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Chapter 6

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investment decisions

Corporate Finance

Ross, Westerfield, and

Jaffe

Outline

2. An example

3. The equivalent annual cost method

TVM

TVM technique.

That is, we should discount future expected

cash flows (specifically, FCFs) back to

present time and compare PV to initial costs:

whether NPV > 0?

Discount cash flows, not earnings.

Relevant cash flows

cash flows need to be addressed.

The cash flows in the capital-budgeting time

line need to be relevant cash flows; that is

they need to be incremental in nature.

Incremental cash flows: those cash flows that

will only occur if the project is accepted.

Ask the right question

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.

Sunk costs

occurred regardless of whether the project is

accepted.

Example: consulting fee for evaluating a

project.

Sunk costs should not be taken into

consideration when evaluating a project.

Opportunity costs

giving up the second best use of resources.

Example: a vacant land.

Opportunity costs should be taken into

consideration when evaluating the project.

Side effects

Erosion occurs when a new project reduces the

sales and cash flows of existing projects.

Synergy occurs when a new project increases

the sales and cash flows of existing projects.

Cash flows due to erosion and synergy are

incremental cash flows.

An example, I

project: producing colored bowling balls.

The estimated life of the project: 5 years.

The cost of test marketing: $250,000.

Would be produced in a vacant building owned by the

firm; the property can be sold for $150,000 after taxes.

The cost of a new machine: $100,000.

The estimated market value of the machine at the end

of 5 years: $30,000.

An example, II

units, 8,000 units, 12,000 units, 10,000 units,

and 6,000 units.

The price of bowling balls in the first year:

$20.

The price of bowling balls will increase at 2%

per year.

No debt financing; no interest expenses.

An example, III

Production costs will increase at 10% per year.

Incremental/marginal corporate tax rate: 34%.

An initial investment (at year 0) in net working

capital: $10,000.

NWC at the end of each year will be equal to 10% of

sales for that year.

NWC at the end of the project is zero.

An example, IV

Depreciation

on the Modified Accelerated Cost Recovery

System (MACRS).

See Table 6.3 (p. 176) for IRS depreciation

schedule.

For a 5-year depreciation, the depreciation

schedule is: 20% (year 1), 32% (year 2), 19.2%

(year 3), 11.5% (year 4), 11.5% (year 5), and 5.8%

(year 6).

An example, V

After-tax salvage cash flow

The estimated salvage market value of the machine

is 30% of $100,000; that is, $30,000.

The machine will have been depreciated to 5.8% of

$100,000 at that time; that is, $5,800.

The taxable amount is $24,200 ($30,000 - $5,800).

The after-tax salvage cash flow is: $30,000 (34%

$24,200) = $21,772.

An example, VI

Decision

less than 16%, we accept the project.

In other words, if the discount rate is higher

than 16%, we have a negative NPV.

NPV

discount rate is the cost of equity.

Suppose that cost of equity is 15%.

NPV = 5473.43 (> 0).

An example, VII

Alternative definitions of OCF

down approach to compute OCF ( = sales

costs taxes).

Another 2 alternative methods: the bottom-up

method, and the tax shield method.

See pp. 186-189.

The equivalent annual cost method

choose between 2 machines of unequal

lives, or (2) whether one should replace an

existing machine with a new one.

Whereas a general capital budgeting

problem is often computed in nominal terms,

the equivalent annual cost (EAC) method

works best in real terms.

Nominal vs. real

2 machines with unequal lives

of machine.

The nominal discount rate (NR) is 13.3%.

The expected inflation rate (E(I)) is 3%. The

real discount rate (RR) is 10%.

(1 + NR) = (1 + RR) (1 + E(I))

(1 + 13.3%) = (1 + 10%) (1 + 3%).

Real cost outflows w/ real

discount rate

Equivalent annual cost

discount real (nominal) cash flows.

For A, the EAC is $321.05.

798.42 PV; 3 N; 10 I/Y; CPT PMT.

For B, the EAC is $289.28.

916.99 PV; 4 N; 10 I/Y; CPT PMT.

B has a lower equivalent annual cost. We

should choose B.

End-of-chapter

Questions and problems: 1-20.

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