Chapter 4.

Capital Budgeting and Cash Flow Analysis

In the previous section, we have discussed the four different rules (or techniques) a firm can use to help decide which project(s) it should undertake, and we have also discussed the strengths and weaknesses of each of those techniques. However, in order for a firm to use any one of those techniques, it needs to first estimate the appropriate cash flows associated with the project. This is actually the most difficult part of capital budgeting. We have to be very careful when we are trying to identify the appropriate cash flows needed to help determine the attractiveness of a project. In general, cash flows can be classified as either relevant or irrelevant cash flows: (i) Relevant cash flows: Relevant cash flows are cash flows that come about as a direct consequence of the decision to take a certain project. Example: A company is debating whether it should start a new recycling program to recycle its by-product for other uses. The cash flows generated by the recycling program (such as sale of the recycled by-product) are relevant cash flows. (ii) Irrelevant cash flows: Irrelevant cash flows are cash flows that come about regardless of whether the proposed action (or project) is taken. Example: In the above company with the proposed recycling program, the salary of the CEO is considered as irrelevant cash flow. In other words, the CEO will get paid regardless of whether the recycling program is implemented. The most logical way to decide if a project should be taken is to look at the cash flows of the firm with the proposed project and without the proposed project. However, it will be too much work to calculate all the future cash flows for the two scenarios. It is better to focus only on the incremental cash flows associated with the project. What are incremental cash flows? The difference between a firms future cash flows with and without the project. As a result, the incremental cash flows associated with the project is defined as follows:
Project CFt = Firm' s CFt with project Firm' s CFt without project

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Is it easy determining the incremental cash flows? It is not as easy as a financial manager would think when it comes to determining the appropriate cash flows for evaluating the project, i.e. determining the incremental cash flows. The relevant cash flows of a project can be classified as initial investment, operating cash flows, and terminal cash flows. 1. Initial investment The initial investment is basically the amount of money the firm has to spend to get the new project started. This usually involves the costs of putting up a new building, new furniture, installing new light fixtures, etc. However, there are a few items a financial manager should be aware of: (i) Sunk cost Sunk cost is a cost that has been paid for prior to making the decision for the projects under consideration. It is easy to understand that sunk cost should not be included in the decision process of choosing the projects. Example: Suppose a building was built in 1990 for $500,000. In 1992, the firm needs to decide if the building should be remodeled for project A (which will generate an income of $50,000) at a cost of $25,000 or for project B (which will generate an income of $72,000) at a cost of $50,000. Identify the relevant and irrelevant cash flows. The $50,000 invested in the building in 1990 is considered the sunk cost because it cannot be recovered and hence irrelevant in the analysis. Example: The CEO of Apple Inc. is debating whether he should license Apples operating system to some PC vendors. The CEO hired a consultant for $50,000 to determine if this is a good move. The consultants report concludes that such move will be disastrous. Reviewing the report, the CEO thinks that the consultants fee should be included in the analysis. What do you think? The consultant fee is considered a sunk cost because that will have to be paid regardless of whether Apple decides to license its operating system or not.

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Example: You are trying to salvage a Spanish galleon laden with gold off the Florida Keys. In your efforts to date, one of your salvage boats worth $200,000 already sank and you are considering abandoning the project. If you go ahead, you estimate that the project will require an additional outlay of $350,000. What is the investment amount that is relevant to your decision? Only the $350,000 requires for the additional outlay should be considered. The $200,000 loss in the sunken boat is considered the sunk cost. (ii) Opportunity cost Opportunity cost is what the firm gives up if a particular project is taken. The concept of opportunity cost is often very difficult to understand. Example: After graduation, you decided to go to graduate school. The annual tuition and fees for graduate school is approximately $25,000. That is the direct cost associated with going to graduate school. What about the opportunity cost? Suppose you could have started with a local advertising company for $30,000. In this case, your opportunity cost will be $30,000. Example: You bought a small deserted paper mill for $120,000 5 years ago and the market price for that piece of land is $500,000. You decide to build a small apartment complex for the price of $350,000 that will generate about $80,000 in rent income a year. Is there any opportunity cost associated with this project? Opportunity cost is $500,000 this is the amount you have to give up for holding on to the land. What about the $120,000 paid for the paper mill? That is your sunk cost. (iii) Installed costs of new assets The installed costs of new assets include how much the firm paid for the new assets (i.e. direct costs) and how much to install them (i.e. installation costs). Example: The firm decides to put in new furniture in the reception area. In this case, the direct cost is $30,000 for the new furniture. The installation cost is $5,000, which includes shipping fee, movers fee, etc.

