CapitalBudgeting:CashFlowsandRisk

CapitalBudgeting:CashFlows andRisk

RelevantIncremental CashFlows
ProjectFreeCashFlows
=NOPAT+Depreciation GrossInvestmentin FixedOperating p gAssets Investmentin OperatingWorkingCapital =EBIT(1 t)+Depreciation GrossInvestment inFixedOperatingAssets (Operating CurrentAssets OperatingCurrent Liabilities)

RelevantIncremental CashFlows
ShippingandInstallation NoncashItems InterestExpense SunkCosts OpportunityCosts Externalities(productcannibalization)

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CapitalBudgeting:CashFlowsandRisk

Depreciation
Straightline MACRS

StraightLineDepreciation
Youpurchaseamachinefor$20,000, whichhasadepreciablelifeof5years. Whatistheannualdepreciation p expense? p Ifyousellthemachineattheendofthe year4for$5,000,whatistheaftertax salvagevalueifthefirmstaxrateis40 percent?

MACRSDepreciation
Halfyearconvention Table132

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CapitalBudgeting:CashFlowsandRisk

MACRSDepreciation
AssetClass Year 1 2 3 4 5 6 3Year 33% 45% 15% 7% 5Year 20% 32% 19% 12% 11% 6%

MACRSDepreciation
Youpurchaseamachinefor$80,000,whichisin the3yearassetclass.Themachinecostsan additional$20,000indeliveryandinstallation. Createadepreciationschedule.

Ifyousellthemachineattheendofyear3for $5,000,whatistheaftertaxsalvagevalueifthe firmstaxrateis40percent?

Example#1
Bridgewell Industries is evaluating the option of purchasing a fork-lift truck costing $60,000. If purchased, the truck will replace 4 workers, each with an average annual salary of $15 $15,000. 000 However However, an experienced fork-lift fork lift operator will have to be hired at a salary of $20,000 per year. Fuel and maintenance expense is expected to be $10,000 per year. At the end of its 5-year life, the truck will have a market value of $10,000. Bridgewell uses straight-line depreciation and depreciates the asset to $0, assigns a 10% required rate of return for this type of investment, and has a marginal tax rate of 40%. Should the fork-lift truck be purchased?

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CapitalBudgeting:CashFlowsandRisk

Example#2
Yourfirm,MulletMan,Inc.,isconsideringaprojectthatwilllast 4yearsandproduceannualsalesof1,250unitsatapriceof $200perunit.Thecosttoproduceeachunitis$100.Assume thatpriceandcostincreaseat3percentperyearafterthefirst year.The Th firm fi requires i net toperating ti working ki capital it lt tobe b 12 percentofnextyearssalesandhasa40percentmarginaltax rate.Theprojectrequiresmachinerycosting$200,000,plusan additional$10,000forshippingand$30,000forinstallation.It isintheMACRS3yearassetclassandisexpectedtohavea $25,000salvagevalueattheendoftheproject.Projectsofthis riskhavea10percentcostofcapital.Inaddition,thefirm spent$100,000lastyeartoimprovetheproductionlinesite. Shouldweinvest?

RiskAnalysis
SensitivityAnalysis ScenarioAnalysis SimulationAnalysis PhasedDecisions

SensitivityAnalysis
WhathappenstoNPVifourassumptions areoff? Foraparticularinput,evaluateabasecase andthendeviationsfromthebasecase.

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CapitalBudgeting:CashFlowsandRisk

SensitivityAnalysis
Change From Base level

Resulting NPV (000s) Rate $113 $100 $88 $76 $65 Unit sales $17 $52 $88 $124 $159 Salvage $85 $86 $88 $90 $91

-30% 30% -15% 0% 15% 30%

SensitivityAnalysis
UnitSales

NPV (000s) 88

Salvage Rate

302010Base102030 (%)

ScenarioAnalysis
Incorporatestheprobability ofchangesin ourinputs Allowsmorethanonetobechangedata time

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CapitalBudgeting:CashFlowsandRisk

Bestscenario:1,600units@$240 Worstscenario:900units@$160
Scenario Best Base Worst Probability 0.25 0 50 0.50 0.25 NPV(000) $279 $88 -$49

E(NPV) = $101.5 (NPV) = 116.6 CV(NPV) = (NPV)/E(NPV) = 1.15

SimulationAnalysis
Specifyadistributionforeachcomponent (mean,standarddeviation) Startwithrandomvalues ComputeNPV(orIRR) Repeatandcreatedistribution

SimulationExampleAssumptions
Normaldistributionforunitsales:
Mean=1,260 Standarddeviation=201

Triangular Ti l distribution di t ib ti for f unit itprice: i

Lowerbound=$163 Mostlikely=$202 Upperbound=$248

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CapitalBudgeting:CashFlowsandRisk

SimulationResults(1,000trials)
Units Mean St. Dev. CV Max Min 1883 685 $248 $163 1260 201 Price $202 $18 NPV $95,914 $59,875 0.62 $353,238 ($45,713)

Prob NPV > 0 = 97%.

