Chap006 Capital Budfageting(1)

8/23/2019 Chap006 Capital Budfageting(1)

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Making CapitalInvestment Decisions

McGraw-Hill/IrwinCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.



Key Concepts and Skills

• Understand MIRR

• Understand forecasting risk

• Understand and be able to conductscenario and sensitivity analysis

• Understand the various methods for computing operating cash flow

• Understand how to set a bid price for a project

• Understand how to evaluate the

equivalent annual cost of a project 10-1



Chapter Outline

• MIRR and IRR

• Evaluating NPV Estimates

• Scenario and Other What-If Analyses

• Some Special Cases of Discounted CashFlow Analysis

10-2



Capital budgeting decisionrules

• Key methods used to rank projects and todecide whether or not they should beaccepted :

– Payback period, – net present value (NPV),

– internal rate of return (IRR),

– modified internal rate of return (MIRR)

11-3



Internal Rate of Return

11-4

• IRR > k = accept the project

• IRR < k = reject the project



Internal Rate of Return

11-5



Modified IRR

11-6

• Better indicator of relative profitability• The discount rate at which the present value of a

project’s cost is equal to the present value of its

terminal value



Evaluating NPV Estimates

• NPV estimates are just that – estimates

• A positive NPV is a good start – now weneed to take a closer look

– Forecasting risk – how sensitive is our NPV tochanges in the cash flow estimates; the moresensitive, the greater the forecasting risk

– Sources of value – why does this project

create value?

11-7



Scenario Analysis

• What happens to the NPV under differentcash flow scenarios?

• At the very least, look at:

– Best case – high revenues, low costs – Worst case – low revenues, high costs

– Measure of the range of possible outcomes

• Best case and worst case are notnecessarily probable, but they can still bepossible

11-8



New Project Example

• Consider the project discussed in the text

• The initial cost is $200,000, and theproject has a 5-year life. There is no

salvage. Depreciation is straight-line, therequired return is 12%, and the tax rate is34%.

• The base case NPV is 15,567

11-9



Summary of Scenario Analysis

Scenario Net Income Cash Flow NPV IRR

Base case 19,800 59,800 15,567 15.1%

Worst Case -15,510 24,490 -111,719 -14.4%

Best Case 59,730 99,730 159,504 40.9%

11-10



Sensitivity Analysis

• What happens to NPV when we changeone variable at a time

• This is a subset of scenario analysiswhere we are looking at the effect of

specific variables on NPV• The greater the volatility in NPV in

relation to a specific variable, the larger the forecasting risk associated with that

variable, and the more attention we wantto pay to its estimation

11-11



Summary of Sensitivity Analysisfor New Project

Scenario Unit Sales Cash Flow NPV IRR

Base case 6,000 59,800 15,567 15.1%

Worst case 5,500 53,200 -8,226 10.3%

Best case 6,500 66,400 39,357 19.7%

11-12



Simulation Analysis

• Simulation is really just an expanded sensitivityand scenario analysis

• Monte Carlo simulation can estimate thousandsof possible outcomes based on conditionalprobability distributions and constraints for eachof the variables

• The output is a probability distribution for NPVwith an estimate of the probability of obtaining apositive net present value

• The simulation only works as well as theinformation that is entered, and very baddecisions can be made if care is not taken toanalyze the interaction between variables

11-13



Making a Decision

• Beware “Paralysis of Analysis” • At some point you have to make a decision

• If the majority of your scenarios havepositive NPVs, then you can feel

reasonably comfortable about accepting theproject

• If you have a crucial variable that leads to anegative NPV with a small change in the

estimates, then you may want to forego theproject

11-14



Example: Cost Cutting

• Your company is considering a new computer system that will initially cost $1 million. It will save$300,000 per year in inventory and receivablesmanagement costs. The system is expected to last

for five years and will be depreciated using 3-year MACRS. The system is expected to have asalvage value of $50,000 at the end of year 5.There is no impact on net working capital. Themarginal tax rate is 40%. The required return is

8%.• Click on the Excel icon to work through the

example

10-15



Example: Setting the BidPrice

• Consider the following information: – Army has requested bid for multiple use

digitizing devices (MUDDs) – Deliver 4 units each year for the next 3 years

– Labor and materials estimated to be $10,000per unit – Production space leased for $12,000 per year – Requires $50,000 in fixed assets with

expected salvage of $10,000 at the end of the

project (depreciate straight-line) – Require initial $10,000 increase in NWC – Tax rate = 34% – Required return = 15%

10-16



Example: Equivalent AnnualCost Analysis

• Burnout Batteries – Initial Cost = $36 each

– 3-year life

– $100 per year to keep

charged – Expected salvage = $5

– Straight-linedepreciation

• Long-lasting Batteries – Initial Cost = $60 each

– 5-year life

– $88 per year to keep

charged – Expected salvage = $5

– Straight-linedepreciation

The machine chosen will be replaced indefinitely andneither machine will have a differential impact on revenue.

No change in NWC is required.

The required return is 15%, and the tax rate is 34%.

10-17



Ethics Issues

• In an L.A. Law episode, an automobilemanufacturer knowingly built cars that had asignificant safety flaw. Rather than redesigning thecars (at substantial additional cost), themanufacturer calculated the expected costs of future lawsuits and determined that it would becheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car. Whatissues does the financial analysis overlook?

10-18

Chap006 Capital Budfageting(1)

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