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McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
7
Chapter Seven
Net Present Value and
Capital Budgeting
Prepared by

Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
7.1 Incremental Cash Flows
7.2 The Majestic Mulch and Compost Company: An Example
7.3 Inflation and Capital Budgeting
7.4 Investments of Unequal Lives: The Equivalent Annual Cost
Method
7.5 Summary and Conclusions
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7.1 Incremental Cash Flows
Cash flows matternot accounting earnings.
Sunk costs dont matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.
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Cash FlowsNot Accounting Earnings
Consider depreciation expense.
You never write a cheque made out to depreciation.
Much of the work in evaluating a project lies in taking
accounting numbers and generating cash flows.
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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 does not mean that it should also have
automatic acceptance. Specifically if another project with a
higher NPV would have to be passed up we should not
proceed.
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 recognize that.
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Estimating Cash Flows
Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT Taxes + Depreciation
Net Capital Spending
Dont forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a
return of net working capital.
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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, its enough to assume that the firms level of debt
(hence interest expense) is independent of the project at
hand.

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7.2 The Majestic Mulch and Compost
Company (MMCC): An Example
Costs of test marketing (already spent): $250,000.
The proposed factory site (which we own) has no resale value.
Cost of the tool making machine: $800,000 (CCA calculations are
based on a class 8, 20-percent rate).
Production (in units) by year during 8-year life of the machine:
6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, and 6,000.
Price during first year is $100; price increases 2-percent per year
thereafter.
Production costs during first year are $64 per unit and increase at
the annual inflation rate of 5-percent per year thereafter.
Fixed production costs are $50,000 each year.
Working capital: initially $40,000, then 15-percent of sales at the
end of each year. Falls to $0 by the projects end.
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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Income:
(1) Sales revenues 600,000 $ 918,000 $ 1,248,480 $ 1,379,570 $ 1,298,919 $ 1,104,081 $ 900,930 $ 689,211 $
The Worksheet for Cash Flows of the
MMCC

Recall that production (in units) by year during 8-year life of the machine is
given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000).
Price during first year is $100 and increases 2% per year thereafter.
Sales revenue in year 5 = 12,000[$100(1.02)
4
] = $1,298,919.
(All cash flows occur at the end of the year.)
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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Income:
(1) Sales revenues 600,000 $ 918,000 $ 1,248,480 $ 1,379,570 $ 1,298,919 $ 1,104,081 $ 900,930 $ 689,211 $
(2) Operating costs 434,000 654,800 896,720 1,013,144 983,509 866,820 736,129 590,327
The Worksheet for Cash Flows of the
MMCC (continued)
Again, production (in units) by year during 8-year life of the machine is
given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000).
Variable costs during first year (per unit) are $64 and (increase 5% per
year thereafter). Fixed costs are $50,000 each year.
Production costs in year 2 = 12,000[$64(1.05)
4
] + 50,000= $983,509.

(All cash flows occur at the end of the year.)
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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Income:
(1) Sales revenues 600,000 $ 918,000 $ 1,248,480 $ 1,379,570 $ 1,298,919 $ 1,104,081 $ 900,930 $ 689,211 $
(2) Operating costs 434,000 654,800 896,720 1,013,144 983,509 866,820 736,129 590,327
(3) 80,000 144,000 115,200 92,160 73,728 58,982 47,186 37,749 CCA
CCA calculations are based on
a class 8, 20% rate (shown at
right)
The machine cost $800,000.
CCA charge in year 5
=$368,640(.20) = $73,728.

