Capital Project Evaluation: - Overview and "Vocabulary" - Methods
Capital Project Evaluation: - Overview and "Vocabulary" - Methods
Capital Project Evaluation: - Overview and "Vocabulary" - Methods
Initial Terminal
outlay Cash flow
0 1 2 3 4 5 6 ... n
5
Components of Cash Flows
• Initial Investment
• Net Cash Flows/Annual Cash Flows
– Revenues and Expenses
– Depreciation and Taxes
– Change in Net Working Capital
– Change in accounts receivable
– Change in inventory
– Change in accounts payable
– Change in Capital Expenditure
– Free Cash Flows
6
Components of Cash Flows
7
Terminal Value for a New Business
• The terminal value included the salvage value of the asset
and the release of the working capital.
• Managers make assumption of horizon period because
detailed calculations for a long period become quite
intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after the
horizon period without involving detailed calculations.
• A simple method of estimating the terminal value at the end
of the horizon period is to employ the following formula,
which is a variation of the dividend—growth model:
NCFn 1 g NCFn 1
TVn
kg kg
8
Additional Aspects of Cash Flow
Analysis
• Opportunity Costs of Resources
• Sunk Costs
• Tax Incentives
– Investment allowance
– Other tax incentives
9
Cost of Capital
10
The Concept of the Opportunity Cost
of Capital
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
OCC
. Equity shares
. . Preference shares
. . Corporate bonds
Government bonds
Risk-free security
Risk
11
The Weighted Average Cost of Capital
• The following steps are involved for calculating
the firm’s WACC:
– Calculate the cost of specific sources of funds
– Multiply the cost of each source by its proportion in
the capital structure.
– Add the weighted component costs to get the WACC.
• Tax adjustment
After-tax cost of debt kd (1 T )
WACC
• Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from
capital)+ (Cost of debt x Proportion of debt
from capital)+
?What is the payback period
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Rationale for the NPV Method
0 1 2 3
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
Rationale for the IRR Method
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN