Chapter 6

Making Capital Investment

Decisions

6-1
Key Concepts and Skills
• Understand how to determine the relevant cash
flows for various types of capital investments.

• Be able to compute depreciation expense for tax

purposes.

• Understand the various methods for computing

operating cash flow.

6-2
Introduction
• We need to evaluate a new project using the Time Value
of Money technique.
• That is, we should discount future expected cash flows
back to present time and compare PV to initial costs:
whether NPV > 0?
• Discount cash flows, not earnings because earnings do
not represent real money.
• This chapter addresses how cash flows are to be
estimated in the real world.
So, remember

Cash flows matter—not accounting earnings

6-3
Relevant cash flows
• But before we do this, a few notions about 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.

So, remember

Incremental cash flows matter

6-4
Relevant cash flows
Ask 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.

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Common Types of Cash Flows
• Sunk costs – costs that have occurred in the past.
E.g. market survey, feasibility study.
• Opportunity costs – costs of lost options for using
the assets.
• Side effects
Positive side effects – benefits to other projects:
Synergy
Negative side effects – costs to other projects:
Erosion
• Changes in net working capital
• Financing costs
• Taxes
6-6
Sunk costs
• A sunk cost is a cost that has already occurred
regardless of whether the project is accepted.
• Example: consulting fee for evaluating a project.

“Will this cash flow occur ONLY if we accept the

project?”

• Sunk costs should not be taken into consideration

when evaluating a project.

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Side effects
• Accepting a new project may have side effects.
• Side effects can be classified as either erosion or synergy.
• 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.
“Will this cash flow occur ONLY if we accept the
project?”
• Cash flows due to erosion and synergy are incremental
cash flows and should be taken into consideration
when evaluating the project.
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Depreciation
• Depreciation itself is a non-cash expense;
however, it is only relevant because it affects
taxes and hence after-tax cash flow.
• Depreciation tax shield = D*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 (Modified Accelerated Cost Recovery
System).
See Table 6.3 (p. 176) for IRS depreciation schedule.
Need to know which asset class is appropriate for
tax purposes
Multiply percentage given in table by the initial cost

6-10
 Computing Depreciation
MACRS applicable percentage for property class
Table 6.3: Recovery
Depreciation under 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
Year
Modified 1 0.3333 0.2000 0.1429 0.1000 0.0500 0.03750
Accelerated Cost 2 0.4445 0.3200 0.2449 0.1800 0.0950 0.07219
Recovery System 3 0.1481 0.1920 0.1749 0.1440 0.0855 0.06677
(MACRS) 4 0.0741 0.1152 0.1249 0.1152 0.0770 0.06177
5  0.1152 0.0893 0.0922 0.0693 0.05713
6  0.0576 0.0892 0.0737 0.0623 0.05285
7    0.0893 0.0655 0.0590 0.04888
8    0.0446 0.0655 0.0590 0.04522
9      0.0656 0.0591 0.04462
10       0.0655 0.0590 0.04461
11       0.0328 0.0591 0.04462
12         0.0590 0.04461
13         0.0591 0.04462
14         0.0590 0.04461
15         0.0591 0.04462
16         0.0295 0.04461
17           0.04462
18           0.04461
19           0.04462
20           0.04461
21           0.02231

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After-tax Salvage
• Book value= Purchase price- Accumulated dep.
• Capital gain/loss on selling= Selling price- Book
value
• After-tax Salvage CF= Selling price- (tax
rate*capital gain/loss).

6-12
Depreciation and After-tax Salvage-
Example
• 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?
Using straight-line.
Using the Three-year MACRS.

6-13
Depreciation and After-tax Salvage-
Example
• if 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
• Capital gain/loss = 17,000-17,000=0
• After-tax salvage = 17,000 - 0.4(17,000 – 17,000) =
17,000

6-14
Depreciation and After-tax Salvage-
Example
Year MACRS% D
1 0.3333 0.3333*(110,000) = 36,663
2 0.4445 0.4445*(110,000) = 48,895
3 0.1481 0.1481*(110,000) = 16,291
4 0.0741 0.0741*(110,000) = 8,151

BV in year 6 = 110,000 – (36,663 + 48,895 +

16,291 + 8,151) = 0

Capital gain/loss= 17,000-0= 17,000

After-tax salvage = 17,000 - 0.4*(17,000 – 0) =
6-15
Interest Expense
• For now, we determine the NPV of the project
independent of financing decisions.
• Later chapters will deal with the impact that the
amount of debt that a firm has in its capital
structure has on firm value.

