Ross Fundamentals of Corporate Finance 13e CH10 PPT

CHAPTER 10
M A K I N G C A P I TA L I N V E S T M E N T D E C I S I O N S
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LEARNING OBJECTIVES
• Determine the relevant cash flows for a

proposed project
• Evaluate whether a project is acceptable
• Explain how to set a bid price for a project
• Evaluate the equivalent annual cost of a project
10-2
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
10-3
RELEVANT CASH FLOWS AND
THE STAND-ALONE PRINCIPLE
• A relevant cash flow for a project is a change in the firm’s overall
future cash flow that comes about as a direct consequence of the
decision to take that project
• Incremental cash flows are the difference between a firm’s future
cash flows with a project and those without the project
• Any cash flow that exists regardless of whether or not a project is
undertaken is not relevant
• Stand-alone principle is the assumption that evaluation of a
project may be based on the project’s incremental cash flows
• Once we have determined incremental cash flows from
undertaking a project, we can view that project as a kind of
“minifirm” with its own future revenues and costs, its own assets,
and its own cash flows
• Then, we will primarily be interested in comparing the cash flows
from this minifirm to the cost of acquiring it
10-4
INCREMENTAL CASH FLOWS
• A sunk cost has already been incurred and cannot be removed and
therefore should not be considered in an investment decision
• Opportunity cost is the most valuable alternative that is given up if
a particular investment is undertaken
• Recall that incremental cash flows for a project include all resulting
changes in the firm’s future cash flows
• Not unusual for a project to have a side, or spillover, effect, both
good and bad
• Erosion occurs when the cash flows of a new project come at the
expense of a firm’s existing projects
• Projects normally require the firm to invest in net working capital
in addition to long-term assets
• Project will generally need some amount of cash on hand to pay
any expenses that arise, as well as initial investment in inventories
and accounts receivable
• Investment in project net working capital closely resembles a loan 10-5
INCREMENTAL CASH FLOWS
(CONTINUED)
• Financing Costs
• In analyzing a proposed investment, we will not include interest
paid or any other financing costs (e.g., dividends or principal
repaid) because we are interested in the cash flow generated by
the assets of the project
• Goal in project evaluation is to compare cash flow from a project to
the cost of acquiring that project in order to estimate NPV
• Other Issues
• We are interested only in measuring cash flow at the time when it
actually occurs, not when it accrues in an accounting sense
• We are always interested in aftertax cash flow because taxes are
definitely a cash outflow
10-6
PRO FORMA FINANCIAL STATEMENTS AND
PROJECT CASH FLOWS
• Pro forma financial statements project future years’ operations
• Suppose we think 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% return on new products.
• Fixed costs for the project, including such things as rent on the
production facility, will run $17,430 per year
• We will need to invest a total of $90,000 in manufacturing
equipment; assume this $90,000 will be 100% depreciated over the
three-year life of the project
• Cost of removing equipment will roughly equal its actual value in
three years, so it will be essentially worthless on a market value
basis as well
• Project will require an initial $20,000 investment in net working
capital, and the tax rate is 21%
10-7
SHARK ATTRACTANT PROJECT:
PROJECTED INCOME STATEMENT & CAPITAL
REQUIREMENTS
• Projected Income Statement:
• Projected Capital Requirements:
10-8
PROJECT CASH FLOWS
• To develop the cash flows from a project, recall that cash flow from
assets has three components:
1.Operating cash flow
2.Capital spending
3.Changes in net working capital
• Once we have estimates of the components of cash flow, we will
calculate cash flow for our minifirm
Project cash flow = Project operating cash flow
− Project change in net working capital
− Project capital spending
Operating cash flow = Earnings before interest and taxes

+ Depreciation
− Taxes 10-9
PROJECT OPERATING CASH FLOW:
SHARK ATTRACTANT PROJECT
Projected Income Statement (L) and Operating Cash Flow (R):
• Projected Total Cash Flows:
10-10
PROJECTED TOTAL CASH FLOW AND VALUE
• The NPV at the 20% required return is:
NPV = − $110,000 + 51,780/1.2 + 51,780/1.22 + 71,780/1.23
= $10,648
• Based on these projections, the project creates over $10,000 in
value and should be accepted
• Return on this investment obviously exceeds 20% because the NPV
is positive at 20%
• After trial and error, the IRR works out to be about 25.8%
• Payback on this project is about 2.1 years
• Average accounting return (AAR) is average net income divided by
average book value
• Net income each year is $21,780 and average of the four book
values for total investment is ($110 + 80 + 50 + 20)/4 = $65
• AAR is $21,780/$65,000 = .3351, or 33.51%
10-11
MORE ABOUT PROJECT CASH FLOW
• Suppose that during a particular year of a project we have the
following simplified income statement:
• Depreciation and taxes are zero, no fixed assets are purchased

