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11

Making Capital Investment Making Capital Investment DecisionsDecisions

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Key Concepts and SkillsKey Concepts and Skills

Understand how to determine the relevant Understand how to determine the relevant cash flows for various types of proposed cash flows for various types of proposed investmentsinvestments

Be able to compute depreciation expense Be able to compute depreciation expense for tax purposesfor tax purposes

Understand the various methods for Understand the various methods for computing operating cash flowcomputing operating cash flow

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Chapter OutlineChapter Outline

Project Cash Flows: A First LookProject Cash Flows: A First Look Incremental Cash FlowsIncremental Cash Flows Pro Forma Financial Statements and Project Pro Forma Financial Statements and Project

Cash FlowsCash Flows More on Project Cash FlowMore on Project Cash Flow Alternative Definitions of Operating Cash FlowAlternative Definitions of Operating Cash Flow Some Special Cases of Cash Flow AnalysisSome Special Cases of Cash Flow Analysis

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Relevant Cash FlowsRelevant Cash Flows The cash flows that should be included in a The cash flows that should be included in a

capital budgeting analysis are those that will capital budgeting analysis are those that will only occur if the project is acceptedonly occur if the project is accepted

These cash flows are called These cash flows are called incremental cash incremental cash flowsflows

The The stand-alone principlestand-alone principle allows us to analyze allows us to analyze each project in isolation from the firm simply by each project in isolation from the firm simply by focusing on incremental cash flowsfocusing on incremental cash flows

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Asking the Right QuestionAsking the Right Question You should always ask yourself “Will this cash You should always ask yourself “Will this cash

flow occur ONLY if we accept the project?”flow occur ONLY if we accept the project?” If the answer is “yes”, it should be included in the If the answer is “yes”, it should be included in the

analysis because it is incrementalanalysis because it is incremental If the answer is “no”, it should not be included in the If the answer is “no”, it should not be included in the

analysis because it will occur anywayanalysis because it will occur anyway If the answer is “part of it”, then we should include If the answer is “part of it”, then we should include

the part that occurs because of the projectthe part that occurs because of the project

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Common Types of Cash FlowsCommon Types of Cash Flows Sunk costs – costs that have accrued in the pastSunk costs – costs that have accrued in the past Opportunity costs – costs of lost optionsOpportunity costs – costs of lost options Side effectsSide effects

Positive side effects – benefits to other projectsPositive side effects – benefits to other projects Negative side effects – costs to other projectsNegative side effects – costs to other projects

Changes in net working capitalChanges in net working capital Financing costsFinancing costs TaxesTaxes

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Pro Forma Statements and Pro Forma Statements and Cash FlowCash Flow

Capital budgeting relies heavily on pro forma Capital budgeting relies heavily on pro forma accounting statements, particularly income accounting statements, particularly income statementsstatements

Computing cash flows – refresherComputing cash flows – refresher Operating Cash Flow (OCF) = EBIT + depreciation – Operating Cash Flow (OCF) = EBIT + depreciation –

taxestaxes OCF = Net income + depreciation when there is no OCF = Net income + depreciation when there is no

interest expenseinterest expense OCF = After Tax Cost savings + Depreciation Tax OCF = After Tax Cost savings + Depreciation Tax

Shield { Cost Savings*(1-T)+ Depreciation*T}Shield { Cost Savings*(1-T)+ Depreciation*T} Cash Flow From Assets (CFFA) = OCF – net capital Cash Flow From Assets (CFFA) = OCF – net capital

spending (NCS) – changes in NWCspending (NCS) – changes in NWC

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Table 10.1 Pro Forma Income Table 10.1 Pro Forma Income StatementStatement

Sales (50,000 units at $4.00/unit)Sales (50,000 units at $4.00/unit) $200,000$200,000

Variable Costs ($2.50/unit)Variable Costs ($2.50/unit) 125,000125,000

Gross profitGross profit $ 75,000$ 75,000

Fixed costsFixed costs 12,00012,000

Depreciation ($90,000 / 3)Depreciation ($90,000 / 3) 30,00030,000

EBITEBIT $ 33,000$ 33,000

Taxes (34%)Taxes (34%) 11,22011,220

Net IncomeNet Income $ 21,780$ 21,780

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Table 10.2 Projected Capital Table 10.2 Projected Capital RequirementsRequirements

