Capital Budgeting

1. Big Picture… Capital Budgeting • Select investments which increase value of firm • Maximize wealth of shareholders • Important to firm’s long-term success • Substantial cost • Cash flows over long time period Capital Budgeting

2. Steps in evaluating capital assets • Determine cost of asset • Estimate incremental cash flows • Very difficult but… • Very important… • Determine decision criteria • Apply decision criteria • Compare actual results to projected Capital Budgeting

3. Incremental After-Tax Cash Flows • Sunk costs • Opportunity costs • Erosion/synergy • Net working capital • Financing costs • Taxes matter Capital Budgeting

4. Sunk costs and opportunity costs • Converting a factory from making Chevy Caprices to pickup trucks… • Cost of factory relevant? • Sunk costs: costs already incurred are not relevant • Sales price of factory relevant? • Opportunity costs: cash flows we would receive if we reject the project. • Relevant Capital Budgeting

5. Erosion/Synergy • Steak N Shake opens in Charleston… • Impact on Mattoon location • Erosion: decrease in sales of existing products • Relevant • Synergy: additional sales of existing products • Relevant Capital Budgeting

6. Net working capital • Project will initially require: • Increase in inventory (use cash) • Increase in A/R (use cash) • Increase in A/P (source) • At the end of the project, • Decrease in inventory (source of cash) • Decrease in A/R (source cash) • Decrease in A/P (use cash) Capital Budgeting

7. Financing costs • Not considered relevant… • Presumably would require rate of return greater than cost of financing Capital Budgeting

8. Taxes • After-tax cash flow is what matters • Tax impact of depreciation • Reduce taxable income without requiring cash expenditure Capital Budgeting

9. Taxes • Sale of asset at end of project • Factory purchased for $10 million 10 years ago. After taking $6 million of depreciation, factory is sold for $5 million. Book ValueGain Cost $10 mil Sales Price $ 5 mil Acc Depr 6 mil Book Value 4 mil Book Value 4 mil Gain 1 mil Capital Budgeting

10. Taxes • Trade asset • No tax on “gain” • Book value + cash paid = Depreciable cost • Sell asset • If market value < book value Book ValueGain Cost $10 mil Sales Price $ 1 mil Acc Depr 6 mil Book Value 4 mil Book Value 4 mil Loss 3 mil Capital Budgeting

11. Evaluating NPV Estimates • Forecasting risk • Scenario analysis • Sensitivity analysis • Managerial options Capital Budgeting

12. Forecasting Risk • Make a wrong decision based on capital budgeting analysis • Accept a project which actually has a negative NPV • Reject a project which actually has a positive NPV • Remember importance of required rate of return in calculating NPV Capital Budgeting

13. Scenario analysis • Calculate NPV using: • Pessimistic assumptions in calculations • Should this result in a negative NPV? • Optimistic assumptions in calculations • Should this result in a negative NPV? Capital Budgeting

14. Sensitivity analysis • What assumptions have the greatest impact on NPV? • Calculate pessimistic and optimistic NPVs while only changing one variable • Which assumption has the biggest impact on NPV? • Example: apartment complex • Change monthly rents • Change vacancy rate • Change repair expense Capital Budgeting

15. Managerial Options When should you reduce or stop expansion? • Option to expand • If project does have large NPV • Option to abandon • If NPV is less than anticipated • Option to wait • If project will have positive NPV in future Raw land… Capital Budgeting