Generally, we can classify incremental cash flows for projects as initial investment outlay, operating cash flow over the project's life, and terminal year cash flow.
Expansion Project Analysis
Initial investment outlay is the upfront costs associated with the project. Components are price, which includes shipping and installation (FCInv)and investment in net working capital (NWCInv).
outlay = FCInv + NWCInv
The investment in NWC must be included in the capital budgeting decision. The investment in net working capital is defined as the difference between the changes in non-cash current assets and changes in non-cash current liabilities (i.e., those other than short-term debt). Cash is excluded because it is generally assumed not to be an operating asset.
NWCInv = change in non-cash current assets - change in non-debt current liabilities = change in NWC
If NWCInv is positive, additional financing is required and represents a cash outflow because cash must be used to fund the net investment in current assets. (If negative, the project frees up cash, creating a cash inflow.) Note that at the termination of the project, the firm will expect to receive an end of project cash inflow (or outflow) equal to initial NWC when the need for the additional working capital ends.
After tax operating cash flows are the incremental cash flows over the capital asset's economic life.
CF = (S-C-D)(1-D)+D = (S-C)(1-T)+(TD)
EBIT = (S-C-D)
S=sales, C=cash operating costs, D=depreciation expense, T=marginal tax rate
Although depreciation is a non-cash operating expense, it is an important part of determining operating cash flow because it reduces the amount of taxes paid by the firm. We can account for depreciation either by adding it back to net income from the project (as in the first cash flow formula) or by adding the tax savings caused by depreciation back to the project's after tax gross profit (as in the second formula). In general, a higher depreciation expense will result in greater tax savings and higher cash flows. This means that accelerated depreciation methods will create higher after-tax cash flows for the project earlier in the project's life as compared to the straight-line method, resulting in a higher net present value for the project. Entress is not included in operating cash flow's for capital budgeting purposes because it is incorporated into the project cost of capital.
Terminal year after tax non-operating cash flows (TNOCF). At the end of the asset's life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.
Sal(t) = pre-tax cash proceeds from sale of fixed capital
B(t) = Book value of the fixed capital sold
Replacement Project Analysis
There are a few key differences in the analysis of a replacement project versus an expansion project. In a replacement project analysis we have two:
1. Reflect the sale of the old asset in the calculation of the initial outlay:
2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset:
Change in cash flow= (change in sales-change in costs)(1-T)+change in (DT)
3. Compute terminal year not operating cash flow:
TNOCF = (Sal(t-new)-Sal(t-old)+NWCInv-T[(Sal(t-new)-B(t-new)-(Sal(t-old)-B(t-old)]
In the CAPM, risk is separated into systematic and unsystematic components. Unsystematic, or company specific, risk can be diversified away, while systematic, or market, risk cannot be diversified away. A diversified investor is compensated for taking on systematic risk, but not unsystematic risk. In a capital budgeting context, beta, a systematic risk measure, is appropriate for measuring project or asset risk when a company is, or the company's investors are, diversified. The project's or asset's beta in conjunction with the CAPM can be used to determine the appropriate discount rate for the asset or project.
Beta risk is based on the equation of the CAPM, or the security market line, which defines a project's required rate of return.
Using a project's beta to determine discount rates is important when the risk of a project is different from the risk of the overall company. Such a project specific discount rate is also called a hurdle rate. Hurdle rates vary from project to project. Simply using the company's WACC will overstate the required return for a conservative project and will understate the required return for an aggressive project.
>> Failing to incorporate economic responses into the analysis. For example, if a profitable product is in an industry with low barriers to entry, competitors may undertake a similar project, lowering profitability.
>> Using standardized templates. Since managers may evaluate hundreds of projects in a given year, they often create templates to streamline the analysis process. However, the template may not be an exact match for the project, resulting in estimation errors.
>> Pet projects of senior management. Projects that have the personal backing of influential members of senior management may contain overly optimistic projections that make the project appear more profitable than it really is. In addition, the project may not be subject to the same level of analysis as other projects
>> Basing investment decisions on EPS or ROE. Manages whose incentive compensation is tied to increasing EPS or ROE may avoid positive long term NPV investments that have the short run effect of reducing EPS or ROE.
>> Using that IRR criterion for project decisions.
>> Poor cash flow estimation. For a complex project, it is easy to double count or fail to include certain cash flows in the analysis. For example, the effects of inflation must be properly accounted for.
>> Misestimation of overhead costs. The cost of a project should include only the incremental overhead costs related to management time and information technology support. These costs are often difficult to quantify, and over or under estimation can lead to incorrect investment decisions.
>> Using the incorrect discount rate. The required rate of return of the project should reflect the project's risk. Simply using the company's WACC as a discount rate without adjusting it for the risk of the project may lead to significant errors in estimating the NPV of the project.
>> Politics involved with spending the entire capital budget. Many managers try to spend their entire capital budgeting for the following year.
>> Failure to generate alternative investment ideas. Generating investment ideas is the most important step of the capital budgeting process. However, once a manager comes up with a good idea, they may go with it rather than coming up with an idea that is better.
>> Improper handling of sunk and opportunity costs.