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Example: Your investment project will require a microcomputer with a sales price of $4,000. The sales tax is 5%. Delivery and setup is $150. Cables to connect the machine to existing printers will cost $50. A cabinet for the machine will cost $200. Which of these expenditures should be included in calculating the investment outlay? What is the investment?
Items Sales price of computer Sales tax (5%) Delivery and setup Cables Cabinets Total Cost $4,000 200 150 50 200 $4,600

Example: In the above example, suppose you have the needed cables on hand. Although used, these cables could be sold for $20. What effect does this have on the investment cost? The price of the cables should be counted as $20 and not $50. Since you have the cables on hand, you save the $50 outlay for new cables. However, by using the old cables, you forego what they could get in the market (i.e. opportunity cost). (iv) Working capital Every new project needs to start out with some working capital. Remember that net working capital is the difference between current assets and current liabilities. We know that if a firm decides to expand its operation by taking on a new project, the firm will need more cash to support the project, more account receivables and inventories to support increased sales and more account payables and accruals to support increased purchases. As a result, change in net working capital would be considered as relevant cash flows associated with the new project. Taxes do not affect the valuation of working capital since the change in net working capital simply represents an internal build up or reduction of current accounts. Example: If a 10-year project requires an initial working capital of $100,000 which will be completely captured in 10 years, what is the NPV that the working capital contributes to the project (if the required rate of return is 10%)?
NPV wc = 100,000 + 100,000 1.110

= $61,445.67

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2. Operating cash flows These are the cash flows resulted from the project directly. It is important to note that taxes play a key role. In such cases, only the after-tax operating cash flows are considered. Example: Suppose the new project takes $250,000 to build a bunch of computers that the firm sells for $300,000. In addition, the firm is in a 30% tax bracket. As a result, the project generated a $35,000 after-tax cash flow. There are a couple of items a financial manager should be aware of when dealing with operating cash flows: (i) Effects on other projects It is important to remember that we are dealing with only incremental cash flows. In this case, we have to be careful how the presence of a new project will affect the cash flows of the firms other existing projects. Example: Suppose Tower Records Inc. has a record store in downtown Chicago and it decides to add another store 3 blocks away from it. In this case, any cash flow generated by this new store cannot be considered as incremental cash flows because they simply represent a transfer from the old store to the new store. Example: On the other hand, suppose Tower Records Inc. decides to put the new store in Gurnee Mills. In this case, the cash flows generated by this new store will be considered as incremental cash flows if there is previously no Tower Records store in Gurnee Mills. (ii) Depreciation Depreciation is simply a reduction in accounting earnings to reflect the reduction in value of the assets. It is important to note that depreciation is not a cash flow itself. Depreciation simply lowers the net income reported and has no impact on the firms cash flows. As a result, depreciation represents a tax benefit to the firm because it lowers the firms taxable income. This is known as the depreciation tax shield.

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Tax shield = tax rate depreciation

Example: HAL, Inc. has a depreciation expense of $120,000 this year. Since the firm will sustain a net loss, it will not pay taxes. What is HALs depreciation tax shield for this year? Since HAL is not paying any taxes this year tax rate = 0 Tax shield=0 Example: ZIP, Inc. has very old equipment that is fully depreciated. The firm will have a net profit of $250,000 this year, and it is in the 34% tax bracket. What is ZIPs depreciation tax shield for this year? Since ZIPs equipment is fully depreciated depreciation = 0 Tax shield = 0 Tax depreciation calculations So far, we know that depreciation does not affect the actual cash flow of a project, but it does provide a tax benefit (in the form of a tax write off) which represents a cash inflow. It is important to understand that we are looking at depreciation from a finance point of view and not an accounting point of view. In this case, it is important to understand the concept rather than all the details of depreciation. We will now discuss some of the techniques for computing depreciation of an asset. (a) Straight line method The straight-line method is the easiest way of calculating the depreciation value of an asset. It assumes that the depreciation value of the asset is identical for every period. The depreciation value is computed as follows:
Cost of asset Salvage value Life of asset

