P1247176258XqwlZ

1
Create Stock Value
Time Value
Risk
Financing
Investment
Cash Flows
Evaluation
Estimating Project Cash Flows
2
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Classification
Discounted CF Methods
Payback
Accounting Rate of Return
Process
Planning
Size
Generate Ideas
Type of Benefits
Estimate Cash Flows
Dependence
Accept/ Reject
Implement
Post- Audit
3
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Classification
Discounted CF Methods
Payback
Accounting Rate of Return
Process
Accept/Reject Projects
Mutually Exclusive Projects
Net Present Value (NPV)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Internal Rate Of Return
4
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Classification
Discounted CF Methods
Payback
Accounting Rate of Return
Process
Accept/Reject Projects
Mutually Exclusive Projects
Net Present Value (NPV)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Internal Rate Of Return
Possibility of Multiple IRR
5
Mutually Exclusive Projects
Project Yr0 Yr1 Yr2 Yr3 Yr4 Yr5 A.State of Art
Facility -400 100 110 120 130 140 B.Low
Cost -200 50 60 70 70 80 NPV_A(12) 24.45 NPV_B(
12) 14.30 IRR_A 14.30 IRR_B 15.95
6
Mutually Exclusive Projects
Net Present Value (NPV)
Internal Rate Of Return
Why the Possible Conflict
Reinvestment Assumption
Scale Differences
Unequal Useful Life
Early versus Late Projects
7
Why the Possible Conflict
NPV
b
IRRa
a
k
k
IRRb
8
Payback
Year 1 2 3 4 5 6 7 8 NCF 2,000 3,000 4,000 3,500
3,000 2,000 1,000 1,000
k10

• Year Cash Flow PV Cash Flow Cumulative
• 2,000 1,818 1,818
• 3,000 2,479 4,298
• 4,000 3,005 7,303
• 3,500 2,391 9,693
• 3,000 1,863 11,556
• 2,000 1,129 12,685
• 1,000 513 13,198
• 8 1,000 467 13,665

Initial investment 12,500. k10 Payback 4
years Discounted Payback(r10)5.84 years NPV
1,165
9
Accounting Rate of Return
After-Tax Cash Flows Project Investment Yr1 Yr
2 Yr3 Yr4 Yr5 A 5,000 800 1,000 350 1,250 3,000
B 7,500 1,250 3,000 2,500 5,000 5,000 C 4,000 60
0 1,200 1,200 2,400 3,000 k12. Target ARR20.
Straight line 5 years. Tax rate35
Projects A B C Total after-tax cash
flow 6,400 16,750 8,400 Total depreciation 5,000
7,500 4,000 Net Income 1,400 9,250 4,400 Average
Net Income 280 1,850 880 Accounting Rate of
Return 11.2 49.3 44.0 Payback 4.53
yrs 3.15 yrs 3.42 yrs NPV -743 3,802 1,574 IRR
7 27 23.37
10
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Replacement
New Products
Biases
Options
Guidelines
Positive NPV Reasons?
Incremental CF
Ignore sunk costs
Consider Opportunity Costs
Consider WC Investments
Consider Terminal Values
11
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Replacement
New Products
Biases
Options
Guidelines
Positive NPV Reasons?
Initial Investment
Periodic Cash Flows
Terminal Value
12
Initial Investment

• A projects initial investment may consist of
  three components
• Cost of acquiring and placing the asset in
  service
• Net proceeds from the sale of the existing
  equipment
• Tax consequences of selling an existing asset

13
Operating Cash Flows

• The incremental operating cash flows (DOCF), per
  period, can be expressed as
• DOCF ( DREV - DCOST - DDEP)(1 - TAX) DDEP
  DWC
• DOCF ( DREV - DCOST)(1 - TAX) TAX DDEP - DWC
• Where
• DREV the change in revenues
• DCOST the change in operating costs
• DDEP the change in depreciation
• DWC the annual increase in working capital
• TAX the marginal tax rate faced by the firm

