Lecture8 - Capital Investment Decisions

FINA1310EFG CORPORATE FINANCE
Lecture 8. Making Capital Investment Decisions
Instructor: Dr. Mingzhu TAI

Faculty of Business and Economics
The University of Hong Kong
Spring semester, 2018-2019

Review of Lecture 7
Common techniques to identify valuable investments:
• Baseline technique:
‒ Net Present Value (NPV)
• Alternative techniques:
‒ The Internal Rate of Return (IRR)
‒ The Payback Rule
‒ The Average Accounting Return (AAR)
‒ The Profitability Index (PI)
• Textbook Reading: Chapter 9
FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 2

Capital Budgeting
• Investment criteria
(Techniques to identify valuable investments)
‒ Lecture 7 (Chapter 9)
• Cash flows
‒ Lecture 8 (Chapter 2 & 10)
• Project analysis
• Cost of Capital

Cash Flow VS Accounting Income
• Project evaluation should base on cash flows
Example:
A project costs $100,000 today and is expected to last for two years, with the
following cash flows and accounting income (assume the discount rate is 20%):
Year 1 Year 2 NPV (r=20%)
Accounting Income +$50,000 +$50,000 $76,389-100,000=-$23,611
Depreciation -$20,000 -$20,000
Change in Accounts Payable +$30,000 -$30,000
Cash Inflow +$100,000 +$40,000 $111,111-100,000=$11,111

Today’s Roadmap
• Determine the relevant cash flows
• Estimating cash flows based on the pro forma financial statements
‒ Project cash flow estimation
 General formula
 Alternative approaches to calculate OCF
‒ More on project cash flows:
 Net working capital
 Depreciation
• Special cases of discounted cash flow analysis
‒ Case I. Evaluating cost-cutting proposals
‒ Case II. Setting bid price
‒ Case III. Evaluating equivalent costs for options with different lives
Today’s Roadmap
 General formula
 Depreciation
Relevant Cash Flows
• The Incremental Cash Flows:

‒ Any and all changes in the firm’s future cash flows that are a direct
consequence of taking the project
‒ Cash flows that will only occur if the project is accepted
• The Stand-alone Principle:

‒ Treat the project as an independent “minifirm” by simply focusing on the
incremental cash flows

Relevant Cash Flows
• How to determine the incremental cash flows:
Will this cash flow occur ONLY if

we accept the project?
YES NO PART of it
Do NOT ONLY include the part that occurs as a

Include it
include it consequence of the project

Incremental Cash Flows
• What you should include:
‒ Direct costs
‒ Opportunity costs
‒ Side effects
‒ Net working capital
‒ Tax consequences
• What you should NOT include
‒ Sunk costs
‒ Financing costs

Opportunity Costs
• Definition:
‒ A benefit that you give up in order to take the project
• Common situations:
‒ When you use existing facilities, equipment, etc., include the current market
value of them as the opportunity costs
• Example:
You are thinking of opening a coffee shop next to HKU campus. You bought the
shopfront last year at $20 million and its market price is $25 million now.
If you expect a cash inflow of $2 million per year forever and the discount rate is
9%. Should you open the coffee shop?

Opportunity Costs
• Definition:
‒ A benefit that you give up in order to take the project
‒ When you use existing facilities, equipment, etc., include the current market
value of them as the opportunity costs
• Example:
You are thinking of opening a coffee shop next to HKU campus. You bought the
shopfront last year at $20 million and its market price is $25 million now.
If you expect a cash inflow of $2 million per year forever and the discount rate is
9%. Should you open the coffee shop?
NPV=$2/0.09-$25= -$2.78 million

Side Effects
• Negative side effects:
‒ Erosion: negative impacts on existing products from the introduction of a new
product
‒ Examples:
 Introducing iphone X reduces the sales of iphone 7
 Building the Shanghai Disney reduced Hong Kong Disney revenue
• Positive side effects:
‒ Cross-selling: positive impacts on existing products from the introduction of a
new product
‒ Examples:
 Promoting printer sales could improve cartridge sales
 Encouraging people to open a savings account may also increase credit card accounts

Sunk Costs
• Definition:
‒ A cost that is already paid for or incurred, and cannot be changed by the decision
today to accept or reject a project
‒ You should not include the R&D costs that already incurred before you decide
whether to produce the product
‒ You should not take into account the money you already spent on the project when
you need to decide whether to continue or terminate the project
• Example:
A real estate company started to build a new estate two years ago and has spent over $1
billion on it. Recently a new analyst report comes out suggesting that the place is
inappropriate for residential development and the expected revenues cannot cover what is
going to further cost to finish the project.
Should the company terminate the project?
How about if the expected revenues can cover the further costs, but cannot cover the
further costs + the $1 billion that is already spent?