Depreciation =

Example: Suppose Lemon Rental Co. buys new Taurus for the price of $18,000 and expects to sell them at $10,000 after using them for two years as rental cars. What is the annual depreciation value of each Taurus if Lemon Rental adopts a straight-line method?
Depreciation = 18000 10000 = $4,000 2

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(b) Modified Accelerated Cost Recovery System (MACRS) The MACRS allows a firm to write off a big portion of an assets book value early in the life of the asset. This is an advantage to the firm because depreciation represents a tax benefit and hence a cash inflow for the firm. Since capital budgeting deals with the time value (or present value) of the cash flows, it is better for a firm to generate a larger cash inflow earlier than later in the life of the asset. If you recall, $1 today is worth more than $1 a year from now. The IRS has classified assets into different classes according to their expected life spans. The following table shows the different classes of assets (according to an assets life span).
Class 3-year 5-year 7-year 10-year 27.5-year 31.5-year Type of property Specially designated tools and devices, and tractor units. Automobiles, trucks, computers, typewriters, copiers, and other designated equipment. Most industrial equipment, office furniture, and fixtures. Certain longer-lived types of equipment. Residential rental real property such as apartment buildings. All nonresidential real property, including commercial and industrial buildings.

And the following table provides the recovery allowance percentages for personal property.
Ownership Year 1 2 3 4 5 6 7 8 9 10 11 Class of Investments 5-year 7-year 20% 14% 32 25 19 17 12 13 11 9 6 9 9 4

3-year 33% 45 15 7

10-year 10% 18 14 12 9 7 7 7 7 6 3

Based on the above table, you might wonder why a firm depreciates a 3-year asset over four years. That is because the recovery period starts in the middle of the first year. This is known as the half-year convention. There is a difference between the straight line and MACRS methods of computing depreciation: the straight line method takes the assets salvage value into consideration, while the MACRS

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method ignores the salvage value (but takes the shipping and installation costs into consideration). Example: Orange Computer Inc. bought a new computer for $25,000 in 1995. Orange Computer paid an additional $2500 for shipping and installation costs. What is the depreciation value of the computer over the life of the computer? The depreciable basis of the new computer is $27,500 (=25000+2500), and the computer is classified as a 5-year asset.
Year 1995 1996 1997 1998 1999 2000 Recovery % 20 32 19 12 11 6 Depreciation 5,500 8,800 5,225 3,300 3,025 1,650

After-tax operating cash flows As we have discussed earlier, depreciation plays a major role in determining the operating cash flow because it represents a tax benefit (in the form of a tax shield). The following formula helps determine the after-tax cash flow in each period.
CFt = [ ( Rt C t Dt )](1 ) + Dt = [ R t C t ](1 ) +Dt

where

Rt = the firms incremental revenue due to the project C t = the firms incremental operating cost due to the project Dt = the firms incremental depreciation due to the project

3. Terminal cash flow When the project is terminated, any assets directly related to the project will be sold and any change in the net working capital (from the initial investment) will be recaptured. So far, we have assumed that the asset purchased for the project lasted exactly the same as the duration of the project. What if a firm decides to sell the asset before the asset reaches the end of its life span? In that case, the firm will have to determine the difference between the assets sale price and the then-existing undepreciated tax book value, and the firm will be taxed based on that difference.

