lecture08_winter09

8/7/2019 Lecture08_winter09

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CAPITAL BUDGETING



PROJECTS WITH UNEQUAL LIVES

• When comparing two mutually exclusiveprojects, the project with the highest NETPRESENT VALUE will be selected

• A problem may happen if the projects havedifferent live times.

• You may be biased towards the longest livingproject, if the Cash Flows are positive.




EXAMPLE

• Toyota engineers have produced an innovative shock

absorption prototype to incorporate in all its cars• There are two models to chose from. One would cost

$12m and last 5 years; the other cost $16m and last for10 years.

•

Both have additional maintenance costs $5m per year.• Which model should Toyota chose if their cost of

capital is 12%




• This example will work differently than an usual NETPRESENT VALUE problem.

•

We are only dealing with Costs. So, we will have anegative NET PRESENT VALUE.

• This does not mean we won’t choose any of the two.

• We will choose the project with the lowest NETPRESENT VALUE of Costs.




• The Cash Flows will be the following

• NPV1=-$30.024• NPV2=-$44.251

0 1 2 3 4 5 6 7 8 9 10Model 1 -12 -5 -5 -5 -5 -5 0 0 0 0 0

Model 2 -16 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5




• The choice is to pick Model 1.

• But is it the right decision?

• In this case, since the cash flows are negative, thelonger project is hurt in the analysis.

• If you chose Model 1, at year 6 you need to startit over again.



REPLACEMENT CHAINS

• In this method you repeat both Projects as

many times you have to until the time horizon

matches.

• In this case you would repeat Model 1 a

second time. Both projects will take 10 years



REPLACEMENT CHAINS

• NPV1=-$30.024-$30.024/(1.12)5=-$47.060

•

NPV2=-$44.251

• The decision is reversed!!!



EAC METHOD

• EAC means Equivalent Annual Cost Method

• You transform the Present Value of each

Project into an Annuity that lasts for the sametime as the corresponding Project.

• In this example NPV1 will be transformed intoa 5 year annuity and NPV2 will be transformedinto a 10 year annuity



EAC METHOD

• You will chose the option with the lowest annualcost.

•

Project 1: -$30.024 at period zero is equivalent toa 5 year annuity of -$8.329

• Project 2: -$44.251 at period zero is equivalent to

a 10 year annuity of -$7.832

• You should pick Model 2 instead.



CASE STUDY: GOODWEEK TIRES

• After extensive research, GT developed a newtire, Super Tread, and must decide whether toinvest in order to produce and market it.

• Research and Development Cost so far havetotaled $10m. Super Tread is to be put in themarket beginning this year and for 4 years.Marketing tests costing $5m shown there is amarket for these tires.

• You must decide whether or not to launch thetires. All Cash Flows are assumed in the end of the year except for the initial investment.




• GT initially will invest $120m in production equipment.This equipment can be sold for $51m at the end of the4 years.

• The tires will be sold in two markets

– OE Market: for the main manufacturers. The expectedprice is $36 per tire. The variable cost is $18 per tire

– R Market: Tires are sold alone. The expected price is $59with the same variable costs.

• GT plans to raise the prices 1% above the inflation rate.

The same will happen to the variable costs. Additionalmarketing costs are expected to be $25m in the firstyear and growing at the inflation rate.




• GT corporate tax is 40%. Annual inflation is 3.25%

for the entire period. The discount rate is 15.9%.

• In the OE Market, 2m cars are expected to be

produced this year and grow by 2.5%. GT plans toearn a share of 11%.

• In the R Market, 14m tires are sold and will grow

by 2%. GT plans to earn a share of 8%.• Depreciation follows a 7 year MACRS. Initial NWC

needs is $11m and become 15% of sales.




• After extensive research, GT developed a newtire, Super Tread, and must decide whether toinvest in order to produce and market it.

• Research and Development Cost so far havetotaled $10m. Super Tread is to be put in themarket beginning this year and for 4 years.Marketing tests costing $5m shown there is amarket for these tires.

• You must decide whether or not to launch thetires. All Cash Flows are assumed in the end of the year except for the initial investment




• GT initially will invest $120m in production equipment.This equipment can be sold for $51m at the end of the4 years.