Financing Costs
• Financing costs could include:
‒ Interest payments, dividends, principal payments, administrative and
transaction costs in issuing bonds or stocks, …
Cash flow to creditors

Cash flow from assets
Cash flow to shareholders
Capital Budgeting Capital Structure

Today’s Roadmap
 General formula
 Depreciation
Pro Forma Financial Statements & Cash Flows
• Cash flows for a firm:
Cash Flow from Assets = Operating cash Flow
- Net Capital Spending
- Change in Net Working Capital
• Cash flows for a project:
Project Cash Flow = Project Operating cash Flow

- Project Capital Spending
- Project Change in Net Working Capital

• Pro Forma Financial Statements:
‒ Financial statements that summarize future business activities based on
certain assumptions and projections
‒ Financial statements made ready ahead of a planned project
‒ They exclude unusual or nonrecurring transactions
• Example:
A firm expect to sell 50,000 shark attractant per year at a price of $4 per can. It
costs $2.50 to produce one can. The product has a 3-year life. The required return
is 20% on this new product.
The fixed cost for the production is $12,000 per year. The firm needs to invest a
total of $90,000 in manufacturing equipment, which will be 100% depreciated over
the 3-year life of the project. In 3 years, the equipment has zero market value.
Assume the project needs an initial $20,000 investment in net working capital, and
the tax rate is 34%.
Summarizing the example:
Project: Selling Shark Attractant
‒ Sales volume = 50,000 cans/year
‒ Unit price = $4/can
‒ Unit cost = $2.50/can
‒ Fixed cost = $12,000/year
‒ Project life = 3 years
‒ One-time capital spending = $90,000
‒ Depreciation: straight-line over 3years, 100% depreciation
‒ Salvage value = $0
‒ Initial investment in NWC = $20,000
‒ Tax rate = 34%
‒ Required rate of return = 20%

Projected Operating Cash Flow
• The Pro Forma Income Statement:
Sales (50,000 units at $4/unit) $200,000
Variable costs ($2.50/unit) 125,000
Fixed Costs 12,000
Depreciation ($90,000/3 years) 30,000
EBIT $33,000
Taxes (34%) 11,220
Net Income $21,780

Projected Operating Cash Flow
Projected Operating Cash Flow = EBIT – Taxes + Depreciation:
EBIT $33,000
Taxes (34%) -11,220
Depreciation ($90,000/3 years) +30,000
Projected Operating Cash Flow (OCF) $51,780

Operating Cash Flow: Alternative Calculations
• The Bottom-Up Approach
Fixed Costs 12,000
EBIT $33,000
Taxes (34%) 11,220
Net Income $21,780
OCF = Net Income + Depreciation

= $21,780 + 30,000
= $51,780

• The Top-Down Approach
Fixed Costs 12,000
EBIT $33,000
Taxes (34%) 11,220
Net Income $21,780
OCF = Sales – Costs - Taxes

= $200,000 – (125,000+12,000) – 11,220
= $51,780

• The Tax Shield Approach
Fixed Costs 12,000
EBIT $33,000
Taxes (34%) 11,220
Net Income $21,780
OCF = (Sales – Costs) × (1-T) + Depreciation × T

= [$200,000 – (125,000+12,000)]×(1-0.34) + 30,000×0.34
= $51,780

Projected Total Cash Flows
Year
0 1 2 3
Project Operating Cash Flow (OCF) +$51,780 +$51,780 +$51,780
Project Capital Spending -$90,000
Project Changes in Net Working Capital -$20,000 +$20,000
Total Project Cash Flow -$110,000 +$51,780 +$51,780 +$71,780

