Week 18 - Making capital investment decisions Flashcards
What is the effect of taking a project on a firm’s cash flows?
Taking a project changes the firm’s overall cash flows both today and in the future.
What key question should a firm ask when evaluating a project’s impact on cash flows?
A firm should compare:
Cash flows without the project
Cash flows with the project
What is the direct consequence of taking a project?
The direct consequence is the change in net cash flows, which includes both additional revenues and new costs associated with the project.
What are incremental cash flows?
Incremental cash flows are the relevant cash flows that result from the direct consequences of taking a project.
What principle focuses only on incremental cash flows when evaluating a project?
The stand-alone principle — it focuses solely on the project’s resulting incremental cash flows.
What are relevant cash flows in project evaluation?
Relevant cash flows are any changes in the firm’s current and future cash flows that result directly from taking the project.
What type of cash flow is NOT relevant in project evaluation?
Any cash flow that exists regardless of whether or not the project is undertaken is not relevant.
What is the first step in evaluating a proposed project?
Obtain a set of pro-forma financial statements, which are projected or estimated financial statements.
What does “pro-forma” mean in financial analysis?
Pro-forma means projected, estimated, or predicted financial data.
How should a project be treated for evaluation purposes?
Treat the project as a mini-firm and forecast its financial statements to reflect future operations.
How can cash flow be derived from financial statements?
Compute cash flows using data from the project’s balance sheets and income statements.
What decision rules are commonly used to evaluate a proposed project?
The key evaluation methods include:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Average Accounting Return (AAR)
What key question should you ask when identifying relevant cash flows?
Ask: “Will this cash flow occur ONLY if we accept this project?”
What should you do if the answer to the key question (“Will this cash flow occur ONLY if we accept this project?”) is yes?
Include the cash flow in the analysis because it is incremental.
What should you do if the answer to the key question (“Will this cash flow occur ONLY if we accept this project?”) is no?
Exclude the cash flow, since it will occur regardless of the project.
What should you do if the answer to the key question (“Will this cash flow occur ONLY if we accept this project?”) is partly?
Include only the portion of the cash flow that occurs because of the project.
What are sunk costs and how should they be treated in cash flow analysis?
Sunk costs are past expenses that cannot be recovered. They should be excluded from project evaluation as they are not incremental
What are opportunity costs and how should they be treated in cash flow analysis?
Opportunity costs are the value of the best alternative foregone. They should be included in cash flow analysis because they are a real economic cost.
What are side effects in project evaluation?
Side effects are impacts on other areas of the firm, such as cannibalisation (when a new product reduces sales of an existing product). They should be included if they affect cash flows.
How do changes in net working capital affect cash flow analysis?
Increases in net working capital (e.g., inventory buildup) are a cash outflow, while decreases are a cash inflow. These changes should be included in project evaluation.
How should financing costs be treated in project evaluation?
Financing costs (e.g., interest expenses) should be excluded from project cash flow analysis as they are accounted for in the discount rate.
How should tax effects be treated in cash flow analysis?
Taxes must be included in project evaluation since they directly impact net cash flows. Consider tax shields from depreciation and other deductions.
Sunk costs example:
The General Milk Company is evaluating the NPV of a new project to make
chocolate milk. As part of the evaluation, the company has paid a consulting
firm £100,000 to perform a test-marketing analysis.
* The test marketing analysis shows that the present value of all the future
cash flows from this project are £300,000. However, the initial investment is
£250,000
* Should we take this project?
* is the £100,000 spent on consultants relevant for the capital budgeting
decision?
The £100,000 spent on the consulting firm is a sunk cost and is not relevant for the capital budgeting decision.
Sunk costs are costs that have already been incurred and cannot be recovered. Since this money has already been spent regardless of whether the project goes ahead or not, it should not factor into the NPV calculation or decision-making.
The key consideration is whether the future cash flows exceed the initial investment.
NPV = Present value of future cash flows - initial investment
NPV = 300,000 - 250,000 = £50,000
Since the NPV is positive, the project is financially viable and should be accepted. The sunk cost of £100,000 is irrelevant to this calculation.