Beginning Ending
Year UCC CCA UCC
1 400,000 $ 80,000 $ 320,000 $
2 720,000 144,000 576,000
3 576,000 115,200 460,800
4 460,800 92,160 368,640
5 368,640 73,728 294,912
6 294,912 58,982 235,930
7 235,930 47,186 188,744
8 188,744 37,749 150,995
Annual CCA
The Worksheet for Cash Flows of the
MMCC (continued)
(All cash flows occur at the end of the year.)
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The Worksheet for Cash Flows of the
MMCC (continued)
(All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Income:
(1) Sales revenues 600,000 $ 918,000 $ 1,248,480 $ 1,379,570 $ 1,298,919 $ 1,104,081 $ 900,930 $ 689,211 $
(2) Operating costs 434,000 654,800 896,720 1,013,144 983,509 866,820 736,129 590,327
(3) 80,000 144,000 115,200 92,160 73,728 58,982 47,186 37,749
(4) 86,000 119,200 236,560 274,266 241,682 178,278 117,615 61,136
(5) Taxes at 40% 34,400 47,680 94,624 109,707 96,673 71,311 47,046 24,454
(6) Net Income 51,600 71,520 141,936 164,560 145,009 106,967 70,569 36,682
[(1) (2) - (3)]
CCA
EBIT
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The Worksheet for Cash Flows of the
MMCC (continued)
(All cash flows occur at the end of the year.)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Investments:
(7) NWC (year end) 40,000 $ 90,000 $ 137,700 $ 187,272 $ 206,936 $ 194,838 $ 165,612 $ 135,139 $ 0 $
(8) Change in NWC (40,000) (50,000) (47,700) (49,572) (19,664) 12,098 29,226 30,473 135,139
(9) Equipment (800,000)
(10) Aftertax salvage 150,000
(11) Total cash flow (840,000) (50,000) (47,700) (49,572) (19,664) 12,098 29,226 30,473 285,139
of investment
[(8) + (9) + (10)]
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Incremental After Tax Cash Flows
(IATCF) of the MMCC
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
(1) Sales 600,000 $ 918,000 $ 1,248,480 $ 1,379,570 $ 1,298,919 $ 1,104,081 $ 900,930 $ 689,211 $
revenues
(2) Operating 434,000 $ 654,800 $ 896,720 $ 1,013,144 $ 983,509 $ 866,820 $ 736,129 $ 590,327 $
costs
(3) 34,400 47,680 94,624 109,707 96,673 71,311 47,046 24,454
(4) 131,600 215,520 257,136 256,720 218,737 165,949 117,755 74,430
(5) Total CF of (840,000) (50,000) (47,700) (49,572) (19,664) 12,098 29,226 30,473 285,139
Investment
(6) IATCF (840,000) 81,600 167,820 207,564 237,056 230,835 195,175 148,228 359,570
Taxes
OCF
[(4) + (5)]
[(1) - (2) - (3)]
(All cash flows occur at the end of the year.)
NPV@10% $500,135
NPV@10% $188,042
NPV@15% $2,280
NPV@20% ($137,896)
IRR 15.07%
If the projects
discount rate is
above 15.07%,
it should not be
accepted (since
NPV > 0).
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7.3 Inflation and Capital Budgeting
Inflation is an important fact of economic life and must be
considered in capital budgeting.
Consider the relationship between interest rates and inflation,
often referred to as the Fisher relationship:
(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)
For low rates of inflation, this is often approximated as
Real Rate ~ Nominal Rate Inflation Rate
While the nominal rate in the U.S. has fluctuated with
inflation, most of the time the real rate has exhibited far less
variance than the nominal rate.
When accounting for inflation in capital budgeting, one must
compare real cash flows discounted at real rates or nominal
cash flows discounted at nominal rates.
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Example of Capital Budgeting under Inflation
Canadian Electronics Inc. (CEI) has an investment opportunity to produce a
new stereo colour TV.
The required investment on January 1 of this year is $32 million. CCA
calculations are based on a class 8, 20% rate. The firm is in the 34% tax
bracket.
This investment will have no resale value at the end of the project (in four
years).
The price of the product on January 1 will be $400 per unit. The price will stay
constant in real terms.
Labour costs will be $15 per hour on January 1. The will increase at 2% per
year in real terms.
Energy costs will be $5 per TV; they will increase 3% per year in real terms.
The inflation rate is 5%.
Revenues are received and costs are paid at year-end.
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Example of Capital Budgeting under Inflation
The riskless nominal discount rate is 4%.
The real discount rate for costs and revenues is 8%. Calculate the
NPV.