• The tires will be sold in two markets

– OE Market: for the main manufacturers. The expectedprice is $36 per tire. The variable cost is $18 per tire

– R Market: Tires are sold alone. The expected price is $59with the same variable costs.

• GT plans to raise the prices 1% above the inflation rate.

The same will happen to the variable costs. Additionalmarketing costs are expected to be $25m in the firstyear and growing at the inflation rate.




• GT corporate tax is 40%. Annual inflation is 3.25%

for the entire period. The discount rate is 15.9%.

• In the OE Market, 2m cars are expected to be

produced this year and grow by 2.5%. GT plans toearn a share of 11%.

• In the R Market, 14m tires are sold and will grow

by 2%. GT plans to earn a share of 8%.• Depreciation follows a 7 year MACRS. Initial NWC

needs is $11m and become 15% of sales.



DETERMINE THE CASH FLOWS

CAPITAL SPENDING

• Depreciation Schedule

– 1st year: 14.3% or $17.16m

– 2nd year: 24.5% or $29.4m

– 3rd year: 17.5% or $21m

– 4th year: 12.5% or $15m

• Book Value at the end of year 4: $37.44m




CAPITAL SPENDING

•

Year 0: -$120m

• Year 4: $51m – 40%*($51m-

$37.44m)=$45.576m




OPERATING CASH FLOWS

• Determine Sales

– OE Market

– R Market

Year 1 Year 2 Year 2 Year 4

Cars Sold 2,000,000 2,050,000 2,101,250 2,153,781

Tires Needed 8,000,000 8,200,000 8,405,000 8,615,125

ST Tires sold 880,000 902,000 924,550 947,664


Tires sold 14,000,000 14,280,000 14,565,6000 14,856,912

ST Tires sold 1,120,000 1,142,400 1,165,248 1,188,553





•

Determine Prices – Growth Rate of Prices: Real Growth Rate is 1%, so

nominal growth rate is (1.01)(1.0325)=1.0428

– Evolution of the PricesYear 1 Year 2 Year 3 Year 4

OE Market $36.00 $37.54 $39.15 $40.82

R Market $59.00 $61.53 $64.16 $66.90





•

Determine Value of SalesYear 1 Year 2 Year 3 Year 4

OE Market $31,680,000 $33,861,802 $36,193,864 $38,686,535

R Market $66,080,000 $70,286,388 $74,760,539 $79,519,496

Total $97,760,000 $104,148,190 $110,954,403 $118,206,031






Revenue $97,760,000 $104,148,190 $110,954,403 $118,206,031

Variable costs $36,000,000 $38,374,206 $40,905,232 $43,603,453Mkt. costs $25,000,000 $25,812,500 $26,651,406 $27,517,577

Depreciation $17,160,000 $29,400,000 $21,000,000 $15,000,000

Earn. Before Taxes $19,600,000 $10,561,484 $22,397,765 $32,085,001

Taxes $7,840,000 $4,224,594 $8,959,106 $12,834,000

Net Income $11,760,000 $6,336,891 $13,438,659 $19,251,001

Operating CF $28,920,000 $35,736,891 $34,438,659 $34,251,001




ADDITIONS TO NET WORKING CAPITAL

Year 0 Year 1 Year 2 Year 3 Year 4

Beginning $0 $11,000,000 $14,664,000 $15,622,229 $16,643,160

Ending $11,000,000 $14,664,000 $15,622,229 $16,643,160 $0

NWC CF -$11,000,000 -$3,664,000 -$958,229 -$1,020,932 $16,643,160




CASH FLOWS

• NPV=-$8,389,451 (<0). Don’t launch the newline of Tires.

Year 0 Year 1 Year 2 Year 3 Year 4

Operating CF $0 $28,920,000 $35,736,891 $34,438,659 $34,251,001

Capital Spending -$120,000,000 $0 $0 $0 $45,576,000

Var. NWC -$11,000,000 -$3,664,000 -$958,229 -$1,020,932 $16,643,160

Total CF -$131,000,000 $25,256,000 $34,778,662 $33,417,727 $96,470,161

PV of CF -$131,000,000 $21,791,199 $25,890,832 $21,464,788 $53,463,731

lecture08_winter09

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