How should the £100,000 spent on test-marketing analysis be treated in project evaluation?
The £100,000 test-marketing cost is a sunk cost because it has already been incurred and cannot be recovered, regardless of whether the project is accepted or rejected. Therefore, it should be excluded from the project’s incremental cash flow analysis.
What is a sunk cost?
A sunk cost is a cost that has already occurred and cannot be recovered. It has no impact on future decisions regarding a project or investment.
Why are sunk costs irrelevant for future decisions?
Sunk costs are irrelevant because they cannot be recovered, regardless of whether a company accepts or rejects a project. Future decisions should only consider future costs and benefits.
Are sunk costs considered when deciding whether to accept or reject a project?
No, sunk costs are not considered in project decisions since they are already incurred and cannot be recovered. Decisions should be based on future incremental costs and benefits.
What are incremental cash outflows?
Incremental cash outflows refer to additional costs that will occur if a project is undertaken. They are relevant for decision-making, unlike sunk costs, which are not.
Opportunity cost example:
suppose a company bought a building 10 years ago for £1 million. The company is considering taking a proposed project which will use the building
* should we treat this building as free?
* what can the company do with the building if the project is not taken?
* does a company give up anything by using it for the new project?
* should we charge £1 million on the new project for using this building?
Should we treat this building as free?
No, the building is not “free.” Even though the company bought the building 10 years ago, the cost of acquiring it (the opportunity cost) is still relevant. In economic terms, we don’t ignore past costs, but we focus on opportunity costs going forward. The building may have had depreciation over time, and its current market value might differ from its initial cost, but it still has an economic value in terms of the potential use or sale.
What can the company do with the building if the project is not taken?
If the project is not taken, the company has several options with the building:
It could sell the building and potentially realise its market value, which may have appreciated or depreciated since it was originally purchased.
It could lease the building to another party, generating rental income.
It could repurpose the building for other internal uses unrelated to the new project.
Does a company give up anything by using it for the new project?
Yes, by using the building for the new project, the company is giving up the opportunity to use the building for another potential use, such as selling or leasing it. This is the opportunity cost of using the building in the new project—any alternative income or benefit that could have been gained by not using it in this way is foregone.
Should we charge £1 million on the new project for using this building?
No, you shouldn’t necessarily charge £1 million for the building. The £1 million is the historical cost, and it’s not the relevant number for the new project. The relevant cost would be the current opportunity cost of using the building, which could be the potential revenue from selling or leasing it. If the building’s current market value or rental income is lower than £1 million, that should be used as the cost of utilising the building for the new project.
What is an opportunity cost?
The opportunity cost is the most valuable alternative that is given up (foregone) when a particular investment or decision is made. It reflects the benefits of the next best option that is not chosen.
What does “there is no such thing as a free lunch” mean in terms of opportunity costs?
“There is no such thing as a free lunch” means that every decision has a cost, even if it’s not immediately apparent. It emphasizes that every choice involves giving up something else, which is the opportunity cost.
Are opportunity costs considered incremental cash flows?
Yes, opportunity costs are considered incremental cash flows. They represent the potential benefits or revenue that could have been earned if a different decision or alternative investment had been chosen.
What are the costs of doing a postgraduate degree in terms of opportunity costs?
The opportunity costs of doing a postgraduate degree include:
The foregone salary or income from not working during the study period.
The potential experience or career advancement opportunities missed while pursuing the degree.
The cost of tuition and other expenses, which could have been invested elsewhere for potentially higher returns.
Side effects example:
* McDonald’s introduce a new Arch Deluxe sandwich. Suppose sales of
the new sandwich are £2.5m, and the costs of producing or selling the
new sandwich are £1.5m
* should we treat only £1.5m as the incremental cash outflow?
* what will happen to sales of the Big Mac?
Should we treat only £1.5m as the incremental cash outflow?
No, the £1.5 million is the direct cost of producing and selling the new Arch Deluxe sandwich, but when assessing incremental cash flows, we need to consider both revenues and costs directly attributable to the new product.