Year 1

Year 2

Year 3

Year 4

Physical
Production
(units)

100,000

200,000

200,000

150,000

Labour Input
(hours)

2,000,000

2,000,000

2,000,000

2,000,000

Energy input,
physical units

200,000

200,000

200,000

200,000

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Present Value of the Tax Shield on CCA
The PV of CCA tax shield is a perpetuity, with an adjustment
for
the 1
st
year 50-percent rule
the sale of the asset at the time when the project is
terminated
The PV of CCA tax shield is given by:
| |
( )
n
c c
Shield Tax CCA
k d k
T d S
k
k
d k
T d C
PV
+

+
+

+

=
1
1
1
5 . 0 1

S = Min[resale value of assets, original price of assets]
C = original price of the assets
d = depreciation rate that applies to the asset class
d = discount rate
n = the time when assets are sold
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Example of Capital Budgeting under Inflation
The depreciation tax shield is a risk-free nominal cash flow, and
is therefore discounted at the nominal riskless rate.
Cost of investment today: C = $32,000,000
Project life: n = 4 years
Class 8 depreciation rate: d = 20%
Asset resale value: S = 0
Finally: k = 0.04 and T
C
= 0.34

The PV of CCA tax shield is given by:


| |
( )
308 , 892 , 8 $
04 . 1
1
2 . 04 .
34 . 2 . 0
04 . 1
04 . 5 (. 1
2 . 04 .
34 . 2 . 000 , 000 , 32
4

=

+

=
=
Shield Tax CCA
PV
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Example of Capital Budgeting under Inflation
Risky Real Cash Flows
Price: $400 per unit with zero real price increase
Labour: $15 per hour with 2% real wage increase
Energy: $5 per unit with 3% real energy cost increase
Year 1 After-tax Real Risky Cash Flows:
After-tax revenues =
$400 100,000 (1-.34) = $26,400,000
After-tax labour costs =
$15 2,000,000 1.02 (1-.34) = $20,196,000
After-tax energy costs =
$5 2,00,000 1.03 (1-.34) = $679,800
After-tax net operating CF =
$26,400,000 - $20,196,000 - $679,800 =$5,524,200
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Example of Capital Budgeting under Inflation
$5,524,200 $31,499,886 $31,066,882 $17,425,007
-$32,000,000
0 1 2 3 4
868 , 590 , 69 $
) 08 . 1 (
007 , 425 , 17 $
) 08 . 1 (
882 , 066 , 31 $
) 08 . 1 (
886 , 499 , 31 $
) 08 . 1 (
200 , 524 , 5 $
32 $
CFs risky
4 3 2
CFs risky
=
+ + + + =
PV
m PV
Year One After-tax revenues = $400 100,000 (1-.34) = $26,400,000
Year One After-tax labour costs = $15 2,000,000 1.02 (1-.34) = $20,196,000
Year One After-tax energy costs = $5 2,00,000 1.03 (1-.34) = $679,800
Year One After-tax net operating CF =$5,524,200
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Example of Capital Budgeting under Inflation
The project NPV can now be computed as the sum of the PV
of the cost, the PV of the risky cash flows discounted at the
risky rate, and the PV of the risk-free CCA tax shield cash
flows discounted at the risk-free discount rate.

NPV = -$32,000,000 + $69,590,868 + $8,892,308 = $46,483,176
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7.4 Investments of Unequal Lives: The
Equivalent Annual Cost Method
There are times when application of the NPV rule can lead to
the wrong decision. Consider a factory that must have an air
cleaner. The equipment is mandated by law, so there is no
doing without.
There are two choices:
The Cadillac cleaner costs $4,000 today, has annual
operating costs of $100 and lasts for 10 years.
The cheaper cleaner costs $1,000 today, has annual
operating costs of $500 and lasts for five years.
Which one should we choose?
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7.4 Investments of Unequal Lives: The
Equivalent Annual Cost Method
At first glance, the cheap cleaner has the lower NPV (r = 10%):
46 . 614 , 4
) 10 . 1 (
100 $
000 , 4 $
10
1
Cadillac
= =

