1

8-1

MAKING CAP ITAL INVESTMENT DEC IS IONS

Chapter 8

8-2

KEY CONCEPTS AND SKILLS

• Determine the relevant cash flows for various types of capital investments

• Compute depreciation expense for tax purposes• Incorporate inflation into capital budgeting• Employ the various methods for computing

operating cash flow• Apply the Equivalent Annual Cost approach

2

8-3

CHAPTER OUTLINE

8.1 Incremental Cash Flows

8.2 The Baldwin Company: An Example

8.3 Inflation and Capital Budgeting

8.4 Alternative Definitions of Cash Flow

8.5 Investments of Unequal Lives: The Equivalent Annual Cost Method

8-4

8.1 INCREMENTAL CASH FLOWS

• Cash flows — as opposed to accounting earnings — matter.

• Sunk costs are irrelevant.• Incremental cash flows matter.• Opportunity costs matter.• Side effects like synergy, cannibalism, and

erosion matter.• Taxes matter: we want incremental after-

tax cash flows

3

8-5

INCREMENTAL CASH FLOWS

• Ask the questions: (1) Will the cash flow be part of the firm if the project is imple-mented? and (2) Will the cash flow be part of the firm if the project is not implemen-ted?

• If the answer to the first question is YESand the answer to the second question is NO, then the cash flow is incrementally affiliated w’ the project and should be included in the cash-flow analysis

8-6

• EXAMPLES CF Part of CF Part of FirmFirm if Impl.? if Not Imp.?

Marketing Survey Yes Yes6 Months Ago

Project’s Purch. Price Yes NoProj’s Annual Revenues Yes NoProj’s Annual Expenses Yes NoSynergy Effects in Yes No

Another DivisionCannibalistic Effects Yes No

in Another Div.Some or All of Exist- Yes Yes

ing Overhead Exp’s

4

8-7

INCREMENTAL CASH FLOWS

• Or, in the case of opportunity costs…• If the answer to the first question is NO

and the answer to the second question is YES, then the cash flow is incrementally affiliated w’ the project and should be included in the cash-flow analysis

• Forgone cash inflows should be treated as cash outflows in the analysis

• Forgone cash outflows should be treated as cash inflows in the analysis

8-8

CASH FLOW: THE BASIS OF CAPITAL BUDGETING DECISIONS

• When performing capital budgeting analysis:

• Always base calculations on cash flow, not income• Earnings ≠ Cash• Need cash for capital spending• Need cash for rewarding shareholders• Therefore, capital expenditure analysis must be based

on cash

5

8-9

CASH FLOWS ≠ ACCOUNTING INCOME

• Much of the work in evaluating a project lies in converting accounting income to cash flow

• Examples of reconciling items:• Depreciation (most common example)

• You never write a check made out to “depreciation.”

• Amortization• Deferrals and Accruals

8-10

INCREMENTAL CASH FLOWS

• Remember: Incremental cash flows arise as a consequence of selecting a project

• Seems like a simple task• Not so, there are many pitfalls in identifying incremental

cash flow

6

8-11

INCREMENTAL CASH FLOWS

• Sunk costs are not relevant• Just because “we have come this far” does not mean

that we should continue to throw good money after bad.• Opportunity costs do matter. Just because a

project has a positive NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.

8-12

INCREMENTAL CASH FLOWS

• Side effects matter.• Erosion and cannibalism are both bad

things. If our new product causes existing customers to demand less of current products, we need to recog-nize the lost cash flows.

• If, however, synergies result that create increased demand of existing products, we also need to recognize the synergistic cash flows.

7

8-13

INCREMENTAL CASH FLOWS

• Allocations• Overhead may be allocated to the new project• Allocations are only relevant if the project increases or

decreases the cash outlay of the entire firm• Salvage Value

• Don’t forget to treat salvage value (after-tax, of course) as a cash inflow at the end of the project

• Changes in Net Working Capital• Many projects require an increase in NWC (e.g., inventory,

receivables, and other current assets) when initiated; this is a cash outlay (outflow) at the beginning of the project

• Don’t forget to reduce NWC at the end of a project requiring increased NWC at time 0; this end-of-horizon reduction will constitute a cash inflow at the end of the project

8-14

ESTIMATING CASH FLOWS

• Operating Cash Flow• Recall that:

OCF = EBIT – Tax Expense + Depreciation Expense

8

8-15

INTEREST EXPENSE

• Later chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value.

• For now, it’s enough to assume that the firm’s level of debt (and, hence, interest expense) is independent of the project at hand.

8-16

8.2 THE BALDWIN COMPANY

• Costs of test marketing (already spent): $250, 000

• Current market value of warehouse (which we own) where the factory would reside: $150,000

• Predicted market value of same warehouse five years from now: $150,000

• Cost of bowling-ball machine: $100,000 (de-preciated according to MACRS 5-year)

• Increase in net working capital: $10,000• Production (in units) by year during 5-year life

of the machine: 5000, 8000, 12000, 10000, & 6000

9

8-17

THE BALDWIN COMPANY

• Price per unit during first year is $20; price in-creases 2% per year thereafter.

