10-1 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

10-2

Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-3

Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-4

Capital Budgeting and

Cash Flows

In the previous chapter we focused on multiple techniques of capital budgeting to evaluate projects.

This chapter is all about how each of the cash flows (CF’s) are determined.

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Project Example - Visual

R = 12%

$ -165,000

1 2 3

CF1 = 63,120

CF2 = 70,800

CF3 = 91,080

The required return for assets of this risk level is 12% (as determined by the firm).

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Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-7

Relevant Cash Flows• The cash flows that should

be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted

• These cash flows are called incremental cash flows

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

10-8

Asking the Right Question

You should always ask yourself: “Will this cash flow occur ONLY IF we accept the project?”

• If the answer is “yes,” it should be included in the analysis because it is incremental

• If the answer is “no,” it should not be included in the analysis because it will occur anyway

• If the answer is “part of it,” then we should include the part that occurs because of the project

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Common Types of Cash Flows

1. Sunk costs – costs that have accrued in the past

2. Opportunity costs – costs of lost options

3. Changes in net working capital (NWC)

4. Financing costs

5. Taxes

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Common Types of Cash Flows

6. Side effects:

• Positive side effects – benefits to other projects

• Negative side effects – costs to other projects

10-11

Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-12

Pro Forma Statements and Cash

FlowDefinitions:

• Operating Cash Flow (OCF) = EBIT + depreciation – taxes

• OCF = Net income + depreciation (when there is no interest expense)

• Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS)

– changes in NW

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Project Pro Forma Income Statement

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

$200,000

Variable Costs ($2.50/unit) 125,000Gross profit $ 75,000Fixed costs 12,000Depreciation ($90,000 / 3) 30,000EBIT $ 33,000Taxes (34%) 11,220Net Income $ 21,780

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Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-15

Projected Capital Requirements

Year

0 1 2 3

NWC $20,000 $20,000 $20,000 $20,000

Net FA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000

10-16

Projected Total Cash Flows

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

Change in NWC

-$20,000 20,000

Net CS -$90,000

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

10-17

Project Example - Visual

R = 20%

$ -110,000

1 2 3

CF1 = 51,780

CF2 = 51,780

CF3 = 71,780

The required return for assets of this risk level is 20% (as determined by the firm).

10-18

Using your calculator

10-19

Evaluate the ProjectEnter the cash flows into the calculator and compute NPV and IRR:

CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1NPV; I = 20;

CPT NPV = $10,648CPT IRR = 25.8%

10-20

What’s Your Decision?

So….Deal or No Deal?

10-21

More on NWC Why do we have to consider changes in

NWC separately? GAAP requires that sales be recorded on

the income statement when made, not when the cash is received.

GAAP also requires that we record the cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers to date.

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

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DepreciationThe depreciation expense used for

capital budgeting should be the depreciation schedule required by the IRS for tax purposes

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

Calculation:

Depreciation tax shield = DTD = depreciation expenseT = marginal tax rate of the firm

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Computing Depreciation

Straight-line depreciationD = (Initial cost – salvage) / number of years

Very few assets are depreciated using the straight-line method for tax purposes

MACRSNeed to know which asset class is appropriate for tax purposes

Multiply percentage given in table by the initial cost

Depreciate to zero

Mid-year convention

10-24

After-tax Salvage

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

Book value = initial cost – accumulated depreciation

After-tax salvage = salvage – T*(salvage – book value at time of sale)

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After-tax Salvage Computation

1.Market Value – Book Value = gain (or loss)

2.Take gain (or loss) x (marginal tax rate)

3.Pay taxes on a gain; Receive a tax benefit on a loss

4.After-tax Salvage =Market Value – taxes paid or

Market Value + tax benefit

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Example: Depreciation and After-tax Salvage

You purchase equipment for $100,000, and it costs $10,000 to have it delivered and installed.

Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in

6 years.

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Example: Depreciation and After-tax Salvage

The company’s marginal tax rate is 40%. What is the depreciation expense and

the after-tax salvage in year 6 for each of the following three scenarios (A-C)?