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Example: Suppose Orange Computer Inc. sold its computer after 4 years (in 1998) for $15,000. How much tax would the firm need to pay if it is in a 40% tax bracket? How would the firm adjust its operating cash flow in 1998? First, we need to determine the computers undepreciated tax book value. From the above table, we know that is $4,675 (=3025+1650). That same amount can be determine the following way:
Undepreciated tax book value =27500 (0.11 +0.06) =$4,675

The difference between the sale price and the undepreciated tax book value is computed as follows:
Difference =15000 4675 =$10,325

The amount of taxes the firm needs to pay is:

Tax =10325 0.4 =$4,130

And the firm needs to adjust its operating cash flow as follows:
Additional cash flow =15000 4130 =$10,870

Examples of cash flow analysis and capital budgeting We will look at two examples to illustrate how we can identify the appropriate cash flows we need to use in capital budgeting.

Example: Scott Investors, Inc., is considering the purchase of a $500,000 computer that has an economic life of 5 years. The computer will be depreciated based on the MACRS method. The market value of the computer will be $100,000 in 5 years. The use of the computer will save five office employees whose annual salaries total $120,000. It also contributes to lower net working capital by $100,000 when they
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buy the computer. The net working capital will be recovered at the end of the period. The corporate tax rate is 34%. Is it worthwhile to buy the computer if the appropriate discount rate is 12%?
(a) Initial cash flow First, we need to determine the firms initial cash flow when it decides to take on the new project. This includes the initial investment in the computer and the savings in working capital (due to the computer).
Year 0 -$500,000 100,000 -$400,000

Computer Net working capital Total cash flow

(b) Depreciation recovery of computer Since the computer has a classified life of 5 years, it will be depreciated using the MACRS method. The following table presents the depreciation value (or recovery value) over its 5-year life (based on the book value of $500,000):
Year 1 2 3 4 5 6 Recovery $100,000 160,000 95,000 60,000 55,000 30,000

(c) Annual after-tax cash flow In this particular situation, the annual after-tax operating cash flow is made up of two components: (1) the after-tax savings on wages, and (2) the depreciation tax-shield from the computer.
Year 1 $79,200 34,000 113,200 Year 2 $79,200 54,400 133,600 Year 3 $79,200 32,300 111,500 Year 4 $79,200 20,400 99,600 Year 5 $79,200 18,700 97,900

After-tax savings on wages Depreciation tax shield After-tax cash flow

(d) Terminal cash flow

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The terminal cash flow discussed here does not include the operating cash flow in the last year (i.e. year 5). This cash flow includes components that are results of the termination of the project (i.e. selling the computer). It is important to remember that the computer has not been fully depreciated, and hence the salvage value (or the sale price) of the computer will not be fully taxable. The computer still has a book value of $30,000 left. As a result, only $70,000 of the salvage value (i.e. the net gain) is taxable. In addition, since the initial working capital will be recaptured by the firm, that will represent cash outflow for the firm from the projects point of view. The terminal cash flow of the project is presented as follows:
Year 5 $100,000 -23,800 -100,000 -$23,800

Sale of computer Tax on computer Recapture of NWC Total terminal cash flow

(e) Annual total after-tax cash flows for the project Using information from part (a), (c) and (d), we can determine the annual after-tax cash flows generated by the project over its 5-year life as follows:
Year 0 1 2 3 4 5 Amount -$400,000 113,200 133,600 111,500 99,600 74,100

Using a financial calculator, we know when the cost of capital is 12%, the NPV of this project is $7,716.04. As a result, the firm should not install the new computer.

Example: The Loving Candy Co. has been studying an investment project calling for the manufacture and introduction of a new candy bar called Yuppie Nougat, targeted for the yuppie

