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Making Investment Decisions Lecture 2 Fall 2009Capital Budgeting Decisions Check ListCapital Budgeting Decisions Check ListSlide 4Slide 5Slide 6Slide 7Application of the NPV Rule and Capital BudgetingOnly Cash Flows Affect Wealth.Only Incremental cash flows are relevantOnly Incremental cash flows are relevantSlide 12Slide 13Slide 14Slide 15Slide 16Slide 17Treat inflation consistentlyExampleStandard ResultTreat inflation consistentlySlide 22Slide 23Treat Inflation ConsistentlySlide 25Slide 26But:ProblemTying up assets uses a valuable resource and must be accounted for.Slide 30Slide 31Rule 4: Tying up assets uses a valuable resource and must be accounted for.Slide 33Slide 34Remember taxesRemember taxes on Capital GainsRemember taxes on Capital GainsRemember taxes and the effect of selling assetsIgnore the means of financing both as a direct cash flow and as its effect on taxes.STEPS IN PROJECT ANALYSIS1Making Investment Decisions Lecture 2 Fall 2009 Advanced Corporate Finance FINA 7330Ronald F. Singer2Capital Budgeting Decisions Check List 1. Net Present Value is the "Discounted value of incremental cash flow”2. Cash flow is:CASH MONEY IN - CASH MONEY OUT3Capital Budgeting Decisions Check List3. Consider only if it is an incremental cash flow, and consider all incremental cash flows: (a) not historical, or averages; (b) consider only cash flows that appear as a result of the project(c) consider the impact of the project on cash flows from other projects(d) exclude fixed or sunk costs (e) exclude allocated overhead unless it will change as a result of the project.4Capital Budgeting Decisions Check List4. Treat inflation consistently:Discount real cash flow by real discount rates Discount nominal cash flows by nominal discount rates Note: Revenues and costs will not necessarily react uniformly to inflation. 5. All Cash Flow should be on an After-Tax basis. Use actual tax changes when paid! Don't forget to allow for the tax on capital gains Use future marginal tax rates applied to future taxable income5Capital Budgeting Decisions Check List6. Include the opportunity cost of the project, even if there is no explicit cash flow realized Account for assets sold and not sold as a result of adoption of a project.7. Account for changes in working capital and only changes in working capital. Recognize that working capital will in general be re-couped at the end of the project. 8. Ignore financing including the tax shield on interest6Capital Budgeting Decisions Check List9. Include Asset's Entire Life10. Include the depreciation tax shield, but not depreciation itself.7Capital Budgeting Decisions Check ListNo matter how complicated the decision: What is important? MAXIMIZE NPV PLAN TO TAKE ALL PROJECTS WITH A POSITIVE NET PRESENT VALUE AND REJECT ALL PROJECTS WITH A NEGATIVE NET PRESENT VALUE8Application of the NPV Rule and Capital Budgeting•For now we are going to assume that the appropriate discount rate is known.•The problem we want to tackle is to forecast the relevant cash flows.9Only Cash Flows Affect Wealth. What is and is not Cash Flow -Expenses are cash flow regardless of whether the accountant capitalizes and depreciates them or expenses them. -Capital expenditures are cash outflows regardless of the fact that accountants depreciate them over a period.10Only Incremental cash flows are relevant •Not historical cash flows, not averages, not sunk costs! •Example 1: Consider a firm having made an investment one year in the past. The project required an initial investment of $10,000; with the expectation of $14,000 to be generated within two years. At a discount rate of 10% should the firm have made the investment?11Only Incremental cash flows are relevant 14,000-1---------------0-----------------1 10,00012Only Incremental cash flows are relevant 14,000-1---------------0-----------------1 10,000 •Of course it should have. The NPV was: NPV = 1,56413Only Incremental cash flows are relevant•NOW THINGS CHANGE. A NEW DEVICE INTRODUCED BY A COMPETITOR MAKES THE PRODUCT OBSOLETE. THUS EXPECTED CASH FLOWS DECLINE TO $7,000. THAT IS THE INVESTMENT, DID NOT PAY OFF AS EXPECTED AND THE PROJECT IS NOW A LOSER. •SUPPOSE THAT FOR AN ADDITIONAL INVESTMENT OF $5,000, YOU CAN REGAIN YOUR COMPETITIVE POSITION, SO THAT EXPECTED CASH FLOW INCREASES TO THE ORIGINAL $14,000. SHOULD YOU MAKE THE NEW INVESTMENT?14Only Incremental cash flows are relevant 14,000-1---------------0-----------------1 -10,000 -5,000•Note that the project, looked at as a whole is still a loser: NPV(-1) = -10,000 - 5,000 + 14,000 (1.1) (1.1)2 = - 2,97515Only Incremental cash flows are relevant 14,000-1---------------0-----------------1 -10,000 -5,000•Note that the project, looked at as a whole is still a loser: NPV(-1) = -10,000 - 5,000 + 14,000 (1.1) (1.1)2 = - 2,975 BUT the additional investment should be made. •Determine the incremental cash flows.•Determine Net Present Value of the incremental cash flowsIncremental Cash Flow: -5,000 + 7,000/(1.1) = 1,363.6516Only Incremental cash flows are relevant•Example 2: Assume that the original cash flow estimates were accurate. But, that you can, by making an additional investment of 1,000 generate total second period cash flow of 15,050. Should the additional investment be made? (Still Assume r= 10%)17Only Incremental cash flows are relevant 14,000 -1---------------------0-----------------------1 initial -10,000 -5,000 1,050 -1---------------------0-----------------------1 Incremental -1,000 NPV (of Additional Investment) = -1000 + 1050 = - 45.45 1.1•Even though, the original project is a winner, do not make the additional investment•You must Ignore Sunk Costs, and consider only incremental cash flows.18Treat inflation consistently•Make sure that inflation is accounted for in a consistent manner. Either:1. State cash flows in terms of actual dollars, at the time the cash flows are received. These are nominal cash flows Or 2. State cash flows in terms of dollars, at the time the projections are made. These are real cash flows. •If cash flows are in nominal terms, use nominal discount rates to discount the cash flows. •If cash flows are in real terms use real

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