• Working Capital: equals $10000 at t = 0 and then changes proportionally to (specifically, as 10% of) same-year sales

• Production costs during first year are $10 per unit and increase 10% per year thereafter.

• Bowling-ball machine can be sold for $30000 at the end of the project (i.e., in 5 years)

• Required rate of return (discount rate) = 10%• Marginal tax rate = 34%

8-18

SIDE CALCULATIONS

t=0 t=1 t=2 t=3 t=4 t=5Oper t=5Term

MACRS% 20.00% 32.00% 19.20% 11.52% 11.52%

Sales 100.00 163.20 249.72 212.20 129.90–Expenses 50.00 88.00 145.20 133.10 87.84–Dep.Exp. 20.00 32.00 19.20 11.52 11.52

Op.Inc. 30.00 43.20 85.32 67.58 30.54

Net WC 10.00 10.00 16.32 24.97 21.22 0.00ΔNet WC +10.00 0.00 +6.32 +8.65 –3.75 –21.22

Gross FA 100.00 100.00 100.00 100.00 100.00 100.00 0.00–Accum.Dep. 0.00 20.00 52.00 71.20 82.72 94.24 0.00

Net FA 100.00 80.00 48.00 28.80 17.28 5.76 0.00ΔNet FA +100.00 –20.00 –32.00 –19.20 –11.52 –11.52 –5.76

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8-19

CASH FLOW CALCULATIONS

t=0 t=1 t=2 t=3 t=4 t=5Oper t=5Term

Op.Inc. 30.00 43.20 85.32 67.58 30.54+ Dep.Exp. 20.00 32.00 19.20 11.52 11.52– TaxExp. 10.20 14.69 29.01 22.98 10.38 8.24

– ΔNet WC +10.00 0.00 +6.32 +8.65 –3.75 –21.22

– ΔNet FA +100.00 –20.00 –32.00 –19.20 –11.52 –11.52 –5.76– Dep.Exp. 20.00 32.00 19.20 11.52 11.52

+ Gain 24.24

CASH FLOW –110.00 39.80 54.19 66.86 59.93 52.91 21.76

74.67

8-20

INCORPORATING “OPP’TY COST”

Thus far, we’ve constructed the cash flows associated with “Invest in the Manufacturing Project”

More precisely, the decision is this:(1) Invest in the Manufacturing Project and then Sell the

Building at Termination (t = 5Term)vs.

(2) Sell the Building Now (t = 0)

Thus, we need to be doing an incremental analysis

(1) We need to incorporate the cash inflow at t = 5Term, and

(2) We need to incorporate the forgone cash inflow as a cash outflow at t = 0

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8-21

“OPP’TY COST”, CONTINUED

(1) We need to incorporate the cash inflow at t = 5Term:

A grossly oversimplified approach is to simply add 150.00 to the previously-determined cash flow for t=5

(2) We need to incorporate the forgone cash inflow as a cash outflow at t = 0

A grossly oversimplified approach is to simply subtract 150.00 from the previously-determined cash flow for t=0

I say that this approach is grossly oversimplified because: (i) either the time-0 sale or the time-5 sale might result in a Gain on Sale, (ii) any Gain would have an implication for Tax Exp., & (iii) the building might have an annual Depreciation Expense which, in turn, would have an implication for Tax Exp.

8-22

CASH FLOW CALCULATIONS

t=0 t=1 t=2 t=3 t=4 t=5Oper t=5Term

Op.Inc. 30.00 43.20 85.32 67.58 30.54+ Dep.Exp. 20.00 32.00 19.20 11.52 11.52– TaxExp. 10.20 14.69 29.01 22.98 10.38 8.24

– ΔNet WC +10.00 0.00 +6.32 +8.65 –3.75 –21.22

– ΔNet FA +100.00 –20.00 –32.00 –19.20 –11.52 –11.52 –5.76– Dep.Exp. 20.00 32.00 19.20 11.52 11.52

+ Gain 24.24

CASH FLOW –110.00 39.80 54.19 66.86 59.93 52.91 21.76

74.67–260.00224.67

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8-238-23

NET PRESENT VALUE & CONCLUSION

Conclusion: The firm is evaluating whether to (a) implement the project today, run it for five years, and then terminate the project and sell the facility or (b) sell the facility today. The incremental analysis just performed is that of option a inexcess of option b. (Option b’s only cash flow is a time-0 inflow of $250K.)

The positive NPV tells us to choose option a.

8-24

NPV OF BALDWIN COMPANY(USING TEXAS INSTRUMENTS BA-II PLUS CALCULATOR)

1

39.80

51.588

–260

CF1

F1

CF0

I

NPV

10

1

54.19CF2

F2

1

66.86CF3

F3

1

59.87CF4

F4

1

224.66CF5

F5

13

8-25

8.4 ALTERNATIVE METHODS FOR COMPUTING OPERATING CASH FLOW

• Bottom-Up Approach• Works only when there is no interest expense• OCF = Net Inc. + Deprec’n Exp.