14
Terminal or Salvage Values

• A projects terminal, or salvage value may
  consist of one or more of the following elements
• Salvage value of equipment
• Recovery of working capital
• Cash flows beyond some initial evaluation period

15
Spectrum Manufacturing Company

• Existing Equipment
• Cost 120,000 Depreciation
  12,000/Year Book Value 60,000
• Salvage Value Today 10,000 Salvage Value in 5
  Years 0
• New Equipment
• Cost 100,000 Depreciation 20,000/Year
  
• Cash Savings 24,000/Year Salvage Value in 5
  Years 0

16
Spectrum Manufacturing Company- Initial Investment

• Installed Cost of Computerized Lathe
  -100,000
• Salvage Value of Old Lathe
  10,000
• Tax Effects from Selling Old Lathe
  20,000
• INITIAL INVESTMENT
  -70,000

17
Spectrum Manufacturing Company - Operating Cash
Flows

• Year 1 Year 2 Year 3 Year 4
  Year 5
• Annual Cash Savings 24,000 24,000
  24,000 24,000 24,000
• D Depreciation (8,000) (8,000) (8,000)
  (8,000) (8,000)
• Taxable Income 16,000 16,000 16,000
  16,000 16,000
• Taxes_at_40 (6,400) (6,400)
  (6,400) (6,400) (6,400)
• After-Tax Income 9,600 9,600
  9,600 9,600 9,600
• Plus D Depreciation 8,000 8,000
  8,000 8,000 8,000
• Annual OCF 17,600 17,600 17,600 17,600
  17,600

18
Spectrum Manufacturing Company- The Projects NPV

• NPV 17,600 PVIFA 5,10 -70,000
• 17,600(3.7908) - 70,000
• -3,282

19
New Product Introduction - Smith Corporation

• NEW PRODUCT FINANCIAL FORECASTS
• ( ALL FIGURES IN 1,000)
• Period
  0 1 2 3 4
  5 6
• Sales
  500 5,500 8,000 14,000 7,000
  4,000
• Operating Expenses
  800 3,410 4,960 8,680 4,340 2,480
  
• Product Promotion 3,000 1,000
• Depreciation
  1,000 1,000 1,000 1,000 1,000 1,000
• Profit Before Taxes - 3,000 - 2,300
  1,090 2,040 4,320 1.660 520
• Taxes _at_ 34 - 1,020 -
  782 371 694 1,469 564 177
• Profit After Taxes - 1,980
  -1,518 719 1,346 2,851 1,096 343
• Level of Working Capital
  250 660 960 1,680 840 480

20
New Product Introduction - Smith Corporation

• CAPITAL PROFIT AFTER TAX
  WORKING TOTAL PRESENT
• YEAR EQUIPMENT DEPRECIATION CAPITAL
  CASH FLOW VALUE _at_20
• 0 - 6,000 - 1,980
  - - 7,980
  - 1,980
• 1 - - 518
  - 250 - 768
  - 640
  
  
• 2 - 1,719
  - 410 1,309
  909
• 3 - 2,346
  - 300 2,046
  1,184
• 4 - 3,851
  - 720 3,131
  1,510
• 5 - 2,096
  840 2,936
  1,180
• 6 - 1,343
  360 1,703
  570
• 7 660 -
  480 1,140
  318
• 
  
  NPV - 2,948

21
Post-Evaluation Period Cash Flow Estimation

• The following equation can be used to estimate
  the cash flows beyond some initial evaluation
  period
• CFn1
• TVn
• (k-g)

22
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Replacement
New Products
Biases
Options
Guidelines
Positive NPV Reasons?
Inflation
Overoptimism
23
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Replacement
New Products
Biases
Options
Guidelines
Positive NPV Reasons?
Abandonment (Gold Mine)
Strategic
Add-on Products
Vertical Integration
Related Diversification
24
Investments (Capital Budgeting)
Evaluation
Estimating Project Cash Flows
Replacement
New Products
Biases
Options
Guidelines
Positive NPV Reasons?
Economies of Scale or Scope
Cost Advantages
Product Differentiation
Distribution Channels