Making Capital Investment Decision - PowerPoint Presentation

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Making Capital Investment Decision

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What is “Making Capital

Investment Decision”?

Does Tesla Really Need a $5 Billion Battery? (https://www.wsj.com/articles/does-tesla-really-need-a-5-billion-battery-factory-1396394466)The plant, dubbed a "gigafactory" by Tesla Chief Executive Elon Musk, would be the world's largest factory by a long shot. Mr. Musk has outlined a proposal to spend $5 billion on it, hiring up to 6,500 workers and creating thousands of ancillary jobs. He compares the undertaking to auto-industry pioneer Henry Ford's early 20th century Rouge complex. It took in iron ore and other raw materials at one end and rolled out completed Model Ts at the other, aiming to control and cut costs at every stage of production.Reducing battery costs is critical for Tesla's forthcoming mass-market car, which is referred to as the Gen III and is expected to have a starting price of around $35,000.Sam Jaffe, a battery consultant with Navigant Research, says the companies he consults for don't understand why Tesla would build such a large factory. Tesla may want to make 35 gigawatt hours of cells a year, they say, but battery makers maintain the benefits of scale disappear at about one gigawatt hour of capacity.Harald Kroeger, who runs Daimler AG's electric-vehicle programs and sits on Tesla's board, said the factory "has some advantages of course, but it has some huge disadvantages as well.

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The Question is how to evaluate such a project or projects like this

Project Cash Flows: A First Look:

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.The relevant cash flows are called “incremental cash flows”.Incremental cash flow: The difference between a firm’s future cash flows with a project and those without a project.

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Important Components to Consider

Relevant Components:

Incremental Cash Flows.Cash Flow – not accounting earningsSide effects (cannibalism and erosion) matterOpportunity costs matterAllocated costs matterTaxes matter: We want incremental after-tax cash flows.Irrelevant Components:Sunk costs do not matterFinancing does not matter

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Incremental CFs are changes in firm’s cash flows that occur as a direct consequence of accepting the project.

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Relevant (I): Cash

Flows—Not Accounting Earnings

Consider depreciation expense. You never write a check made out to “depreciation”.Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.Example: A company just paid $1 million for a building, as part of a new capital budgeting project. $1 million is a cash outflow. Assuming straight line depreciation for 20 years, only $50,000 is considered as accounting expense in the current year. Current earnings are reduced by $50,000; remaining 950,000 will be expensed over the following 19 years. For capital budgeting purposes, the relevant cash flow at date 0 is the full $1 million, not the reduction in earnings of $50,000.

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Relevant (II): Opportunity Costs

Opportunity costs

do matter. If we are giving up a valuable alternative when we take a particular investment, we have to take that into consideration. Example: Weinstein Company has an empty warehouse in Philadelphia that can be used to store a new line of electronic pinball machines. The company hopes to sell these machines to northeastern customers. Should the warehouse be considered a cost in the decision to sell the machines?Yes!! The company could have sold the warehouse or rented it to an other company.

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Relevant (III): Side Effects

Side effects matter.

Erosion or cannibalism is a bad thing. If our new product causes existing customers to demand less of current products, we need to recognize that.Example:Introducing iPhone and impact of iPhone on iPod market

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Relevant (IV): Allocated Costs

Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects.

Example:Project to open a Home Depot store might have total advertising expense allocated to it. If the allocated cost is an incremental cost of the project, then it should be considered as cash outflow. So, one must ask the question: What is the difference between the cash flows of the entire firm with the project and the cash flows of the entire firm without the project?If Home Depot’s advertising expenses will increase when the new store opens, then this is an incremental cash flow. Otherwise it is not.

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Relevant (V): Tax

Taxes matter.

Every cash flows should be “after-tax” basis

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Irrelevant (I): Sunk Costs

Sunk costs are not relevant

Costs that we have already paid or have already incurred the liability to pay. Such costs cannot be changed by the decision today to accept or reject the project.Example: General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation the company had paid a consulting firm $100,000 to perform a test-marketing analysis. This expenditure was made last year. Is this cost relevant for capital budgeting decision?No!! Once the company incurred the expense, the cost became irrelevant for any future decision (the consulting fee must be paid whether or not the company launches the new line).

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Irrelevant (II): Financing Costs

In analyzing a proposed investment, we will NOT include interest paid or any other financing costs such as dividends.

Firms are interested in the cash flow generated by the assets of the project. Therefore they typically calculate a project’s cash flows under the assumption that the project is financed only with equity. Any adjustments for debt financing are reflected in the discount rate, not the cash flows.