• Top-Down Approach• OCF = Sales – Exp’s – Tax Exp.• Don’t subtract non-cash deductions

• Tax Shield Approach• OCF = (Sales – Exp’s)∙(1 – Tax Rate)

+ Deprec’n Exp. x Tax Rate

8-26

8.5 INVESTMENTS OF UNEQUAL LIVES

• There are times when application of the NPV rule can lead to the wrong decision. Consider a factory that must have an air cleaner that is mandated by law. There are two choices:• The “Cadillac cleaner” costs $4,000 today, has

annual operating costs of $100, and lasts 10 years.

• The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500, and lasts 5 years.

• Assuming a 10% discount rate, which one should we choose?

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8-27

REPLACEMENT CHAIN APPROACH

The Cadillac cleaner NPV:

The Cheapskate cleaner NPV:

NPV = −4000 − 100 / 0.10 ∙ ( 1 − 1/1.1010 ) = −4614

NPV = −1000− 500 / 0.10 ∙ ( 1 − 1/1.105 )

= −2895

8-28

INVESTMENTS OF UNEQUAL LIVES

At first glance, the Cheapskate cleaner has a higher NPV.

10

–100

–4,614.46

– 4,000

CF1

F1

CF0

I

NPV

10

5

–500

–2,895.39

–1,000

CF1

F1

CF0

I

NPV

10

Cadillac Air Cleaner Cheapskate Air Cleaner

15

8-29

INVESTMENTS OF UNEQUAL LIVES

• This overlooks the fact that the Cadillac cleaner lasts twice as long.

• When we incorporate that fact, the Cadillac clea-ner is actually cheaper (i.e., has a higher NPV).

• Two methods exist to analyze this situation further:• Replacement Chain

• Repeat projects until they begin and end at the same time.• Compute NPV for the “repeated projects.”

• The Equivalent Annual Cost Method

8-30

REPLACEMENT CHAIN APPROACH

The Cadillac cleaner time line of cash flows:

-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10

-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10

The Cheapskate cleaner time line of cash flows over ten years:

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8-31

REPLACEMENT CHAIN APPROACH

The Cadillac cleaner NPV:

The Cheapskate cleaner NPV over ten years:

NPV = −4000 − 100 / 0.10 ∙ ( 1 − 1/1.1010 ) = −4614

NPV = −1000− 500 / 0.10 ∙ ( 1 − 1/1.104 )− 1500 / 1.105

− 500 / 0.10 ∙ ( 1 − 1/1.105 ) / 1.105

= −4693

8-32

REPLACEMENT CHAIN APPROACH

10

–100

–4,614

–4,000

CF1

F1

CF0

I

NPV

10

4

–500

–4,693

–1,000

CF1

F1

CF0

I

NPV

10

Cadillac Air Cleaner Cheapskate Air Cleaner

1

–1,500CF2

F2

5

–500CF3

F3

17

8-33

EQUIVALENT ANNUAL COST (EAC)• EAC is the annual annuity payment implied by a

project’s NPV• In other words:• if the present value of an annuity is set equal to the

project NPV • and an annual payment is computed• using the same term and rate as the NPV; then,• the payment is the EAC

• The EAC for the Cadillac filter is $750.98• The EAC for the Cheapskate filter is $763.80• In general, select the EAC with the lower cost.

This suggests a decision to reject the Cheapskate filter which had the more attractive raw NPV

8-34

EQUIVALENT ANNUAL COST (CONT’D)

The Cheapskate cleaner time line of cash flows:

-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10

–751 -751 -751 -751 -751 -751 -751 -751 -751 -751

0 1 2 3 4 5 6 7 8 9 10

Math: −4614 = C / 0.10 ∙ ( 1 − 1/1.1010 ),so C = 750.98

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8-35

EQUIVALENT ANNUAL COST (CONT’D)

The Cadillac cleaner time line of cash flows:

-$1,000 –500 -500 -500 -500 -500

0 1 2 3 4 5

Math: −2895 = C / 0.10 ∙ ( 1 − 1/1.105 ),so C = 763.80

–764 -764 -764 -764 -764

0 1 2 3 4 5

Ten 764 outflows are worse than ten

751 outflows

8-36

CADILLAC EAC WITH A CALCULATOR

10

–100

–4,614.46

–4,000

CF1

F1

CF0

I

NPV

10 750.98

10

–4,614.46

10

PMT

I/Y

FV

PV

N

PV

Net Present Value Equivalent Annual Cost

19

8-37

CHEAPSKATE EAC WITH A CALCULATOR

5

–500

–2,895.39

–1,000

CF1

F1

CF0

I

NPV

10 763.80

10

-2,895.39

5

PMT

I/Y

FV

PV

N

PV

Net Present Value Equivalent Annual Cost

8-38

QUICK QUIZ

• How do we determine if cash flows are relevant to the capital budgeting decision?

• What are the different methods for computing operating cash flow, and when are they important?

• How should cash flows and discount rates be matched when inflation is present?

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