The incremental cash inflow is the sales revenue of £2.5 million from the new sandwich, while the incremental cash outflow includes not just the £1.5 million in production costs, but also any other additional costs associated with the launch of the new sandwich, such as marketing, distribution, or any fixed costs that may increase as a result of the new product.
Furthermore, the opportunity costs should be considered. If, for example, resources (like marketing or production capacity) were shifted from other products (e.g., the Big Mac) to launch the Arch Deluxe, this may result in a loss of sales for the Big Mac, which needs to be accounted for in the incremental analysis.
What will happen to sales of the Big Mac?
The introduction of a new product like the Arch Deluxe could lead to cannibalisation of Big Mac sales. This means that some customers who would have bought a Big Mac may now prefer the new sandwich instead.
The degree of cannibalization depends on factors such as how similar the two products are, how well the Arch Deluxe is marketed, and whether the new sandwich is perceived as a superior option.
Therefore, if Big Mac sales decrease as a result of the Arch Deluxe introduction, this loss should be factored in when assessing the overall impact of the new product.
What are side effects (spillover effects)?
Side effects (spillover effects) are the unintended consequences of a business decision or investment, which can be either positive or negative, affecting other products or services.
What is meant by negative side effects, such as erosion or cannibalisation?
Negative side effects, like erosion or cannibalisation, occur when a new product or line takes away sales or profits from existing products or lines. This could happen when consumers switch from old products to the new ones.
How should cash flows be adjusted for negative side effects?
For negative side effects like erosion, cash flows from the new product line should be adjusted downwards to reflect lost profits on other product lines that have been cannibalised by the new product.
What are positive side effects in terms of business decisions?
Positive side effects occur when the new product or service has a beneficial impact on existing products or services, such as attracting new customers who also buy other goods from the company.
How should cash flows be adjusted for positive side effects?
Cash flows from the new product line should be adjusted upwards if there is a benefit to the other product lines, such as increased sales or customer acquisition due to the new offering.
Are both negative and positive side effects considered incremental cash flows?
Yes, both negative and positive side effects are considered incremental cash flows because they represent the additional cash flows generated (positive side) or lost (negative side) as a result of the new product or decision.
What is Net Working Capital (NWC)?
Net Working Capital (NWC) is the difference between a company’s current assets and current liabilities. It is calculated as:
NWC = cash + inventory + receivables − payables
It represents the capital required to fund day-to-day operations.
What does an investment in NWC represent?
The investment in NWC represents an incremental cash outflow because it requires a company to allocate resources to cash, inventory, and receivables while managing payables.
Why is cash at hand important for a project?
Cash at hand is necessary to cover any expenses that arise during the project’s operation. It ensures liquidity to meet immediate needs and obligations.
Why is inventory needed in a project?
Inventory needs to be built up to ensure that there is enough stock to meet demand and avoid stockouts. This investment is part of the NWC.
Why are accounts receivable important?
Accounts receivable are needed to cover credit sales. When products or services are sold on credit, the company must manage the receivables to ensure the cash flow is maintained.
What happens to NWC as a project approaches its end?
As the project nears its end, all the investment in NWC is recovered. The change in NWC in later years represents cash inflows, as assets such as receivables and inventory are liquidated.
How is cash flow impacted when NWC is recovered?
When NWC is recovered:
Accounts receivable are collected.
The need for cash on hand is reduced as fewer expenses arise.
Remaining inventory is sold.
These actions result in cash inflows.
What is the goal of project evaluation in terms of cash flow?
The goal of project evaluation is to estimate the cash flow generated by the proposed project, which is called cash flow from assets (CFFA).
How is cash flow from assets (CFFA) calculated?
CFFA = CFs to creditors + CFs to shareholders
This represents the total cash flow generated by the project that is distributed to both creditors (debt holders) and shareholders (equity holders)
How do companies typically handle project financing?
Due to economies of scale, companies generally do not finance individual projects separately. Instead, they finance the entire company at one time, spreading the capital across all projects.
