Project Evaluation Roadmap. Capital Budgeting Process. Capital Expenditure. Major Cash Flow Components. Cash Flows... COMM2501 Financial Management

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1 COMM501 Financial Manageent Project Evaluation 1 (Capital Budgeting) Project Evaluation Roadap COMM501 Financial Manageent Week 7 Week 7 Project dependencies Net present value ethod Relevant cash flows Noinal versus real Sensitivity analysis Week 8 Advanced concepts Internal rate of return ethod Accounting rate of return ethod Payback ethod Coparison of ethods (Soe of the slides have been adapted fro Frino, Introduction to Corporate Finance with the perission of Pearson Education Australia Liited. Copyright 001.) Lecture 7 COMM501 Project Evaluation 1 Capital Expenditure Capital Budgeting Process Cash outlay expected to generate future cash benefits over a life greater than one year Exaples: Expansion of existing operations Replaceent of plant Long ter advertising capaign Research and developent expenditures 1. Capital investent proposal. Estiate cash flows 3. Evaluate alternatives 4. Post-copletion audit (how did we do?) Lecture 7 COMM501 Project Evaluation 1 3 Lecture 7 COMM501 Project Evaluation 1 4 Cash Flows... Major Cash Flow Coponents Conventional: initial outflow followed by a series of inflows Non-conventional: where initial outflow is followed by a ixture of inflows and outflows Initial investent (cash outflow at tie zero) Operating cash inflows (increental after-tax cash inflows during the project s lifetie) Terinal cash flow (after-tax non-operating cash flow in final year): Soe probles are siplified by assuing the terinal cash flow to equal salvage value for the project Lecture 7 COMM501 Project Evaluation 1 5 Lecture 7 COMM501 Project Evaluation 1 6 Week 7 -- Project Evaluation 1 1

2 COMM501 Financial Manageent Dependencies Capital Budgeting Methods Independent Acceptance or rejection will not influence other projects Mutually exclusive Only one of a nuber of projects can be accepted Contingent Acceptance depends on acceptance of other project(s) Capital rationing Fixed aount of total funds available liits which projects ay be accepted 1. Net present value (NPV). Internal rate of return (IRR) 3. Average accounting rate of return (ARR) 4. Payback period (PP) Lecture 7 COMM501 Project Evaluation 1 7 Lecture 7 COMM501 Project Evaluation 1 8 Net Present Value (NPV) NPV Exaple Net present value (NPV) is the present value of future cash flows less the initial cash outlay or investent Future cash flows are discounted at an appropriate cost of capital for the project s level of risk The capital project with the largest NPV will axiise shareholder wealth What is the NPV of a project requiring $100 outlay and returning $106 in one year if the opportunity cost of capital is 7%? 106 NPV = 100 = Reject the project Why? Lecture 7 COMM501 Project Evaluation 1 9 Lecture 7 COMM501 Project Evaluation 1 10 Strengths of the NPV Method Relevant Cash Flows Assists decision-aking which axiises wealth of shareholders Takes tie value of oney into account Takes all cash flows into account Use cash flows not accounting incoe Ignore sunk costs Include opportunity costs Include side effects Include taxation Be careful with inflation Separate investent and financing decisions Beware of allocated overhead Lecture 7 COMM501 Project Evaluation 1 11 Lecture 7 COMM501 Project Evaluation 1 1 Week 7 -- Project Evaluation 1

3 COMM501 Financial Manageent Cash Flows Not Accounting Incoe Accounting Incoe Exaple Copany buys a achine for $100,000 year project Machine depreciated straight line over project life EBDIT is $53 in first year, $66 in second year; tax rate is 36% What is the accounting incoe, and what are the net cash flows? Year EBDIT Depn 36% Net Incoe 0 1 Lecture 7 COMM501 Project Evaluation 1 13 Lecture 7 COMM501 Project Evaluation 1 14 Cash Flows Ignore Sunk Costs Year 0 1 Operating Cash Flows* 53 Investent (100) Taxes (1) Net Cash Flow after tax (100) 5 *Assuing EBDIT=Operating cash flows 66 (6) 60 Sunk costs are unavoidable cash outflows incurred in the past, and no longer relevant to influencing whether a project should be undertaken Sunk costs ust be paid whether or not a project is approved Lecture 7 COMM501 Project Evaluation 1 15 Lecture 7 COMM501 Project Evaluation 1 16 Sunk Costs Exaple Sunk Costs Exaple Market research for a project has deterined that it will yield net cash flows of $75,000 for years The initial outlay is $15,000 and the discount rate is 10% Should the $10,000 payent to be ade to the arket research copany be included in the NPV analysis? Project NPV if arketing costs (incorrectly) included: NPV = + 135k = 4.83 reject! k Lecture 7 COMM501 Project Evaluation 1 17 Lecture 7 COMM501 Project Evaluation 1 18 Week 7 -- Project Evaluation 1 3