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market. As a consequence, Loving Candy expects to use the finest foreign chocolate and to price the candy very high relative to its cost; otherwise no self-respecting yuppie would even think of buying it. Part of the expense will consist of a vast marketing program, complete with endorsements by yuppie heroes. The project is expected to last eight years, after which time yuppie will be more interested in dentures than candy bars. The introduction of the candy bar requires 400 new machines costing $10,000 each. Installing each machine costs $100. The machines will be depreciated on a straight-line basis over 5 years. The production facility will be located on a site the company already owns. The company could rent the space that the candy facility will occupy for $500,000 per year. Loving company expects to sell 2,000,000 bars per year for the entire life of the project. The price will be $2.50 per candy bar, with a production cost of $0.50. The plan schedules the marketing expense per candy bar at $1.00. Outlets for the candy bar have been chosen with yuppies in mind, the aim being to have Yuppie Nougat available wherever Perrier is sold. The firm expects to maintain an average inventory of about 500,000 bars, and expects no other increase in working capital. The appropriate after-tax discount rate (or required rate of return) for Yuppie Nougat is 18%. Should Loving Candy help sweeten the world with Yuppie Nougat (assuming its tax rate is 34%)? (a) Initial cash flow At the very beginning, the following costs has been incurred:
Year 0 $4,000,000 40,000 250,000 $4,290,000

Cost of machines ( 400 10,000) Installation cost ( 400 100) 4,000 Working capital (i.e. inventory, 500,000 0.50 )

(b) Annual after-tax cash flows First, we need to determine the annual operating income of the firm (year 1-8) as follows:
Sales ( 2,000,000 $2.50) Production cost ( 2,000,000 $0.50) Marketing expense ( 2,000,000 $1) $5,000,000 -1,000,000 -2,000,000

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Rent Operating income

-500,000 1,500,000

Next, we need to figure out the depreciation. We know that the machines will be fully depreciated in 5 years. Since the installed cost of the machines is $4,040,000, the annual depreciation is $808,000 (using the straight-line method). Since the firm faces a tax rate of 34%, the tax shield will be $274,720. As a result, we can determine the annual after-tax cash flow from the project using the after-tax operating income and depreciation tax shield (only for the first five years) as follows:
Years 1-5 $990,000 274,720 $1,264,720 Years 6-8 $990,000 0 $990,000

After-tax operating income Tax shield After-tax cash flow

(c) After-tax terminal cash flow Since the working capital can be recaptured, it is not taxable. (e) Annual total after-tax cash flows (Year 0-8)
Year 0 1 2 3 4 5 6 7 8 Total after-tax outflows -$4,290,000 1,264,720 1,264,720 1,264,720 1,264,720 1,264,720 990,000 990,000 1,240,000

Using a financial calculator, we know when the cost of capital is 18% the NPV of this project is $672,396. As a result, the firm should introduce Yuppie Nougat.

At this point in time, we have focused solely on determining the cash flows of new project. However, in most situations a firm will face a replacement project rather than a new project. In other words, a firm is trying to decide whether it should upgrade a machine or an asset that is still functioning but is not as efficient as the new machine.

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When a financial manager is dealing with a replacement project, he/she has to be very careful because the old machine will generate opportunity costs throughout the life of the new machine and they are often ignored by the financial manager. We will look at the analysis of a replacement project with an example. Example: The Durst Equipment Company has purchased a machine 5 years ago at a cost of $100,000. It had an expected life of 10 years at the time of purchase and an expected salvage value of $10,000 at the end of the 10 years. It is being depreciated by the straight-line method toward a salvage value of $10,000. A new machine can be purchased for $150,000, including installation costs. Over its 5-year life, it will reduce cash operating expenses by $50,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and it will be depreciated over a 3-year recovery period rather than its 5-year economic life. The old machine can be sold today for $65,000. The firms tax rate is 34%. The appropriate discount rate (i.e. cost of capital) is 15%. Before we proceed with the analysis, it is best that we first determine the depreciation and remaining book value associated with the old machine. We know the old machine (with an expected life of 10 years) was bought 5 years ago, so this machine has a remaining life of 5 years. At the end of its life, the machine will have a salvage value of $10,000. Since this machine will have its depreciation determined with a straight-line technique, we know its annual depreciation will be as follows:
Annual depeciation = 100000 10000 = $9,000 10

Since the machine is 5 years old, that means the firm has written off a total of $45,000 (

= 9000 5 ) in depreciation. That means the machine currently has a remaining book value of
$55,000 ( = 100000 45000 ). 1. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
Year 0 -$150,000 65,000 -3,400 -$88,400

