Chapter

10

Making Capital
Investment Decisions

10-1
McGraw-Hill/Irwin

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

Chapter Outline
Capital Budgeting and Cash
Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Special Cases of DCF Analysis
o Cost Cutting
10-2

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 (CFs) are
determined.
10-3

Project Example Visual

R = 12%
1

$ -165,000

10-4

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).

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
Cash flows that will occur
whether or not we accept a
project are NOT relevant.

These cash flows are called

incremental cash flows

10-5

The stand-alone principle

allows us to analyze each

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

10-6

If the answer is part of it, then we

should include the part that occurs
because of the project

Common Types of
Cash Flows
1. Sunk costs costs that have
accrued in the past: Should
they be included?
2. Opportunity costs costs of
lost options

10-7

3. Changes in net working capital

(NWC)
o Assumed to be recovered at

Common Types of
Cash Flows
6. Side effects:
Positive side effects
benefits to other projects
Negative side effects
(erosion) costs to other
projects

10-8

Pro Forma Statements and

Cash Flow
Capital budgeting relies heavily on pro forma

accounting statements, particularly income

statements
Computing Net Cash Flows (NCFs):

1. Initial Cash Outlay = Project Cost + Change in

NWC
2. Operating Cash Flows (OCFs)

Tax Shield Approach:

OCF = (Sales - Costs) (1 - T) + Depreciation * T

(OCF = EBIT + Depreciation Taxes)

3. Terminal Cash Flow = Salvage Value Taxes +

Recovery of NWC

Pro Forma
Statements and Cash
Flow
CF Definitions (MUST KNOW AT ALL
TIMES):
Operating Cash Flow
(OCF)=

EBIT + depreciation
OCF =taxes
NI + Dep.

(when there is no interest

expense)

Cash Flow From Assets (CFFA) =

OCF net capital spending (NCS)
changes in NWC (NWC)

10-10

Different Ways to Compute

OCFs
MUST KNOW AT ALL TIMES
o Most common financial calculation for OCF is:
OCF = EBIT + Depreciation Taxes
o The top-down approach to calculating OCF
yields:
OCF = Sales Costs Taxes
Do not subtract non-cash deductions

o The tax-shield approach is:

OCF = (Sales Costs).(1 tC) + tC .
Depreciation
10-11

o The bottom-up approach is:

OCF = Net income + Depreciation

Example: Pb. 5 Ch.10

Most common financial calculation
for OCF:
OCF = EBIT + Depreciation Taxes
OCF = $50,200 + 6,800 17,570 =
$39,430
Top-down approach:
OCF = Sales Costs Taxes
(Depreciation is NOT deducted here)

OCF = $108,000 51,000 17,570 =

$39,430
Tax-shield approach:
OCF = (Sales Costs)(1 T) +
T.Dep.
OCF = ($108,000 51,000)(1 .35) + .
35(6,800) = $39,430

Getting Started: The

Project
You have been thinking about starting a new
project to produce mobile phone plastic
cases. Your business plan can be
summarized as follows:

o You estimate you can sell 50,000 pieces @ $4

each. Production cost is $2.5 per unit. Project is
expected to have a life a three years. The
machine needed would cost $90,000 and will be
fully depreciated over the life of the project.
o Fixed costs (for rent of production facility and
other) are estimated at $12,000
o The project is expected to require an initial
investment in net working capital of $20,000.
10-13
o Similar projects offer a 20% rate of return

Getting Started:
Project Pro Forma
Income Statement

10-14

OCF = EBIT + Dep Tax =

51,780.00

Projected Total Cash

Flows
OCF
NWC
NCS
=
CFFA

Capital
spending at
the time of
project
inception
(i.e.,
the
initial

10-15

NCS
=

+ Purchase price of the

new asset
Selling price of the asset
replaced (if applicable)
+ Costs of site preparation,
setup, and startup
+(-) Increase (decrease) in
tax liability due to sale of
old asset at other than

Project Example Visual

R = 20%
1

$ -110,000

10-16

CF1 =
51,780

2
CF2 =
51,780

3
CF3 =
71,780

The required return for assets of this

risk level is 20% (as determined by
the firm).

Whats Your
Decision?
So...What
do you
think? Deal
or No Deal?

10-17

More on NWC
Why do we have to consider changes in

NWC separately?