Decision Making
Year
0 1 2 3
Project Operating Cash Flow (OCF) +$51,780 +$51,780 +$51,780
Project Capital Spending -$90,000
Project Changes in Net Working Capital (NWC) -$20,000 +$20,000
Total Project Cash Flow -$110,000 +$51,780 +$51,780 +$71,780
• Calculating the NPV and IRR based on the projected cash flow:
51,780 51,780 71,780
𝑁𝑁𝑁𝑁𝑁𝑁=−$110,000 + + + = $10,648
1.2 1.22 1.23
IRR=25.8%
Should you take this new project and start producing the shark attractant?

Today’s Roadmap
 General formula
 Depreciation
More on Project Cash Flows: NWC
Why do we need to take NWC into account?
• Revenues and costs are recorded when transactions occur, not when
cash flows occur:
‒ Accounts receivables: some of the sales could be on credit and the cash
inflow is delayed
‒ Accounts payables: some of the costs could be actually paid later and the cash
outflow is delayed
• Inventory is needed to support sales:
‒ “Invest” cash to build up inventory at the beginning, and “cash out” by
consuming the inventory at the end

Beginning of Year End of Year Over the Year
Sales $900
costs $750
Accounts receivable $100 $110 +$10 ← Cash inflow < Sales
Inventory 100 80 -$20 ← Cash outflow < Costs
Accounts payable 100 70 -$30 ← Cash outflow > Costs
Net Working Capital (NWC) $100 $120 ∆NWC: +$20 ← Net cash flow
< Acc. income
Assume depreciation and tax are zero:
Total Cash Flow = + Operating Cash Flow
- Capital Spending
- Change in NWC
= $150 – 0 – 20 = $130

Beginning of Year End of Year Over the Year
Sales $900
costs $750
Accounts receivable $100 $110 +$10 ← Cash inflow < Sales
Inventory 100 80 -$20 ← Cash outflow < Costs
Accounts payable 100 70 -$30 ← Cash outflow > Costs
Net Working Capital (NWC) $100 $120 ∆NWC: +$20 ← Net cash flow
< OCF
Assume depreciation and tax are zero:
Total Cash Flow = Cash inflow – Cash outflow
= ($900-10) – ($750-20+30)
= $130

More on Project Cash Flows: Depreciation
• How accounting depreciation affects OCF?
‒ It is a noncash deduction:
 Exclude depreciation in the top-down approach
 Add back depreciation in the bottom-up approach
‒ It affects tax:
 Depreciation provides a tax shield
• A few concepts
‒ Tax life: length of time until the book value decreases to zero
‒ Economic life: how long the asset is in service
‒ Salvage value: the value of asset when it is disposed

Computing Depreciation
• Straight-line depreciation:
‒ Every year the asset value depreciate by the same amount
(A residential property is depreciated straight-line over 27.5 years)
Annual Depreciation = Initial Cost / Tax Life
• MACRS (Modified Accelerated Cost Recovery System):

‒ Every asset is assigned to a particular asset class
‒ Each asset class has a specific tax life
‒ At the end of the tax life, the book value equals to zero
‒ Every year for each asset class, a percentage of depreciation is specified
Annual Depreciation = Initial Cost × MACRS Percentage

MACRS
Asset Class
Year Three-Year Five-Year Seven-Year
(Equipment used in research) (Autos, computers) (Most industrial equipment)
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
Total 100% 100% 100%

MACRS
For a research equipment (three-year tax life) with initial cost of $100,000:
Year MACRS Percentage Depreciation Ending Book Value

1 33.33% 33.33% × $100,000=$33,330 $66,670
2 44.45 44.45% × $100,000=$44,450 $22,220
3 14.81 14.81% × $100,000=$14,810 $7,410
4 7.41 7.41% × $100,000=$7,410 $0