YearYear

00 11 22 33

NWCNWC $20,000$20,000 $20,000$20,000 $20,000$20,000 $20,000$20,000

NFANFA 90,00090,000 60,00060,000 30,00030,000 00

TotalTotal $110,000$110,000 $80,000$80,000 $50,000$50,000 $20,000$20,000

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Table 10.5 Projected Total Cash Table 10.5 Projected Total Cash FlowsFlows

YearYear

00 11 22 33

OCFOCF $51,780$51,780 $51,780$51,780 $51,780$51,780

Change Change in NWCin NWC

-$20,000-$20,000 20,00020,000

NCSNCS -$90,000-$90,000

CFFACFFA -$110,00-$110,00 $51,780$51,780 $51,780$51,780 $71,780$71,780

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Making The DecisionMaking The Decision Now that we have the cash flows, we can apply Now that we have the cash flows, we can apply

the techniques that we learned in chapter 9the techniques that we learned in chapter 9 Enter the cash flows into the calculator and Enter the cash flows into the calculator and

compute NPV and IRRcompute NPV and IRR CFCF00 = -110,000; C01 = 51,780; F01 = 2; C02 = = -110,000; C01 = 51,780; F01 = 2; C02 =

71,78071,780 NPV; I = 20; CPT NPV = 10,648NPV; I = 20; CPT NPV = 10,648 CPT IRR = 25.8%CPT IRR = 25.8%

Should we accept or reject the project?Should we accept or reject the project?

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More on NWCMore on NWC Why do we have to consider changes in NWC Why do we have to consider changes in NWC

separately?separately? GAAP requires that sales be recorded on the income GAAP requires that sales be recorded on the income

statement when made, not when cash is receivedstatement when made, not when cash is received GAAP also requires that we record cost of goods sold GAAP also requires that we record cost of goods sold

when the corresponding sales are made, whether we when the corresponding sales are made, whether we have actually paid our suppliers yethave actually paid our suppliers yet

Finally, we have to buy inventory to support sales Finally, we have to buy inventory to support sales although we haven’t collected cash yetalthough we haven’t collected cash yet

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DepreciationDepreciation

The depreciation expense used for capital The depreciation expense used for capital budgeting should be the depreciation schedule budgeting should be the depreciation schedule required by the IRS for tax purposesrequired by the IRS for tax purposes

Depreciation itself is a non-cash expense; Depreciation itself is a non-cash expense; consequently, it is only relevant because it consequently, it is only relevant because it affects taxesaffects taxes

Depreciation tax shield = DTDepreciation tax shield = DT D = depreciation expenseD = depreciation expense T = marginal tax rateT = marginal tax rate

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Computing DepreciationComputing Depreciation Straight-line depreciationStraight-line depreciation

D = (Initial cost – salvage) / number of yearsD = (Initial cost – salvage) / number of years Very few assets are depreciated straight-line for tax Very few assets are depreciated straight-line for tax

purposespurposes MACRSMACRS

Need to know which asset class is appropriate for Need to know which asset class is appropriate for tax purposestax purposes

Multiply percentage given in table by the initial costMultiply percentage given in table by the initial cost Depreciate to zeroDepreciate to zero Mid-year conventionMid-year convention

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After-tax SalvageAfter-tax Salvage

If the salvage value is different from the If the salvage value is different from the book value of the asset, then there is a tax book value of the asset, then there is a tax effecteffect

Book value = initial cost – accumulated Book value = initial cost – accumulated depreciationdepreciation

After-tax salvage = salvage – T(salvage – After-tax salvage = salvage – T(salvage – book value)book value)

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Example: Depreciation and After-Example: Depreciation and After-tax Salvagetax Salvage

You purchase equipment for $100,000 and it You purchase equipment for $100,000 and it costs $10,000 to have it delivered and costs $10,000 to have it delivered and installed. Based on past information, you installed. Based on past information, you believe that you can sell the equipment for believe that you can sell the equipment for $17,000 when you are done with it in 6 years. $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. What The company’s marginal tax rate is 40%. What is the depreciation expense each year and the is the depreciation expense each year and the after-tax salvage in year 6 for each of the after-tax salvage in year 6 for each of the following situations?following situations?