How should taxes be considered in project evaluation?
taxes are a definite cash outflow and must be accounted for in project evaluation. All cash flows should be after-tax numbers (i.e., after-tax incremental cash flows) to accurately reflect the financial impact.
How do after-tax cash flows differ from accounting profits (net income)?
After-tax cash flows are actual cash movements that reflect the impact of taxes, while accounting profits (net income) are calculated based on accounting principles, which do not necessarily represent the true cash inflows or outflows.
Are sunk costs included in incremental cash flows?
No, sunk costs are not included because they have already occurred and cannot be recovered.
Are opportunity costs included in incremental cash flows?
Yes, opportunity costs are included because they represent the value of the next best alternative that is foregone.
Are side effects (spillover effects) included in incremental cash flows?
Yes, side effects, whether positive or negative, are included as they affect cash flows from other products or services.
Is net working capital (NWC) included in incremental cash flows?
Yes, NWC is included, as it represents the cash needed for day-to-day operations and affects the cash flow over time.
Are financing costs included in incremental cash flows?
No, financing costs (like interest) are not included in incremental cash flows because they are accounted for in the discount rate used in project evaluation.
Are tax effects included in incremental cash flows?
Yes, tax effects are included as they directly impact the cash flows after taxes, which need to be considered for accurate project evaluation.
What are pro-forma financial statements?
Pro-forma financial statements are projected, estimated, or predicted financial statements that reflect future operations of the project. They are used to forecast expected financial outcomes.
How should you treat a proposed project during evaluation?
Treat the project as a mini-firm, meaning you should forecast its financial statements just as you would for an actual business, accounting for future revenues, costs, and expenses.
What should the pro-forma financial statements of the mini-firm reflect?
The pro-forma financial statements should reflect the future operations of the project, including expected revenues, costs, profits, and cash flows.
How do you compute the future cash flow from the project?
Future cash flow is computed based on the pro-forma financial statements, primarily derived from the income statement and balance sheet. This includes revenue, expenses, changes in working capital, and capital expenditures.
How do you derive cash flow from the balance sheet and income statement?
To derive cash flow:
From the income statement: Start with net income, adjust for non-cash expenses (like depreciation), and account for changes in working capital.
From the balance sheet: Consider changes in assets and liabilities, particularly changes in current assets (like receivables and inventory) and current liabilities (like payables).
Which techniques are used to evaluate a project?
The evaluation techniques include:
NPV (Net Present Value)
IRR (Internal Rate of Return)
Payback Period
AAR (Average Accounting Return)
These techniques help assess whether the project will generate sufficient returns.
Pro-forma financial statements example:
The manager of ACF Confectionaries plc. is planning to launch a new
division in Bailrigg. The new division will produce and sell vanilla and
chocolate muffins. The CFO projects some figures about future sales and
costs with the information on the next slide
* You are asked to evaluate whether they should take the project
Sales Volume: 50,000 boxes per year
Sales Price per Box: £4
Variable Costs per Box: £2.50
Fixed Costs: £12,000 per year
Initial Equipment Cost: £90,000
Depreciation: Straight-line over 3 years, with no salvage value
Tax Rate: 34%
Discount Rate (Cost of Capital): 20%
Working Capital: £20,000 (required for stock and flexibility, not expected to change except for a £20,000 release in Year 3)
Pro-Forma P&L (Profit and Loss Account) for Years 1, 2, and 3:
Sales: 50,000 boxes × £4 = £200,000
Variable Costs: 50,000 boxes × £2.50 = £125,000
Contribution Margin (EBIT): £200,000 - £125,000 = £75,000
Fixed Costs: £12,000 per year
Depreciation: £90,000 / 3 years = £30,000 per year
EBIT (Earnings Before Interest and Taxes): £75,000 - £12,000 - £30,000 = £33,000
Taxes (34% of EBIT): £33,000 × 34% = £11,220
Net Income: £33,000 - £11,220 = £21,780 per year
Operating Cash Flow (OCF):
OCF = EBIT + Depreciation - Taxes
OCF = £33,000 + £30,000 - £11,220 = £51,780
Changes in Net Working Capital (NWC):
Initial NWC at Year 0: £20,000 (investment in working capital)
Year 1 and Year 2: No change in NWC
Year 3: Release of £20,000 from NWC (as working capital is returned to the company)
Capital Expenditures (CapEx):
Initial Equipment Investment: £90,000 in Year 0, no further capital spending in Years 1-3.
