Chapter 1: Investment decisions.

Chapter 1: Investment decisions

PART A – Project’s Cash Flows

Forecasting earnings

A capital budget lists the projects and investments that a company plans to undertake during the coming year. Firms forecast the project’s future consequences for the firm determining the incremental earnings of a project. That is, the amount by which the firm’s earnings are expected to change.

Earnings and cash flows are not the same. To pass from earnings to cash flows we should add depreciation and amortization, subtract capital expenditures, and subtract the increase in NWC.

Feasibility Study

Revenue and Cost Estimates

• Estimated life of the project: four years
• Revenue estimates:

        -Sales = 100,000 units/year.

        -Per Unit Price = $235.

• Cost Estimates:

        -Up-Front R&D = $15,000,000.

        -Up-Front New Equipment = $7,500,000 (Expected life of the new equipment is         5 years (housed in existing lab)).

        -Annual Overhead = $3,000,000.

        -Per Unit Cost = $95.

• Cost of the feasibility study: $300,000  [pic 1]

Are taxes relevant even if we make losses? Yes, for example, in year 0 the company will owe 6$ million less. The firm should credit this tax savings to the project’s incremental earnings forecast.

Capital Expenditures and Depreciation

Investments in plant, property and equipment are a cash expense not directly listed as expense but a fraction of cost deducted each year as depreciation. Some methods are:

• Straight Line Depreciation: Asset’s cost is divided equally over its life ($7.5 million ÷ 5 years = $1.5 million/year).
• Modified Accelerated Cost Recovery System (MACRS).[pic 2]

Net Working Capital (NWC)  

The cash included in NWC is cash that is not invested to earn a market rate of return (non-invested cash held in the firm’s checking account, in a company safe or cash box). Firms may need to maintain a minimum cash balance to meet unexpected expenditures, and inventories of raw materials and finished products to accommodate production uncertainties and demand fluctuations. Also customers may not pay for the goods they purchase immediately (receivables). While sales are immediately counted as part of earnings, the firm does not receive any cash until the customers actually pay. In the same way, payables measure the credit the firm has received from its suppliers.

[pic 3]

Most projects require investment in NWC:

1. Cash held at registers, safe box or checking account.
2. Inventories of raw materials or finished product.
3. Receivables: earned but not charged (credit offered to customers)
4. Payables: spent but not paid (credit received by suppliers)

Trade credit: difference between receivables & payables.[pic 4]

• Recall sales were 23.500, so if receivables are the 15% of sales, receivables are: 3.525.
• Recall COGS were 9500, so if payables are the 15% of COGS, payables are: 1.425.

Indirect effects

1. Project Externalities: There are indirect effects of the project that may increase or decrease the profits of other business activities of the firm. Cannibalization is an example, is when sales of a new product displaces sales of existing product. Would customers of HomeNet have purchased existing Linksys wireless routers?
2. Opportunity costs: The value a resource could have provided in its best alternative use. Home net’s equipment will be housed in an existing lab, but what is the opportunity cost of using the space for its best alternative? Renting it out?. Because this value is lost when the resource is used by the project, we should include the opportunity cost as an incremental cost of the project.
3. Further... sales, the average selling price, the average cost per unit will vary over time.

Where should we allocate the $300,000 of the feasibility study? This cost is not part of the cost of the project, we should not include this 300.000$ as part of the cost because is money we spend to know if the project is good or not, so it’s a sunk cost. If we do the feasibility study we spend this quantity and it doesn’t matter if we do the project or no.

PART B – Evaluating Risk-Free Projects

Assume that we have projects with known and certain future cash flows.

• The methods and rules to decide whether to invest are: 1)Net present value rule. 2)Internal rate of return rule. 3)Payback period and payback rule. 4)Profitability index.
• Project selection: 1)Mutually exclusive projects. 2)Scalable projects with limited resources.

How to compare present and future? A euro today is worth more than one tomorrow. There is the possibility to earn interest. For example, if interest is 10% a year, investing 10 million today gives 11 million in a year:

• 10.000.000 x (1 + 0.1) = 11.000.000

The future value in a year of 10 million is 11 million and the present value of 11 million in a year is 10 million.

Future and Present Values

The future value is the amount to which an investment will grow after earning interest:[pic 5]

The present value is the value today of a future expected cash flow:

[pic 6]

Net Present Value: an example

[pic 7]

[pic 8]

Cash flows: immediate $81.6 million “outflow” and an “inflow” of $28 million per year for 4 years. Therefore, if discount rate is r = 0.10, the NPV is 7.2. Discount rate depends on the riskiness of the cash flows:

• Equal to risk-free rate (government bond) if cash flows are certain.
• Higher risk implies greater discount and lower present value. So the value today of a risky asset is lower than if the same asset was not risky.

The NPV Rule:

1. Forecast future cash flows.
2. Estimate a discount rate.
3. Discount future cash flows.
4. Go ahead if the present value of the payoff exceeds investment. If NPV > 0

NPV investment rule: when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In the case of a stand-alone project, we must accept the project if it’s NPV is positive.

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