9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 350 Project Analysis and Evaluation 11 IN THE SUMMER OF 2013, the movie R.I.P.D., starring Ryan Reynolds and Jeff Bridges, was dead on arrival at the box office. The R.I.P.D. slogan was “To protect and serve the living,” but many critics and movie-goers disagreed. One critic said “Expect a sad afterlife for it on cable.”Others were even more harsh, saying “Unfortunately, the interesting drabness of the afterlife’s police department is paired with the colorless paucity of the film’s heavies” and “Less a bad movie than simply not a movie, R.I.P.D. gives every indication of having been a sloppy first-draft script.” Looking at the numbers, Universal Pictures spent close to $130 million making the movie, plus millions more for marketing and distribution. Unfortunately for Universal Pictures, R.I.P.D. did not allow the executives to rest peacefully, pulling in only $33.6 million worldwide. In fact, about four of 10 movies lose money at the box office, though DVD sales often help the final tally. Of course, there are movies that do quite well. Also in 2013, the Lions Gate movie Hunger Games: Catching Fire raked in about $425 million in the U.S. at a production cost of $130 million. So, obviously, Universal Pictures didn’t plan to lose $100 or so million on R.I.P.D., but it happened. As this particular box office bomb shows, projects don’t always go as companies think they will. This chapter explores how this can happen, and what companies can do to analyze and possibly avoid these situations. For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com. Learning Objectives After studying this chapter, you should understand: LO1 LO2 LO3 LO4 How to perform and interpret a sensitivity analysis for a proposed investment. How to perform and interpret a scenario analysis for a proposed investment. How to determine and interpret cash, accounting, and financial break-even points. How the degree of operating leverage can affect the cash flows of a project. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 1/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance LO5 How capital rationing affects the ability of a company to accept projects. In our previous chapter, we discussed how to identify and organize the relevant cash flows for capital investment decisions. Our primary interest there was in coming up with a preliminary estimate of the net present value for a proposed project. In this chapter, we focus https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 2/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. on assessing the reliability of such an estimate and on some additional considerations in project analysis. Page 351 We begin by discussing the need for an evaluation of cash flow and NPV estimates. We go on to develop some useful tools for such an evaluation. We also examine additional complications and concerns that can arise in project evaluation. 11.1 Evaluating NPV Estimates As we discussed in Chapter 9, an investment has a positive net present value if its market value exceeds its cost. Such an investment is desirable because it creates value for its owner. The primary problem in identifying such opportunities is that most of the time we can’t actually observe the relevant market value. Instead, we estimate it. Having done so, it is only natural to wonder whether our estimates are at least close to the true values. We consider this question next. THE BASIC PROBLEM Suppose we are working on a preliminary discounted cash flow analysis along the lines we described in the previous chapter. We carefully identify the relevant cash flows, avoiding such things as sunk costs, and we remember to consider working capital requirements. We add back any depreciation; we account for possible erosion; and we pay attention to opportunity costs. Finally, we double-check our calculations; when all is said and done, the bottom line is that the estimated NPV is positive. Now what? Do we stop here and move on to the next proposal? Probably not. The fact that the estimated NPV is positive is definitely a good sign; but, more than anything, this tells us that we need to take a closer look. If you think about it, there are two circumstances under which a DCF analysis could lead us to conclude that a project has a positive NPV. The first possibility is that the project really does have a positive NPV. That’s the good news. The bad news is the second possibility: A project may appear to have a positive NPV because our estimate is inaccurate. Notice that we could also err in the opposite way. If we conclude that a project has a negative NPV when the true NPV is positive, we lose a valuable opportunity. PROJECTED VERSUS ACTUAL CASH FLOWS There is a somewhat subtle point we need to make here. When we say something like “The projected cash flow in Year 4 is $700,”what exactly do we mean? Does this mean that we think the cash flow will actually be $700? Not really. It could happen, of course, but we would be surprised to see it turn out exactly that way. The reason is that the $700 projection is based on only what we know today. Almost anything could happen between now and then to change that cash flow. Loosely speaking, we really mean that if we took all the possible cash flows that could occur in four years and averaged them, the result would be $700. So, we don’t really expect a projected cash flow to be exactly right in any one case. What we do expect is that if we evaluate a large number of projects, our projections will be right on average. FORECASTING RISK The key inputs into a DCF analysis are projected future cash flows. If the projections are seriously in error, then we have a classic GIGO (garbage in, garbage out) system. In such a case, no matter how carefully we arrange the numbers and manipulate them, the resulting answer can still be grossly misleading. This is the danger in using a relatively sophisticated https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 3/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. technique like DCF. It is sometimes easy to get caught up in number crunching and forget the underlying nuts-and-bolts economic reality. Page 352 The possibility that we will make a bad decision because of errors in the projected cash flows is called forecasting risk (or estimation risk). Because of forecasting risk, there is the danger that we will think a project has a positive NPV when it really does not. How is this possible? It happens if we are overly optimistic about the future, and, as a result, our projected cash flows don’t realistically reflect the possible future cash flows. forecasting risk The possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk. Forecasting risk can take many forms. For example, Microsoft spent several billion dollars developing and bringing the Xbox One game console to market. Technologically more sophisticated than its competition, the Xbox One was the best way to play against competitors over the Internet and included other features, such as the Kinect motion detector. However, Microsoft sold only four million Xboxes in the first four months of sales, which was at the low end of Microsoft’s expected range and noticeably fewer than the 6.6 million Sony PS4s sold. Since the Xbox was arguably the best available game console at the time, why didn’t it sell better? A major reason given by analysts was that the Xbox cost $100 more than the PS4. So far, we have not explicitly considered what to do about the possibility of errors in our forecasts; so one of our goals in this chapter is to develop some tools that are useful in identifying areas where potential errors exist and where they might be especially damaging. In one form or another, we will be trying to assess the economic “reasonableness” of our estimates. We will also be wondering how much damage will be done by errors in those estimates. SOURCES OF VALUE The first line of defense against forecasting risk is simply to ask, “What is it about this investment that leads to a positive NPV?”We should be able to point to something specific as the source of value. For example, if the proposal under consideration involves a new product, then we might ask questions such as the following: Are we certain that our new product is significantly better than that of the competition? Can we truly manufacture at lower cost, or distribute more effectively, or identify undeveloped market niches, or gain control of a market? These are just a few of the potential sources of value. There are many others. For example, in 2004, Google announced a new, free e-mail service: Gmail. Why? Free e-mail service is widely available from big hitters like Microsoft and Yahoo! and, obviously, it’s free! The answer is that Google’s mail service is integrated with its acclaimed search engine, thereby giving it an edge. Also, offering e-mail lets Google expand its lucrative keyword-based advertising delivery. So, Google’s source of value is leveraging its proprietary Web search and ad delivery technologies. A key factor to keep in mind is the degree of competition in the market. A basic principle of economics is that positive NPV investments will be rare in a highly competitive environment. Therefore, proposals that appear to show significant value in the face of stiff competition are particularly troublesome, and the likely reaction of the competition to any innovations must be closely examined. To give an example, in 2008, demand for flat screen LCD televisions was high, prices were high, and profit margins were fat for retailers. But, also in 2008, manufacturers of the screens, such as Samsung and Sony, were projected to pour several billion dollars into new production facilities. Thus, anyone thinking of entering this highly profitable market would do well to reflect on what the supply (and profit margin) situation will look like in just a few years. And, in fact, the high prices did not last. By 2014, television sets that had been selling for well over $1,000 only two years before were selling for around $300–$400. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 4/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. It is also necessary to think about potential competition. For example, suppose home improvement retailer Lowe’s identifies an area that is underserved and is thinking about opening a Page 353 store. If the store is successful, what will happen? The answer is that Home Depot (or another competitor) will likely also build a store, thereby driving down volume and profits. So, we always need to keep in mind that success attracts imitators and competitors. The point to remember is that positive NPV investments are probably not all that common, and the number of positive NPV projects is almost certainly limited for any given firm. If we can’t articulate some sound economic basis for thinking ahead of time that we have found something special, then the conclusion that our project has a positive NPV should be viewed with some suspicion. Concept Questions 11.1a What is forecasting risk? Why is it a concern for the financial manager? 