4 COMM501 Financial Manageent Sunk Costs Exaple Include Opportunity Costs Project NPV if arketing costs (correctly) excluded: NPV = + 15k = 5.17 accept! k If a project uses resources that could be put to soe other use (i.e. has an opportunity cost), then the dollar value of the alternative use ust be included as a cash outflow Lecture 7 COMM501 Project Evaluation 1 19 Lecture 7 COMM501 Project Evaluation 1 0 Opportunity Cost Exaple Opportunity Cost Exaple A copany owns achinery that can be: 1. Leased at $3 per year, or. Used in a project that yields $0 for years and costs $30 (opportunity cost of capital is 10%) Should the project be taken on? Project NPV if (incorrectly) ignore possible lease payents as cash outflow: 0 0 NPV = + 30 = 4.7 accept! Lecture 7 COMM501 Project Evaluation 1 1 Lecture 7 COMM501 Project Evaluation 1 Opportunity Cost Exaple Include Side Effects Project NPV if (correctly) include possible lease payents as cash outflow: NPV = + 30 = 0.5 reject! Include positive or negative cash flows that ipact other aspects of the business as a result of taking on the current project Cannibalisation of custoers Reduced costs fro suppliers due to volue discounts Lecture 7 COMM501 Project Evaluation 1 3 Lecture 7 COMM501 Project Evaluation 1 4 Week 7 -- Project Evaluation 1 4

5 COMM501 Financial Manageent Side Effects Exaple Side Effects Exaple Copany sells 00 sedans a year which each net $30,000 Anticipating a new sports car for years which will net $40,000 each and cost $10,000,000 to set up Custoer deand expected to fully shift to sports cars (discount rate is 10%) Project NPV if (incorrectly) exclude lost revenue on sedan: 8 8 NPV = + 10 = 3.88 accept! Lecture 7 COMM501 Project Evaluation 1 5 Lecture 7 COMM501 Project Evaluation 1 6 Side Effects Exaple Include Taxation Project NPV if (correctly) include lost revenue on sedan: NPV = + 10 = 6.53 reject! 3 ajor ipacts 1. Represents a cash outlay. Depreciation tax deduction provides a tax shield (rate set down by ATO iportant) 3. Capital gains tax increases aount of tax Lecture 7 COMM501 Project Evaluation 1 7 Lecture 7 COMM501 Project Evaluation 1 8 Should the following 1 year project be undertaken? i. buy achine for $100 with salvage value of $90 ii. EBDIT = 0 iii. ATO Depreciation 10% iv. Capital Expenditure at end of year is 15 v. Corporate vi. Opportunity cost of capital (after tax) = 6.4% (inflation is 0%) Step 1: calculate tax Lecture 7 COMM501 Project Evaluation 1 9 Lecture 7 COMM501 Project Evaluation 1 30 Week 7 -- Project Evaluation 1 5

6 COMM501 Financial Manageent Step : calculate net cash flow after tax: Step 3: calculate NPV: NPV = How uch lower is tax because of depreciation deduction (i.e. tax shield)? = = 3. 6 Lecture 7 COMM501 Project Evaluation 1 31 Lecture 7 COMM501 Project Evaluation 1 3 Be Careful With Inflation Consider $100 which can be invested at 10% when inflation is 6%. How any $1 haburgers can be bought in 1 year if their price rises in line with inflation? Buy now => 100/1=100 haburgers Buy in 1 year =>110/1.06 = haburgers Your real gain 3.8% 1 + noinal rate = real rate Fisher Relation ( 1 + real rate)( 1 + inflation rate) Rearranging : 1 + noinal rate = inflation rate Applied to previous exaple : real rate = 1 = or 3.8% Lecture 7 COMM501 Project Evaluation 1 33 Lecture 7 COMM501 Project Evaluation 1 34 Inflation and Discounting Inflation Exaple Consistency principle (iportant!) Discount real cash flows at real interest rates, and noinal cash flows at noinal interest rates Should the following project be taken on? Project costs $1,000 Cash flow of $1,400 in years Noinal interest rate is 10% Inflation rate is 6% p.a Noinal cash flows/noinal interest rate Real cash flows/real discount rate Real cash flow Real interest rate NPV = Lecture 7 COMM501 Project Evaluation 1 35 Lecture 7 COMM501 Project Evaluation 1 36 Week 7 -- Project Evaluation 1 6

7 COMM501 Financial Manageent Separate Financing and Investent Project ust ake sense regardless of how financed Therefore, financing costs are excluded fro relevant cash flows Do not include interest expense or other financing costs in cash flows Allocated Overhead Only increental costs are relevant Is allocated overhead increental? Overhead allocations should be excluded unless the cost is increental to the fir as a whole Lecture 7 COMM501 Project Evaluation 1 37 Lecture 7 COMM501 Project Evaluation 1 38 Questions to ask: Sensitivity Analysis What are the key assuptions behind cash flow estiates? What effect do these assuptions have on the calculated NPV? The inputs that have the greatest ipact on NPV are called value drivers See saple spreadsheet on CD (Unit 4) Worked Exaple Rapid Corp is evaluating the construction of a special greenhouse The greenhouse will cost $180,000 but will generate an extra $40,000 in cash flow (EBITDA) in the first year and this will grow by $15,000 each year thereafter for three years If the greenhouse can be depreciated on a straightline basis over 4 years, tax rate is 30%, and the required after-tax return is 1%, should Rapid Corp build the greenhouse? Microsoft Excel Worksheet Lecture 7 COMM501 Project Evaluation 1 39 Lecture 7 COMM501 Project Evaluation 1 40 Week 7 -- Project Evaluation 1 7

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