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10.1
10.2
The relevant cash flows in this case will consist of those generated by the new machine less those that would have been retained by replacing the old machine. The decision should centre on the differences in cash flows between the two machines.
10.3
10.4
10.5
10.6
cost of foregone opportunities. or the most valuable alternative use of a resource or an asset that the firm gives up by accepting a project. Example: - A firm is considering a project proposal that requires storing additional products/goods. - The firm now has excess storage capacity suitable for the new proposal. - If the firm does not use the storage capacity for the new project, it could rent the space for 25,000 a year. Required: Should the business attach a cost to this storage space if corporate managers decided to go ahead with the new project?
10.7
10.8
10.9
10.10
10.11
10.12
Financing costs: In analysing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets for a project. Our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project to estimate NPV. As a general principle, capital budgeting analyses require separating investment and financing decisions. In other words, corporate managers evaluate a capital budgeting project independently of the source of funds used to finance the project. Therefore, corporate managers include operating cash flows and investment cash flows in their estimations, but not financing cash flows.
10.13
1. Measuring cash flow when it actually occurs, not when it accrues in an accounting sense (i.e. accounting profit). 2. After-tax cash flow because taxes are definitely a cash outflow.
10.14
10.15
10.16
Sales (50,000 units at $4.00/unit) Variable Costs ($2.50/unit) Gross profit Fixed costs Depreciation ($90,000 / 3) EBIT Taxes (34%) Net Income
10.17
Total project cash flow = Project operating cash flow Project change in net working capital Project capital spending
Operating Cash Flow (OCF) = EBIT + Depreciation Taxes = $33,000+$30,000 $11,220 =$51,780
10.18
Year 0
Op Cash Flow Change in NWC Capital Spending Total
1
$51,780
2
$51,780
3
$51,780 +$20,000 0
$71,780
10.19
NPV = 51,780/1.2 + 51,780/(1.2)2+71,780/(1.2)3 110,000 = $10,648 Based on these projections, the project creates over $10,000 in value and should be accepted.
10.20
10.21
Forecasting risk how sensitive is NPV to changes in the cash flow estimates?
The more sensitive, the greater the forecasting risk Need to understand the assumptions that underlie the cash flow forecasts
10.22
Scenario Analysis
What happens to NPV under different cash flows scenarios? At the very least look at: Base case based on forecasted future cash flows Best case revenues are high and costs are low Worst case revenues are low and costs are high Measures the range of possible outcomes While best case and worst case are not necessarily probable, they can still be possible
10.23
Base Case Unit Sales Price per unit Var cost/unit Fixed cost/year 6,000 $80 $60 $50,000
10.24 Calculate Net Income for the base case Sales Variable costs Fixed costs Depreciation EBIT Taxes (34%) Net Income $480,000 360,000 50,000 40,000 30,000 10,200 19,800
ash Flo
10.25
Now want to recalculate the NPV using a variety of different scenarios. Establish the best & worst cases by using the upper & lower bounds for each variable. Worst case Best case Unit sales Price per unit Variable cost Fixed costs 5,500 $75 $62 $55,000 6,500 $85 $58 $45,000
NPV Base
10.26
Scenario
Cash Flow
NPV
IRR
What conclusions can we draw from this? Should we undertake the project? Scenario analysis is useful in telling us what can happen and helping us estimate the potential for disaster, but it does not tell us whether to take a project.
10.27
Sensitivity Analysis
What happens to NPV when we vary one variable at a time. This is a subset of scenario analysis where 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 want to pay to its estimation In the first table on the next page, we calculate cash flow, NPV and IRR assuming all variables are fixed at the level of the base case, other than sales volume. Sales volume is allowed to vary between the best (6,500 units) & worst (5,500 units) cases In the second table, we assume all variables are fixed other than fixed costs.
10.28
NPV
$15,567 -$8,226 $39,357
IRR
15.1% 10.3% 19.7%
Cash Flow
$59,800 $56,500 $63,100
NPV
$15,567 $3,670 $27,461
IRR
15.1% 12.7% 17.4%
10.29
Making A Decision
Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage, but it does not tell us what to do about possible errors. However, at some point you have to make a decision If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project