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Example: Straight-line Example: Straight-line DepreciationDepreciation

Suppose the appropriate depreciation schedule Suppose the appropriate depreciation schedule is straight-lineis straight-line D = (110,000 – 17,000) / 6 = 15,500 every year for 6 D = (110,000 – 17,000) / 6 = 15,500 every year for 6

yearsyears BV in year 6 = 110,000 – 6(15,500) = 17,000BV in year 6 = 110,000 – 6(15,500) = 17,000 After-tax salvage = 17,000 - .4(17,000 – 17,000) = After-tax salvage = 17,000 - .4(17,000 – 17,000) =

17,00017,000

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Example: Three-year MACRSExample: Three-year MACRS

YearYear MACRS MACRS percentpercent

DD

11 .3333.3333 .3333(110,000) = .3333(110,000) = 36,66336,663

22 .4444.4444 .4444(110,000) = .4444(110,000) = 48,88448,884

33 .1482.1482 .1482(110,000) = .1482(110,000) = 16,30216,302

44 .0741.0741 .0741(110,000) = .0741(110,000) = 8,1518,151

BV in year 6 = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = 0

After-tax salvage = 17,000 - .4(17,000 – 0) = $10,200

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Example: Seven-Year MACRSExample: Seven-Year MACRS

YearYear MACRS MACRS PercentPercent

DD

11 .1429.1429 .1429(110,000) = 15,719.1429(110,000) = 15,719

22 .2449.2449 .2449(110,000) = 26,939.2449(110,000) = 26,939

33 .1749.1749 .1749(110,000) = 19,239.1749(110,000) = 19,239

44 .1249.1249 .1249(110,000) = 13,739.1249(110,000) = 13,739

55 .0893.0893 .0893(110,000) = 9,823.0893(110,000) = 9,823

66 .0893.0893 .0893(110,000) = 9,823.0893(110,000) = 9,823

BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718

After-tax salvage = 17,000 - .4(17,000 – 14,718) = 16,087.20

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Example: Replacement ProblemExample: Replacement Problem

Original MachineOriginal Machine Initial cost = 100,000Initial cost = 100,000 Annual depreciation = 9000Annual depreciation = 9000 Purchased 5 years agoPurchased 5 years ago Book Value = 55,000Book Value = 55,000 Salvage today = 65,000Salvage today = 65,000 Salvage in 5 years = Salvage in 5 years =

10,00010,000

New MachineNew Machine Initial cost = 150,000Initial cost = 150,000 5-year life5-year life Salvage in 5 years = 0Salvage in 5 years = 0 Cost savings = 50,000 Cost savings = 50,000

per yearper year 3-year MACRS 3-year MACRS

depreciationdepreciation Required return = Required return =

10%10% Tax rate = 40%Tax rate = 40%

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Replacement Problem – Replacement Problem – Computing Cash FlowsComputing Cash Flows

Remember that we are interested in Remember that we are interested in incremental cash flowsincremental cash flows

If we buy the new machine, then we will If we buy the new machine, then we will sell the old machinesell the old machine

What are the cash flow consequences of What are the cash flow consequences of selling the old machine today instead of selling the old machine today instead of in 5 years?in 5 years?

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Replacement Problem – Pro Replacement Problem – Pro Forma Income StatementsForma Income Statements

YearYear 11 22 33 44 55

Cost Cost SavingsSavings

50,00050,000 50,00050,000 50,00050,000 50,00050,000 50,00050,000

Depr.Depr.

NewNew 49,50049,500 67,50067,500 22,50022,500 10,50010,500 00

OldOld 9,0009,000 9,0009,000 9,0009,000 9,0009,000 9,0009,000

Increm.Increm. 40,50040,500 58,50058,500 13,50013,500 1,5001,500 (9,000)(9,000)

EBITEBIT 9,5009,500 (8,500)(8,500) 36,50036,500 48,50048,500 59,00059,000

TaxesTaxes 3,8003,800 (3,400)(3,400) 14,60014,600 19,40019,400 23,60023,600

NINI 5,7005,700 (5,100)(5,100) 21,90021,900 29,10029,100 35,40035,400

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Replacement Problem – Incremental Replacement Problem – Incremental Net Capital SpendingNet Capital Spending

Year 0Year 0 Cost of new machine = 150,000 (outflow)Cost of new machine = 150,000 (outflow) After-tax salvage on old machine = 65,000 - .4(65,000 After-tax salvage on old machine = 65,000 - .4(65,000

– 55,000) = 61,000 (inflow)– 55,000) = 61,000 (inflow) Incremental net capital spending = 150,000 – 61,000 Incremental net capital spending = 150,000 – 61,000

= 89,000 (outflow)= 89,000 (outflow) Year 5Year 5

After-tax salvage on old machine = 10,000 - .4(10,000 After-tax salvage on old machine = 10,000 - .4(10,000 – 10,000) = 10,000 (outflow because we no longer – 10,000) = 10,000 (outflow because we no longer receive this)receive this)

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Replacement Problem – Cash Flow Replacement Problem – Cash Flow From AssetsFrom Assets

