Chap006 Capital Budfageting

Making Capital Investment Decisions
McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills

Understand MIRR Understand forecasting risk Understand and be able to conduct scenario and sensitivity analysis Understand the various methods for computing operating cash flow Understand how to set a bid price for a project Understand how to evaluate the equivalent annual cost of a project
10-1
Chapter Outline
MIRR and IRR Evaluating NPV Estimates Scenario and Other What-If Analyses Some Special Cases of Discounted Cash Flow Analysis
10-2
Capital budgeting decision rules

Key methods used to rank projects and to decide whether or not they should be accepted :
Payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR)
11-3
Internal Rate of Return
IRR > k = accept the project IRR < k = reject the project
11-4
Internal Rate of Return
11-5
Modified IRR
Better indicator of relative profitability The discount rate at which the present value of a projects cost is equal to the present value of its terminal value
11-6
Evaluating NPV Estimates

NPV estimates are just that estimates A positive NPV is a good start now we need to take a closer look
Forecasting risk how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk Sources of value why does this project create value?
11-7
Scenario Analysis
What happens to the NPV under different cash flow scenarios? At the very least, look at:
Best case high revenues, low costs Worst case low revenues, high costs Measure of the range of possible outcomes
Best case and worst case are not necessarily probable, but they can still be possible
11-8
New Project Example

Consider the project discussed in the text The initial cost is $200,000, and the project has a 5-year life. There is no salvage. Depreciation is straight-line, the required return is 12%, and the tax rate is 34%. The base case NPV is 15,567
11-9
Summary of Scenario Analysis

Scenario Net Income Cash Flow NPV IRR
Base case
19,800
59,800
15,567
15.1%
Worst Case
-15,510
24,490
-111,719
-14.4%
Best Case
59,730
99,730
159,504
40.9%
11-10
Sensitivity Analysis
What happens to NPV when we change one variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation
11-11
Summary of Sensitivity Analysis for New Project

Scenario Unit Sales Cash Flow NPV IRR
Base case
6,000
59,800
15,567
15.1%
Worst case
5,500
53,200
-8,226
10.3%
Best case
6,500
66,400
39,357
19.7%
11-12
Simulation Analysis
Simulation is really just an expanded sensitivity and scenario analysis Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value The simulation only works as well as the information that is entered, and very bad decisions can be made if care is not taken to analyze the interaction between variables
11-13
Making a Decision
Beware Paralysis of Analysis At some point you have to make a decision If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project
11-14
Example: Cost Cutting

Your company is considering a new computer system that will initially cost $1 million. It will save $300,000 per year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%. Click on the Excel icon to work through the example
10-15
Example: Setting the Bid Price

Consider the following information:
Army has requested bid for multiple use digitizing devices (MUDDs) Deliver 4 units each year for the next 3 years Labor and materials estimated to be $10,000 per unit Production space leased for $12,000 per year Requires $50,000 in fixed assets with expected salvage of $10,000 at the end of the project (depreciate straight-line) Require initial $10,000 increase in NWC Tax rate = 34% Required return = 15%
10-16
Example: Equivalent Annual Cost Analysis

Burnout Batteries
Initial Cost = $36 each 3-year life $100 per year to keep charged Expected salvage = $5 Straight-line depreciation
Long-lasting Batteries
Initial Cost = $60 each 5-year life $88 per year to keep charged Expected salvage = $5 Straight-line depreciation
The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required. The required return is 15%, and the tax rate is 34%.
10-17
Ethics Issues
In an L.A. Law episode, an automobile manufacturer knowingly built cars that had a significant safety flaw. Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car. What issues does the financial analysis overlook?
10-18

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Making Capital Investment Decisions

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Capital budgeting decision rules

Internal Rate of Return

Internal Rate of Return

Evaluating NPV Estimates

New Project Example

Summary of Scenario Analysis

Summary of Sensitivity Analysis for New Project

Example: Cost Cutting

Example: Setting the Bid Price

Example: Equivalent Annual Cost Analysis

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