during the year, and we assume the only components of NWC are
accounts receivable and payable.
• Beginning and ending amounts for these accounts are as follows:
10-12
(CONTINUED)
• What is total cash flow for the year?
• Operating cash flow in this case is the same as EBIT because there
are no taxes or depreciation; thus, it equals $190
• Net working capital actually declined by $25, which means that $25
was freed up during the year.
• There was no capital spending, so the total cash flow for the year is:
Total CF = Operating CF − Change in NWC − Capital spending
= $190 − ( − 25 ) − 0
= $215
• $215 total cash flow must be “dollars in” less “dollars out” for the
year. We could therefore ask a different question: What were cash
revenues for the year? Also, what were cash costs?
• During the year, we had sales of $500, but accounts receivable rose
by $30, so cash inflow is $500 − 30 = $470
• Costs during the year were $310, but accounts payable increased by
$55, so cash costs for the period are $310 − 55 = $255 10-13
(CONCLUDED)
• We calculate that cash inflows less cash outflows are $470 − 255 =
$215, just as we had before
Cash flow = Cash inflow − Cash outflow

= ($500 − 30) − (310 − 55)
= ($500 − 310) − (30 − 55)
= Operating cash flow − Change in NWC
= $190 − (−25)
= $215
10-14
DEPRECIATION:
MODIFIED ARCS DEPRECIATION (MACRS)
• Depreciation is a noncash deductible and has cash flow
consequences only because it influences the tax bill
• Accelerated cost recovery system (ACRS) is a depreciation method
under U.S. tax law allowing for the accelerated write-off of property
under various classifications
• Modified ACRS depreciation (MACRS) is characterized by every asset
being assigned to a particular class
• Once an asset’s tax life is determined, depreciation for each year is
computed by multiplying the cost of the asset by a fixed percentage
• Expected salvage value and expected economic life not explicitly
considered in the calculation of depreciation
• Typical depreciation classes are shown below:
10-15
DEPRECIATION: MODIFIED ARCS
DEPRECIATION (MACRS) (CONTINUED)
• Consider an automobile, which are normally classified as five-year
property, costing $12,000. Based on the table below, we see that the
relevant figure for the first year of a five-year asset is 20%
• Depreciation in first year is $12,000 × .20 = $2,400

• Relevant percentage in the second year is 32%, so depreciation in
second year is $12,000 × .32 = $3,840
10-16
DEPRECIATION:
BONUS DEPRECIATION
• Prior to 2018, “bonus” depreciation was permitted
• Based on the Protecting Americans from Tax Hikes (PATH) Act of
2015, the size of the bonus in 2017 was 50%
• This means a firm can take a depreciation deduction of 50% of the
cost on an eligible asset in the first year and then depreciate the
remaining 50% using the MACRS schedules
• In late 2017, Congress passed the Tax Cuts and Jobs Act, which
increased the bonus depreciation to 100% for 2018, lasting until the
end of 2022
• After 2022, it drops by 20% per year until it reaches zero after 2026
• Implication is that most firms will not use the MACRS schedules until
2023 unless they wish to
10-17
DEPRECIATION:
BOOK VALUE VERSUS MARKET VALUE
• Book value of an asset can differ substantially from market value
• Recall the example on slide 16 of the $12,000 car:
• Book value after first year is $12,000 less first year’s depreciation of
$2,400, or $9,600
• Remaining book values are summarized below:
• Suppose we wanted to sell the car after five years and, based on
historical averages, it is worth 25% of the purchase price, or $3,000
• We must pay taxes at ordinary income tax rate on difference
between sale price of $3,000 and book value of $691.20 10-18
MACRS DEPRECIATION
10-19
ALTERNATIVE DEFINITIONS OF OPERATING
CASH FLOW
• There are different definitions of project operating cash flow that
are commonly used, both in practice and in finance texts
• Keep in mind that when we speak of cash flow, we literally mean
dollars in less dollars out
• For a particular project and year under consideration, suppose we
have the following estimates:
Sales = $1,500
Costs = $700
Depreciation = $600
• With these estimates, notice that EBIT is:
EBIT = Sales − Costs − Depreciation = $1,500 − 700 − 600 = $200
• Assume no interest is paid and TC , the corporate tax rate, is 21%, so
the tax bill is: Taxes = EBIT × TC = $200 × .21 = $42
• Project operating cash flow, OCF, is:
OCF = EBIT + Depreciation − Taxes = $200 + 600 − 42 = $758 10-20
THE BOTTOM-UP APPROACH
• With the bottom-up approach, we begin with the accountant’s
bottom line (net income) and add back any noncash deductions,
such as depreciation
• Crucial to remember this definition of operating cash flow (as net
income plus depreciation) is correct only if there is no interest
expense subtracted in the calculation of net income
• Because we are ignoring any financing expenses, such as interest, in
our calculations of project OCF, we can write project net income as:
Project net income = EBIT − Taxes = $200 − 42 = $158
• If we add the depreciation to both sides, we arrive at a slightly
different and very common expression for OCF:
10-21
THE TOP-DOWN APPROACH
• In the top-down approach, we start at the top of the income