10-18

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 havent
collected cash yet.

Depreciation
The 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

= D.T

Where D is depreciation expense and T is

rate of the firm
10-19

marginal tax

Computing
Depreciation
Straight-line depreciation

D = (Initial cost salvage) / number of years

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

To compute depreciation expense:

o First need to know which asset class is

appropriate for tax purposes

o Multiply percentage given in table by the
initial cost
o Depreciate to zero
10-20

After-tax Salvage
If the salvage(market) value

is different from the book

value of the asset, then there
is a tax Book
effectValue =
Initial cost accumulated
depreciation

10-21

CF toAfter-tax
consider
is AT Salvage:
salvage
=
Salvage T*(Salvage BV@ time
of sale)

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

10-22

4.After-tax Salvage =
Market Value taxes paid

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.
10-23

Example:
Depreciation and
After-tax Salvage
The companys marginal tax rate is 40%.
What is the depreciation expense and the
after-tax salvage (AT-Salvage) in year 6
for each of the following three scenarios?
A. Straight line Depreciation
B. MACRS 3-years
C. MACRS 6 years
0
$ -110,000
10-24

6
Sell =
$17,000

A: 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
Book Value = Initial cost accumulated
depreciation
AT-Salvage = 17,000 - 0.4.(17,000 17,000)
After-tax salvage =
= 17,000
Salvage T*(Salvage BV@ time of sale)
10-25

A: Straight-Line
The companys marginal tax rate
is 40%.
Market Selling Price
= $17,000
Book Value at year 6 = $17,000
Capital gain/loss
=
0
Taxes paid on gain/loss = ($0).40 =
$0

10-26

After-tax salvage value:

17,000 -After-tax
.40 (17,000
salvage
= 17,000) =
Salvage T*(Salvage BV@ time of
$17,000
sale)

B: 3-year MACRS
1

MACRS
percent
.3333

.4445

.1481

.0741

Year

10-27

Depreciation
per year
.3333.(110,000) Dep1=
$36,663
.4445.(110,000) Dep2=
$48,895
.1481.(110,000) Dep3=
$16,291
.0741.(110,000) Dep4=
$8,151

B: 3-Year MACRS
The companys marginal tax rate
is 40%.
Market Selling Price
= $17,000
Book Value at year 6:
$ 0
Capital gain/loss
= $17,000
Taxes paid on gain/loss =
($17,000).40
= $ 6,800
AT salvage value: 17,000 - .40
(17,000 0) =
$10,200
After-tax
salvage =
10-28

Salvage T*(Salvage BV@ time of

sale)

C: 7-Year MACRS
Year
1

10-29

MACRS
Depreciation
Percent
Per year
.1429 .1429(110,000) =
D1=$15,719

.2449

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

.1749

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

.1249

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

C: 7-year MACRS
The companys marginal tax rate
is 40%.
Market Selling Price = $17,000
Book Value at year 6 = $14,729
Capital gain /loss
= $ 2,271

10-30

Taxes paid on gain/loss =

$2,271x40%
= $908.40
After-tax salvage value:
17,000 - After-tax
.40 (17,000
salvage=14,729) =
Salvage T*(Salvage BV@ time of
$16,091.60
sale)

Example: Cost
Cutting
1. Your company is considering a new computer

system with initial cost =$1 million.

2. It will generate $300,000 per year cost
savings.
3. System expected to last for 5 years and will
be depreciated using 3-year MACRS.
4. System expected to have a salvage value
of $50,000 at the end of year5.
5. There is no impact on NWC.
6. The marginal tax rate is 40%.
7. The required return is 8%.

10-31

Cost Cutting - Analysis

Initial Cost
Savings
Tax Rate
Expected
Salvage
Discount
Rate

1,000,0
00
300,00
0
40%
50,000
8%

10-32

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?

10-33

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

10-34

After-tax salvage = salvage

T (salvage book value at time
of sale)

Formulas
(continued)
Operating
Cash Flow Formula:
Bottom-Up Approach
OCF = NI + depreciation
Top-Down Approach
OCF = Sales Costs Taxes
Tax Shield Approach
OCF = (Sales Costs)(1 T) +
Depreciation*T
10-35

What are the most

important topics of
this chapter?

10-36

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