Cost of new machine Sale of old machine Tax on old machine Total cash flow

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We have to be very careful with the amount of taxes the firm needs to pay on the sale of the old machine. The firm needs only to pay taxes on any gain resulted from the sale of the old machine. We know the old machine was sold for $65,000 but it has a remaining book value of $55,000. In that case, the firm has made a profit of $10,000, which means the tax will be $3,400 (

= 10000 0.34 ).
2. What incremental cash flows will occur at the end of Year 1 through Year 5 as a result of replacing the old machine? With the new machine, the firm will be able to save operating expenses by $50,000 a year. This represents an increase in before-tax operating cash flow of $50,000. Since the firm faces a 34% tax bracket, which means it will enjoy an after-tax operating cash flow of $33,000 (=

50000 0.66 ) a year.

We have to keep in mind that the firm will not enjoy the full tax shield resulted from the depreciation of the new machine. This is because it needs to take into consideration the opportunity cost resulted from the old machines depreciation (that it could enjoy if the new machine was not purchased). As a result, the financial manager needs to look at the changes in depreciation resulted from the replacement of the old machine with the new machine. We can easily determine the annual depreciation of the new machine (with a MACRS class of 3 years), and we know the old machine has an annual depreciation of $9,000. As a result, we can determine the tax shield the firm will enjoy when it replaces the old machine with the new machine as follows:
Year 1 2 3 4 5 New $49,500 67,500 20,500 10,500 0 Old $9,000 9,000 9,000 9,000 9,000 Depreciation $40,500 58,500 13,500 1,500 -9,000 Tax shield $13,770 19,890 4,590 510 -3,060

We can now combine the firms tax shield together with its increase in after-tax operating cash flows to determine its overall after-tax cash flows.
Year 1 Year 2 Year 3 Year 4 Year 5

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After-tax savings on expenses Depreciation tax shield After-tax cash flow

$33,000 13,770 $46,770

$33,000 19,890 $52,890

$33,000 4,590 $37,590

$33,000 510 $33,510

$33,000 -3,060 $29,940

3. What terminal cash flow will occur at the end of Year 5 if the new machine is purchased? Since the new machine has no salvage value at the end of its life, the firm will not be able to sell it for monetary amount. However, if the firm had stayed with the old machine, it would have a salvage value of $10,000. This represents an opportunity cost to the firm for replacing the old machine. It is important to keep in mind that with a straight-line depreciation technique, the firm first subtracted the old machines salvage value from its cost before determining its annual depreciation. As a result, the salvage value of a machine (under a straight-line technique) represents its remaining book value. Hence, the firm will not be taxed for the salvage value of the old machine because it has not profited from the sale.
Year 5 $0 -10,000 0 -$10,000

Salvage value of new machine Opportunity cost from salvage value of old machine Tax on salvage value of old machine Total terminal cash flow

4. Should the firm replace the old machine with the new one? The firm will make the decision on whether it should replace the old machine with the new machine once it puts the relevant cash flows associated with the replacement project together.
Year 0 1 2 3 4 5 Amount -$88,400 46,770 52,890 37,590 33,510 19,940

With a cost of capital of 15%, the replacement projects NPV will be $46,051.19. In this case, it will be a good idea for the firm to go ahead with the project.

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Example: The Erickson Toy Corporation currently uses an injection-molding machine that was purchased 2 years ago. This machine is being depreciated on a straight-line basis toward a $500 salvage value, and it has 6 years of remaining life. Its current book value is $2,600, and it can be sold at $3,000 at this time. Thus, the annual depreciation expense is ($2,600-500)/6=$350 per year. The firm is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class. The replacement machine would permit an output expansion, so sales would rise by $1,000 per year; even so, the new machines much greater efficiency would still cause operating expenses to decline by $1,500 per year. The new machine would require that inventories be increased by $2,000, but accounts payable would simultaneously increase by $500. The firms marginal federal-plus-state tax rate is 40%, and its cost of capital is 15%. Should it replace the old machine? (a) Initial investment The firm pays $8,000 for the new machine but this is offset by the $3,000 received from the sale of the old machine. The firm has to be very careful when dealing with the tax on the sale of the old machine. Since the old machine still has a book value of $2,600, the firm made a profit of $400 by selling it at $3,000. Hence, the tax on the old machine is $160. In addition, the firm also needs to worry about the change in net working capital resulted from the new machine. Keep in mind that a firm's net working capital is defined as current asset current liability . We know the inventory of $2,000 represents a current asset for the firm, but the account payable of $500 represents a current liability. Hence the change in the firm's NWC is $2,000 $500 =$1,500 .
Year 0 -$8,000 3,000 -160 -1,500 -$6,660