Cash Flow from Assets (CFFA):
CFFA = OCF – Capital Spending – Change in NWC
Year 0: CFFA = £0 – £90,000 – £20,000 = -£110,000 (initial investment)
Year 1-2: CFFA = £51,780 (OCF) – £0 (no CapEx) – £0 (no change in NWC) = £51,780
Year 3: CFFA = £51,780 (OCF) – £0 (no CapEx) + £20,000 (release of NWC) = £71,780
NPV = T∑t=0 C_t/(1+r)ˆt
NPV = -110,000 + 51,780/(1+0.2) + 51,780/(1+0.2)ˆ2 + 71,780/(1+0.2)ˆ3
Year 0: -£110,000
Year 1: £51,780 / 1.20 = £43,150
Year 2: £51,780 / (1.20)^2 = £35,958
Year 3: £71,780 / (1.20)^3 = £41,870
NPV = 10,648
NPV = £10,648: Since the NPV is positive, it means the project is expected to add value to the company.
The project should be accepted, as it has a positive NPV of £10,648. This suggests that the expected cash inflows from the project exceed the costs and investments, making it a worthwhile endeavour.
What is Operating Cash Flow (OCF)?
Operating Cash Flow (OCF) is the cash generated from a company’s core operating activities. It can be calculated using:
OCF = EBIT + Depreciation – Taxes
How is OCF calculated when there is no interest expense?
When there is no interest expense, OCF can also be calculated as:
OCF = Net Income + Depreciation
What is Cash Flow from Assets (CFFA)?
Cash Flow from Assets (CFFA) represents the total cash flow generated by a project or company’s assets. It is calculated as:
CFFA = OCF – Net Capital Spending (CapEX) – Changes in Net Working Capital (NWC)
What are the three approaches to compute Operating Cash Flow (OCF)?
The three approaches to compute OCF are:
Bottom-Up Approach
Top-Down Approach
Tax Shield Approach
How is OCF calculated using the Bottom-Up Approach?
The Bottom-Up Approach formula is:
OCF = EBIT + Depreciation – Taxes
Where EBIT = Sales (S) - Operating Costs (C) - Depreciation (D) and Taxes are based on EBIT.
How is OCF calculated using the Top-Down Approach?
The Top-Down Approach formula is:
OCF = (Sales - Operating Costs) – (Sales - Operating Costs - Depreciation) × Tax Rate (T)
How is OCF calculated using the Tax Shield Approach?
The Tax Shield Approach formula is:
OCF = (Sales - Operating Costs) × (1 - Tax Rate) + Depreciation × Tax Rate
This approach incorporates the tax shield from depreciation.
What is the nature of NPV estimates?
NPV estimates are only estimates and are based on assumptions and projections. They provide an indication but are not guaranteed to be accurate.
What does a positive NPV indicate about a project?
A positive NPV is a good starting point and suggests that the project is expected to generate value, but further examination is necessary to account for potential uncertainties or inaccuracies.
What is a Type II error in the context of NPV estimation?
A Type II error occurs when a bad project is incorrectly accepted due to inaccurate NPV estimates. This happens when an incorrect or overly optimistic estimate leads to accepting a project that ultimately doesn’t perform well.
What is a Type I error in the context of NPV estimation?
A Type I error occurs when a good project is incorrectly rejected due to inaccurate NPV estimates. This happens when pessimistic or flawed estimates cause the rejection of a project that would have been profitable.
What is the importance of understanding sources of value in a project?
It’s crucial to be able to articulate why the project creates value. Understanding the sources of value helps in justifying why a project should be undertaken, especially when evaluating its potential for generating returns.
Why are positive NPV projects rare in highly competitive markets?
