© 2000 John Petroff
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© 2000 John Petroff |
2)- Review of different project types
a)- Replacement of equipment
The calculation is conducted on incremental after tax cash flows resulting from the project, including the initial cash outlay, discounted at an appropriate discount rate (as spelled out in Chapter 2). Additional comments on cash flows are presented in the next section. In this case of equipment replacement, there may be no incremental cash inflow, i.e. no additional revenue, but there is a reduction in cash expenses (e.g. less maintenance and repair expense, operating cost, energy consumption, etc.). The discount rate that should be used in this case is the average cost of capital which should be adjusted for a lower risk premium than that of the overall firm. The lower risk premium is justified by the decrease in likelihood that the equipment will fail, and, therefore, that sales would be lost as they may have been with the old equipment. If the new equipment does not reduce the chance of missed sales but merely maintains sales pattern as it is, the discount rate must be exactly the same as that of the overall company. If, on the contrary, sales could be disrupted by equipment failure the discount rate must be higher.
b)- Expansion of existing sales
This type of project involves,
for instance, major promotional campaigns or expansion of an existing
plant. As explained in Chapter
2, each annual incremental after-tax cash flow is calculated
by
- adding new revenues generated by sales solely related to the
project,
- deducting additional costs (including depreciation) that are
associated with these sales,
- deducting applicable tax (calculated at the marginal rate),
and
- adding back depreciation.
The cash outlay should include payment for the new facility, equipment or promotional campaign, and also for the additional working capital (accounts receivable and inventory) that will be necessary to attain the planned sales volume. In this case, the discount rate to be used is the average company cost of capital itself because the expansion of sales (as long as such expansion is moderate) does not add to the risk of the firm. The weighted average cost of capital is further discussed in the next chapter.
a)- New products:
The introduction of new products is the most risky of all projects for the firm because the firm will have to deal with unfamiliar customers and competitors. The cash flows are calculated as in the case of sales expansion, with the same attention given to the increased working capital. A major difficulty in estimation relates to realistic sales projections. Market research is an added outlay that is often necessary to support forecasts.
Another difficulty resides in the selection of an appropriate discount rate. One method for choosing such a rate is to find out what banks will charge for the incremental capital the firm will need for the project, or the yield that must be offered if a bond has to be floated. This marginal cost of capital is far from perfect because it assumes a different capital structure. Another approach is to use a risk premium obtained from stock market pricing of risk (i.e. BETA calculation), for firms engaged in this particular product line or a product as similar as possible.
See review questions Q-10E2.1 through Q-10E2.15.
See research assignment R-10E2.1.
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