statement with sales and work our way down to net cash flow by
subtracting costs, taxes, and expenses
• Leave out any strictly noncash items (e.g., depreciation)
10-22
THE TAX SHIELD APPROACH
• Tax shield approach views OCF as having two components:
• What the project’s cash flow would be if there were no
depreciation expense
• Would-have-been cash flow is $632
• Depreciation multiplied by tax rate (i.e., depreciation tax shield)
• $600 depreciation deduction saves us $600 × .21 = $126 in taxes
• Tax shield definition of OCF is:
• Assuming TC = 21%, the OCF works out to be:

OCF = ($1,500 − 700) × .79 + 600 × .21
= $632 + 126
= $758
10-23
SOME SPECIAL CASES OF DISCOUNTED
CASH FLOW ANALYSIS
• Three special cases involving discounted cash flow analysis are
particularly important because problems similar to these are so
common:
1. Investments that are primarily aimed at improving efficiency
and thereby cutting costs
2. Competitive bids
3. Evaluating equipment options with different economic lives
10-24
EVALUATING COST-CUTTING PROPOSALS
• Suppose we 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. Assume the equipment has a
five-year life and is depreciated to zero on a straight-line basis over
that period. It will actually be worth $20,000 in five years. Should we
automate? The tax rate is 21%, and the discount rate is 10%.
• Identify the relevant incremental cash flows
• Initial cost is $80,000, and aftertax salvage value is $20,000 × (1 − .21)
= $15,800 because book value will be zero in five years
• No working capital consequences
• Examine operating cash flows
• Buying new equipment affects operating cash flows in two ways:
• We save $22,000 before taxes every year
• We have an additional depreciation deduction. In this case, the
depreciation is $80,000/5 = $16,000 per year
10-25
(CONTINUED)
• Because project has operating income of $22,000 and depreciation
deduction of $16,000, taking the project will increase EBIT by
$22,000 − 16,000 = $6,000
• Because EBIT is rising for the firm, taxes will increase
• Increase in taxes will be $6,000 × .21 = $1,260
• We can now compute operating cash flow in the usual way:
• Operating cash flow could be calculated using a different approach:

• $22,000 pretax saving is $22,000 × (1 − .21) = $17,380 after taxes
• Extra $16,000 in depreciation isn’t a cash outflow, but it reduces our
taxes by $16,000 × .21 = $3,360
• Sum of these two components is $17,380 + 3,360 = $20,740 10-26
(CONCLUDED)
• Here are the relevant cash flows:
• At 10 percent, it’s straightforward to verify that the NPV here is

$8,431, so we should go ahead and automate
10-27
TO BUY OR NOT TO BUY
10-28
SETTING THE BID PRICE:
AN EXAMPLE
• If a competitive bid must be submitted to win a job, the winner is
whoever submits the lowest bid
• Imagine we 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 five specially
modified trucks each year for the next four years, for a total of 20
trucks in all. We need to decide what price per truck to bid.
• Suppose we can buy the truck platforms for $10,000 each
• Facilities we need can be leased for $24,000 per year
• Labor and material cost for modification is about $4,000 per truck
• Total cost per year will be $24,000 + 5 × (10,000 + 4,000) = $94,000
• What price per truck should we bid if we require a 20% return?
• We will need to invest $60,000 in new equipment, which will be
depreciated straight-line to a zero salvage value over the four years.
It will be worth about $5,000 at the end of that time.
• Need to invest $40,000 in raw materials inventory and other working
capital items. The relevant tax rate is 21%. 10-29
AN EXAMPLE (CONTINUED)
• Capital spending and net working capital investment
• We must spend $60,000 today for new equipment, and the aftertax
salvage value is $5,000 × (1 − .21) = $3,950
• We need to invest $40,000 today in working capital
• Lowest price we can profitably charge will yield a zero NPV at 20%
• Determine what operating cash flow must be for the NPV to equal
zero by calculating PV of $43,950 nonoperating cash flow from the
last year and subtracting it from $100,000 initial investment
• $100,000 − 43,950/1.204 = $100,000 − 21,195 = $78,805
10-30
AN EXAMPLE (CONTINUED II)
• Operating cash flow is now an unknown ordinary annuity amount.
• The four-year annuity factor for 20% is 2.58873, so we have:
NPV = 0 = −$78,805 + OCF × 2.58873
• This implies that operating cash flow needs to be $30,442 each year:
OCF = $78,805/2.58873 = $30,442
• Final problem is to find out what sales price results in an operating
cash flow of $30,442
• Recall operating cash flow can be written as net income plus
depreciation (the bottom-up definition)
• Depreciation here is $60,000/4 = $15,000
• Given this, we can determine that net income must be:
Operating cash flow = Net income + Depreciation
$30,442 = Net income + $15,000
Net income = $15,442
10-31
AN EXAMPLE (CONCLUDED)
• If net income is $15,442, then our income statement is as follows:
• We can solve for sales by noting that:

