CF: Lecture Notes (Handout #2)

Topic # 2: MAKING CAPITAL INVESTMENT DECISIONS

Specific Objectives
 Identification and understanding of Relevant Cash Flows
 Preparing Pro Forma Financial Statements
 Project Cash Flows and Evaluating with NPV, IRR, Pay Back, PI

Outline
 Projected Investment Cash Flows
 Pro Forma Financial Statements
 Estimating NPV Estimates

One of the most important aspects of a manager's job is to evaluate the feasibility of new
initiatives and to make sound investment decisions. This includes conducting a thorough and
reliable analysis using the appropriate financial decision-making tools. In this course, participants
will learn six capital budgeting rules that provide a framework for making sound project
investment decisions. Participants will examine how the rules differ from one another, and which
rules are most appropriate for different project settings.
The goal of a business is to maximize shareholder wealth by generating profit and acquiring
assets. In order to do so, you as the manager of your business need to be able to determine which
capital investment projects will generate a positive cash flow and when resources are constrained,
as they often are in a small/start-up business or for most businesses in the current credit-crunch,
rank projects in order of priority based on the value they create.
How you conduct you capital investment appraisal is important, get it wrong and you’ll be
eroding shareholder value and possibly jeopardizing the entire existence of the business. All
capital investment projects must be expected to provide returns in excess of the cost of financing
them. The trouble is recognizing the need for investment is difficult, it’s even harder to identify
what possible investments there are, determine how to evaluate them and to collect sufficient data
to do that evaluation. Identifying the need for investment can be problematic in many businesses
because strategic planning is rarely carried out and when it is carried out it is independent of any
budgeting process. This separation of budgeting and planning can have an affect on the
businesses ability to translate strategy into action. To overcome such problems the business needs
to include resource allocation in its strategic planning process.
Once the need for investment has been recognized, a list of possible investment projects needs to
be identified. However generating ideas for strategic investment involves a level of risk and an
investment of time on behalf of the proposer, therefore unless a business creates a culture that
encourages and rewards staff for putting forward proposals the business will miss many strategic
investment opportunities.
When strategic investment decisions are evaluated against financial criteria, it’s easy to overlook
other intangible benefits to the business, such as increased prestige or improved employee moral.
An over reliance on financial appraisal tools has also been criticized for biasing decision makers
against capital investment decisions, therefore hindering the ability of a business to carry out
research and development, thereby reducing the businesses level of innovation.
When collecting the data required evaluating an investment project you may be tempted to
consider the historic cost, book value or routine profit and loss information. However such
information includes charges for overheads and depreciation which reflect past decisions,
therefore as strategic investment decisions are about the future, only the resulting cash flows
should be considered

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 CF: Lecture Notes (Handout #2)
Brief Introduction:
This chapter dwells more into capital budgeting, recalling cash flow estimates are critical input
into NPV analysis. We will look more closely into relevant cash flows and projected cash flows
as well.
A. Relevant Cash Flows
 The cash flows that should be included in a capital budgeting analysis are those that will only
occur if the project is accepted
 These cash flows are called incremental cash flows
 The stand-alone principle allows us to analyze each project in isolation from the firm simply
by focusing on incremental cash flows
B. Common Types of Cash Flows
 Sunk costs – (costs that have accrued in the past) A cost that has already been incurred and
cannot be removed and therefore should not be considered in an investment decision?
 Opportunity costs – (costs of lost options)
The most valuable alternative that is given up if a particular investment is undertaken.
 Side effects
o Positive side effects – benefits to other projects: To be considered
o Negative side effects – costs to other projects: To be considered
 Changes in NWC- Why do we have to consider changes in NWC separately?
 GAAP requires that sales be recorded on the income statement when made, not when
cash is received
 GAAP also requires that we record cost of goods sold when the corresponding sales are
made, whether we have actually paid our suppliers yet
 Finally, we have to buy inventory to support sales although we haven’t collected cash yet
 Financing costs: In analyzing the a proposed investment project we will not include the
interest paid or any other financing cost such as dividend or principal repaid because we are
interested in the cash flow generated by the assets of the project.
 Taxes: we will consider it as well because when ever we say Incremental cash flows that
means after tax incremental cash flows.

C. Pro Forma Statements and Cash Flow

o Capital budgeting relies heavily on pro forma accounting statements, particularly income
statements
o Operating Cash Flow (OCF) = EBIT + depreciation – taxes
o OCF = Net income + depreciation when there is no interest expense
o Cash Flow from Assets (CFFA) = OCF – net capital spending (NCS) – Changes in NWC

Problem: Sales = 50,000 units, Price = Rs. 4/unit, VC = Rs. 2.5/unit, FC = Rs. 12,000, Required
Rate of Return = 20%, Manufacturing Equipment Cost = Rs. 90,000, Depreciation = 100%
depreciated in 3 years. CA Investment = Rs. 20,000. Tax = 34%. Requirement: Calculate the
NPV, IRR, and Discounted Pay Back by developing Pro-forma Income statement, projected
capital requirements & Projected Total Cash Flows.
D. Other Methods for Computing OCF
Financial Data: Sales = Rs. 15,000, Costs = Rs. 7,000, Depreciation = Rs. 6,000, Tax rate =
34%,
 Bottom-Up Approach: Works only when there is no interest expense
 OCF = NI + depreciation
 Top-Down Approach: OCF = Sales – Costs – Taxes
 Don’t subtract non-cash deductions
 Tax Shield Approach: OCF = (Sales – Costs) (1 – T) + Depreciation*T

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 CF: Lecture Notes (Handout #2)
An example of Different Sales levels in each Next Year . Initial fixed capital investment = Rs.
800,000 Depreciation Method = MACRS, Initial Working Capital = Rs. 20,000 and then 15% of the
revenues in each year. At the end of the 8 th year the book value is 0 but it will almost be sold out with Rs.
160,000. Variable Cost = Rs. 60/unit, Fixed Cost = Rs. 25,000/year, tax Rate = 34%, RRR = 15% and
Sales, Price and MACRS % are as follows:

Years 1 2 3 4 5 6 7 8
Sales 3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000
Price/unit 120 120 120 110 110 110 110 110
MACRS % 14.29 24.49 17.49 12.49 8.93 8.93 8.93 4.45

Answer: Table # 1: Depreciation Expense

Year % Depreciation Expenses Ending Book
1 14.29 .1429 × Rs. 800000 = Rs.114320 Rs. 685,680
2 24.49 .2449 × 800,000 = 195,920 489,760
3 17.49 .1749 × 800,000 = 139,920 349,840
4 12.49 .1249 × 800,000 = 99,920 249,920
5 8.93 .0893 × 800,000 = 71,440 178,480
6 8.93 .0893 × 800,000 = 71,440 107,040
7 8.93 .0893 × 800,000 = 71,440 35,600
8 4.45 .0445 × 800,000 = 35,600 0
100 800,000

Table # 2: Pro-Forma Income Statements (in Rs.)

Time (in Yrs) 1 2 3 4 5 6 7 8
Revenues 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000
Less Var. Cost 180,000 300,000 360,000 390,000 360,000 300,000 240,000 180,000
Less Fixed Cost 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
Gross Profit 155,000 275,000 335,000 300,000 275,000 225,000 175,000 125,000
Less Dep. Exp 114,320 195,920 139,920 99,920 71,440 71,440 71,400 35,600
EBIT 40,680 79,080 195,080 200,080 203,560 153,560 103,560 89,400
Less Taxes 13,831 26,887 66,327 68,027 96,210 52,210 35,210 30,396
Net income 26,849 52,193 128,753 132,053 134,350 101,350 68,350 59,004

Table # 3: Working Capital Investment (in Rs.)

Time (in Yrs) 0 1 2 3 4 5 6 7 8
Revenues 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000
NWC (Needed) 20,000 54000 90000 108000 107250 99000 82500 66000 49500
Cash Flow (20,000) (34,000) (36,000) (18,000) 750 8,250 16,500 16,500 16,500

Table # 4: Total Cash Flows Statement (all values in Rs. except IRR & Pay Back)
Years
Time (in Yrs) 0 1 2 3 4 5 6 7 8
OCF 141,169 248,113 268,673 231,973 205,790 172,790 139,790 94,604
Δ in NWC -20,000 -34,000 -36,000 -18,000 750 8,250 16,500 16,500 66,000
Cap. Spend -800,000 105,600
Total CFs -820,000 107,169 212,113 250,673 232,723 214,040 189,290 156,290 266,204
Cum. CF -820,000 -712,831 -500,718 -250,045 -17,322 196,718 386,008 542,298 808,502
Discounted CF -820,000 93,190 160,388 164,821 133,060 106,416 81,835 58,755 87,023
NPV = 65,488, IRR = 17.24%, Pay Back = 4.08 Years

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 CF: Lecture Notes (Handout #2)
Topic 2: MAKING CAPITAL INVESTMENT DECISIONS
Practice Questions & Problems
Question 1: Relevant cash flows: Ashfaq Gardner ltd is looking at setting up new manufacturing
plant in Patoki to produce garden tools. The company bought some Land six years ago for Rs. 5
million in anticipation of using it as a warehouse and distribution site, but the company has since
decided to rent these facilities from competitor instead. If the Land were sold today the company
would receive Rs.5.3 million. The company wants to build its new manufacturing plant on this
land, the plant will Cost Rs.11.6 million to build and the site requires Rs.425,000 worth of
grading before it is suitable for construction. What is the proper cash flow amount to use as the
initial investment in fixed assets when evaluating this project why?

