic Mulch & Compost Co Net Working Capital – Table 9. 12 9 -25

Majestic Mulch & Compost Co MMC Pro Forma Income Statements 9 -26 Majestic Mulch & Compost Co MMC Pro Forma Income Statements 9 -26

Majestic Mulch & Compost Co MMC Projected Cash Flows – Table 9. 14 9 Majestic Mulch & Compost Co MMC Projected Cash Flows – Table 9. 14 9 -27

Evaluating NPV Estimates • NPV estimates are only estimates • Forecasting risk: – Sensitivity Evaluating NPV Estimates • NPV estimates are only estimates • Forecasting risk: – Sensitivity of NPV to changes in cash flow estimates • The more sensitive, the greater the forecasting risk • Sources of value • Be able to articulate why this project creates value 9 -28

Scenario Analysis • Examines several possible situations: – Worst case – Base case or Scenario Analysis • Examines several possible situations: – Worst case – Base case or most likely case – Best case • Provides a range of possible outcomes 9 -29

Scenario Analysis Example Note: “Lower” ≠ Worst “Upper” ≠ Best 9 -30 Scenario Analysis Example Note: “Lower” ≠ Worst “Upper” ≠ Best 9 -30

Scenario Analysis Example 9 -31 Scenario Analysis Example 9 -31

Problems with Scenario Analysis • Considers only a few possible outcomes • Assumes perfectly Problems with Scenario Analysis • Considers only a few possible outcomes • Assumes perfectly correlated inputs – All “bad” values occur together and all “good” values occur together • Focuses on stand-alone risk, although subjective adjustments can be made 9 -32

Sensitivity Analysis • Shows how changes in an input variable affect NPV or IRR Sensitivity Analysis • Shows how changes in an input variable affect NPV or IRR • Each variable is fixed except one – Change one variable to see the effect on NPV or IRR • Answers “what if” questions 9 -33

Sensitivity Analysis: Unit Sales 9 -34 Sensitivity Analysis: Unit Sales 9 -34

Sensitivity Analysis: Fixed Costs 9 -35 Sensitivity Analysis: Fixed Costs 9 -35

Sensitivity Analysis: • Strengths – Provides indication of stand-alone risk. – Identifies dangerous variables. Sensitivity Analysis: • Strengths – Provides indication of stand-alone risk. – Identifies dangerous variables. – Gives some breakeven information. • Weaknesses – Does not reflect diversification. – Says nothing about the likelihood of change in a variable, – Ignores relationships among variables. 9 -36

Disadvantages of Sensitivity and Scenario Analysis • Neither provides a decision rule. – No Disadvantages of Sensitivity and Scenario Analysis • Neither provides a decision rule. – No indication whether a project’s expected return is sufficient to compensate for its risk. • Ignores diversification. – Measures only stand-alone risk, which may not be the most relevant risk in capital budgeting. 9 -37

Managerial Options • Contingency planning • Option to expand – Expansion of existing product Managerial Options • Contingency planning • Option to expand – Expansion of existing product line – New products – New geographic markets • Option to abandon – Contraction – Temporary suspension • Option to wait • Strategic options 9 -38

Capital Rationing • Capital rationing occurs when a firm or division has limited resources Capital Rationing • Capital rationing occurs when a firm or division has limited resources – Soft rationing – the limited resources are temporary, often self-imposed – Hard rationing – capital will never be available for this project • The profitability index is a useful tool when faced with soft rationing 9 -39

Chapter 9 END Chapter 9 END

TI BA II+ Font Installation Close Powerpoint until the fonts are installed Print this TI BA II+ Font Installation Close Powerpoint until the fonts are installed Print this page before closing Powerpoint Steps to installing the fonts using Windows XP or Vista: • Go to this link: http: //education. ti. com/educationportal/downloadcenter/Software. Detail. do? website=US&app. Id=61 61 • Download and [Save] the Windows designated file to your hard drive. Do not [Run] the file you are attempting to download. • Unzip the file to a location that you can easily navigate to on your computer (I’d advise using your desktop for this). Unzip by double clicking the file, choosing browse in the window that pops up, and then setting your unzip location to your desktop by selecting desktop. • You’ll have 4 files on your laptop. Two of them will have Icons ~ you’ll need to use these. • Go to “Start” “Control Panel” “Fonts. ” You can drag and drop the font file into your font folder or select “File” “Install New Font” and indicate the location of the icon files • Restart Power. Point, and open the slideshow you were attempting to view. Steps to installing the fonts on a Mac: • Go to this link: http: //education. ti. com/educationportal/downloadcenter/Software. Detail. do? website=US&app. Id=61 61 • Download the Mac designated file to your computer. • Double click the file that was downloaded. • Restart Power. Point 9 -41