Positive NPV projects are rare in highly competitive arenas because competition tends to drive down profits, making it harder for projects to maintain a positive NPV. Companies often need to find unique advantages (e.g., innovative products or lower costs) to achieve positive NPV.
What should be understood if a project shows a large positive NPV?
If a project appears to have a large positive NPV, it’s important to understand where the value is coming from, such as better products, lower production costs, or other significant advantages. Without a clear reason for the positive NPV, the estimates may be inaccurate or overly optimistic.
What is forecasting (estimation) risk?
Forecasting risk refers to mistakes made when estimating cash flows or the discount rate (cost of capital). These errors can lead to inaccurate NPV calculations and affect the project’s evaluation.
How should the sensitivity of NPV to cash flow estimates be assessed?
To assess forecasting risk, it’s important to estimate the sensitivity of NPV to changes in cash flow estimates. The more sensitive the NPV is to changes, the greater the forecasting risk.
What are some useful tools to manage forecasting risk?
Scenario analysis and sensitivity analysis are useful tools for managing forecasting risk. They help assess how changes in key assumptions (like cash flow or discount rate) affect NPV and provide a range of possible outcomes.
What is Scenario Analysis in project evaluation?
Scenario Analysis examines NPV under several possible situations to assess the impact of cash flows that differ from forecasts. It helps to understand how changes in key variables affect the outcome of a project.
What are the three key scenarios examined in Scenario Analysis?
The three key scenarios are:
Worst Case – revenues are low and costs are high.
Base Case (Most Likely Case) – considered the most likely or expected outcome.
Best Case – revenues are high and costs are low.
What does Scenario Analysis provide?
Scenario Analysis provides a range of possible outcomes, allowing decision-makers to understand the potential variability in project performance based on different assumptions.
What is Sensitivity Analysis in project evaluation?
Sensitivity Analysis shows how changes in an input variable affect NPV. It isolates one variable at a time to assess its impact on the project’s outcome.
How does Sensitivity Analysis work?
In Sensitivity Analysis, each variable is fixed except one. The analysis focuses on how sensitive NPV is to changes in that one variable.
How is Sensitivity Analysis related to Scenario Analysis?
Sensitivity Analysis is a subset of Scenario Analysis, focusing specifically on the effect of one variable on NPV at a time, rather than examining multiple variables at once.
What does a volatile NPV indicate in Sensitivity Analysis?
The more volatile the NPV is in respect to a specific variable, the larger the forecasting risk associated with that variable. This means that the variable requires more attention in the estimation process.
What type of questions does Sensitivity Analysis answer?
Sensitivity Analysis answers “what if” questions by showing how different assumptions or changes in specific variables affect the overall outcome of the project.
When is a decision about a project typically made?
A decision about a project has to be made once all the relevant analyses (such as NPV, Scenario Analysis, and Sensitivity Analysis) are complete.
What does it mean if the majority of scenarios have positive NPVs?
If the majority of scenarios have positive NPVs, then you can feel reasonably comfortable about proceeding with the project, as it is likely to create value.
What should be considered if a crucial variable leads to a negative NPV with a small change in estimates?
If a crucial variable leads to a negative NPV with a small change in estimates, this indicates high forecasting risk. In such cases, you may decide to forego the project because of the uncertainty.
What are managerial actions in capital budgeting?
Managerial actions refer to the ability of managers to modify a project even after it starts, allowing for adjustments based on changing circumstances or new information.
How do real options affect project evaluation?
Real options allow flexibility to make decisions during the project’s life. Ignoring these options can underestimate the project’s NPV, as they provide opportunities for additional value (e.g., expanding, deferring, or abandoning a project).
What is capital rationing in capital budgeting?
Capital rationing occurs when a firm has limited resources and cannot undertake all positive NPV projects. The company must prioritise which projects to fund.
What is soft rationing in capital budgeting?
Soft rationing refers to temporary or self-imposed resource constraints. These limitations are typically short-term, and the company might be able to access more capital later.
What is hard rationing in capital budgeting?
Hard rationing refers to permanent capital constraints where the firm will never have enough resources to fund certain projects, regardless of their potential NPV.
