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
MI NUS
PROCEEDS FROM SALE OF EXISTING ASSETS
MI NUS
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 - I nvestment
=
+ + +
-
DISCOUNT FACTOR

N
T
k
t
1
) 1 (
1
DF =
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 - I nvestment= 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




NINV
R
CFAT
N
T
T

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 290
business 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 1970s 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 Meds 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)