11.1b What are some potential sources of value in a new project? 11.2 Scenario and Other What-If Analyses Excel Master It! Excel Master coverage online Our basic approach to evaluating cash flow and NPV estimates involves asking what-if questions. Accordingly, we discuss some organized ways of going about a what-if analysis. Our goal in performing such an analysis is to assess the degree of forecasting risk and to identify the most critical components of the success or failure of an investment. GETTING STARTED We are investigating a new project. Naturally, the first thing we do is estimate NPV based on our projected cash flows. We will call this initial set of projections the base case. Now, however, we recognize the possibility of error in these cash flow projections. After completing the base case, we thus wish to investigate the impact of different assumptions about the future on our estimates. One way to organize this investigation is to put upper and lower bounds on the various components of the project. For example, suppose we forecast sales at 100 units per year. We know this estimate may be high or low, but we are relatively certain it is not off by more than 10 units in either direction. We thus pick a lower bound of 90 and an upper bound of 110. We go on to assign such bounds to any other cash flow components we are unsure about. When we pick these upper and lower bounds, we are not ruling out the possibility that the actual values could be outside this range. What we are saying, again loosely speaking, is that it is unlikely that the true average (as opposed to our estimated average) of the possible values is outside this range. An example is useful to illustrate the idea here. The project under consideration costs $200,000, has a fiveyear life, and has no salvage value. Depreciation is straight-line to zero. The required return is 12 percent, and https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 5/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance the tax rate is 34 percent. In addition, we have compiled the following information: https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 6/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. With this information, we can calculate the base-case NPV by first calculating net income: Page 354 Operating cash flow is thus $30,000 + 40,000 – 10,200 = $59,800 per year. At 12 percent, the five-year annuity factor is 3.6048, so the base-case NPV is: Thus, the project looks good so far. SCENARIO ANALYSIS The basic form of what-if analysis is called scenario analysis. What we do is investigate the changes in our NPV estimates that result from asking questions like: What if unit sales realistically should be projected at 5,500 units instead of 6,000? scenario analysis The determination of what happens to NPV estimates when we ask what-if questions. Once we start looking at alternative scenarios, we might find that most of the plausible ones result in positive NPVs. In this case, we have some confidence in proceeding with the project. If a substantial percentage of the scenarios look bad, the degree of forecasting risk is high and further investigation is in order. We can consider a number of possible scenarios. A good place to start is with the worst-case scenario. This will tell us the minimum NPV of the project. If this turns out to be positive, we will be in good shape. While we are at it, we will go ahead and determine the other extreme, the best case. This puts an upper bound on our NPV. To get the worst case, we assign the least favorable value to each item. This means low values for items like units sold and price per unit and high values for costs. We do the reverse for the best case. For our project, these values would be the following: With this information, we can calculate the net income and cash flows under each scenario (check these for yourself): https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 7/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance What we learn is that under the worst scenario, the cash flow is still positive at $24,490. That’s good news. The bad news is that the return is –14.4 percent in this case, and the https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 8/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. NPV is −$111,719. Because the project costs $200,000, we stand to lose a little more than half of the original investment under the worst possible scenario. The best case offers an attractive 41 percent return. Page 355 The terms best case and worst case are commonly used, and we will stick with them; but they are somewhat misleading. The absolutely best thing that could happen would be something absurdly unlikely, such as launching a new diet soda and subsequently learning that our (patented) formulation also just happens to cure the common cold. Similarly, the true worst case would involve some incredibly remote possibility of total disaster. We’re not claiming that these things don’t happen; once in a while they do. Some products, such as personal computers, succeed beyond the wildest expectations; and some turn out to be absolute catastrophes. For example, in April 2010, BP’s Gulf of Mexico oil rig Deepwater Horizon caught fire and sank following an explosion, leading to a massive oil spill. The leak was finally stopped in July after releasing over 200 million gallons of crude oil into the Gulf. BP’s costs associated with the disaster have already exceeded $43 billion, not including opportunity costs such as lost government contracts. Nonetheless, our point is that in assessing the reasonableness of an NPV estimate, we need to stick to cases that are reasonably likely to occur. Instead of best and worst, then, it is probably more accurate to use the words optimistic and pessimistic. In broad terms, if we were thinking about a reasonable range for, say, unit sales, then what we call the best case would correspond to something near the upper end of that range. The worst case would simply correspond to the lower end. Not all companies complete (or at least publish) all three estimates. For example, Almaden Minerals, Ltd., made a press release with information concerning its Elk Gold Project in British Columbia. Here is a table of the possible outcomes given by the company: https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 9/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. As you can see, the NPV is projected at C$28.7 million in the base case and C$67.9 million in the best case. Unfortunately, Almaden did not release a worst-case analysis, but we hope the company also examined this possibility. Page 356 As we have mentioned, there are an unlimited number of different scenarios that we could examine. At a minimum, we might want to investigate two intermediate cases by going halfway between the base amounts and the extreme amounts. This would give us five scenarios in all, including the base case. Beyond this point, it is hard to know when to stop. As we generate more and more possibilities, we run the risk of experiencing “paralysis of analysis.”The difficulty is that no matter how many scenarios we run, all we can learn are possibilities—some good and some bad. Beyond that, we don’t get any guidance as to what to do. Scenario analysis is thus useful in telling us what can happen and in helping us gauge the potential for disaster, but it does not tell us whether to take a project. Unfortunately, in practice, even the worst-case scenarios may not be low enough. Two recent examples show what we mean. The Eurotunnel, or Chunnel, may be one of the new wonders of the world. The tunnel under the English Channel connects England to France and covers 24 miles. It took 8,000 workers eight years to remove 9.8 million cubic yards of rock. When the tunnel was finally built, it cost $17.9 billion, or slightly more than twice the original estimate of $8.8 billion. And things got worse. Forecasts called for 16.8 million passengers in the first year, but only 4 million actually used it. Revenue estimates for 2003 were $2.88 billion, but actual revenue was only about one-third of that. The major problems faced by the Eurotunnel were increased competition from ferry services, which dropped their prices, and the rise of low-cost airlines. In 2006, things got so bad that the company operating the Eurotunnel was forced into negotiations with creditors to chop its $11.1 billion debt in half to avoid bankruptcy. The debt reduction appeared to help. In 2007, the Eurotunnel reported its first profit of €1 million ($1.6 million). By 2013, the Chunnel had a profit of €101 million ($138 million). Sales for the year were €1.09 billion ($1.49 billion), the first year its sales exceeded €1 billion, and for the first time it transported more than 10 million passengers in a year. Another example is the personal transporter, or Segway. Trumpeted by inventor Dean Kamen as the replacement for automobiles in cities, the Segway came to market with great expectations. At the end of September 2003, the company recalled all of the transporters due to a mandatory software upgrade. Worse, the company had projected sales of 50,000 to 100,000 units in the first five months of production; but, three years later, only about 23,500 had been sold. SENSITIVITY ANALYSIS Sensitivity analysis is a variation on scenario analysis that is useful in pinpointing the areas where forecasting risk is especially severe. The basic idea with a sensitivity analysis is to freeze all of the variables except one and then see how sensitive our estimate of NPV is to changes in that one variable. If our NPV estimate turns out to be very sensitive to relatively small changes in the projected value of some component of project cash flow, then the forecasting risk associated with that variable is high. sensitivity analysis Investigation of what happens to NPV when only one variable is changed. To illustrate how sensitivity analysis works, we go back to our base case for every item except unit sales. We can then calculate cash flow and NPV using the largest and smallest unit sales figures. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 10/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. FIGURE 11.1 Sensitivity Analysis for Unit Sales Page 357 For comparison, we now freeze everything except fixed costs and repeat the analysis: What we see here is that given our ranges, the estimated NPV of this project is more sensitive to changes in projected unit sales than it is to changes in projected fixed costs. In fact, under the worst case for fixed costs, the NPV is still positive. The results of our sensitivity analysis for unit sales can be illustrated graphically as in Figure 11.1. Here we place NPV on the vertical axis and unit sales on the horizontal axis. When we plot the combinations of unit sales versus NPV, we see that all possible combinations fall on a straight line. The steeper the resulting line is, the greater the sensitivity of the estimated NPV to changes in the projected value of the variable being investigated. Sensitivity analysis can produce results that vary dramatically depending on the assumptions. For example, in early 2011, Bard Ventures announced its projections for a molybdenum mine in British Columbia. At a cost of capital of 10 percent and an average molybdenum price of $19 per ton, the NPV of the new mine would be $112 million with an IRR of 12.4 percent. At a high price of $30 per ton, the NPV would be $1.152 billion, and the IRR would be 32.0 percent. As we have illustrated, sensitivity analysis is useful in pinpointing which variables deserve the most attention. If we find that our estimated NPV is especially sensitive to changes in a variable that is difficult to forecast (such as unit sales), then the degree of forecasting risk is high. We might decide that further market research would be a good idea in this case. Because sensitivity analysis is a form of scenario analysis, it suffers from the same drawbacks. 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. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 11/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance SIMULATION ANALYSIS Scenario analysis and sensitivity analysis are widely used. With scenario analysis, we let all the different variables change, but we let them take on only a few values. With sensitivity analysis, we let only one variable change, but we let it take on many values. If we combine the two approaches, the result is a crude form of simulation analysis. simulation analysis A combination of scenario and sensitivity analysis. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 12/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. If we want to let all the items vary at the same time, we have to consider a very large number of scenarios, and computer assistance is almost certainly needed. In the simplest case, we start with Page 358 unit sales and assume that any value in our 5,500 to 6,500 range is equally likely. We start by randomly picking one value (or by instructing a computer to do so). We then randomly pick a price, a variable cost, and so on. Once we have values for all the relevant components, we calculate an NPV. We repeat this sequence as much as we desire, probably several thousand times. The result is many NPV estimates that we summarize by calculating the average value and some measure of how spread out the different possibilities are. For example, it would be of some interest to know what percentage of the possible scenarios result in negative estimated NPVs. Because simulation analysis (or simulation) is an extended form of scenario analysis, it has the same problems. Once we have the results, no simple decision rule tells us what to do. Also, we have described a relatively simple form of simulation. To really do it right, we would have to consider the interrelationships between the different cash flow components. Furthermore, we assumed that the possible values were equally likely to occur. It is probably more realistic to assume that values near the base case are more likely than extreme values, but coming up with the probabilities is difficult, to say the least. For these reasons, the use of simulation is somewhat limited in practice. However, recent advances in computer software and hardware (and user sophistication) lead us to believe it may become more common in the future, particularly for large-scale projects. Concept Questions 11.2a What are scenario, sensitivity, and simulation analysis? 11.2b What are the drawbacks to the various types of what-if analysis? 11.3 Break-Even Analysis It will frequently turn out that the crucial variable for a project is sales volume. If we are thinking of creating a new product or entering a new market, for example, the hardest thing to forecast accurately is how much we can sell. For this reason, sales volume is usually analyzed more closely than other variables. Break-even analysis is a popular and commonly used tool for analyzing the relationship between sales volume and profitability. There are a variety of different break-even measures, and we have already seen several types. For example, we discussed (in Chapter 9) how the payback period can be interpreted as the length of time until a project breaks even, ignoring time value. All break-even measures have a similar goal. Loosely speaking, we will always be asking, “How bad do sales have to get before we actually begin to lose money?”Implicitly, we will also be asking, “Is it likely that things will get that bad?”To get started on this subject, we first discuss fixed and variable costs. FIXED AND VARIABLE COSTS In discussing break-even, the difference between fixed and variable costs becomes very important. As a result, we need to be a little more explicit about the difference than we have been so far. Variable Costs By definition, variable costs change as the quantity of output changes, and they are zero when production is zero. For example, direct labor costs and raw material costs are usually considered variable. This makes sense because if we shut down operations tomorrow, there will be no future costs for labor or raw materials. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 13/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance variable costs Costs that change when the quantity of output changes. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 14/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. FIGURE 11.2 Output Level and Variable Costs Page 359 We will assume that variable costs are a constant amount per unit of output. This simply means that total variable cost is equal to the cost per unit multiplied by the number of units. In other words, the relationship between total variable cost (VC), cost per unit of output (v), and total quantity of output (Q) can be written simply as: For example, suppose variable costs (v) are $2 per unit. If total output (Q) is 1,000 units, what will total variable costs (VC) be? Similarly, if Q is 5,000 units, then VC will be 5,000 × $2 = $10,000. Figure 11.2 illustrates the relationship between output level and variable costs in this case. In Figure 11.2, notice that increasing output by one unit results in variable costs rising by $2, so “the rise over the run”(the slope of the line) is given by $2/1 = $2. EXAMPLE 11.1 Variable Costs The Blume Corporation is a manufacturer of pencils. It has received an order for 5,000 pencils, and the company has to decide whether to accept the order. From recent experience, the company knows that each pencil requires 5 cents in raw materials and 50 cents in direct labor costs. These variable costs are expected to continue to apply in the future. What will Blume’s total variable costs be if it accepts the order? https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 15/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. In this case, the cost per unit is 50 cents in labor plus 5 cents in material for a total of 55 cents per unit. At 5,000 units of output, we have: Page 360 Therefore, total variable costs will be $2,750. Fixed Costs Fixed costs, by definition, do not change during a specified time period. So, unlike variable costs, they do not depend on the amount of goods or services produced during a period (at least within some range of production). For example, the lease payment on a production facility and the company president’s salary are fixed costs, at least over some period. fixed costs, Costs that do not change when the quantity of output charges during a particular time period. Naturally, fixed costs are not fixed forever. They are fixed only during some particular time, say, a quarter or a year. Beyond that time, leases can be terminated and executives “retired.” More to the point, any fixed cost can be modified or eliminated given enough time; so, in the long run, all costs are variable. Notice that when a cost is fixed, that cost is effectively a sunk cost because we are going to have to pay it no matter what. Total Costs Total costs (TC) for a given level of output are the sum of variable costs (VC) and fixed costs (FC): So, for example, if we have variable costs of $3 per unit and fixed costs of $8,000 per year, our total cost is: TC = $3 × Q + $8,000 If we produce 6,000 units, our total production cost will be $3 × 6,000 + $8,000 = $26,000. At other production levels, we have the following: By plotting these points in Figure 11.3, we see that the relationship between quantity produced and total costs is given by a straight line. In Figure 11.3, notice that total costs equal fixed costs when sales are zero. Beyond that point, every one-unit increase in production leads to a $3 increase in total costs, so the slope of the line is 3. In other words, the marginal, or incremental, cost of producing one more unit is $3. marginal, or incremental, cost The change in costs that occurs when there is a small change in output. EXAMPLE 11.2 Average Cost versus Marginal Cost Suppose the Blume Corporation has a variable cost per pencil of 55 cents. The lease payment on the production facility runs $5,000 per month. If Blume produces 100,000 pencils per year, what are the total https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 16/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance costs of production? What is the average cost per pencil? https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 17/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. The fixed costs are $5,000 per month, or $60,000 per year. The variable cost is $.55 per pencil. So the total cost for the year, assuming that Blume produces 100,000 pencils, is: Page 361 The average cost per pencil is $115,000/100,000 = $1.15. Now suppose that Blume has received a special, one-shot order for 5,000 pencils. Blume has sufficient capacity to manufacture the 5,000 pencils on top of the 100,000 already produced, so no additional fixed costs will be incurred. Also, there will be no effect on existing orders. If Blume can get 75 cents per pencil for this order, should the order be accepted? What this boils down to is a simple proposition. It costs 55 cents to make another pencil. Anything Blume can get for this pencil in excess of the 55-cent incremental cost contributes in a positive way toward covering fixed costs. The 75-cent marginal, or incremental, revenue exceeds the 55-cent marginal cost, so Blume should take the order. The fixed cost of $60,000 is not relevant to this decision because it is effectively sunk, at least for the current period. In the same way, the fact that the average cost is $1.15 is irrelevant because this average reflects the fixed cost. As long as producing the extra 5,000 pencils truly does not cost anything beyond the 55 cents per pencil, then Blume should accept anything over that 55 cents. marginal, or incremental, revenue The change in revenue that occurs when there is a small change in output. ACCOUNTING BREAK-EVEN The most widely used measure of break-even is accounting break-even. The accounting