Question 2: Relevant Cash Flow: Haq-Bahu Builders, currently sells 30,000 single-story homes
per year at Rs.450,000 each and 12,000 luxury homes per year at Rs.850,000 each. The company
wants to introduce a new flat to fill out its product line; it hopes to sell 19,000 of these flats per
year at Rs.120,000 each. An independent consultant has determined that if Haq-Bahu Builders,
introduce the new Flat, it should boost the sales of its existing Single-story homes by 4,500 units
per year, and reduce the sales of its luxury homes by 900 units per year. What is the amount to
use as the annual sales figure when evaluating this project? Why?

Question 3: Calculating Projected Net Income: Adeel enterprise proposed new investment has
projected sales of Rs.740,000. Variable cost is 60 percent of the sales and fixed cost is
Rs.173,000, depreciation is Rs.75,000. prepare a pro forma income statement assuming a tax rate
of 35 percent. What is the project net income?

Question 4: OCF from several approaches: Gafoor Cloth House, proposed new project has
projected sales of Rs.96,000 costs of Rs.49,000 and depreciation of Rs4,500. The tax rate is 35%.
Calculating operating cash flow using the four different approaches describes in the chapter and
show that answer is same?

Question 5: Calculating OCF: Consider the following income statement of Bashir & Sons
Rs
Sales 876,400
Cost 547,300
Depreciation 128,000

EBIT ?
Taxes (34%) ?
Net income ?

Question 6: Calculating Depreciation: Shah-nwaz, newly purchased a piece of industrial

equipment costs Rs.925000 and is classified as seven year under straight line. Calculate the
annual depreciation allowance and end-of-the-year book values for this equipment?

Question 7: Calculating salvage value: Sultan Mirza, Considers an asset that costs Rs.468,000
and its depreciation straight line to zero over its eight year tax life. The assets is to be used in a
five year project at the end of the project, the assets can be sold for Rs.72,000. If the relevant tax
rate is 35 % what is the after tax cash flow from the sale of this asset?

Question 8: Calculating salvage value: Ali has an asset used in four year project falls in the five
year straight line for tax purpose. The asset has an acquisition cost of Rs.8,400,000 and it will be
sold for Rs.1,750,000 at the end of the project. If the tax rate is 35 % what is the after-tax cash
flow from the sale of this asset?

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 CF: Lecture Notes (Handout #2)

Question 9: Calculating project OCF: Ehsan Chapal Store, considering a three year expansion
project that requires the initial fixed assets investment of Rs.4.2 million. The fixed assets will be
depreciated straight line to zero over its three year tax life after which time it will be worthless.
The project is estimated to generate Rs.3,100,000 in annual sales with costs of & Rs.990,000. If
the tax rate is 35 % what is the OCF for this project?

Question 10: Calculating project NPV: In the previous problem suppose the required return on
the project is 12 %, what is the project NPV?

Question 11: Calculating the project cash flow from assets: In the previous problem suppose
the project requires an initial investment in net working capital of Rs.300,000 and the fixed asset
will have a market value of Rs.210,000 at the end of the project. What is the project year 0 cash
flow? year1? year2? Year3? What is the new NPV?

Question 12: NPV and modified ACRS: In the previous problem suppose the fixed assets
actually falls into the three year MACRS class. All the other facts are the same. What is the
project year 1 net cash flow now? Year 2? Year 3? What is the new NPV?

Question 13: Project evaluation: Hardees is looking at a new cooling system with an installed
cost of Rs. 440,000. This cost will be deprecated straight line to zero over project five year life, at
the end of which the cooling system can be scrapped for Rs.60,000. This cooling system will save
the firm Rs.130,000 per year in pre-tax operating cost and the system requires the initial
investment in net working capital of Rs.34,000. If the tax rate is 34 % and the discount rate is 10
% what is the NPV of this project?

Question 14: Project evaluation: K&Ns is contemplating the purchase of a new Rs.840,000
computer based order entry system. The system will be depreciated straight line to zero over five
year life. It will worth Rs.75,000 at the end of the project. K&Ns will save Rs.330,000 before
taxes per year in order processing cost and they will be able to reduce working capital by
Rs.125,000. If the tax rate is 35 % what is the IRR for this project?

Question 15: Project evaluation: In the previous problem suppose K&Ns required return on the
project is 20 % and pretax cost saving are Rs.380,000 per year. Will K&Ns accept the project?
What if the pretax cost saving are Rs.280,000 per year? At what level pretax cost saving could
K&Ns be indifferent between accepting the project and not accepting project?

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