6-16
Incremental Cash Flows-summary
• Cash flows matter—not accounting earnings.
• Incremental cash flows matter.
• Sunk costs do not matter.
• Opportunity costs matter.
• Side effects like synergy and erosion matter.
• Taxes matter: we want incremental after-tax
cash flows.

6-17
Estimating Cash Flows-
example
• Baldwin Company is considering an investment
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.
6-18
Estimating Cash Flows-
example
• Production by year for the 5-year life: 5,000
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.
• The machine will be depreciated according to a
five-years MACRS schedule.

6-19
Estimating Cash Flows-
example
• First-year production costs: $10 per unit.
• 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.

6-20
Estimating Cash Flows-
example
Year Units Price/unit Revenue Cost/unit Cost
1 5000 20 100000 10 50000
2 8000 20.4 163200 11 88000
3 12000 20.808 249696 12.1 145200
4 10000 21.22416 212241.6 13.31 133100
5 6000 21.648643 129891.9 14.641 87846
Revenues (sales)= Units*Price/unit
Cost= Units*Cost/unit

6-21
Estimating Cash Flows-
example
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).

Year MACRS% Depreciation

1 0.20 0.20(100,000) = 20,000
2 0.32 0.32(100,000) = 32,000
3 0.192 0.192(100,000) = 19,200
4 0.115 0.115(100,000) = 11,500
5 0.115 0.115(100,000) = 11,500

Depreciation=% of each year*Initial cost

6-22
Estimating Cash Flows-
example Year 1 Year 2 Year 3 Year 4 Year 5
Sales 100000 163200 249696 212241.6 129892
Costs 50000 88000 145200 133100 87846
Dep. 20000 32000 19200 11500 11500
Income before tax 30000 43200 85296 67641.6 30545.9
Tax 10200 14688 29001 22998.14 10385.6
Net Income 19800 28512 56295 44643.46 20160.3
OCF 39800 60512 75495 56143.46 31660.3
NWC 10000 16320 24970 21224.16

 OCF = sales – costs – taxes or EBIT + Dep. – Taxes or Net income + Dep.

 NWC at the end of each year is equal to 10% of sales for that year.

6-23
Estimating Cash Flows-
example
• The estimated salvage market value of the
machine is $30,000.
• The machine will have been depreciated to
$5,800 at that time (100000 – 20000 – 32000 –
19200 – 11500 – 11500).
• Capital gain/loss= $30,000 – $5,800= 24,200.
• The after-tax salvage cash flow is: $30,000 –
(34% × $24,200) = $21,772.

6-24
Estimating Cash Flows-
example
Incremental After-Tax Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
OCF 39800 60512 75495 56143 31660
Capital
-100000
investment
Opp. Cost -150000 150000
NWC 10000 10000 16320 24970 21224
ΔNWC -10000 0 -6320 -8650 3745 21224
after-tax
21772
Salvage
Total CF -260000 39800 54192 66846 59889 224656

 ΔNWC=NWC Yeart – NWC Yeart-1 if the Δ is increase then this is cash

outflow (negative). If Δ is decrease this is cash inflow (positive).
 Total CF=OCF + Capital investment + Opp. Cost + ΔNWC + After-tax
salvage.
6-25
Estimating Cash Flows-
example
• The firm uses no debt. Thus the appropriate
discount rate is the cost of equity.
• Suppose that cost of equity is 15%.
• NPV = 5473.43 (> 0).
• IRR = 15.68% (> 15%).
• If the IRR is higher than discount rate (cost of
equity), we have a positive NPV and hence accept
the project.
• If the discount rate is higher than 15.68%, we have a
negative NPV and hence reject the project.