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Cash Flows in Making Capital Investment Decision

Pro-Forma Financial Statements and Project Cash Flows

 

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Some Special Cases in Making Capital Investment Decisions

(1) Cost Cutting Proposals

(2) Investments of Unequal Lives

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Special Case #1) Cost Cutting

Cost savings will increase pretax income

But, we have to pay taxes on this amountDepreciation will reduce our tax liabilityDoes the present value of the cash flow associated with the cost savings exceed the cost?If yes, then proceed.

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Example 1)

We are considering automating some part of an existing production process. The necessary equipment costs $80,000.

The automation will save $22,000 (before taxes). The equipment has 5 year life and is depreciated straight-line to zero over five years. The machine will be worth $20,000 in five years. Should we automate?Discount rate is 10%Tax rate 34%

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Solution #1)

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Cost savings increase our pretax income by $22,000. We have to pay taxes on this amount , so our tax bill also increases.

Operating

Cash Flow = EBIT – Taxes +

Depreciation

Depreciation = $80,000/5=$16,000

EBIT= Sales- Costs-Depreciation

EBIT = $22,000 – $16,000 = $6,000

Taxes = EBIT x Tax rate = $6,000 x 0.34 = $2,040

OCF = $6,000 - $2,040 + $16,000 = $19,960

Other relevant

cash flows

Cost of the machine ($80,000)

After-tax salvage value (20,000 x (1-0.34) = $13,200)

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There are times when application of the NPV rule can lead to the wrong decision.

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Special Case #2) Unequal Lives

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Consider

a factory that must have an air cleaner that is mandated by law. There are two choices:The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100, and lasts 10 years.The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500, and lasts 5 years.Assuming a 10% discount rate, which one should we choose?

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Example #2)

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Solution #2) First Attempt

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At first glance, the Cheapskate cleaner has a higher NPV.

This overlooks the fact that the Cadillac cleaner lasts twice as long.

When we incorporate the difference in lives, the Cadillac cleaner is actually cheaper (i.e., has a higher NPV).

10

–

100

–4,614.46

– 4,000

CF1

F1/N

CF0

I

NPV

10

5

–500

–2,895.39

–1,000

CF1

F1/N

CF0

I

NPV

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Cadillac Air Cleaner

Cheapskate Air Cleaner

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Solution #2)

Second (Correct) Attempt

Equivalent Annual Cost (EAC)The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows.For example, the EAC for the Cadillac air cleaner is $750.98.The EAC for the Cheapskate air cleaner is $763.80, thus we should reject it.

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750.98

10

–4,614.46

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PMT

I/Y

FV

PV

N

PV

763.80

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-2,895.39

5

PMT

I/Y

FV

PV

N

PV

Cadillac

Cheapskate

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Excel Example 3) Baldwin Company

Baldwin Company is considering to invest a new bowling ball machine which costs $100,000 (depreciated straight line for 5 years). Baldwin Company is able to sell the machine for $30,000 after 5 years.

According to test marketing, costed $250,000, there is a demand for these new improved bowling balls.If invested, Baldwin company is planning to use an existing factory site (which they own) valued $150,000. By using the new machine, Baldwin Company is planning to produce: Price during the first year is $20, and increase 2% per year thereafter.Production costs during the first year are $10, and increase 10% per year thereafter.The project requires increase in net working capital: $10,000, recovered at the end of the projectTax Rate=34% and discount rate=10%Should Baldwin Company invest in the new bowling ball machine?

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Year

1

Year 2

Year 3

Year

4

Year 5

5,000 units

8,000 units

12,000 units

10,000 units

6,000 units

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Excel Example 4

) PUTZ Inc.

You have been hired as a consultant for Pristine Urban-tech Zither, Inc. (PUTZ), manufacturers of zithers. The market for zithers is growing quickly. The company bought some land three years ago for $1.4 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $1.5 million on an after-tax basis. In four years, the land could be sold for $1.6 million after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing reports is as follows:The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ bring to bear, we feel that the company will be able to sell 3,200, 4,300, 3,900, and 2,800 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued. PUTZ believes that fixed costs for the project will be $425,000 per year, and variable costs are 15% of sales. The equipment necessary for production will cost $4.2 million and will be depreciated according to three-year straight-line. At the end of the project, the equipment can be scrapped for $400,000. Net working capital of $125,000 will be required immediately.Net Working Capital is recovered at the end of the project. PUTZ has a 38% tax rate, and the required return on the project is 13%. What is the NPV of the project? Assume the company has other profitable projects.

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Is Change of Style Evidence of Skill?

Thanks!

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