Evaluating projects (1) Class 3 Financial Management, 15.414MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Today Evaluating projects • Measuring cashflows • Taxes, depreciation, and working capital Reading • Brealey and Myers, Chapters 6 and 12.1 – 12.3 • Myers (1984)MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Capital budgeting What projects should the firm take? • Marketing and advertising • R&D • Choices among different production processes • Expanding into new products, industries, or markets • Investments in new technology • Acquisitions 3MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Example Boeing is evaluating whether or not to proceed with development of a new regional jet. The firm expects development to take 2 years, cost roughly $750 million, and it hopes to get unit costs down to $32 million. Boeing forecasts that it can sell 30 planes each year at an average price of $41 million. How would you evaluate this project? 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Review Valuation The value of any asset or project equals the net present value of its expected cashflows • NPV = CF0 + ... CFCFCFCFCF 5 5 4 4 3 3 2 21 + + + + + + + + + + • r = opportunity cost of capital Rate of return required on investments in the financial market with similar risk • A project creates value (NPV > 0) only if it has a higher return than other investments with the same risk r) (1 r) (1 r) (1 r) (1 r) (1 5MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Evaluating projects Forecasting cashflows What cashflows are relevant? What are the differences between earnings and cashflows? How uncertain are the cashflow forecasts? How sensitive is NPV to our assumptions? How can we take into account strategic concerns? 6MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows Incremental cashflows The difference between the firm’s overall cashflows with and without the project, including any competitive or strategic side effects Considerations • Sunk cost • Project interactions • Opportunity costs • Inflation • Average vs. marginal costs • Investments in working capital • Depreciation • Taxes • Real options • Projects with different lives 7MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 1 Ignore sunk costs A sunk cost is a cashflow that must be incurred whether or not the project is accepted. Example Motorola has the opportunity to supply 5,000 cell phones to the Summer Olympics. The accounting department estimates that each phone costs $15 to make, of which $5 represents overhead and $10 represents labor and materials. What is the cost of the sponsorship deal? 8MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 2 Remember opportunity costs Any cashflow that the firm gives up if it takes the project. Example Modigliani Import Co. owns an empty warehouse in Boston. The warehouse cost $200,000 to build and has a current value of $250,000. MIC would like to import a new line of Italian lamps, which will be stored in the warehouse. What is the cost of the warehouse space? 9MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Opportunity costs, cont. Example 2 Boeing is evaluating a new regional jet. If it proceeds with development, the firm will have to invest $200 million next year in R&D. The cash is currently invested in short-term securities yielding 2%. An accounting executive argues that the project should be charged for lost interest, amounting to $4 million per year ($200 million × 0.02). Is he right? 10MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 3 Marginal costs Decisions should be based on marginal, not average, costs. Example Boeing is negotiating with Air Canada over the price of 20 new 737s. Air Canada offers $40 million per plane. Based on past data, Boeing estimates that the average cost of a new 737 is $30 million in labor and materials. How valuable is the Air Canada offer? 11MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 4 Project interactions Recognize project interactions / strategic issues in the cashflow forecasts Loss leaders, cannibalization of existing product lines, … Example Wegmans, a supermarket chain based in Rochester, NY, is thinking about installing movie rental centers in its stores. Each rental center costs $80,000 to build, and Wegmans forecasts that profits will be $7,000 in perpetuity. If the discount rate is 10%, should Wegmans go ahead with the plan? 12MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Project interactions, cont. Example 2 Boeing is evaluating a new regional jet. The firm expects development to take 2 years and cost roughly $750 million. Boeing forecasts sales of 30 planes per year and expects profits of $9 million on each sale. Example 3 Baldwin, a profitable widget maker, has developed a product called the Turbo-Widget (TW). Baldwin has invested $300,000 in R&D to develop TWs, and expects that TWs will capture a large share of the market. 13MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 5 Inflation Discount nominal cashflows using nominal rates; discount real cashflows using real rates. Warnings • Discount rates are typically nominal rates ⇒ cashflow forecasts should be nominal, too. • Some cashflows are inherently nominal (e.g., depreciation tax shields). • Forecasting nominal growth → forecasting real growth + inflation. 14MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Measuring cashflows 6 Working capital Short-term assets and liabilities that the firm generates in the course of doing business. Current assets – inventory, accounts receivable, cash Current liabilities – accounts payable Net working capital = CA – CL Investments in NWC are costly. An increase in NWC represents a cash outflow; a decrease in NWC represents a cash inflow. 15MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Working capital Assets Liabs. and equity Current assets cash accounts receivable inventory Long-term assets equipment buildings land intangibles Current liabilities accounts payable Long-term debt bank loans bonds Equity common stock retained earnings 16MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 3 Example GM has just designed a new Saturn. It forecasts sales of 200,000 cars per year at an average price of $18,000. Costs are expected to be $17,000 / car. The model will sell for 4 years and GM expects an inventory of 40,000 cars. What are the cashflows?