YearYear 00 11 22 33 44 55

OCFOCF 46,20046,200 53,40053,400 35,40035,400 30,60030,600 26,40026,400

NCSNCS -89,000-89,000 -10,000-10,000

In In NWCNWC

00 00

CFFACFFA -89,000-89,000 46,20046,200 53,40053,400 35,40035,400 30,60030,600 16,40016,400

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Replacement Problem – Replacement Problem – Analyzing the Cash FlowsAnalyzing the Cash Flows

Now that we have the cash flows, we can Now that we have the cash flows, we can compute the NPV and IRRcompute the NPV and IRR Enter the cash flowsEnter the cash flows Compute NPV = 54,812.10Compute NPV = 54,812.10 Compute IRR = 36.28%Compute IRR = 36.28%

Should the company replace the Should the company replace the equipment?equipment?

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Other Methods for Computing OCFOther Methods for Computing OCF

Bottom-Up ApproachBottom-Up Approach Works only when there is no interest expenseWorks only when there is no interest expense OCF = NI + depreciationOCF = NI + depreciation

Top-Down ApproachTop-Down Approach OCF = Sales – Costs – TaxesOCF = Sales – Costs – Taxes Don’t subtract non-cash deductionsDon’t subtract non-cash deductions

Tax Shield ApproachTax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation*TOCF = (Sales – Costs)(1 – T) + Depreciation*T

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Example: Cost CuttingExample: Cost Cutting Your company is considering a new computer system Your company is considering a new computer system

that will initially cost $1 million. It will save $300,000 a that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. year in inventory and receivables management costs. The system is expected to last for five years and will be The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%.marginal tax rate is 40%. The required return is 8%.

Click on the Excel icon to work through the exampleClick on the Excel icon to work through the example

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Example: Equivalent Annual Cost Example: Equivalent Annual Cost AnalysisAnalysis

Burnout BatteriesBurnout Batteries Initial Cost = $36 eachInitial Cost = $36 each 3-year life3-year life $100 per year to keep $100 per year to keep

chargedcharged Expected salvage = $5Expected salvage = $5 Straight-line depreciationStraight-line depreciation

Long-lasting BatteriesLong-lasting Batteries Initial Cost = $60 eachInitial Cost = $60 each 5-year life5-year life $88 per year to keep $88 per year to keep

chargedcharged Expected salvage = $5Expected salvage = $5 Straight-line depreciationStraight-line depreciation

The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required.

The required return is 15% and the tax rate is 34%.

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Example: Setting the Bid PriceExample: Setting the Bid Price Consider the following information:Consider the following information:

Army has requested bid for multiple use digitizing devices Army has requested bid for multiple use digitizing devices (MUDDs)(MUDDs)

Deliver 4 units each year for the next 3 yearsDeliver 4 units each year for the next 3 years Labor and materials estimated to be $10,000 per unitLabor and materials estimated to be $10,000 per unit Production space leased for $12,000 per yearProduction space leased for $12,000 per year Requires $50,000 in fixed assets with expected salvage of Requires $50,000 in fixed assets with expected salvage of

$10,000 at the end of the project (depreciate straight-line)$10,000 at the end of the project (depreciate straight-line) Require initial $10,000 increase in NWCRequire initial $10,000 increase in NWC Tax rate = 34%Tax rate = 34% Required return = 15%Required return = 15%

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Quick QuizQuick Quiz How do we determine if cash flows are relevant How do we determine if cash flows are relevant

to the capital budgeting decision?to the capital budgeting decision? What are the different methods for computing What are the different methods for computing

operating cash flow and when are they operating cash flow and when are they important?important?

What is the basic process for finding the bid What is the basic process for finding the bid price?price?

What is equivalent annual cost and when What is equivalent annual cost and when should it be used?should it be used?

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End of ChapterEnd of Chapter

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Comprehensive ProblemComprehensive Problem

A $1,000,000 investment is depreciated using a A $1,000,000 investment is depreciated using a seven-year MACRS class life. It requires seven-year MACRS class life. It requires $150,000 in additional inventory, and will $150,000 in additional inventory, and will increase accounts payable by $50,000. It will increase accounts payable by $50,000. It will generate $400,000 in revenue and $150,000 in generate $400,000 in revenue and $150,000 in cash expenses annually, and the tax rate is cash expenses annually, and the tax rate is 40%. What is the incremental cash flow in years 40%. What is the incremental cash flow in years 0, 1, 7, and 8?0, 1, 7, and 8?