Cost of new machine Sale of old machine Tax on old machine Change in NWC Total cash flow

(b) Depreciation recovery of computer Determining the depreciation recovery of the new machine is a little bit tricky because we need to take into consideration of opportunity cost of lost depreciation from the old machine.

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Year 1 2 3 4 5 6

New $1,600 2,560 1,520 960 880 480

Old $350 350 350 350 350 350

Recovery $1,250 2,210 1,170 610 530 130

Tax shield $500 884 468 244 212 52

(c) Annual after-tax operating cash flow

Year 1 $1,500 500 2,000 Year 2 $1,500 884 2,384 Year 3 $1,500 468 1,968 Year 4 $1,500 244 1,744 Year 5 $1,500 212 1,712 Year 6 $1,500 52 1,552

After-tax revenue and savings on expenses Depreciation tax shield After-tax cash flow

(d) Terminal cash flow

Year 6 $800 -320 -500 1,500 $1,480

Salvage value of new machine Tax on salvage value Opportunity cost of old machine Recapture of NWC Total terminal cash flow

(e) Annual after-tax cash flows for the project

Year 0 1 2 3 4 5 6 Amount -$6,660 2,000 2,384 1,968 1,744 1,712 3,032

Using a financial calculator, we know when the cost of capital is 15% the NPV of this project is $1,334.89. As a result, the firm should replace the old machine. Problems with estimating cash flows As we have mentioned earlier, the most difficult part of capital budgeting is the estimation of the appropriate (or relevant) cash flows associated with a project. So far, we have discussed the issue

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of identifying the appropriate cash flows and have not discussed the technique of estimating them. The techniques of estimating the cash flows are beyond the scope of this course. We will, however, discuss some of the problems with estimating cash flows. Studies have shown that, in general, there is a tendency for upward cash flow estimation bias. In other words, financial managers are too optimistic with their estimation of future cash flows. As a result, projects with negative NPV will become positive. Many firms have now begun to track specific managers and adjust for historic optimism. For example, if Bob consistently overestimate the cash flows of previous projects by 15%, then the cash flows of future projects will be adjusted downward by 15% to correct for the optimism. On the other hand, a financial manager could understate the true profitability of a project by not taking into consideration of managerial options. These are investment opportunities that resulted from the current decision to pursue a particular project. Examples of such options include (i) the opportunity to develop follow-up products, (ii) the opportunity to expand product markets, (iii) the opportunity to expand or retool manufacturing plants, etc. As a result, firms are beginning to incorporate the value of such options to the NPV of the project. Evaluating projects with unequal lives So far, the discussion relating to techniques comparing the attractiveness of projects assumes that the projects have equal lives. However, this is usually not the case. As a result, we will focus on techniques to evaluate projects with unequal lives. There are two ways of doing it: (i) replacement chain approach, and (ii) equivalent annual annuity approach. (i) Replacement chain approach This approach simply assumes that it is possible to equate the lives of projects to an equal life span. In other words, extend the life of the shorter-life project to match the life of the longer-life project by reinvesting in the shorter project at the end of its original life span. Example: Office Automation, Inc., is obliged to choose between two copiers, XX40 or RH45. XX40 costs less than RH45, but its economic life is shorter. The costs and the after-tax operating cash flows of these two copiers are given as follows.
Copier Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

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XX40 RH45

-$700 -$900

$500 $490

$500 $485

$500 $480

$475

$470

$465

If the firms cost of capital is 14%, which copier should the firm choose? Since the life of XX40 is shorter than that of RH45, we will extend the life of this copier.
Year 0 -$700 -$700 Year 1 $500 $500 Year 2 $500 $500 Year 3 $500 -$700 -$200 Year 4 $500 $500 Year 5 $500 $500 Year 6 $500 $500