Net income = (Sales − Costs − Depreciation) × (1 − TC)
$15,442 = (Sales − $94,000 − $15,000) × (1 − .21)
Sales = $15,442/.79 + 94,000 + 15,000
= $128,546
• Because the contract calls for five trucks per year, the sales price has
to be $128,546/5 = $25,709 per truck
10-32
EVALUATING EQUIPMENT OPTIONS WITH
DIFFERENT LIVES
• This approach is necessarily on when the following are true:
1. Possibilities under evaluation have different economic lives
2. We will need whatever we buy more or less indefinitely (i.e., when
it wears out, we will buy another one
• Imagine we are in the business of manufacturing stamped metal
subassemblies. Whenever a stamping mechanism wears out, we
must replace it with a new one to stay in business. We are
considering which of two stamping mechanisms to buy. Ignoring
taxes, which one should we choose if we use a 10% discount rate?
• Machine A costs $100 to buy and $10 per year to operate. It wears
out and must be replaced every two years.
• Machine B costs $140 to buy and $8 per year to operate. It lasts for
three years and must then be replaced.
10-33
EVALUATING EQUIPMENT OPTIONS WITH
DIFFERENT LIVES (CONTINUED)
• Computing the PV of the costs for each machine tells us A effectively
provides 2 years’ worth of stamping services for $117.36, whereas B
effectively provides 3 years’ worth for $159.89:
• Machine A: PV = −$100 − $10/1.1 − $10/1.12 = −$117.36
• Machine B: PV = −$140 − $8/1.1 − $8/1.12 − $8/1.13 = −$159.89
• Equivalent annual cost (EAC) is the PV of a project’s costs calculated
on an annual basis
• For Machine A, we need to find a two-year ordinary annuity with a
PV of −$117.36 at 10%, where two-year annuity factor is 1.7355
PV of costs = − $117.36 = EAC × 1.7355
EAC = − $117.36 / 1.7355 = − $67.62
• For machine B, the three-year annuity factor is 2.4869
PV of costs = − $159.89 = EAC × 2.4869
EAC = − $159.89/2.4869 = − $64.30 10-34
SELECTED CONCEPT QUESTIONS
• What are the relevant incremental cash flows for project
evaluation?
• Explain what erosion is and why it is relevant.
• What is the definition of project operating cash flow? How does
this differ from net income?
• Why is it important to consider changes in net working capital in
developing cash flows? What is the effect of doing so?
• What are the top-down and bottom-up definitions of operating
cash flow?
• In setting a bid price, we used a zero NPV as our benchmark.
Explain why this is appropriate.
10-35
END OF CHAPTER
CHAPTER 10
10-36

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CHAPTER 10

• Determine the relevant cash flows for a

• Evaluate whether a project is acceptable

• Explain how to set a bid price for a project

• Evaluate the equivalent annual cost of a project

• 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

• Projected Capital Requirements:

Operating cash flow = Earnings before interest and taxes

• Projected Total Cash Flows:

• Depreciation and taxes are zero, no fixed assets are purchased

Cash flow = Cash inflow − Cash outflow

• Depreciation in first year is $12,000 × .20 = $2,400

• In the top-down approach, we start at the top of the income

• Assuming TC = 21%, the OCF works out to be:

• Operating cash flow could be calculated using a different approach:

• At 10 percent, it’s straightforward to verify that the NPV here is

• We can solve for sales by noting that:

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