Chapter 10

Making Capital
Investment Decisions

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Understand how to determine the
relevant cash flows for various types
of proposed investments
• Understand the various methods for
computing operating cash flow
• Understand how to set a bid price for
a project
• Understand how to evaluate the
equivalent annual cost of a project

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 Chapter Outline
• Project Cash Flows: A First Look
• Incremental Cash Flows
• Pro Forma Financial Statements and
Project Cash Flows
• More about Project Cash Flow
• Alternative Definitions of Operating Cash
Flow
• Some Special Cases of Discounted Cash
Flow Analysis

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 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 difference between a firms’ future CFs with
a project and those without the project.
– The change in a firm’s future CFs is a direct
consequence of taking the project

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 Relevant Cash Flows
• The stand-alone principle
• The assumption that evaluation of a project
may be based on the project’s incremental
CFs.
• By viewing projects as “mini-firms,” we
imply that the firm as a whole constitutes a
portfolio of mini-firms. As a result, the value
of the firm equals the combined value of its
components

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 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

• Sunk cost – a cost that has already been

incurred and cannot be removed and therefore
it is not relevant to an investment decision.
– E.g., Consulting fee
• Opportunity cost – the most valuable
alternative that is given up if a particular
investment is undertaken
– E.g., Converting an old cotton mill we bought years
ago for $100,000 into upmarket condominiums

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Common Types of Cash Flows
• Side effects
▪ Positive side effects – benefits to other
projects
▪ E.g., you will establish a new distribution
system with this project that can be used for
existing or future projects
▪ Negative side effects (i.e., Erosion) – costs
to other projects
▪ E.g., McDonald’s introduction of the Arch
Deluxe sandwich. Instead of generating all
new sales, it primarily reduced sales in the
Big Mac and the Quarter Pounder.

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Common Types of Cash Flows
• Changes in net working capital
– Most projects will require an initial investment in
inventories and accounts receivable to cover
credit sales. Then, we recover NWC at the end
of the project.
• Financing costs
– We do not include financing costs in a project
evaluation because they are the financing-
related CFs while we are interested in the CFs
directly generated by the assets of the project
(ie., OCF).
• Taxes
– We are interested in after-tax incremental CFs
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 Pro Forma Statements and
Cash Flow
• Capital budgeting relies heavily on pro
forma accounting statements, particularly
income statements
• Computing cash flows – refresher
▪ 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 NWC

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 Example: Prepare pro forma financial
statements; project CFs; and compute the
project’s NPV
• We can sell 50,000 cans of shark attractant per year
at a price of $4 per can. It costs us about $2.50 per
can to make the attractant, and a new product such as
this one typically has only a three-year life. We require
a 20 percent return on new products. Fixed costs for
the project, including such things as rent on the
production facility, will run $12,000 per year. We will
need to invest a total of $90,000 in manufacturing
equipment. Assuming that this $90,000 will be 100%
depreciated over the 3-year life of the project. The
cost of removing the equipment will roughly equal its
actual value in three years, so it will be essentially
worthless on a market value basis. Finally, the project
will require an initial $20,000 investment in net
working capital, and the tax rate is 34%.
 Table 10.1 Pro Forma Income
Statement, Shark Attractant Project

Sales (50,000 units at $4.00/unit) $200,000

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

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Table 10.2 Projected Capital
Requirements
Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000

NFA 90,000 60,000 30,000 0

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

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Table 10.5 Projected Total
Cash Flows

Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change -$20,000 20,000
in NWC
NCS -$90,000

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

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Should we accept or reject
the project?
 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 cash
is received
▪ GAAP also requires that we record cost of
goods sold (COGS) when the corresponding
sales are made, whether we have actually paid
our suppliers yet
▪ Finally, we have to buy inventory to support
sales, although we haven’t collected cash yet

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 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
• Depreciation tax shield = D x T
▪ D = depreciation expense
▪ T = marginal tax rate

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 Computing Depreciation
• Straight-line depreciation
▪ D = (Initial cost – salvage) / number of years
▪ Very few assets are depreciated straight-line
for tax purposes
• MACRS depreciation (Modified ACR)
▪ Need 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

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 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)

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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. The company’s marginal tax rate is
40%. What is the depreciation expense
each year and the after-tax salvage in year
6 for each of the following situations?