Since the firms cost of capital is 14%, using a financial calculator, we can determine the NPVs for (extended) XX40 and RH45: XX40: RH45: $771.85 $964.19

As a result, the manager will pick RH45 rather than XX40. It is important to note that sometimes it is essential to extend the lives of both projects to make them match. For example, if project A has a life span of 4 years and project B has a life span of 6 years, then we need to expand the lives of the projects to 12 years. The easiest way is to determine if the life span of the longer project can be divided by the life span of the shorter project. If that is possible, then we simply extend the life span of the shorter project to match that of the longer project. If that is not possible, then we need to find a number that is divisible by the life spans of the two projects and extend the life spans of those projects to match that newfound number.

(ii) Equivalent annual annuity approach A manager can run into problems with the replacement chain approach if the common newfound number between the two projects turns out to be a very large number. In that case, it will be easier to use the equivalent annual annuity approach, which includes a 3-step procedure. It is easier to illustrate the technique by looking at the same example.

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Example: Suppose the manager at Office Automation, Inc., decides to use the equivalent annual annuity approach rather than the replacement chain approach. Would the manager still pick RH45 rather than XX40? Step 1: Find the NPV of each project over its initial life. XX40: RH45: $460.82 $964.19

Step 2: Find an annuity that has the same NPV as each project. Using a financial calculator, we can determine the annuity (with a cost of capital of 14%) that matches each of the two copiers. XX40: RH45: $198.49 $247.95

Step 3: Find the NPV of each project assuming an infinite life span. To determine the NPV of a project with infinite life span and constant cash flow, we can simply use the following equation:
NPV = constant annual cash flow cost of capital

As a result, the NPVs of XX40 and RH45 assuming constant cash flow and infinite life span are as follows:
NPV XX 40 = NPV RH 45 = 198.49 = $1,417.79 0.14 247.95 = $1,771.07 0.14

Using the equivalent annual annuity approach, the manager will still choose RH45 over XX40. Abandonment value So far, it has always been assumed that a firm will operate its projects until the end of its physical life. However, sometimes it is much better for the firm to abandon its projects before they reach the end of their physical lives.

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Example: Suppose ABC, Inc. is interested in purchasing a new computer to serve as its new server. This new computer has an estimated life of 5 years. The following table presents the computers after-tax annual cash flows and its net abandonment value (which is the computers net salvage value):
Year 0 1 2 3 4 5 After-tax cash flow -$12,000 3,000 3,500 4,000 3,000 2,000 Net abandonment value $12,000 11,000 8,000 4,000 1,000 0

Assuming that the firm has a 12% cost of capital, should the firm operate the computer until the end of its 5-year life? If not, what is its optimal economic life? Using a financial calculator, we know that the NPV of the computer (if the firm operates it for 5 years) is -$642.72. In this case, it is not advisable that the firm operates it for 5 years. Lets examine the NPV of the firm if it abandons the computer before the end of its life span. We will start with the case where the firm abandons it after 4 years. The following is the computers cash flows:
Year 0 1 2 3 4 After-tax cash flow -$12,000 3,000 3,500 4,000 4,000

Using the financial calculator, the NPV of the computer is -$1,142.06. Hence, the economic life of the computer is not 4 years. We will continue the procedure for the cases when the firm abandons the computer after 3, 2 and 1 year. The following is the result: After 3 years After 2 years After 1 year NPV = -$837.01 NPV = -$153.70 NPV = $500.00

Based on the above information, ABC Inc. should operate the computer for only 1 year.

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It is important that a manager take into consideration the abandonment value of a project. From the above example, we have shown that it is not profitable for ABC Inc. to operate the computer for the full 5 years, but it is profitable for it to operate the computer for just 1 year. Unfortunately, this is not very common practice among financial managers for two reasons. (1) Abandoning a project in mid-stream does not look good for a manager. (2) It is very difficult to estimate the abandonment value of a project.

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