$ -110,000

6

Sell = $17,000

543210

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Example A: Straight-line

Suppose the appropriate depreciation schedule is straight-line:

D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years

BV in year 6 = 110,000 – 6(15,500) = 17,000

After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000

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Example A: Straight-Line

The company’s marginal tax rate is 40%.

Market Selling Price = $17,000Book Value at year 6: $17,000Capital gain/loss = 0

Taxes paid on gain/loss = ($0).40 = $0

After-tax salvage value: 17,000 - .40 (17,000 – 17,000)

= $17,000

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Example B: Three-year MACRS

Year MACRS percent

Depreciation per year

1 .3333 .3333(110,000) D1= $36,663

2 .4445 .4445(110,000) D2= $48,895

3 .1481 .1481(110,000) D3= $16,291

4 .0741 .0741(110,000) D4= $8,151

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Example B: MACRS The company’s marginal tax rate

is 40%.

Market Selling Price = $17,000Book Value at year 6: $ 0Capital gain/loss = $17,000

Taxes paid on gain/loss = ($17,000).40 = $ 6,800

After-tax salvage value: 17,000 - .40 (17,000 – 0)

= $10,200

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Example C: Seven-Year MACRS

Year MACRS Percent

Depreciation Per year

1 .1429 .1429(110,000) = D1=$15,719

2 .2449 .2449(110,000) = D2=$26,939

3 .1749 .1749(110,000) = D3=$19,239

4 .1249 .1249(110,000) = D4=$13,739

5 .0893 .0893(110,000) = D5= $ 9,823

6 .0892 .0892(110,000) = D6= $ 9,812

10-33

Example C: MACRS The company’s marginal tax rate

is 40%.

Market Selling Price = $17,000Book Value at year 6: $14,729Capital gain /loss = $ 2,371

Taxes paid on gain/loss = ($17,000).40 = $ 908.40

After-tax salvage value: 17,000 - .40 (17,000 – 14,729)

= $16,091.60

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Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-35

Replacement Problem

Every problem we have presented thus far represents a newly purchased asset.

What if we have an old asset to replace with a new asset?

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Example: Replacement Problem

Original MachineInitial cost = 100,000Annual depreciation =

9,000Purchased 5 years

agoBook Value = 55,000Salvage today =

65,000Salvage in 5 years =

10,000

New MachineInitial cost = 150,0005-year lifeSalvage in 5 years =

0Cost savings =

50,000 per year3-year MACRS

depreciationRequired return = 10%Tax rate = 40%

10-37

Replacement Problem Computing Cash Flows Remember that we are

interested in incremental cash flows

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

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

10-38

Replacement Problem Pro Forma Income Statements

Year 1 2 3 4 5

Cost Savings

50,000 50,000 50,000 50,000 50,000

Depr.

New 49,995 66,675 22,215 11,115 0

Old 9,000 9,000 9,000 9,000 9,000

Increm. 40,995 57,675 13,215 2,115 (9,000)

EBIT 9,005 (7,675) 36,785 47,885 59,000

Taxes 3,602 (3,070) 14,714 19,154 23,600

NI 5,403 (4,605) 22,071 28,731 35,40010-38

10-39

Replacement Problem Incremental Net Capital

Spending

Year 0 Cost of new machine = 150,000

(outflow) After-tax salvage on old machine =

65,000 - .4(65,000 – 55,000) = 61,000 (inflow)

Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow)

Year 5 After-tax salvage on old machine =

10,000 - .4(10,000 – 10,000) = 10,000 (outflow because we no longer receive this)

10-40

Replacement Problem Cash Flow From Assets

Year 0 1 2 3 4 5

OCF 46,398

53,070 35,286 30,846 26,400

NCS -89,000

-10,000

In NWC

0 0

CFFA

-89,000

46,398

53,070 35,286 30,846 16,400

10-41

Replacement Problem Analyzing the Cash

FlowsNow that we have the cash flows, we can compute the NPV and IRR1. Enter the cash flows2. Compute the NPV and the IRRCompute NPV = $54,801.74Compute IRR = 36.28%

Should the company replace the equipment?