break-even point is simply the sales level that results in a zero project net income. accounting break-even The sales level that results in zero project net income. To determine a project’s accounting break-even, we start off with some common sense. Suppose we retail onepetabyte computer disks for $5 apiece. We can buy disks from a wholesale supplier for $3 apiece. We have accounting expenses of $600 in fixed costs and $300 in depreciation. How many disks do we have to sell to break even—that is, for net income to be zero? FIGURE 11.3 Output Level and Total Costs https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 18/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 19/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. For every disk we sell, we pick up $5 − 3 = $2 toward covering our other expenses (this $2 difference between the selling price and the variable cost is often called the contribution margin Page 362 per unit). We have to cover a total of $600 + 300 = $900 in accounting expenses, so we obviously need to sell $900/2 = 450 disks. We can check this by noting that at a sales level of 450 units, our revenues are $5 × 450 = $2,250 and our variable costs are $3 × 450 = $1,350. Thus, here is the income statement: Remember, because we are discussing a proposed new project, we do not consider any interest expense in calculating net income or cash flow from the project. Also, notice that we include depreciation in calculating expenses here, even though depreciation is not a cash outflow. That is why we call it an accounting break-even. Finally, notice that when net income is zero, so are pretax income and, of course, taxes. In accounting terms, our revenues are equal to our costs, so there is no profit to tax. Figure 11.4 presents another way to see what is happening. This figure looks a lot like Figure 11.3 except that we add a line for revenues. As indicated, total revenues are zero when output is zero. Beyond that, each unit sold brings in another $5, so the slope of the revenue line is 5. From our preceding discussion, we know that we break even when revenues are equal to total costs. The line for revenues and the line for total costs cross right where output is at 450 units. As illustrated, at any level of output below 450, our accounting profit is negative, and at any level above 450, we have a positive net income. FIGURE 11.4 Accounting Break-Even https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 20/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 21/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. ACCOUNTING BREAK-EVEN: A CLOSER LOOK Page 363 In our numerical example, notice that the break-even level is equal to the sum of fixed costs and depreciation, divided by price per unit less variable costs per unit. This is always true. To see why, we recall all of the following variables: Project net income is given by: From here, it is not difficult to calculate the break-even point. If we set this net income equal to zero, we get: Divide both sides by (1 – T) to get: S – VC – FC – D = 0 As we have seen, this says that when net income is zero, so is pretax income. If we recall that S = P × Q and VC = v × Q, then we can rearrange the equation to solve for the break-even level: This is the same result we described earlier. USES FOR THE ACCOUNTING BREAK-EVEN Why would anyone be interested in knowing the accounting break-even point? To illustrate how it can be useful, suppose we are a small specialty ice cream manufacturer with a strictly local distribution. We are thinking about expanding into new markets. Based on the estimated cash flows, we find that the expansion has a positive NPV. Going back to our discussion of forecasting risk, we know that it is likely that what will make or break our expansion is sales volume. The reason is that, in this case at least, we probably have a fairly good idea of what we can charge for the ice cream. Further, we know relevant production and distribution costs reasonably well because we are already in the business. What we do not know with any real precision is how much ice cream we can sell. Given the costs and selling price, however, we can immediately calculate the break-even point. Once we have done so, we might find that we need to get 30 percent of the market https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 22/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. just to break even. If we think that this is unlikely to occur, because, for example, we have only 10 percent of our current market, then we know our forecast is questionable and there is a real Page 364 possibility that the true NPV is negative. On the other hand, we might find that we already have firm commitments from buyers for about the break-even amount, so we are almost certain we can sell more. In this case, the forecasting risk is much lower, and we have greater confidence in our estimates. There are several other reasons why knowing the accounting break-even can be useful. First, as we will discuss in more detail later, accounting break-even and payback period are similar measures. Like payback period, accounting break-even is relatively easy to calculate and explain. Second, managers are often concerned with the contribution a project will make to the firm’s total accounting earnings. A project that does not break even in an accounting sense actually reduces total earnings. Third, a project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense. This is true because we could have earned more by investing elsewhere. Such a project does not lose money in an out-of-pocket sense. As described in the following sections, we get back exactly what we put in. For noneconomic reasons, opportunity losses may be easier to live with than out-of-pocket losses. Concept Questions 11.3a How are fixed costs similar to sunk costs? 11.3b What is net income at the accounting break-even point? What about taxes? 11.3c Why might a financial manager be interested in the accounting break-even point? 11.4 Operating Cash Flow, Sales Volume, and Break-Even Excel Master It! Excel Master coverage online Accounting break-even is one tool that is useful for project analysis. Ultimately, however, we are more interested in cash flow than accounting income. So, for example, if sales volume is the critical variable, then we need to know more about the relationship between sales volume and cash flow than just the accounting break-even. Our goal in this section is to illustrate the relationship between operating cash flow and sales volume. We also discuss some other break-even measures. To simplify matters somewhat, we will ignore the effect of taxes. We start off by looking at the relationship between accounting break-even and cash flow. ACCOUNTING BREAK-EVEN AND CASH FLOW Now that we know how to find the accounting break-even, it is natural to wonder what happens with cash flow. To illustrate, suppose the Wettway Sailboat Corporation is considering whether to launch its new Margo-class sailboat. The selling price will be $40,000 per boat. The variable costs will be about half that, or $20,000 per boat, and fixed costs will be $500,000 per year. The Base Case The total investment needed to undertake the project is $3,500,000. This amount will be depreciated straight-line to zero over the five-year life of the equipment. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 23/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. The salvage value is zero, and there are no working capital consequences. Wettway has a 20 percent required return on new projects. Page 365 Based on market surveys and historical experience, Wettway projects total sales for the five years at 425 boats, or about 85 boats per year. Ignoring taxes, should this project be launched? To begin, ignoring taxes, the operating cash flow at 85 boats per year is: At 20 percent, the five-year annuity factor is 2.9906, so the NPV is: In the absence of additional information, the project should be launched. Calculating the Break-Even Level To begin looking a little closer at this project, you might ask a series of questions. For example, how many new boats does Wettway need to sell for the project to break even on an accounting basis? If Wettway does break even, what will be the annual cash flow from the project? What will be the return on the investment in this case? Before fixed costs and depreciation are considered, Wettway generates $40,000 – 20,000 = $20,000 per boat (this is revenue less variable cost). Depreciation is $3,500,000/5 = $700,000 per year. Fixed costs and depreciation together total $1.2 million, so Wettway needs to sell (FC + D)/(P – v) = $1.2 million/20,000 = 60 boats per year to break even on an accounting basis. This is 25 boats less than projected sales; so, assuming that Wett-way is confident its projection is accurate to within, say, 15 boats, it appears unlikely that the new investment will fail to at least break even on an accounting basis. To calculate Wettway’s cash flow in this case, we note that if 60 boats are sold, net income will be exactly zero. Recalling from the previous chapter that operating cash flow for a project can be written as net income plus depreciation (the bottom-up definition), we can see that the operating cash flow is equal to the depreciation, or $700,000 in this case. The internal rate of return is exactly zero (why?). Payback and Break-Even As our example illustrates, whenever a project breaks even on an accounting basis, the cash flow for that period will equal the depreciation. This result makes perfect accounting sense. For example, suppose we invest $100,000 in a five-year project. The depreciation is straight-line to a zero salvage, or $20,000 per year. If the project exactly breaks even every period, then the cash flow will be $20,000 per period. The sum of the cash flows for the life of this project is 5 × $20,000 = $100,000, the original investment. What this shows is that a project’s payback period is exactly equal to its life if the project breaks even every period. Similarly, a project that does better than break even has a payback that is shorter than the life of the project and has a positive rate of return. The bad news is that a project that just breaks even on an accounting basis has a negative NPV and a zero return. For our sailboat project, the fact that Wettway will almost surely break even on an accounting basis is partially comforting because it means that the firm’s “downside” risk (its potential loss) is limited, but we still don’t know if the project is truly profitable. More work is needed. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 24/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. SALES VOLUME AND OPERATING CASH FLOW Page 366 At this point, we can generalize our example and introduce some other break-even measures. From our discussion in the previous section, we know that, ignoring taxes, a project’s operating cash flow, OCF, can be written simply as EBIT plus depreciation: For the Wettway sailboat project, the general relationship (in thousands of dollars) between operating cash flow and sales volume is thus: What this tells us is that the relationship between operating cash flow and sales volume is given by a straight line with a slope of $20 and a y-intercept of –$500. If we calculate some different values, we get: These points are plotted in Figure 11.5, where we have indicated three different break-even points. We discuss these next. CASH FLOW, ACCOUNTING, AND FINANCIAL BREAK-EVEN POINTS We know from the preceding discussion that the relationship between operating cash flow and sales volume (ignoring taxes) is: OCF = (P – v) × Q – FC If we rearrange this and solve for Q, we get: FIGURE 11.5 Operating Cash Flow and Sales Volume https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 25/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 26/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. This tells us what sales volume (Q) is necessary to achieve any given OCF, so this result is more general than the accounting break-even. We use it to find the various break-even points in Figure 11.5. Page 367 Accounting Break-Even Revisited Looking at Figure 11.5, suppose operating cash flow is equal to depreciation (D). Recall that this situation corresponds to our break-even point on an accounting basis. To find the sales volume, we substitute the $700 depreciation amount for OCF in our general expression: This is the same quantity we had before. Cash Break-Even We have seen that a project that breaks even on an accounting basis has a net income of zero, but it still has a positive cash flow. At some sales level below the accounting break-even, the operating cash flow actually goes negative. This is a particularly unpleasant occurrence. If it happens, we actually have to supply additional cash to the project just to keep it afloat. To calculate the cash break-even (the point where operating cash flow is equal to zero), we put in a zero for OCF: cash break-even The sales level that results in a zero operating cash flow. Wettway must therefore sell 25 boats to cover the $500 in fixed costs. As we show in Figure 11.5, this point occurs right where the operating cash flow line crosses the horizontal axis. Notice that a project that just breaks even on a cash flow basis can cover its own fixed operating costs, but that is all. It never pays back anything, so the original investment is a complete loss (the IRR is –100 percent). Financial Break-Even The last case we consider is that of financial break-even, the sales level that results in a zero NPV. To the financial manager, this is the most interesting case. What we do is first determine what operating cash flow has to be for the NPV to be zero. We then use this amount to determine the sales volume. financial break-even The sales level that results in a zero NPV. To illustrate, recall that Wettway requires a 20 percent return on its $3,500 (in thousands) investment. How many sailboats does Wettway have to sell to break even once we account for the 20 percent per year opportunity cost? The sailboat project has a five-year life. The project has a zero NPV when the present value of the operating cash flows equals the $3,500 investment. Because the cash flow is the same each year, we can solve for the unknown amount by viewing it as an ordinary annuity. The five-year annuity factor at 20 percent is 2.9906, and the OCF can be determined as follows: https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 27/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance Wettway thus needs an operating cash flow of $1,170 each year to break even. We can now plug this OCF into the equation for sales volume: So, Wettway needs to sell about 84 boats per year. This is not good news. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 28/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. As indicated in Figure 11.5, the financial break-even is substantially higher than the accounting break-even. This will often be the case. Moreover, what we have discovered is that the sailboat project has a substantial degree of forecasting risk. We project sales of 85 boats per year, but it takes 84 just to earn the required return. Page 368 Conclusion Overall, it seems unlikely that the Wettway sailboat project would fail to break even on an accounting basis. However, there appears to be a very good chance that the true NPV is negative. This illustrates the danger in looking at just the accounting break-even. What should Wettway do? Is the new project all wet? The decision at this point is essentially a managerial issue—a judgment call. The crucial questions are these: 1. How much confidence do we have in our projections? 2. How important is the project to the future of the company? 3. How badly will the company be hurt if sales turn out to be low? What options are available to the company in this case? We will consider questions such as these in a later section. For future reference, our discussion of the different break-even measures is summarized in Table 11.1. TABLE 11.1 Summary of Break-Even Measures https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 29/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 30/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 369 Concept Questions 11.4a If a project breaks even on an accounting basis, what is its operating cash flow? 11.4b If a project breaks even on a cash basis, what is its operating cash flow? 11.4c If a project breaks even on a financial basis, what do you know about its discounted payback? 11.5 Operating Leverage Excel Master It! Excel Master coverage online We have discussed how to calculate and interpret various measures of break-even for a proposed project. What we have not explicitly discussed is what determines these points and how they might be changed. We now turn to this subject. THE BASIC IDEA Operating leverage is the degree to which a project or firm is committed to fixed production costs. A firm with low operating leverage will have low fixed costs compared to a firm with high operating leverage. Generally speaking, projects with a relatively heavy investment in plant and equipment will have a relatively high degree of operating leverage. Such projects are said to be capital intensive. operating leverage The degree to which a firm or project relies on fixed costs. Anytime we are thinking about a new venture, there will normally be alternative ways of producing and delivering the product. For example, Wettway Corporation can purchase the necessary equipment and build all of the components for its sailboats in-house. Alternatively, some of the work could be farmed out to other firms. The first option involves a greater investment in plant and equipment, greater fixed costs and depreciation, and, as a result, a higher degree of operating leverage. IMPLICATIONS OF OPERATING LEVERAGE Regardless of how it is measured, operating leverage has important implications for project evaluation. Fixed costs act like a lever in the sense that a small percentage change in operating revenue can be magnified into a large percentage change in operating cash flow and NPV. This explains why we call it operating “leverage.” The higher the degree of operating leverage, the greater is the potential danger from forecasting risk. The reason is that relatively small errors in forecasting sales volume can get magnified, or “levered up,” into large errors in cash flow projections. From a managerial perspective, one way of coping with highly uncertain projects is to keep the degree of operating leverage as low as possible. This will generally have the effect of keeping the break-even point (however measured) at its minimum level. We will illustrate this point in a bit, but first we need to discuss how to measure operating leverage. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 31/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance MEASURING OPERATING LEVERAGE One way of measuring operating leverage is to ask: If quantity sold rises by 5 percent, what will be the percentage change in operating cash flow? In other words, the degree of operating leverage (DOL) is defined such that: degree of operating leverage (DOL) The percentage change in operating cash flow relative to the percentage change in quantity sold. Percentage change in OCF = DOL × Percentage change in Q https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 32/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Based on the relationship between OCF and Q, DOL can be written as:1 Page 370 The ratio FC/OCF simply measures fixed costs as a percentage of total operating cash flow. Notice that zero fixed costs would result in a DOL of 1, implying that percentage changes in quantity sold would show up one for one in operating cash flow. In other words, no magnification, or leverage, effect would exist. To illustrate this measure of operating leverage, we go back to the Wettway sailboat project. Fixed costs were $500 and (P − v) was $20, so OCF was: OCF = –$500 + 20 × Q Suppose Q is currently 50 boats. At this level of output, OCF is –$500 + 1,000 = $500. If Q rises by 1 unit to 51, then the percentage change in Q is (51 – 50)/50 = .02, or 2%. OCF rises to $520, a change of P – v = $20. The percentage change in OCF is ($520 – 500)/500 = .04, or 4%. So a 2 percent increase in the number of boats sold leads to a 4 percent increase in operating cash flow. The degree of operating leverage must be exactly 2.00. We can check this by noting that: This verifies our previous calculations. Our formulation of DOL depends on the current output level, Q. However, it can handle changes from the current level of any size, not just one unit. For example, suppose Q rises from 50 to 75, a 50 percent increase. With DOL equal to 2, operating cash flow should increase by 100 percent, or exactly double. Does it? The answer is yes, because, at a Q of 75, OCF is: OCF = –$500 + 20 × 75 = $1,000 Notice that operating leverage declines as output (Q) rises. For example, at an output level of 75, we have: The reason DOL declines is that fixed costs, considered as a percentage of operating cash flow, get smaller and smaller, so the leverage effect diminishes. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 33/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 371 EXAMPLE 11.3 Operating Leverage The Sasha Corp. currently sells gourmet dog food for $1.20 per can. The variable cost is 80 cents per can, and the packaging and marketing operations have fixed costs of $360,000 per year. Depreciation is $60,000 per year. What is the accounting break-even? Ignoring taxes, what will be the increase in operating cash flow if the quantity sold rises to 10 percent above the break-even point? The accounting break-even is $420,000/.40 = 1,050,000 cans. As we know, the operating cash flow is equal to the $60,000 depreciation at this level of production, so the degree of operating leverage is: Given this, a 10 percent increase in the number of cans of dog food sold will increase operating cash flow by a substantial 70 percent. To check this answer, we note that if sales rise by 10 percent, then the quantity sold will rise to 1,050,000 × 1.1 = 1,155,000. Ignoring taxes, the operating cash flow will be 1,155,000 × $.40 – 360,000 = $102,000. Compared to the $60,000 cash flow we had, this is exactly 70 percent more: $102,000/60,000 = 1.70. OPERATING LEVERAGE AND BREAK-EVEN We illustrate why operating leverage is an important consideration by examining the Wettway sailboat project under an alternative scenario. At a Q of 85 boats, the degree of operating leverage for the sailboat project under the original scenario is: Also, recall that the NPV at a sales level of 85 boats was $88,720, and the accounting break-even was 60 boats. An option available to Wettway is to subcontract production of the boat hull assemblies. If the company does this, the necessary investment falls to $3,200,000 and the fixed operating costs fall to $180,000. However, variable costs will rise to $25,000 per boat because subcontracting is more expensive than producing in-house. Ignoring taxes, evaluate this option. For practice, see if you don’t agree with the following: NPV at 20% (85 units) = $74,720 Accounting break-even = 55 boats Degree of operating leverage = 1.16 What has happened? This option results in a slightly lower estimated net present value, and the accounting break-even point falls to 55 boats from 60 boats. Given that this alternative has the lower NPV, is there any reason to consider it further? Maybe there is. The degree of operating leverage is substantially lower in the second case. If Wettway is worried about the possibility of an overly optimistic projection, then it might prefer to subcontract. There is another reason why Wettway might consider the second arrangement. If sales turned out to be better than expected, the company would always have the option of starting to produce in-house at a later date. As a practical matter, it is much easier to increase https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 34/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. operating leverage (by purchasing equipment) than to decrease it (by selling off equipment). As we discuss in a later chapter, one of the drawbacks to discounted cash flow analysis is that it is difficult to explicitly include options of this sort in the analysis, even though they may be quite important. Page 372 Concept Questions 11.5a What is operating leverage? 11.5b How is operating leverage measured? 11.5c What are the implications of operating leverage for the financial manager? 11.6 Capital Rationing Capital rationing is said to exist when we have profitable (positive NPV) investments available but we can’t get the funds needed to undertake them. For example, as division managers for a large corporation, we might identify $5 million in excellent projects, but find that, for whatever reason, we can spend only $2 million. Now what? Unfortunately, for reasons we will discuss, there may be no truly satisfactory answer. capital rationing The situation that exists if a firm has positive NPV projects but cannot find the necessary financing. SOFT RATIONING The situation we have just described is called soft rationing. This occurs when, for example, different units in a business are allocated some fixed amount of money each year for capital spending. Such an allocation is primarily a means of controlling and keeping track of overall spending. The important thing to note about soft rationing is that the corporation as a whole isn’t short of capital; more can be raised on ordinary terms if management so desires. soft rationing The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. If we face soft rationing, the first thing to do is to try to get a larger allocation. Failing that, one common suggestion is to generate as large a net present value as possible within the existing budget. This amounts to choosing projects with the largest benefit–cost ratio (profitability index). Strictly speaking, this is the correct thing to do only if the soft rationing is a one-time event—that is, it won’t exist next year. If the soft rationing is a chronic problem, then something is amiss. The reason goes all the way back to Chapter 1. Ongoing soft rationing means we are constantly bypassing positive NPV investments. This contradicts the goal of our firm. If we are not trying to maximize value, then the question of which projects to take becomes ambiguous because we no longer have an objective goal in the first place. HARD RATIONING With hard rationing, a business cannot raise capital for a project under any circumstances. For large, healthy corporations, this situation probably does not occur very often. This is fortunate because, with hard rationing, our DCF analysis breaks down, and the best course of action is ambiguous. hard rationing The situation that occurs when a business cannot raise financing for a project under any circumstances. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 35/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance The reason DCF analysis breaks down has to do with the required return. Suppose we say our required return is 20 percent. Implicitly, we are saying we will take a project with a return that exceeds this. However, if we face hard rationing, then we are not going to take a new project no matter what the return on that project is, so the whole concept of a required return is ambiguous. About the only interpretation we can give this situation is that the required return is so large that no project has a positive NPV in the first place. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 36/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 373 https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/46!/4/490/2@0:100 37/37 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 312 Making Capital Investment Decisions 10 IS THERE GREEN IN GREEN? General Electric (GE) thinks so. Through its “Ecomagination” program, the company planned to double research and development spending on green products. By 2009, GE had invested over $5 billion in its Ecomagination program, and it announced it would invest another $10 billion from 2011 to 2015. As an example, GE’s Next Evolution® Series Locomotive required over $600 million in development, but it allows railroads to move one ton of freight more than 480 miles with a single gallon of fuel. GE’s green initiative seems to be paying off. Revenue from green products has totaled more than $130 billion since its launch in 2005, with $25 billion in 2012 alone. Even further, revenues from Ecomagination products were growing at twice the rate of the rest of the company’s revenues. The company’s internal commitment to green reduced its energy consumption by 32 percent from its 2004 baseline by 2012, and the company reduced its water consumption by 46 percent from its 2006 baseline, another considerable cost savings. As you no doubt recognize from your study of the previous chapter, GE’s decision to develop and market green technology represents a capital budgeting decision. In this chapter, we further investigate such decisions, how they are made, and how to look at them objectively. This chapter follows up on our previous one by delving more deeply into capital budgeting. We have two main tasks. First, recall that in the last chapter, we saw that cash flow estimates are the critical input in a net present value analysis, but we didn’t say much about where these cash flows come from; so we will now examine this question in some detail. Our second goal is to learn how to critically examine NPV estimates, and, in particular, how to evaluate the sensitivity of NPV estimates to assumptions made about the uncertain future. For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com. Learning Objectives After studying this chapter, you should understand: https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 1/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance LO1 LO2 LO3 LO4 How to determine the relevant cash flows for a proposed project. How to determine if a project is acceptable. How to set a bid price for a project. How to evaluate the equivalent annual cost of a project. So far, we’ve covered various parts of the capital budgeting decision. Our task in this chapter is to start bringing these pieces together. In particular, we will show you how to “spread the numbers” for a proposed investment or project and, based on those numbers, make an initial assessment about whether the project should be undertaken. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 2/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. In the discussion that follows, we focus on the process of setting up a discounted cash flow analysis. From the last chapter, we know that the projected future cash flows are the key element in such an evaluation. Accordingly, we emphasize working with financial and accounting information to come up with these figures. Page 313 In evaluating a proposed investment, we pay special attention to deciding what information is relevant to the decision at hand and what information is not. As we will see, it is easy to overlook important pieces of the capital budgeting puzzle. We will wait until the next chapter to describe in detail how to go about evaluating the results of our discounted cash flow analysis. Also, where needed, we will assume that we know the relevant required return, or discount rate. We continue to defer in-depth discussion of this subject to Part 5. 10.1 Project Cash Flows: A First Look The effect of taking a project is to change the firm’s overall cash flows today and in the future. To evaluate a proposed investment, we must consider these changes in the firm’s cash flows and then decide whether they add value to the firm. The first (and most important) step, therefore, is to decide which cash flows are relevant. RELEVANT CASH FLOWS incremental cash flows The difference between a firm’s future cash flows with a project and those without the project. What is a relevant cash flow for a project? The general principle is simple enough: A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project. Because the relevant cash flows are defined in terms of changes in, or increments to, the firm’s existing cash flow, they are called the incremental cash flows associated with the project. The concept of incremental cash flow is central to our analysis, so we will state a general definition and refer back to it as needed: The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project. This definition of incremental cash flows has an obvious and important corollary: Any cash flow that exists regardless of whether or not a project is undertaken is not relevant. THE STAND-ALONE PRINCIPLE stand-alone principle The assumption that evaluation of a project may be based on the project’s incremental cash flows. In practice, it would be cumbersome to actually calculate the future total cash flows to the firm with and without a project, especially for a large firm. Fortunately, it is not really necessary to do so. Once we identify the effect of undertaking the proposed project on the firm’s cash flows, we need focus only on the project’s resulting incremental cash flows. This is called the stand-alone principle. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 3/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance What the stand-alone principle says is that once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of “minifirm” with its own future revenues and costs, its own assets, and, of course, its own cash flows. We will then be primarily interested in comparing the cash flows from this minifirm to the cost of acquiring it. An important consequence of this approach is that we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 4/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 314 Concept Questions 10.1a What are the relevant incremental cash flows for project evaluation? 10.1b What is the stand-alone principle? 10.2 Incremental Cash Flows We are concerned here with only cash flows that are incremental and that result from a project. Looking back at our general definition, we might think it would be easy enough to decide whether a cash flow is incremental. Even so, in a few situations it is easy to make mistakes. In this section, we describe some common pitfalls and how to avoid them. SUNK COSTS sunk cost A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. A sunk cost, by definition, is a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project. Put another way, the firm will have to pay this cost no matter what. Based on our general definition of incremental cash flow, such a cost is clearly not relevant to the decision at hand. So, we will always be careful to exclude sunk costs from our analysis. That a sunk cost is not relevant seems obvious given our discussion. Nonetheless, it’s easy to fall prey to the fallacy that a sunk cost should be associated with a project. For example, suppose General Milk Company hires a financial consultant to help evaluate whether a line of chocolate milk should be launched. When the consultant turns in the report, General Milk objects to the analysis because the consultant did not include the hefty consulting fee as a cost of the chocolate milk project. Who is correct? By now, we know that the consulting fee is a sunk cost: It must be paid whether or not the chocolate milk line is actually launched (this is an attractive feature of the consulting business). OPPORTUNITY COSTS opportunity cost The most valuable alternative that is given up if a particular investment is undertaken. When we think of costs, we normally think of out-of-pocket costs—namely those that require us to actually spend some amount of cash. An opportunity cost is slightly different; it requires us to give up a benefit. A common situation arises in which a firm already owns some of the assets a proposed project will be using. For example, we might be thinking of converting an old rustic cotton mill we bought years ago for $100,000 into upmarket condominiums. If we undertake this project, there will be no direct cash outflow associated with buying the old mill because we already own it. For purposes of evaluating the condo project, should we then treat the mill as “free”? The answer is no. The mill is a valuable resource used by the project. If we didn’t use it here, we could do something else with it. Like what? The obvious answer is that, at a minimum, we could sell it. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 5/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance Using the mill for the condo complex thus has an opportunity cost: We give up the valuable opportunity to do something else with the mill.1 There is another issue here. Once we agree that the use of the mill has an opportunity cost, how much should we charge the condo project for this use? Given that we paid $100,000, it might seem that we should charge this amount to the condo project. Is this correct? The answer is no, and the reason is based on our discussion concerning sunk costs. The fact that we paid $100,000 some years ago is irrelevant. That cost is sunk. At a minimum, the opportunity cost that we charge the project is what the mill would sell for today (net of any selling costs) because this is the amount we give up by using the mill instead of selling it.2 SIDE EFFECTS erosion The cash flows of a new project that come at the expense of a firm’s existing projects. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 6/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Remember that the incremental cash flows for a project include all the resulting changes in the firm’s future cash flows. It would not be unusual for a project to have side, or spillover, Page 315 effects, both good and bad. For example, in 2014, the time between the theatrical release of a feature film and the release of the DVD had shrunk to 17 weeks compared to 29 weeks in 1998, although several studios have shorter times. This shortened release time was blamed for at least part of the decline in movie theater box office receipts. Of course, retailers cheered the move because it was credited with increasing DVD sales. A negative impact on the cash flows of an existing product from the introduction of a new product is called erosion.3 In this case, the cash flows from the new line should be adjusted downward to reflect lost profits on other lines. In accounting for erosion, it is important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition. Erosion is relevant only when the sales would not otherwise be lost. Side effects show up in a lot of different ways. For example, one of The Walt Disney Company’s concerns when it built Euro Disney (now known as Disneyland Paris) was that the new park would drain visitors from the Florida park, a popular vacation destination for Europeans. There are beneficial spillover effects, of course. For example, you might think that Hewlett-Packard would have been concerned when the price of a printer that sold for $500 to $600 in 1994 declined to below $100 by 2014, but such was not the case. HP realized that the big money is in the consumables that printer owners buy to keep their printers going, such as ink-jet cartridges, laser toner cartridges, and special paper. The profit margins for these products are substantial. NET WORKING CAPITAL Normally a project will require that the firm invest in net working capital in addition to long-term assets. For example, a project will generally need some amount of cash on hand to pay any expenses that arise. In addition, a project will need an initial investment in inventories and accounts receivable (to cover credit sales). Some of the financing for this will be in the form of amounts owed to suppliers (accounts payable), but the firm will have to supply the balance. This balance represents the investment in net working capital. It’s easy to overlook an important feature of net working capital in capital budgeting. As a project winds down, inventories are sold, receivables are collected, bills are paid, and cash balances can be drawn down. These activities free up the net working capital originally invested. So the firm’s investment in project net working capital closely resembles a loan. The firm supplies working capital at the beginning and recovers it toward the end. FINANCING COSTS In analyzing 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 of the project. As we mentioned in Chapter 2, interest paid, for example, is a component of cash flow to creditors, not cash flow from assets. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 7/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. More generally, our goal in project evaluation is to compare the cash flow from a project to the cost of acquiring that project in order to estimate NPV. The particular mixture of debt Page 316 and equity a firm actually chooses to use in financing a project is a managerial variable and primarily determines how project cash flow is divided between owners and creditors. This is not to say that financing arrangements are unimportant. They are just something to be analyzed separately. We will cover this in later chapters. OTHER ISSUES There are some other things to watch out for. First, we are interested only in measuring cash flow. Moreover, we are interested in measuring it when it actually occurs, not when it accrues in an accounting sense. Second, we are always interested in aftertax cash flow because taxes are definitely a cash outflow. In fact, whenever we write incremental cash flows, we mean aftertax incremental cash flows. Remember, however, that aftertax cash flow and accounting profit, or net income, are entirely different things. Concept Questions 10.2a What is a sunk cost? An opportunity cost? 10.2b Explain what erosion is and why it is relevant. 10.2c Explain why interest paid is not a relevant cash flow for project evaluation. 10.3 Pro Forma Financial Statements and Project Cash Flows The first thing we need when we begin evaluating a proposed investment is a set of pro forma, or projected, financial statements. Given these, we can develop the projected cash flows from the project. Once we have the cash flows, we can estimate the value of the project using the techniques we described in the previous chapter. Excel Master It! Excel Master coverage online GETTING STARTED: PRO FORMA FINANCIAL STATEMENTS pro forma financial statements Financial statements projecting future years’ operations. Pro forma financial statements are a convenient and easily understood means of summarizing much of the relevant information for a project. To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital. To illustrate, suppose we think we can sell 50,000 cans of shark attractant per year at a price of $4 per can. It costs us about $2.50 per can to make the attractant, and a new product such as this one typically has only a three-year life (perhaps because the customer base dwindles rapidly). We require a 20 percent return on new products. