Chapters 10 13 Exam 3 Study Guide Stand alone principle a company is the sum of all its projects kind of like a portfolio Add up all the subsidiaries Can analyze a project separate from the company by evaluating them as independent with their own assets revenues costs etc Use cash flow not accounting info Use relevant cash flows if they are not contingent on the project IDGAF Incremental cash flows any and all changes in future cash flows direct consequence of taking on the project After tax cash flows the tax bill is a cash outlay even though it s based on accounting numbers use marginal tax rates incremental Dos Don ts Include opportunity cost anything that is lost or foregone from taking on a project Can be big but also ignored Ignoring this makes you more likely to accept a project that you shouldn t o Ex If you are using some space in a warehouse you already own you should include a fair market value of the space you are using as an opportunity cost Include side effects both good and bad o Erosion cannibalism when you introduce a new product it takes away from the old products Considered negative and needs to be taken into account Look at sales from new product minus sales lost on old products Erosion is only relevant when the sales would not otherwise be lost Include changes in net working capital projects require incremental cash investments and are going to be included in payables These investments are often recovered as the project ends o If the accounts receivable is 90 days you need to be able to pay all your project bills without the accounts receivable there to cover it 1 worth of extra for the beginning will balance out in the end Don t include allocated costs preexisting for company and not incremental to project Not sales like administrative costs covered through sales corporate costs Don t include sunk costs already paid accrued Decision is based on future costs which isn t this Like research and development already done Don t include financing costs even cash interests or divided payments or principal payments Only real cash flows This is because o Financing decisions don t have to be connected to the decision to do something Although they are important they are analyzed separately o NPV actual cash flows because it s discounted pulled out interest By doing this you are taking the financing costs out of it and trying to put it back is double counting it Pro Forma Financial Statements statement of cash flows balance sheet income statement is for the project as if you went through with it Cash flow items 1 Operating cash flow EBITDA EBIT depreciation cash taxes sales operating expenses 2 Capital spending expenditures amount invested in project usually in time d very beginning of year 1 purchase price of new asset for replacement projects selling price of asset replaced if applicable change of sale preparation set up and start up change in tax liability due to sale of old asset at other than book value 3 Changes in NWC increase in current assets increase in current liabilities outdoor at time 0 and come back at end of project 4 Depreciation non cash deduction but affects taxes which are a cash flow a MACRS modified accelerated cost recovery system most assets are b Depreciation is an expense so you pay less taxes required to be depreciated using this Each asset is classified into a specific class depreciated to 0 Follows a midyear convention depreciation in the beginning The IRS allows you to use this instead of straight line Tax depreciation creates a cash flow when calculating operating cash flow sales expenses depreciation which reduces the amount that can be taxed take out more c Assets are put in categories regardless of how long it is actually used d Technology 3 years trucks 5 and equipment 7 for tax purposes If the project ends and there is any value of the equipment left that can be sold afterwards Creates a cash flow but will have taxes Have to adjust if it wasn t fully depreciated 5 Taking more depreciation upfront gives you an incentive to use production equipment as soon as possible and contribute to economy Only depreciate for the second half of the first year so depreciating a 5 year asset involves 6 calendar years An increase in an asset is considered a use of cash Salvage Value any gain from selling the assets after using them in the project Net cash gain Salvage value tax on salvage value Net cash gain Salvage value salvage value book value tax rate NWC CA CL If you look at the projected assets and liabilities you can see how much NWC you will need You need to come up with this money to cover expenses but at the end of the project this will get paid back Actually this gets paid back and reversed every period So if you had to borrow 100K for NWC this gets repaid at the end of the period But actually every period it gets paid back but then needed again Setting the bid price Make sales x and NPV 0 Solve for sales to see minimum required Look through all of the costs you will incur and fit what the minimum amount you will need to be sure you won t be in the red because of this All of the cash in and out flows that are used in NPV etc are estimates Trying to forecast future business Always going to be wrong just a matter of how wrong The risk comes in when the estimation is really off and you lose a lot of money on the project Cash flow forecasting error projecting the future involves the potential for error Forecasting risk the danger of making a bad value destroying decision because of errors in projected cash flows 4 tools to analyze estimating error and forecasting risk These are used for overall project or to identify a possible problem area within the project Sensitivity analysis given a whole list of cash flows Look at every assumption and see what happens as you change one variable at a time Change one to a worse number and check NPV Some are more fixed than given so don t have to worry and small ones aren t problems But how sensitive is NPV to a change in sales and how bad of a change is actually likely to occur Is this gonna be a problem o NWC is usually pretty standard but what about labor cost being affected by things like insurance o Raw materials attached to commodity markets oil o This is good to use because you know what you changed and you can identify what s important and tightly manage these areas o The process is also simple excel Break even analysis what causes NPV to go to zero o How bad would something have to be to bring NPV
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