PRODUCT DEVELOPMENT“Creating Value Internally”

TYPES OF CAPITAL EXPENDITURES

• PURCHASE NEW EQUIPMENT

• REPLACE EXISTING ASSETS

• INVESTMENTS IN WORKING CAPITAL

• MERGER AND ACQUISITION ANALYSIS

THE CAPITAL BUDGETING PROCESS

• GENERATE PROJECT PROPOSALS

• ESTIMATE CASH FLOWS

• EVALUATE ALTERNATIVES

• SELECT PROJECTS

ESTIMATING CASH FLOWS

• CASH FLOWS MUST BE INCREMENTAL

• USE AFTER TAX CASH FLOWS

• INDIRECT EFFECTS MUST BE INCLUDED

• SUNK COSTS MUST NOT BE CONSIDERED

• USE OPPORTUNITY COSTS TO MEASURE VALUE OF RESOURCES

NET INVESTMENT IS THE INITIAL CASH OUTLAY

PROJECT COST PLUS SHIPPING AND INSTALLATION

PLUS

INCREASES IN NET WORKING CAPITAL

MINUS

PROCEEDS FROM SALE OF EXISTING ASSETS

MINUS

TAXES ASSOCIATED WITH SALE OF OLD

EQUALS

NET INVESTMENT

CASH FLOWS AFTER TAX

• CHANGE IN REVENUE

• LESS: CHANGE IN OPERATING COSTS

• LESS: CHANGE IN DEPRECIATION

• EQUALS: CHANGE IN OPERATING EARNINGS

• LESS: TAXES

• EQUALS: CHANGE IN AFTER TAX OPERATING EARNINGS

• PLUS: CHANGE IN DEPRECIATION

• LESS: CHANGE IN NET WORKING CAPITAL

• EQUALS: NET CASH FLOW

DECISION CRITERIA

• NET PRESENT VALUE

• INTERNAL RATE OF RETURN

• PROFITABILITY INDEX

• PAYBACK PERIOD

NET PRESENT VALUE

Present value of an investment = discounted value of cash flows- investment

PV = future cash flows - Investment

= + + +

-

DISCOUNT FACTOR

N

Tk t

1)1(

1DF =

the amount by which cash flows received in the future lose value

DISCOUNT FACTOR

Discount Factor for cash flows discounted for one year at 10%

DF= 1/1.10 = .909

Discount Factor for cash flows discounted for two years at 5%

DF= 1/(1.05)2= .952

NPV- EXAMPLE

PV= (CFAT)/(1+R)N + (CFAT)/(1+R)N+1

PV =(100)/(1.10)1 + (100)/(1.10)2

PV= (100)(.909) + (100)(.826)

PV= 173.50

SUBTRACT NET INVESTMENT

Net investment is the initial cash outlay for the project

Discounted Cash Flow - Investment= NPV

Decision Rule: If NPV> 0, Accept Project

NPV - EXAMPLE

IF NINV IS $150, THEN;

NPV = $173.50 - 150 = $23.50

INTERNAL RATE OF RETURN

NINVR

CFATN

TT

1 )1(

The interest rate that equates DCF with Net Investment

$100/(1+ R)1 + $100/(1+R)2 = $150

IRR = .10

PAYBACK PERIOD (PB)

PB = NET INVESTMENT/ANNUAL CASH FLOWS

PB = $150/$100 = 1.50 YEARS

PROFITABILITY INDEX

PI= PV of CASH FLOWS

NINV

PI = $90.90 + $82.60$150

= 1.16

Management 290business policy

exercise

Calculate the net present value of a project with a net investment of $20,000 for equipment and an additional net working capital

investment of $5,000 at time zero.The project is expected to generate net cash flows of $7,000 per

year over a 10 year period. In addition the working capital will be recovered at the end of the tenth year.

The required rate of return on the project is 11%. What is the meaning of the computed net present value figure.

SOLUTION TO CAPITAL BUDGETING PROBLEM

NET INVESTMENT = $20,000 + $5,000 = $25,000

CASH FLOW AFTER TAX = $7,500/year

THEREFORE; CFAT for ten years = N)11.1(/7500$10

1

= $7500(5.889) = $44168

AND, Recovery of Working Capital is; $5000/(1.11)10 = $5000(.352) = $1760

NPV = -$25000 + $44168 + $1760 = $20,928

CLUB MED

THE BUSINESS THEY ARE IN;

• They operated more than 100 villages in 36 countries

• The 1970’s image- “ a round trip ticket to sun,sea,…, and sex

• 1997 loss was more than $230 million

• They had lost family and younger segments

THE STRATEGIC PLAN -Three year, $580 million outlay;

•Advertising campaign aimed at families

•offer off-peak prices and packages

•close unprofitable villages

•renovate two-thirds of the remaining ones

CLUB MED

THE $58 MILLION PLAN;

• $330 million in renovations (26 villages)

• $180 million for marketing and advertising

• $70 million for working capital

THE FINANCING;

• Issue $70 million in common stock

• Borrow $270 million in short term notes (from bank)

• Issue $140 million in debt (bonds)

CLUB MED

THE RESULTS;

European revenues rose 9.7% to $1 billion

Canned 70 of Club Med’s middle managers

Fired 13 of 14 top managers

Cut $15 million from operating budget

Closed eight villages

In 1998, earned $30 million on revenues of $1.5 billion

Stock price recovered to $103 from $70 (1997)