Salvage Value
• Assume the equipment is sold for $30,000 at the end of year 2:
‒ Book value: $22,220
‒ Market value: $30,000
The equipment is over-depreciated
‒ The over-depreciation provides more tax shield than it should
Additional tax liability: 34% × ($30,000-$22,220)=$2,645.20
• Assume the equipment is sold for $20,000 at the end of year 2:
‒ Book value: $22,220
‒ Market value: $20,000
The equipment is under-depreciated
‒ The under-depreciation provides less tax shield than it should
A tax refund: 34% × ($22,220-$20,000)=$754.80

A Detailed Example
A firm is investigating the feasibility of a new production line:
• Operation
‒ The variable cost is $60 per unit and total fixed costs are $50,000 every year
‒ Sales projection is as below:
Year Unit Sales Unit Price

1 8,000 $120
2 12,500 $115
3 11,000 $110
4 7,000 $110

A Detailed Example
A firm is investigating the feasibility of a new production line:
• Fixed assets
‒ $800,000 needs to be invested today (year 0)
‒ The fixed assets depreciate on a straight-line basis over the four years
‒ At the end of year 4, book value is zero and market salvage value is expected to be 20% of the
initial cost
• Working Capital
‒ The project requires $40,000 in net working capital to start
(e.g. inventory + accounts receivable – accounts payable)
‒ Subsequently, NWC will be 15% of annual sales at the end of each year
• Additional information
‒ Tax rate is 34%
‒ Required return is 25%

A Detailed Example
• Pro forma income statement:
Year 1 Year 2 Year 3 Year 4
Unit Price $120 $115 $110 $110
Unit Sales 8,000 12,500 11,000 7,000
Revenues (Total Sales) $960,000 $1,437,500 $1,210,000 $770,000
Variable Costs ($60 × Unit Sales) 480,000 750,000 660,000 420,000
Fixed Costs 50,000 50,000 50,000 50,000
Depreciation
200,000 200,000 200,000 200,000
(Initial Cost/ Tax Life = $800,000/4)
EBIT $230,000 $437,500 $300,000 $100,000
Taxes (34%) 78,200 148,750 102,000 34,000
Net Income $151,800 $288,750 $198,000 $66,000

A Detailed Example
• Projected operating cash flow (OCF)
EBIT $230,000 $437,500 $300,000 $100,000
Depreciation 200,000 200,000 200,000 200,000
Taxes (34%) 78,200 148,750 102,000 34,000
Projected Operating Cash Flow $351,800 $488,750 $398,000 $266,000

A Detailed Example
• Projected changes in net working capital (NWC):
Year 0 Year 1 Year 2 Year 3 Year 4
Revenues (Total Sales) $960,000 $1,437,500 $1,210,000 $770,000
Net Working Capital (15% × Sales) $40,000 144,000 215,625 181,500 115,500
Changes in NWC -$40,000 -$104,000 -$71,625 +$34,125 +$66,000
NWC Recovery +115,500
Total Changes in NWC -$40,000 -$104,000 -$71,625 +$34,125 +$181,000

A Detailed Example
• Projected capital spending:
After-tax Salvage = Salvage Value – (Salvage Value – Ending Book Value) × Tax Rate
=$800,000 × 20% - (800,000 × 20% - 0) × 34%
=$160,000-160,000 × 34%
=$105,600

Initial Investment -$800,000
After-tax Salvage $105,600
Capital Spending -$800,000 $105,600

A Detailed Example
• Projected Cash Flows:
Project Operating Cash Flow $351,800 $488,750 $398,000 $266,000
Total Changes in NWC -$40,000 -$104,000 -$71,625 $34,125 $181,000
Total Project Cash Flow -$840,000 $247,800 $417,125 $432,125 $552,600
Cumulative Cash Flow -$840,000 -$592,200 -$175,075 $257,050 $809,650
Discounted Cash Flow (r=25%) -$840,000 $198,240 $266,960 $221,248 $226,345
Net Present Value (NPV) $72,793
Internal Rate of Return (IRR) 29.22%
Payback 2.41 years

Today’s Roadmap
 General formula
 Depreciation
Case I. Evaluating Cost-Cutting Proposals
A factory is thinking of replacing an old machine with a cost-effective new one:
• Old machine:
‒ Bought 5 years ago at $100,000 and depreciate in a straight-line basis
‒ Has a 10 year tax life and salvage value expected to be $10,000
‒ Could be sold for $60,000 now
• New machine:
‒ Costs $120,000 to purchase now and depreciate in a straight-line basis
‒ Has a 5 year tax life and salvage value expected to be $20,000
• Change by the new machine:
‒ It saves before-tax cost by $20,000 every year
‒ It reduces inventory needs and frees up net working capital by $10,000

• Capital Spending: Initial Investment
‒ Cash outflow: -$120,000
(Purchasing the new machine)
‒ Cash inflow: $60,000 – 3,400 = $56,600
 The current book value of the old machine: $100,000 – 5 × 100,000/10=$50,000
 The old machine’s selling price = $60,000
 The additional tax liability: (60,000-50,000) × 34% = $3,400
• Capital Spending: End of the Project
‒ Cash inflow: $20,000 – (20,000 - 0 ) × 34% = $13,200
 Selling the new machine at its salvage value
‒ Adjustment: - [$10,000 – (10,000 - 0 ) × 34%] = - $6,600
 An opportunity cost: a cash inflow you would have otherwise received by selling the old
machine

• Operating Cash Flow
‒ The Tax-Shield Approach:
OCF = (Sales - Costs) × (1-T) + Depreciation × T
‒ The incremental cash flow generated by the cost-cutting project:

∆OCF = (∆Sales - ∆Costs) × (1-T) + ∆Depreciation × T
 ∆Sales = $0
 ∆Costs = - $20,000
 ∆Depreciation = ($120,000/5 – 100,000/10) = $14,000
∆OCF = [$0 – (-20,000)] × (1-0.34) + 14,000 × 0.34 = $17,960

• Total project cash flow:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
OCF 17,960 17,960 17,960 17,960 17,960
Changes in NWC $10,000 -10,000
Total Cash Flow -$53,400 $17,960 $17,960 $17,960 $17,960 $14,560
• With 15% required return:

NPV = $5,114

Case II. Setting the Bid Price
• In business practice, suppliers need to compete against each other
‒ For example, chicken farms may need to bid to become the supplier to KFC
• If you win:
‒ You get the job and could potentially make money from it
‒ Normally your bid is the lowest among all competitors, and it could be too low such that you
cannot make enough money to cover the costs
(The winner’s curse)
• To set the bid price:
‒ You need to figure out the base bid price: the price that you break even
‒ A price above the base bid price is acceptable
‒ A price below the base bid price should not be considered

You are bidding for a contract under which you could sell 5 truck per year over the
next 4 years:
• Bid price (per truck): P ?
• Annual fixed cost = $24,000
• Variable cost = $14,000
• Initial investment = $60,000
• Depreciation: straight-line to zero over the four years
• Salvage value = $5,000
• Initial investment in net working capital = $40,000
• Tax rate = 39%
• Required return = 20%

• Operating Cash Flow
‒ The Bottom-Up Approach:
OCF = Net Income + Depreciation
= (Sales – Costs - Depreciation) × (1-T) + Depreciation
= [5 × P – (24,000 + 5 × 14,000) – 60,000/4] × (1-0.39) + 60,000/4
= 3.05 × P – 51,490
• After-tax Salvage
Salvage - (Salvage – Ending book value) × T
= $5,000 – (5,000 - 0) × 0.39
= $3,050

• Total Project Cash Flow:
OCF + OCF + OCF + OCF + OCF
Changes in NWC -40,000 40,000
Total Cash Flow -$100,000 + OCF + OCF + OCF $43,050 + OCF

1
1− 43,050
1.24
𝑁𝑁𝑁𝑁𝑁𝑁 =−$100,000 + 𝑂𝑂𝑂𝑂𝑂𝑂 × +
0.2 1.24

1
1− 43,050
1.24
𝑁𝑁𝑁𝑁𝑁𝑁 =−$100,000 + 𝑂𝑂𝑂𝑂𝑂𝑂 × +
0.2 1.24
• The base bid price solves for NPV = 0:
𝑂𝑂𝑂𝑂𝑂𝑂 = 3.05 × 𝑃𝑃 – 51,490 = $30,609
𝑃𝑃 = $26,918
• You should set a bid price no less than $26,918