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Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis

10-43

Other Methods for Computing OCF

Bottom-Up ApproachWorks only when there is no interest

expenseOCF = NI + depreciation

Top-Down ApproachOCF = Sales – Costs – TaxesDon’t subtract non-cash deductions

Tax Shield ApproachOCF = (Sales – Costs)(1 – T) + Depreciation*T

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Example: Cost Cutting

1. Your company is considering a new computer system that will initially cost $1 million.

2. It will save $300,000 per year in inventory and receivables management costs.

3. The system is expected to last for five years and will be depreciated using 3-year MACRS.

10-45

Example: Cost Cutting (continued)

4. The system is expected to have a salvage value of $50,000 at the end of year 5.

5. There is no impact on net working capital.

6. The marginal tax rate is 40%. 7. The required return is 8%.

Task: Click on the Excel icon to work through the example

10-46

Example: Setting the Bid Price

Consider the following information:

1. The Army has requested bids for multiple use digitizing devices (MUDDs)

2. Deliver 4 units each year for the next 3 years

3. Labor and materials estimated to be $10,000 per unit

4. Production space leased for $12,000 per year

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Example: Setting the Bid Price (continued)

5. Requires $50,000 in fixed assets with expected salvage of $10,000 at the end of the project (depreciate straight-line)

6. Requires an initial $10,000 increase in NWC

7. Tax rate = 34%8. Firm’s required return = 15%

Task: Click on the Excel icon to work through the example

10-48

Example: Equivalent Annual Cost Analysis

Burnout BatteriesInitial Cost = $36 each

3-year life$100 per year to keep charged

Expected salvage = $5

Straight-line depreciation

Long-lasting BatteriesInitial Cost = $60 each

5-year life$88 per year to keep chargedExpected salvage = $5

Straight-line depreciation

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Example: Equivalent Annual Cost Analysis

(continued)

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%.

10-50

Ethics Issues

In an L.A. Law episode, an automobile manufacturer knowingly built cars that had a significant safety flaw. Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car. What issues does the financial analysis overlook?

10-51

Quick Quiz

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

2. What are the different methods for computing operating cash flow and when are they important?

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

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

10-52

Comprehensive Problem

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

10-53

Terminology

• Incremental cash flows• Sunk costs• Opportunity costs• Stand-alone (or independent) projects

• Net Working Capital (NWC)• Operating Cash Flow (OCF)• Cash Flow From Assets (CFFA)

10-54

Terminology (continued)

• Straight line depreciation• MACRS depreciation• Market value vs. book value• After-tax salvage value• Bid price• Equivalent Annual Cost

(EAC)

10-55

Formulas

• Operating Cash Flow (OCF) = EBIT + depreciation – taxes

• OCF = Net income + depreciation (when there is no interest expense)

• Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NW

• After-tax salvage = salvage – T (salvage – book value at time

of sale)

10-56

Formulas (continued)

Operating Cash Flow Formula:

Bottom-Up ApproachOCF = NI + depreciation

Top-Down ApproachOCF = Sales – Costs – Taxes

Tax Shield ApproachOCF = (Sales – Costs)(1 – T) + Depreciation*T

10-57

Key Concepts and Skills

• Compute the relevant cash flows for proposedinvestments.

• Compare and contrast the various methods for computing operating cash flow.

• Compute a bid price for a project

• Compute and evaluate the equivalent annual cost of a project

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1. The cash flows for a project are computed using incremental cash flows considering depreciation and after-tax salvage values.

2. Straight-line and MACRS methods of depreciation are used to compute the depreciation of an asset.

What are the most important topics of this chapter?

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3. Cash Flows From Assets (CFFA) computes the annual cash flows for capital budgeting purposes.

4. Replacement decisions involve the cash flows of the “old” asset as well as the “new” asset.

What are the most important topics of this chapter?

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Questions?