6-26
Other Methods for Computing OCF
• In our previous calculation, we used the top-down
approach to compute OCF.
• Top-Down Approach
 OCF = Sales –Costs – Taxes
• Another 2 alternative methods: the bottom-up method,
and the tax shield method.
• Bottom-Up Approach
 OCF = NI + depreciation
• Tax Shield Approach
 OCF = (Sales – Costs)*(1 – T) + Depreciation*T

6-27
Tax Shield Approach-example
• Raphael Restaurant is considering the purchase of a $9,000
soufflé maker. The soufflé maker has an economic life of five
years and will be fully depreciated by the straight-line
method. The machine will produce 1,500 soufflés per year,
with each costing $2.30 to make and priced at $4.75. Assume
that the discount rate is 14 percent and the tax rate is 34
percent. Should Raphael make the purchase?

6-28
Tax Shield Approach-example
• Using the tax shield approach to calculating OCF, we get:
OCF = (Sales – Costs)*(1 – T) + T*Depreciation
OCF = [($4.75 × 1,500) – ($2.30 × 1,500)](1 – 0.34) +
0.34($9,000/5)
OCF = $3,037.50

• So, the NPV of the project is:

NPV = –$9,000 + $3,037.50(PVIFA14%,5)
NPV = $1,427.98

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• Annuity= equal periodic cashflow

6-30
7.3 Inflation and Capital
Budgeting
• Inflation is an important fact of economic life and must be
considered in capital budgeting.
• Consider the relationship between interest rates and inflation,
often referred to as the Fisher equation:
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
• For low rates of inflation, this is often approximated:
Real Rate  Nominal Rate – Inflation Rate
• In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows discounted at
nominal rates.

6-31
Some Special Cases of Discounted
Cash Flow Analysis
• Investments of Unequal Lives: Equivalent Annual Cost
(EAC) Method
 Suppose a firm must choose between two machines of
unequal lives. Both machines can do the same job, but
they have different operating costs and will last for
different time periods.
 In this case applying NPV, may lead to wrong decision.
 To adjust for the difference in lives, we need to calculate
the equivalent annual cost(EAC). This approach puts costs
on a per-year basis.
 The EAC is the value of the payment annuity that has the
same PV as our original set of cash flows.

6-32
Some Special Cases of Discounted
Cash Flow Analysis
• Investments of Unequal Lives: Equivalent
Annual Cost (EAC) Method
• Example:
Consider a factory that must have an air cleaner that is
mandated by law. There are two choices:
• The “Cadillac cleaner” costs $4,000 today, has annual pre-
tax operating costs of $100, and lasts 3 years.
• The “Cheapskate cleaner” costs $1,000 today, has annual
pre-tax operating costs of $500, and lasts 5 years.
• For both projects use straight-line depreciation to zero
over the project’s life and assume a salvage value of $50.
• Assuming a 10% discount rate and tax rate is 35%, which
one should we choose?

6-33
Some Special Cases of Discounted
Cash Flow Analysis
• The two cleaners have unequal lives, so they can only be
compared by expressing both on an equivalent annual
basis, which is what the EAC method does.

• The EAC is the value of the level payment annuity that

has the same PV as our original set of cash flows.

6-34
Some Special Cases of Discounted
Cash Flow Analysis
•  To calculate the EAC, we first need the OCF and NPV of each
option.
• Both cases: after-tax salvage value = $50 – 0.35*(50 – 0) = $32.5
• The OCF and NPV for Cadillac cleaner is:
OCF = – $100(1 – 0.35) + 0.35($4000/3) = $401.67
NPV = –$4000 + $401.67(PVIFA10%,3) + ($32.5/1.103) = –$2976.69
EAC = –$2976.69/ (PVIFA10%,3) = –$1196.95
And the OCF and NPV for Cheapskate cleaner is:
OCF = –$500(1 – 0.35) + 0.35($1000/5) = –$255
NPV = –$1000 – $255(PVIFA10%,5) + ($32.5/1.105) = –$1946.4
EAC = –$1946.47 / (PVIFA10%,5) = –$513.47

6-35
Some Special Cases of Discounted
Cash Flow Analysis
• Thus, you prefer the Cheapskate cleaner
because it has the lower (less negative)
annual cost.

6-36