Case III. Evaluating Costs with Different Lives
• Machine A: • Machine B:
‒ Initial Cost = $100 ‒ Initial Cost = $120
‒ Annual Maintenance Cost = $20 ‒ Annual Maintenance Cost = $15
‒ Life = 2 years ‒ Life = 3 years
‒ Depreciation: straight-line basis ‒ Depreciation: straight-line basis
‒ Salvage value = $20 ‒ Salvage value = $20
‒ Tax rate = 40% ‒ Tax rate = 40%

‒ Required return = 10% ‒ Required return = 10%

• Machine A:
Year 0 Year 1 Year 2
Capital Spending -$100 $12
Depreciation Tax Shield $20 $20
After-Tax Operating Cost -$12 -$12
Total Costs -$100 $8 $20
• Machine B:
Capital Spending -$120 $12
Depreciation Tax Shield $16 $16 $16
After-Tax Operating Cost -$9 -$9 -$9
Total Costs -$120 $7 $7 $19
• Machine A:
8 20
𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = −$100 + + 2
= −$76.20
1 + 0.1 1 + 0.1
• Machine B:
7 7 19
𝑃𝑃𝑃𝑃 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = −$120 + + 2
+ 3
= −$93.58
1 + 0.1 1 + 0.1 1 + 0.1
• PV(Total Costs of A) < PV(Total Costs of B):

Does this mean that A is a better option?

• The Equivalent Annual Cost (EAC):
‒ If we assume the same amount of cost is paid every year, then EAC is the
annual cost that gives the same PV of total costs
• Machine A:
𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸 1−1/ 1+0.1 2
+ = 𝐸𝐸𝐸𝐸𝐸𝐸 × = −$76.20
(1+0.1) 1+0.1 2 0.1
EAC = -$43.90
• Machine B:
𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸 1−1/ 1+0.1 3
+ + = 𝐸𝐸𝐸𝐸𝐸𝐸 × = −$93.58
(1+0.1) 1+0.1 2 1+0.1 3 0.1
EAC = -$37.63

• The Equivalent Annual Cost (EAC):
‒ If we assume the same amount of cost is paid every year, then EAC is the
annual cost that gives the same PV of total costs
• General case:
‒ For an equipment with a life of N years, EAC is the annual cash flow that
forms an annuity with N periods:
𝑁𝑁
1 − 1/ 1 + 𝑟𝑟
𝐸𝐸𝐸𝐸𝐸𝐸 × = 𝑃𝑃𝑃𝑃(𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶)
𝑟𝑟

Next Lecture
• Project Analysis
‒ Textbook Reading: Chapter 11
FINA1310EFG, 2017-2018 Lecture 9: Project Analysis and Evaluation 57

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FINA1310EFG CORPORATE FINANCE

Lecture 8. Making Capital Investment Decisions

Instructor: Dr. Mingzhu TAI

Spring semester, 2018-2019

• Textbook Reading: Chapter 9

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 2

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 3

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 4

• The Incremental Cash Flows:

• The Stand-alone Principle:

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 7

Will this cash flow occur ONLY if

Do NOT ONLY include the part that occurs as a

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 8

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 9

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 10

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 11

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 12

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 13

Cash flow to creditors

Capital Budgeting Capital Structure

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 14

• Cash flows for a project:

Project Cash Flow = Project Operating cash Flow

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 16

FINA1310EFG, 2018-2019 Lecture 8: Making Capital Investment Decisions 18

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Projected Operating Cash Flow = EBIT – Taxes + Depreciation:

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OCF = Net Income + Depreciation

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OCF = Sales – Costs - Taxes

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OCF = (Sales – Costs) × (1-T) + Depreciation × T

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Annual Depreciation = Initial Cost / Tax Life

• MACRS (Modified Accelerated Cost Recovery System):

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Year MACRS Percentage Depreciation Ending Book Value

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Year Unit Sales Unit Price

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Year 0 Year 1 Year 2 Year 3 Year 4

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‒ The incremental cash flow generated by the cost-cutting project:

∆OCF = [$0 – (-20,000)] × (1-0.34) + 14,000 × 0.34 = $17,960

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