HistogramofResults
12% Probability of f NPV 10% 8% 6% 4% 2% 0%
($ 60 ($ ,00 30 0) ,0 00 ) $3 $0 0, 0 $6 00 0, $9 000 0 $1 ,00 20 0 $1 ,00 50 0 $1 ,00 80 0 $2 ,00 10 0 $2 ,00 40 0 $2 ,00 70 0 $3 ,00 00 0 $3 ,00 30 0 $3 ,00 60 0 ,0 00

PhasedDecisions
Createadecisiontree Reevaluateprojectatkeypoints Proceedorendproject?

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CapitalBudgeting:CashFlowsandRisk

Example#3
Yourfirmisconsideringtheintroductionofanewproduct. Themarketingdepartmenthasestimatedthat100,000units willbesoldnextyearfor$50perunit.Unitsalesareexpected toincreaseat6percentforeachofthefoursubsequentyears andthepriceisexpectedtoincreaseattherateofinflation,3 percent.Costsareestimatedtobe25percentofsales. Productionequipmentof$9millionisneeded.Forsimplicity, assumenochangesinnetoperatingworkingcapitalandno depreciationorsalvagevalue. Thefirmsmarginaltaxrateis 40percent.Ifthefirmsnominalrequiredrateofreturnfora projectofthisriskis13.3percent,shouldyourfirmmove forwardwiththeproduct?

Inflation
Useanominaldiscountratewithnominal cashflows Usearealdiscountratewithrealcashflows (1+rn)=(1+rr)x(1+i) rn =rr +i +(rr xi)

Example#4

Seeendofnotes.

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CapitalBudgeting:CashFlowsandRisk

SuggestedProblems
Questions:
133through135

Problems:
131through137

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1. BridgewellIndustriesisevaluatingtheoptionofpurchasingaforklifttruckcosting$60,000. If purchased, the truck will replace 4 workers, each with an average annual salary of $15,000. However, an experienced forklift operator will have to be hired at a salary of $20,000peryear.Fuelandmaintenanceexpenseisexpectedtobe$10,000peryear.Atthe endofits5yearlife,thetruckwillhaveamarketvalueof$10,000.Bridgewellusesstraight line depreciation and depreciates the asset to $0, assigns a 10% required rate of return for this type of investment, and has a marginal tax rate of 40%. Should the forklift truck be purchased? 2. Yourfirm,MulletMan,Inc.,isconsideringaprojectthatwilllast4yearsandproduceannual sales of 1,250 units at a price of $200 per unit. The cost to produce each unit is $100. Assume that price and cost increase at 3 percent per year after the first year. The firm requires net operating working capital to be 12 percent of next years sales and has a 40 percent marginal tax rate. The project requires machinery costing $200,000, plus an additional $10,000 for shipping and $30,000 for installation. It is in the MACRS 3year asset class and is expected to have a $25,000 salvage value at the end of the project. Projects of this risk have a 10 percent cost of capital. In addition, the firm spent $100,000 last year to improvetheproductionlinesite.Shouldweinvest? 3. Your firm is considering the introduction of a new product. The marketing department has estimatedthat100,000unitswillbesoldnextyearfor$50perunit.Unitsalesareexpected to increase at 6 percent for each of the four subsequent years and the price is expected to increase at the rate of inflation, 3 percent. Costs are estimated to be 25 percent of sales. Production equipment of $9 million is needed. For simplicity, assume no changes in net operatingworkingcapitalandnodepreciationorsalvagevalue.Thefirmsmarginaltaxrate is 40 percent. If the firms nominal required rate of return for a project of this risk is 13.3 percent,shouldyourfirmmoveforwardwiththeproduct? 4. TheMuschampEquipmentCompanypurchasedamachine5yearsagoatacostof$90,000. Ithadanexpectedlifeof10yearsatthetimeofpurchaseandanexpectedsalvagevalueof $10,000 at the end of 10 years. It is being depreciated by the straight line method to zero, orby$9,000peryear.Anewmachinecanbepurchasedfor$150,000,includinginstallation costs. Over its 5year life, it will reduce cash operating expenses by $50,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and it will be depreciated over a 3year recoveryperiodratherthanits5yeareconomiclife.Theoldmachinecanbesoldtodayfor $65,000. The firms tax rate is 34 percent. The appropriate discount rate is 15 percent. ShouldMuschampEquipmentCompanypurchasethenewmachinenow?