10-0 Making Capital Investment Decisions Chapter 10 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

10-1

Making Capital Investment Decisions

Chapter 10

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter Outline

• Relevant and Irrelevant Cash Flows• How to Evaluate a Project• Capital Budgeting Example • Special Types of Projects

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Relevant Cash Flows

• Incremental cash flows: cash flows that will only occur if the project is accepted.- Opportunity Costs- Side Effects- Change in NWC- Taxes

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Irrelevant Cash Flows

• Sunk costs • Financing costs

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How to Evaluate a Project

• 1. Calculate the Pro Forma Income Statements

• 2. Compute CF from AssetsCash Flow From Assets = OCF – net capital spending – changes in NWC where:operating cash flow (OCF) = EBIT + depr – taxesnet capital spending includes: - initial investment + after tax salvage value at the end change in NWC: always adds up to 0

• 3. Apply the Evaluation Criteria NPV, IRR, etc. 5

Capital Budgeting Example• Project X

you expect to sell 500 stereo amplifiers in year 1 at $8,000 each, unit sales grow at 10% per year variable cost = $5,000/unit fixed costs = $610,000/year Initial investment = $1,100,000 (use straight line depreciation) The project has a 4-year life In 4 years the equipment sells for $550,000 The initial investment in NWC = $900,000 Tax rate = 34%

• If the required rate of return = 20%, should you accept the project? 6

Special Types of Projects• Cost Cutting

evaluate: after-tax cost saving + depreciation tax shield instead of OCF

• Setting the Bid Price

find the OCF that sets the NPV = 0, then find the NI, sales, and finally the unit price

• Equivalent Annual Cost (EAC)use for evaluating projects of different economic livesEAC=PMT in an annuity where the PV is the NPV of the projects CFs

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