Chapter Ten

Making Capital Investment Decision

Allen Zhu BFIN350 Advanced Corporate Finance 1

 Chapter Outline
1. Project Cash Flows: A First Look
2. Incremental Cash Flows
3. Pro Forma Financial Statements and Project Cash Flows
4. More on Project Cash Flow
5. Alternative Definitions of Operating Cash Flow
6. Applying the Tax Shield Approach to the Majestic Mulch
and Compost Company Project
7. Some Special Cases of Discounted Cash Flow Analysis
8. Summary and Conclusions
9. Appendix A – More on Inflation and Capital Budgeting
10. Appendix B – Capital Budgeting with Spreadsheets

10-2
© 2016 McGraw-Hill Education Limited
 Key Concepts and Skills
1. Understand how to determine the relevant
cash flows for a proposed project
2. Know how to project the cash flows and
determine if a project is acceptable
3. Understand the various methods for
computing operating cash flow
4. Be able to compute the CCA tax shield
5. Know how to evaluate cost-cutting proposals
6. Be able to analyze replacement decisions
7. Understand how to evaluate the equivalent
annual cost of a project
8. Know how to set a bid price for a project

10-3
 LO1
10.1: 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

10-4
 LO1
Asking the Right Question
You should always ask yourself “Will this cash flow
occur (or not 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 (or does not occur) because of the
project

10-5
 LO1
10.2: Common Types of Cash Flows
• Sunk costs – costs that have been incurred in
the past
• Opportunity costs – costs of lost options
• Side effects
• Positive side effects – benefits to other projects
• Negative side effects – costs to other projects
• Changes in net working capital
• Financing costs
• Inflation
• Capital Cost Allowance (CCA)

10-6
 10.3: Pro Forma Statements and Cash Flow
LO2

• Capital budgeting relies heavily on pro forma

accounting statements, particularly
statements of comprehensive income
• Computing cash flows – refresher
• Operating Cash Flow (OCF) = EBIT + depreciation
– taxes

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

spending (NCS) – changes in NWC

10-7
 Example – New Bottling Machine?
ABC Corporation is considering buying a new
bottling machine for $90,000. The machine
will be good for 3 years and will allow the
company to process and sell an additional
50,000 bottles per year at $4 per bottle.
Variable costs will be $2.50 per unit. Fixed
costs will be $12,000 per year. This project will
require an upfront investment in inventory of
$20,000 that will be reclaimed at the end of
the project. Depreciation will be straight line
with no salvage. The tax rate is 34% and the
required return is 20%.

10-8
Example:
LO2 Pro Forma Statement of Comprehensive Income

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
10-9
 Example: Projected Capital Requirements
LO2

Year

0 1 2 3

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

Net Fixed 90,000 60,000 30,000 0

Assets
Total $’s $110,000 $80,000 $50,000 $20,000
Invested
10-10
Example: Projected Incremental Cash Flows
LO2

Year
0 1 2 3

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

Change -$20,000 20,000
in NWC

Capital -$90,000
Spending

CFFA -$110,000 $51,780 $51,780 $71,780

10-11
 LO2 Making The Decision
• Now that we have the cash flows, we can apply
the techniques that we learned in chapter 9
• Assume the required return is 20%
• Enter the cash flows into the calculator and
compute NPV and IRR
• CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780
• NPV; I = 20; CPT NPV = 10,648
• CPT IRR = 25.8%
• Should we accept or reject the project?

10-12
 LO1
10.4: More on NWC
• Why do we have to consider changes in NWC
separately?
• GAAP requires that sales be recorded on the
statement of comprehensive income when
made, not when cash is received
• GAAP also requires that we record cost of goods
sold when the corresponding sales are made,
regardless of whether we have actually paid our
suppliers yet
• Finally, we have to buy inventory to support sales
although we haven’t collected cash yet

10-13
 LO1 NWC Example
• CWT Corp. reported sales of $998 and costs of
$734. We have the following info:
Beginning Ending
Accounts receivable $100 $110
Inventory 100 80
Accounts payable 100 70
Net working capital $100 $120

• What are the cash inflows?

• What are the Cash outflows?
• What is net cash flow?
10-14
 LO1
NWC Example - continued
• Cash Inflows
= Sales – Increase in A/R
= 998 – (110 – 100) = 988
• Cash Outflows
= Costs – Increase in A/P + Increase in Inventory
= 734 – (70 – 100) + (80 – 100) = 744
• Net Cash Flow
= Cash Inflow – Cash Outflow
= 988 – 744 = 244

10-15
 LO1
NWC Example - continued
Or alternatively:
• Change in NWC
= Increase in A/R + Increase in Inventory – Increase in A/P
= 10 + (-20) – (-30) = 20
• Net Cash Flow
= Sales – Costs – Change in NWC
= 998 – 734 – 20 = 244

10-16
 LO4 Capital Cost Allowance (CCA)
• CCA is depreciation for tax purposes
• The depreciation expense used for capital
budgeting should be calculated according
to the CCA schedule dictated by the tax
code
• Depreciation itself is a non-cash expense,
consequently, it is only relevant because it
affects taxes
• Depreciation tax shield = DT
• D = depreciation expense
• T = marginal tax rate

10-17
LO4 Computing Depreciation
• Need to know which asset class is
appropriate for tax purposes
• Straight-line depreciation
• D = (Initial cost – salvage) / number of years
• Very few assets are depreciated straight-line
for tax purposes
• Declining Balance
• Multiply percentage given in CCA table by the
un-depreciated capital cost (UCC)
• Half-year rule
• Can use PV of CCA Tax Shield Formula:

10-18
LO4 PV of CCA Tax Shield Formula
IdTc 1 + 0.5r S n dTc 1
PV tax shield on CCA = ´ - ´
d + r 1+ r d + r (1 + r ) n

Where:
• I = Total Capital Investment
• d = CCA tax rate
• Tc = Corporate Tax Rate
• r = discount rate
• Sn = Salvage value in year n
• n = number of periods in the project

10-19
 LO4 Example: Depreciation and 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%. If the applicable CCA rate is 20% and the
required return on this project is 10%, what is the
present value of the CCA tax shield?