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 Example: 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: Three-year
MACRS
Year MACRS D BV in year 6 =
percent 110,000 – 36,663 –
1 .3333 .3333(110,000) 48,895 – 16,291 –
= 36,663 8,151 = 0
2 .4445 .4445(110,000)
= 48,895 After-tax salvage
= 17,000 -
3 .1481 .1481(110,000)
.4(17,000 – 0) =
= 16,291
$10,200
4 .0741 .0741(110,000)
= 8,151

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 Example: Seven-Year
MACRS
Year MACRS D BV in year 6 =
Percent
110,000 – 15,719 –
1 .1429 .1429(110,000) = 26,939 – 19,239 –
15,719
13,739 – 9,823 –
2 .2449 .2449(110,000) =
26,939 9,812 = 14,729
3 .1749 .1749(110,000) =
19,239 After-tax salvage
4 .1249 .1249(110,000) = = 17,000 –
13,739 .4(17,000 –
5 .0893 .0893(110,000) = 9,823 14,729) =
16,091.60
6 .0892 .0892(110,000) = 9,812

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Other Methods for Computing
OCF
• Bottom-Up Approach
▪ Works only when there is no interest expense
▪ OCF = NI + depreciation
• Top-Down Approach
▪ OCF = Sales – Costs – Taxes
▪ Don’t subtract non-cash deductions
• Tax Shield Approach
▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T

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 Example: Replacement
Problem
• Original Machine • New Machine
▪ Initial cost = 100,000 ▪ Initial cost = 150,000
▪ Annual depreciation = ▪ 5-year life
9,000 ▪ Salvage in 5 years =
▪ Purchased 5 years ago 0
▪ Book Value = 55,000 ▪ Cost savings =
▪ Salvage today = 50,000 per year
65,000 ▪ 3-year MACRS
▪ Salvage in 5 years = depreciation
10,000 • Required return = 10%
• Tax rate = 40%

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 3 special cases of
discounted cash flow analysis
 Case 1: Evaluating cost-cutting
proposals

• You are considering automating some part of an

existing production process. The necessary
equipment costs $80,000 to buy and install. The
automation will save $22,000 per year (before
taxes) by reducing labor and material costs.
Assuming that the equipment has a 5-year life and
is depreciated to 0 on a straight-line basis over the
period. It will actually be worth $20,000 in 5 years.
The tax rate is 34%; the discount rate is 10%.
Should we automate?

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Case 2: Setting the bid price
• You are in the business of buying stripped-down truck
platforms and then modifying them to customer
specifications for resale. A local distributor has requested
bids for 5 specially modified trucks each year for the next 4
years, for a total of 20 trucks in all.
• Suppose you can buy the truck platforms for $10,000 each.
The facilities we need can be leased for $24,000 per year.
The labor and material cost to do the modification works out
to be about $4,000 per truck. You will need to invest
$60,000 in new equipment. This equipment will be
depreciated straight-line to a 0 salvage value over the 4
years. It will worth about $5,000 at the end of that time. You
also need to invest $40,000 in raw materials inventory and
other working capital items. The relevant tax rate is 39%.
What price per truck should you bid if you require a 20%
return on your investment?
 Case 3: Evaluating equipment
options with different lives
• Note: This approach is necessary
only when 02 special circumstances
exits:
– Different economic lives;
– Indefinite need.
 Case 3: Evaluating equipment
options with different lives
• You are in the business of
manufacturing stamped metal
subassemblies. Whenever a
stampling mechanism wears out, you
have to replace it with a new one to
stay in business. You are considering
which of two stamping mechanisms
to buy.
• Machine A costs $100 to buy and
$10 per year to operate. It wears out
 Case 3: Evaluating equipment
options with different lives
• Note:
– The costs are not directly comparable
because of the difference in economic
lives.
– Comparison of Equivalent Annual Cost
(EAC) works.
• EAC: The present value of a project’s costs
calculated on an annual basis.
 Quick Quiz
• How do we determine if cash flows are
relevant to the capital budgeting decision?
• What are the different methods for
computing operating cash flow and when
are they important?
• What is equivalent annual cost and when
should it be used?

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