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 8/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance Fixed costs for the project, including such things as rent on the production facility, will run $12,000 per year.4 Further, we will need to invest a total of $90,000 in manufacturing equipment. For simplicity, we will assume that this $90,000 will be 100 percent depreciated over the three-year life of the project.5 Furthermore, the cost of removing the equipment will roughly equal its actual value in three years, so it will be essentially worthless on a market value basis as well. Finally, the project will require an initial $20,000 investment in net working capital, and the tax rate is 34 percent. TABLE 10.1 Projected Income Statement, Shark Attractant Project https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 9/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 317 TABLE 10.2 Projected Capital Requirements, Shark Attractant Project In Table 10.1, we organize these initial projections by first preparing the pro forma income statement. Once again, notice that we have not deducted any interest expense. This will always be so. As we described earlier, interest paid is a financing expense, not a component of operating cash flow. We can also prepare a series of abbreviated balance sheets that show the capital requirements for the project as we’ve done in Table 10.2. Here we have net working capital of $20,000 in each year. Fixed assets are $90,000 at the start of the project’s life (Year 0), and they decline by the $30,000 in depreciation each year, ending up at zero. Notice that the total investment given here for future years is the total book, or accounting, value, not market value. At this point, we need to start converting this accounting information into cash flows. We consider how to do this next. PROJECT CASH FLOWS To develop the cash flows from a project, we need to recall (from Chapter 2) that cash flow from assets has three components: operating cash flow, capital spending, and changes in net working capital. To evaluate a project, or minifirm, we need to estimate each of these. Once we have estimates of the components of cash flow, we will calculate cash flow for our minifirm just as we did in Chapter 2 for an entire firm: Project cash flow = Project operating cash flow − Project change in net working capital − Project capital spending We consider these components next. Project Operating Cash Flow To determine the operating cash flow associated with a project, we first need to recall the definition of operating cash flow: https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 10/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance Operating cash flow = Earnings before interest and taxes + Depreciation − Taxes TABLE 10.3 Projected Income Statement, Abbreviated, Shark Attractant Project https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 11/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 318 TABLE 10.4 Projected Operating Cash Flow, Shark Attractant Project TABLE 10.5 Projected Total Cash Flows, Shark Attractant Project To illustrate the calculation of operating cash flow, we will use the projected information from the shark attractant project. For ease of reference, Table 10.3 repeats the income statement in more abbreviated form. Given the income statement in Table 10.3, calculating the operating cash flow is straightforward. As we see in Table 10.4, projected operating cash flow for the shark attractant project is $51,780. Project Net Working Capital and Capital Spending We next need to take care of the fixed asset and net working capital requirements. Based on our balance sheets, we know that the firm must spend $90,000 up front for fixed assets and invest an additional $20,000 in net working capital. The immediate outflow is thus $110,000. At the end of the project’s life, the fixed assets will be worthless, but the firm will recover the $20,000 that was tied up in working capital.6 This will lead to a $20,000 inflow in the last year. On a purely mechanical level, notice that whenever we have an investment in net working capital, that same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign. PROJECTED TOTAL CASH FLOW AND VALUE https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 12/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance Given the information we’ve accumulated, we can finish the preliminary cash flow analysis as illustrated in Table 10.5. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 13/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Now that we have cash flow projections, we are ready to apply the various criteria we discussed in the last chapter. First, the NPV at the 20 percent required return is: Page 319 NPV = − $110,000 + 51,780/1.2 + 51,780/1.22 + 71,780/1.23 = $10,648 Based on these projections, the project creates over $10,000 in value and should be accepted. Also, the return on this investment obviously exceeds 20 percent (because the NPV is positive at 20 percent). After some trial and error, we find that the IRR works out to be about 25.8 percent. In addition, if required, we could calculate the payback and the average accounting return, or AAR. Inspection of the cash flows shows that the payback on this project is just a little over two years (verify that it’s about 2.1 years).7 From the last chapter, we know that the AAR is average net income divided by average book value. The net income each year is $21,780. The average (in thousands) of the four book values (from Table 10.2) for total investment is ($110 + 80 + 50 + 20)/4 = $65. So the AAR is $21,780/65,000 = 33.51 percent.8 We’ve already seen that the return on this investment (the IRR) is about 26 percent. The fact that the AAR is larger illustrates again why the AAR cannot be meaningfully interpreted as the return on a project. Concept Questions 10.3a What is the definition of project operating cash flow? How does this differ from net income? 10.3b For the shark attractant project, why did we add back the firm’s net working capital investment in the final year? 10.4 More about Project Cash Flow In this section, we take a closer look at some aspects of project cash flow. In particular, we discuss project net working capital in more detail. We then examine current tax laws regarding depreciation. Finally, we work through a more involved example of the capital investment decision. Excel Master It! Excel Master coverage online A CLOSER LOOK AT NET WORKING CAPITAL In calculating operating cash flow, we did not explicitly consider the fact that some of our sales might be on credit. Also, we may not have actually paid some of the costs shown. In either case, the cash flow in question would not yet have occurred. We show here that these possibilities are not a problem as long as we don’t forget to include changes in net working capital in our analysis. This discussion thus emphasizes the importance and the effect of doing so. https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 14/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Suppose that during a particular year of a project we have the following simplified income statement: Page 320 Depreciation and taxes are zero. No fixed assets are purchased during the year. Also, to illustrate a point, we assume that the only components of net working capital are accounts receivable and payable. The beginning and ending amounts for these accounts are as follows: Based on this information, what is total cash flow for the year? We can first just mechanically apply what we have been discussing to come up with the answer. Operating cash flow in this particular case is the same as EBIT because there are no taxes or depreciation; thus, it equals $190. Also, notice that net working capital actually declined by $25. This just means that $25 was freed up during the year. There was no capital spending, so the total cash flow for the year is: Total cash flow = Operating cash flow − Change in NWC − Capital spending = $190 − (225) − 0 = $215 Now, we know that this $215 total cash flow has to be “dollars in” less “dollars out” for the year. We could therefore ask a different question: What were cash revenues for the year? Also, what were cash costs? To determine cash revenues, we need to look more closely at net working capital. During the year, we had sales of $500. However, accounts receivable rose by $30 over the same time period. What does this mean? The $30 increase tells us that sales exceeded collections by $30. In other words, we haven’t yet received the cash from $30 of the $500 in sales. As a result, our cash inflow is $500 − 30 = $470. In general, cash income is sales minus the increase in accounts receivable. Cash outflows can be similarly determined. We show costs of $310 on the income statement, but accounts payable increased by $55 during the year. This means that we have not yet paid $55 of the $310, so cash costs for the period are just $310 − 55 = $255. In other words, in this case, cash costs equal costs less the increase in accounts payable.9 Putting this information together, we calculate that cash inflows less cash outflows are $470 − 255 = $215, just as we had before. Notice that: Cash flow = Cash inflow − Cash outflow = ($500 − 30) − (310 − 55) = ($500 − 310) − (30 − 55) = Operating cash flow − Change in NWC = $190 − (− 25) = $215 https://phoenix.vitalsource.com/#/books/1259798224/cfi/6/44!/4/4/520/2@0:52.2 15/38 9/4/2017 University of Phoenix: Fundamentals of Corporate Finance PRINTED BY: peaches2294@email.phoenix.edu. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. Page 321 IN THEIR OWN WORDS . . . Samuel Weaver on Capital Budgeting at the Hershey Company The capital program at The Hershey Company and most Fortune 500 or Fortune 1,000 companies involves a three-phase approach: planning or budgeting, evaluation, and postcompletion reviews. The first phase involves identification of likely projects at strategic planning time. These are selected to support the strategic objectives of the corporation. This identification is generally broad in scope with minimal financial evaluation attached. Projects are classified as new product, cost savings, capacity expansion, etc. As the planning process focuses more closely on the short-term plans (or budgets), major capital expenditures are discussed more rigorously. Project costs are more closely honed, and specific projects may be reconsidered. Each project is then individually reviewed and authorized. Planning, developing, and refining cash flows underlie capital analysis at Hershey. Once the cash flows have been determined, the application of capital evaluation techniques such as those using net present value, internal rate of return, and payback period is routine. Presentation of the results is enhanced using sensitivity analysis, which plays a major role for management in assessing the critical assumptions and resulting impact. The final phase relates to postcompletion reviews in which the original forecasts of the project’s performance are compared to actual results and/or revised expectations. Capital expenditure analysis is only as good as the assumptions that underlie the project. The old cliché of GIGO (garbage in, garbage out) applies in this case. Incremental cash flows primarily result from incremental sales or margin improvements (cost savings). For the most part, a range of incremental cash flows can be identified from marketing research or engineering studies. However, for a number of projects, correctly discerning the implications and the relevant cash flows is analytically challenging. For example, when a new product is introduced and is expected to generate millions of dollars’ worth of sales, the appropriate analysis focuses on the incremental sales after accounting for cannibalization of existing products. One of the problems that we face at Hershey deals with the application of net present value, NPV, versus internal rate of return, IRR. ...
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