10-20
LO4 Example: Depreciation and Salvage continued
The delivery and installation costs are capitalized in the
cost of the equipment
110,000 ´ 0.20 ´ 0.40 1 + 0.5 ´ 0.10
PV tax shield on CCA = ´
0.20 + 0.10 1 + 0.10

17,000 ´ 0.20 ´ 0.40 1

- ´
0.20 + 0.10 (1 + 0.10) 6

= 25,441.05

10-21
 10.5: Other Methods for Computing OCF
LO3

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

10-22
 LO4
10.6: Salvage Value versus UCC

10-23
 LO5 10.7: Cost Cutting – Example
• Your company is considering a new production system
that will initially cost $1 million. It will save $300,000 a
year in inventory and receivables management costs.
The system is expected to last for five years and will be
depreciated at a CCA rate of 20%. The system is
expected to have a salvage value of $50,000 at the
end of year 5. There is no impact on net working
capital. The marginal tax rate is 40%. The required
return is 8%.
• Click on the Excel icon to work through the example

10-24
 LO6
Example: Replacement Problem
• Original Machine • New Machine
• Initial cost = 100,000 • Initial cost = 150,000
• CCA rate = 20% • 5-year life
• Purchased 5 years ago • Salvage in 5 years = 0
• Salvage today = 65,000 • Cost savings = 50,000 per year
• Salvage in 5 years = • CCA rate = 20%
10,000 • Required return = 10%
• Tax rate = 40%
• 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?

10-25
 Example: Replacement Problem continued
LO6

• If we sell the old equipment today, then we will receive

$65,000 today. However, we will also NOT receive $10,000
in 5 years
• The appropriate number to use in the NPV analysis is the
net salvage value
• Always consider after-tax cash flows
• You can use your calculator for the cash flows and salvage,
but there are no short cuts for finding the PV of the CCA
tax shield

10-26
 Example: Replacement Problem continued
LO6

Net present value of the project is:

é 1 ù
ê1 - 5 ú 10,000
NPV = -150,000 + 65,000 + 50,000(1 - 0.4) ê 1.1 ú - 5
ê 0.10 ú 1.10
ë û

65,000 ´ 0.2 ´ 0.4 1 + 0.5 ´ 0.1 10,000 ´ 0.2 ´ 0.4 1

- ´ + ´
0.10 + 0.20 1.10 0.10 + 0.20 1.105

150,000 ´ 0.2 ´ 0.4 1 + 0.5 ´ 0.1

+ ´
0.10 + 0.20 1.10

NPV = 45,806.54

Therefore, the old equipment should be replaced.

10-27
 Example: Equivalent Annual Cost Analysis
LO7

• Machine A
• Initial Cost = $150,000
• Pre-tax operating cost =
$65,000
• Expected life is 8 years
• Machine B
• Initial Cost = $100,000
• Pre-tax operating cost =
$57,500
• Expected life is 6 years

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 10%, the applicable CCA rate is 20%
and the tax rate is 40%.
Which machine should you buy?

10-28
 LO8
Example: Setting the Bid Price
• Consider the example in the textbook:
• Need to produce 5 modified trucks per year for 4 years
• We can buy the truck platforms for $10,000 each
• Facilities will be leased for $24,000 per year
• Labour and material costs are $4,000 per truck
• Need $60,000 investment in new equipment,
depreciated at 20% (CCA class 8)
• Expect to sell equipment for $5,000 at the end of 4 years
• Need $40,000 in net working capital
• Tax rate is 43.5%
• Required return is 20%

10-29
 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?

10-30
 10.8: Summary
You should know:
• How to determine the relevant incremental
cash flows that should be considered in capital
budgeting decisions
• How to calculate the CCA tax shield for a given
investment
• How to perform a capital budgeting analysis
for:
• Replacement problems
• Cost cutting problems
• Bid setting problems
• Projects of different lives

10-31
Appendix A – Impact of Inflation
• The interest rate used in the capital budgeting analysis can be in
either nominal or real terms
• Real Rate = Nominal Rate – Expected Inflation
• Also, cash flows can be either nominal or real

10-32 © 2016 McGraw-Hill Education Limited

How to handle inflation
• Key – Be consistent
• Nominal cash flows must be discounted by the nominal
discount rate
• Real cash flows must be discounted by the real discount
rate
• NPV is the same under the two different approaches
• Use the approach that is simpler for the information
that you’re given

10-33 © 2016 McGraw-Hill Education Limited

Appendix B – Capital Budgeting with
Spreadsheets
• Spreadsheets are almost essential for capital budgeting, especially
when using pro forma statements
• Since spreadsheets completely integrate the different tables needed
for the capital budgeting analysis, changing on variable instantly
recalculates the results for the entire spreadsheet
• Very useful for sensitivity analysis calculations

10-34
© 2016 McGraw-Hill Education Limited