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FIN 301

Class Notes

Chapter 8: Using DCF Analysis to Make Investment Decisions
Capital Budgeting: is the process of planning for capital expenditures (long term investment). Planning process involves 1- Estimating the cash flows associated with the investment project (ch. 8) 2- Evaluating the stream of the cash flows associated with the project (ch. 7). Examples of Capital expenditures:The purchase of a new piece of equipment, land, or a building. The replacement of an existing machine or equipment. Lease vs. Buy analysis

Principles of Estimating Cash Flows: • Net investment (NINV) • Net cash flows (NCF’s) 1. Measure on an incremental basis: NINV and NCF both are measured on incremental basis, i.e. you only include the cash flows that result from adopting project and these cashflows would not exist had we not adopt the project. For example, XYZ Co. owns an old equipment that produce 10,000 units a year which results in an annual sales of $10,000,000. If XYZ Co. sell this equipment and buy a new one, it will be able to produce and sell 15,000 items a year for a total of $15,000,000. The cash flow estimated from this replacement project is: NINV = the Cash flowsassociated with buying the new equipment - the Cash flows associated with selling the old equipment. NCF should include only 15,000,000 – 10,000,000 = 5,000. 2. Include changes in NWC: Net Working Capital = Current Assets – Current Liabilities. NWC is the additional investment in current assets (cash, receivables, and inventory) that is not financed by spontaneous increase in current liabilities. InitialNWC is included in the cash flow estimation of NINV. Further NWC is included in the cash flow estimation of NCF. All NWC should be recovered by the end of the period. 3. Include indirect effects: Example, GM estimate $2.5 billion revenue from selling the new Saturn cars. Some of those sales ($400 million) will come from customers who otherwise would have bought another model form GM, say Pontiac.Therefore, Saturn takes away $400 million in sales from the other model. For cash flow purposes only $2.1 billion will be considered as the revenue form Saturn. 1

4. Exclude sunk costs: A sunk cost is a cash outlay that has already occurred or that will occur regardless of whether the project is accepted. Thus they have no incremental effect and are irrelevant to the analysis. For Example, youdecided to use part of a location that you already own to place new equipment. The value of the location or the used part of it is not relevant to the cash flow estimation since you pay for it regardless of the project. Sunk Cost is not included in the ash flow estimation of the project because it can not be recovered. 5. Measure value of resources in terms of their opportunity costs: Always askyourself: what if I did not use this asset in this project, how much cash flow it would generate? If this asset would generate cash flows had you not use it in the project, then you should include theses cash flows as opportunity cost. For example, if you are not using the current location to place your assets, you could sell it to someone else for $60,000. You will basically lose $60,000 becauseyou decided to use the location and not sell it. This $60,000 should be included in NINV because it is the opportunity cost. 6. If inflation is expected during the life of the project, cash flows must be adjusted upward to nominal values. The adjustment should reflect the added price changes in the prices of the products, labor costs, etc., rather than a general inflation rate, such as theConsumer Price Index. ESTIMATING PROJECT CASH FLOWS Two Types: 1- New Project 2- Replacement project

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Estimating cash flows for a new

project

1- Calculating the Net Investment (NINV) NINV = [New project cost + installation and shipping costs + Initial investment in NWC] 2- Calculating the Annual Net Cash Flows (NCF) Net cash flows are the cash inflows from the project minus cash outflows...