CAPITAL BUDGETING ANALYSIS AND EVALUATION Standalone Principal the principle that a company should decide whether or not to accept or reject a project based on comparing similar projects with the same risk It is important to capital budgeting to add value to the firm Relevant Incremental Cash Flows include cash flows that will ONLY occur if the project is accepted Opportunity Costs Side Effects Erosion Net Working Capital Tax Effects Depreciation After Tax Cash flows only Non Relevant Sunk Costs Allocated costs Tax Expense Financing Costs From or to Creditors Stockholders Opportunity Cost the loss of potential gain from other alternatives when one alternative is chosen The most valuable alternative that is given up if a particular project is undertaken EX If you GIVE UP a job to go to school you must ADD lost wages to the cost of school Sunk Cost a cost that we have already paid or have already incurred the liability to pay Sunk costs cannot be changed as a result of accepting or rejecting the project Usually happened in the past EX Already paid a consultant on the new product line Not relevant because it is already paid for and does not change regardless of whether you accept or reject project Side Effects acceptance of one project affecting another project helping or hurting Synergy benefit Erosion Cannibalism new project revenues gained but take revenue from new item to a line of existing products may attract existing product line or service more attention to other items in the line bringing NEW business to existing items EX A car company introduces top of the line model that attracts media attention to the company increasing sales of other already existing models in ADDITION to the new model Net Working Capital short term net working capital Cash inventory Accounts Receivable Accounts Payable Since a project usually needs to be financed in year 0 with short term net working capital it is important to include it in capital budgeting analysis This effect of NWC occurs at the BEGINNING and the END of the projects life when NWC is recovered Financing Costs Are NOT included in capital budgeting analysis like Interest Expense However financing costs ALREADY are a part of the cash flows from a project and ARE REFLECTED by the DISCOUNT RATE used to discount the project cash flows if you included financing costs you would double the effect Taxes Companies that pay income taxes must consider the impact income taxes have on cash flows for long term investments and make the necessary adjustments Investment and working capital cash flows are not adjusted because these cash flows do not affect taxable income Revenue cash inflows and expense cash outflows are adjusted by multiplying the cash flow by 1 tax rate this is the AFTER TAX RATE Proforma Financial Statement projected financial statements estimating the unknown future of the project Depreciation Depreciation calculated on the income statement is represented by using Straight Line Depreciation By doing so this results in lower depreciation expense in the early years leading to a higher Net Income This then translates to a lower accumulated depreciation expense on the balance sheet leading to a higher Net Fixed Assets making the firm look more valuable Depreciation for tax purposes firms use accelerated depreciation MACRS for calculation This puts more of the depreciation expense in the earlier years and less in the later years By doing so the firm will have a greater tax shield lowering the firm s taxable income making the cash flows higher BID PRICE the price a buyer is WILLING to pay for a security When you are SETTING the bid price the lowest acceptable bid that could be taken is the one that makes the NPV 0 just earning the required rate of return EX Best explained in class notes Different Functional Lives For projects with different functional lives you have to adjust the cash flows and calculate what is known as equivalent annual cost EAC which spreads out the cost evenly over the projects life Ex Best example in class notes Chapter 10 Battery life example Forecasting risk the danger of making a bad decision because an error in projected cash flows decreases value of project CALCULATIONS for CASH ITEMS Operating Cash Flows Sales Costs 1 Tax Rate Depreciation Tax Rate After Tax Salvage Selling Price Selling Price Book Value t Cash Flow from Assets Operating Cash Flow CHANGE in NWC CHANGE in Capital Spending Depreciation Expense Depreciation Rate Initial Investment Depreciation Tax Shield Depreciation Expense Tax Rate Book Value Cost Accumulated Depreciation Equation use varies with examples Scenario Analysis Worst Case Best Case The process of estimating the expected value of a portfolio after a given period of time assuming specific changes in the values of the portfolio s securities or key factors that would affect security values NPV such as changes in the interest rate Methods for scenario analysis include finding what the standard deviation of a security then compute what value would be expected for the portfolio if each security generated returns two or three standard deviations ABOVE best case and BELOW worst case below the AVERAGE return Based on YOUR scenarios can be bad good for forecasting portfolio returns Sensitivity Analysis Change one variable at a time A technique used to determine how different values of an INDPENDENT variable will impact a PARTICULAR DEPENDANT NPV variable under a given set of assumptions Best bet for forecasting portfolio returns Breakeven Analysis What causes NPV to go to zero Helps in knowing how much should be produced and sold at a minimum to ensure that the project does not lose money Different than Sensitivity Analysis because Simulation Analysis Estimating thousands of possible scenarios Results NPV found using computer software tweaking many variables at a time and repeats this process many times With all the NPVs the computer software then creates a distribution of NPV and determines expected NPV and a variance of NPV Some disadvantages of Simulations is that you don t know how the computer got such numbers creates confidence where none is warranted and the results are a function of the parameters SET by the analyst If you start with the wrong parameters you could get misleading results CAPITAL MARKET HISTORY Percentage vs Dollar Returns Risk Vs Reward The Riskier higher standard deviation the stock is the more you should be rewarded higher returns Rank of Risk and Return 1 Small
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