When making capital budgeting decisions,
managers need to only consider cash flows that are relevant to the project
Referred to as Incremental Cash Flows
Incremental Cash Flows
Cash flows that will occur if and only if a firm accepts a project
are used to make capital budgeting decisions.
The NPV of a project is
the PV of free cash flows (FCF)
How does a firm estimate FCF?
earnings before interest and taxes + depreciation - capital expenditures - net operating working capital
EBIT(1-T)
Also referred to as operating income
i.e. after tax operating income
Equal to EBIT - taxes
EBIT =
Sales Revenue - Operating Costs
Operating costs include: variable costs, fixed costs and depreciation
Depreciation
Allocates the cost of an asset over its useful life
Congress sets depreciation rates
Accelerated depreciation
- Allows for greater costs to be allocated in earlier years
Straight line depreciation
- Allocates cost of asset evenly over useful life
Depreciation is
a non-cash expense
i.e. only relevant because it affects taxes
*More depreciation lowers tax bill
CAPEX (Capital Expenditures)
Expenditures used by a firm to purchase buildings or equipment
In this class, usually only relevant in year 0 of the project
NOWC (Net Operating Working Capital)
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Current assets:
Cash, inventory, and other assets that can be turned into cash within one year
Current liabilities:
accounts payable, ST loans, and other debt with a maturity less than one year
Notes payable:
ST interest bearing notes.
NOWC =
current assets minus non-interest bearing liabilities.
Firm's investment in NOWC resembles a loan
Supplies NOWC at beginning of project and gets it back at end
Other Issues to Consider in Cash Flow Estimation
Replacement Projects
Sunk Costs
Opportunity Costs
Externalities
Replacement Projects: A firm can choose from two types of projects
Expansion: firm makes a new investment
Replacement: firm replaces existing assets to save costs
Replacement project cash flows likely
influence current relevant cash flows
Sunk Cost:
outlay that was incurred in the past an cannot be recovered whether the project is undertaken or not
i.e. a cost the firm will have to pay no matter what.
Sunk costs are
not relevant in the capital budgeting decision
Because you cannot recover the cost of the sunk cost
Not handling Sunk costs properly can lead to incorrect decisions
Opportunity Costs:
return that could be earned on assets the firm already owns if the assets were not used for the new project
i.e. cost of lost options
Externalities
An effect on the firm that is not projected in cash flows
Negative externality
New project reduces the cash flows of existing project
Loss of cash flows should be considered a cost in the analysis
Difficult for managers to address
Positive Externalities
New project increases the cash flow of existing project
Managers must consider positive externalities when making capital budgeting decisions.
There is uncertainty regarding the cash flows of a particular project
If economy isn't as strong as projected, what will happen to sales?
If variable costs increase, what will happen to profits?
How do managers consider stand-alone risk of projects?
Sensitivity Analysis
Scenario Analysis
Monte-Carlo Simulation
Sensitivity Analysis
Percentage change in NPV resulting from given change in an input variable
How do managers perform sensitivity analyses?
Find the "base case"
Increase and decrease important variables, one at a time, and measure the effect on NPV
If NPV is too sensitive to changes, manager may reconsider project
base case" -
The cash flows in the most likely economic scenario
Important variables to consider
: sales, variable costs, fixed costs, equipment costs, cost of capital
Scenario Analysis
Consider the effect of all variables changing at once on NPV
How to?
Find base case scenario for all components (sales, costs, etc) and calculate NPV
Compare to worst case and best case scenario
Find standard deviation and coefficient of variation of NPV
Managers may reconsider projects with
high stand-alone risk
Or at least adjust the cost of capital estimation
Monte Carlo Analysis
Sophisticated version of Scenario Analysis
How to??
Computer randomly picks values for each variable (sales, costs, etc.)
Stores values in memory
Repeats process thousands of times
SD and CV calculated based on
computer's value of inputs
Optimal Capital Budget:
the annual investment in long term assets that maximizes the value of the firm.
If a firm can receive financial for all projects, firm should accept
all projects with positive NPVs
all mutually exclusive projects with higher NPVs
Reasonable assumption that large, mature firms can finance all projects
If a firm has difficulty raising all the capital it needs,
a firm must engage in capital rationing
Firms must use capital in most efficient way
Managers must maximize NPV while not
exceeding capital constraints
Difficult and complex process
The Post Audit
Comparison of actual vs. expected results for a given project
Two purposes
- improve forecasts
- improve operations
Improve forecasts:
allows for biases and forecast errors regarding variables of project to be corrected
Improve operations:
if original estimates of project's sales or costs are inaccurate, managers are held accountable.