= t
t
NPV
39 . 895 , 2
) 10 . 1 (
500 $
000 , 1 $
5
1
cheap
= =

= t
t
NPV
This overlooks the fact that the Cadillac cleaner lasts twice as
long.
When we incorporate that, the Cadillac cleaner is actually
cheaper.
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7.4 Investments of Unequal Lives: The
Equivalent Annual Cost Method
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 cheaper cleaner time line of cash flows over 10 years:
20 . 693 , 4 $
) 10 . 1 (
500 $
) 10 . 1 (
000 , 1 $
) 10 . 1 (
500 $
000 , 1 $
10
6
5
5
1
cheap
= =

= = t
t
t
t
NPV
46 . 614 , 4
) 10 . 1 (
100 $
000 , 4 $
10
1
Cadillac
= =

= t
t
NPV
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Investments of Unequal Lives
Replacement Chain
Repeat the projects forever, find the PV of that
perpetuity.
Assumption: Both projects can and will be repeated.
Matching Cycle
Repeat projects until they begin and end at the same
timelike we just did with the air cleaners.
Compute NPV for the repeated projects.
The Equivalent Annual Cost Method
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Investments of Unequal Lives: EAC
The Equivalent Annual Cost Method
Applicable to a much more robust set of circumstances
than replacement chain or matching cycle.
The Equivalent Annual Cost is the value of the level
payment annuity that has the same PV as our original set
of cash flows.
NPV = EAC A
r
T

For example, the EAC for the Cadillac air cleaner is
$750.98

= =
= =
10
1
10
1
) 10 . 1 (
98 . 750 $
46 . 614 , 4
) 10 . 1 (
100 $
000 , 4 $
t
t
t
t
The EAC for the cheaper air cleaner is $763.80
which confirms our earlier decision to reject it.
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Example of Replacement Projects
Consider a Belgian Dentists office; he needs an autoclave to
sterilize his instruments. He has an old one that is in use, but
the maintenance costs are rising and so he is considering
replacing this indispensable piece of equipment.
New Autoclave
Cost = $3,000 today,
Maintenance cost = $20 per year
Resale value after 6 years = $1,200
NPV of new autoclave (at r = 10%):
6
6
1
) 10 . 1 (
200 , 1 $
) 10 . 1 (
20 $
000 , 3 $ 74 . 409 , 2 $ + =

= t
t

=
6
1
) 10 . 1 (
29 . 553 $
74 . 409 , 2 $
t
t
EAC of new autoclave = -$553.29
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Example of Replacement Projects
Existing Autoclave
Year 0 1 2 3 4 5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600 500
Total Annual Cost
Total Cost for year 1 = (900 1.10 850) + 200 = $340
340 435
Total Cost for year 2 = (850 1.10 775) + 275 = $435
478
Total Cost for year 3 = (775 1.10 700) + 325 = $478
620
Total Cost for year 4 = (700 1.10 600) + 450 = $620
Total Cost for year 5 = (600 1.10 500) + 500 = $660
660
Note that the total cost of keeping an autoclave for the first year
includes the $200 maintenance cost as well as the opportunity cost of
the foregone future value of the $900 we didnt get from selling it in
year 0 less the $850 we have if we still own it at year 1.
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Example of Replacement Projects
340 435 478 620 660
- New Autoclave
+ EAC of new autoclave = -$553.29
- Existing Autoclave
Year 0 1 2 3 4 5
Maintenance 0 200 275 325 450 500
Resale 900 850 775 700 600 500
Total Annual Cost
We should keep the old autoclave until its cheaper to buy
a new one.
Replace the autoclave after year 3: at that point the new
one will cost $553.29 for the next years autoclaving and
the old one will cost $620 for one more year.
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7.5 Summary and Conclusions
Capital budgeting must be placed on an incremental basis.
Sunk costs are ignored
Opportunity costs and side effects matter
Inflation must be handled consistently
Discount real flows at real rates
Discount nominal flows at nominal rates
When a firm must choose between two machines of unequal
lives:
the firm can apply either the matching cycle approach
or the equivalent annual cost approach