Chapter 10

Making Capital Investment

Decisions

10-1

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-2
 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-3
 Capital Budgeting and
Cash Flows
In the previous chapter we
focused on multiple techniques
of capital budgeting to evaluate
projects.

This chapter is all about how

each of the cash flows (CF’s)
are determined.

10-4
 Project Example - Visual
R = 12%
1 2 3

$ -165,000 CF1 = CF2 = CF3 =

63,120 70,800 91,080

The required return for assets of this risk level

10-5
is 12% (as determined by the firm).
 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-6
 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
10-7
 Relevant Cash Flows
Ex: Company A is considering engaging in a project.
- The project will require a land lot which was bought
by the company 2 years ago at the price of 3 billion
dong.
- The current price of the land lot is 4 billion dong.
- In order to protect the land, the company built a
hurdle around the border of the land lot. The cost of
building the hurdle is 100 mil dong.
- If company A accepts the project, the hurdle will be
removed. The cost of removing the hurdle is 30 mil
dong.
- Things obtained from removing the hurdle can be
liquidated at the price of 15 mil dong.
10-8
What are the relevant cash flows?
 Asking 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
• If the answer is “part of it,” then we should include
the part that occurs because of the project

10-9
 Common Types of Cash Flows

1. Sunk costs – costs that have accrued in

the past

2. Opportunity costs – costs of lost options

3. Changes in net working capital (NWC)

4. Financing costs

10-10
5. Taxes
 Common Types of Cash Flows
6. Side effects:
• Positive side effects – benefits to other
projects
• Negative side effects – costs to other
projects

10-11
 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-12
 Pro Forma Statements and
Cash Flow
Definitions:
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation
(when there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF
– net capital spending (NCS)
– changes in NW

10-13
 Project Pro Forma Income
Statement
Sales (50,000 units at $200,000
$4.00/unit)
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
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 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-15
 Projected Capital
Requirements
Year

0 1 2 3

NWC $20,000 $20,000 $20,000 $0

Net FA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $0

10-16
 Projected Total Cash Flows
Year
0 1 2 3

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

Change -$20,000 20,000
in NWC
Net CS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

10-17
 Project Example - Visual
R = 20%
1 2 3

$ -110,000 CF1 = CF2 = CF3 =

51,780 51,780 71,780

The required return for assets of this risk level

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is 20% (as determined by the firm).
 Using your calculator

10-19
 Evaluate the Project
Enter the cash flows into the
calculator and compute NPV
and IRR:

CF0 = -110,000; C01 = 51,780;

F01 = 2; C02 = 71,780; F02 = 1
NPV; I = 20;

CPT NPV = $10,648

10-20
CPT IRR = 25.8%
 What’s Your Decision?

So….Deal
or No Deal?

10-21
 More on NWC
 Why do we have to consider changes in NWC
separately?
 GAAP requires that sales be recorded on the income
statement when made, not when the cash is received.
 GAAP also requires that we record the cost of goods
sold when the corresponding sales are made, whether
we have actually paid our suppliers to date.
 Finally, we have to buy inventory to support sales,
although we haven’t collected cash yet.

10-22
 Depreciation
The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
IRS for tax purposes

Depreciation itself is a non-cash expense; consequently,

it is only relevant because it affects taxes

Calculation:

Depreciation tax shield = DT

D = depreciation expense
T = marginal tax rate of the firm
10-23
 Computing Depreciation
Straight-line depreciation
D = (Initial cost – salvage) / number of years
Very few assets are depreciated using the straight-line
method for tax purposes
MACRS
Need to know which asset class is appropriate for tax
purposes
Multiply percentage given in table by the initial cost
Depreciate to zero
Mid-year convention

10-24
 After-tax Salvage
 If the salvage value is different from
the book value of the asset, then there
is a tax effect
 Book value = initial cost – accumulated
depreciation
 After-tax salvage = salvage –
T*(salvage – book value at time of sale)
10-25
 After-tax Salvage
Computation
1. Market Value – Book Value = gain (or loss)

2. Take gain (or loss) x (marginal tax rate)

3. Pay taxes on a gain; Receive a tax benefit on a loss

4. After-tax Salvage =
Market Value – taxes paid or
Market Value + tax benefit

10-26
 Example: Depreciation and
After-tax 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.

10-27
 Example: Depreciation and
After-tax Salvage
The company’s marginal tax rate is 40%.
What is the depreciation expense and the
after-tax salvage in year 6 for each of the
following three scenarios (A-C)?

0 1 2 3 4 5 6

$ -110,000 Sell =
$17,000
10-28
 Example A: Straight-line
Suppose 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

After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000

10-29
 Example A: Straight-Line
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $17,000
Capital gain/loss = 0

Taxes paid on gain/loss = ($0).40 = $0

After-tax salvage value:

17,000 - .40 (17,000 – 17,000)
= $17,000
10-30
 Example B: Three-year
MACRS
Year MACRS Depreciation
percent per year
1 .3333 .3333(110,000) D1=
$36,663
2 .4445 .4445(110,000) D2=
$48,895
3 .1481 .1481(110,000) D3=
$16,291
4 .0741 .0741(110,000) D4=
10-31 $8,151
 Example B: MACRS
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $ 0
Capital gain/loss = $17,000

Taxes paid on gain/loss = ($17,000).40

= $ 6,800

After-tax salvage value:

17,000 - .40 (17,000 – 0)
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= $10,200
 Example C: Seven-Year
MACRS
Year MACRS Depreciation
Percent Per year
1 .1429 .1429(110,000) = D1=$15,719
2 .2449 .2449(110,000) = D2=$26,939
3 .1749 .1749(110,000) = D3=$19,239
4 .1249 .1249(110,000) = D4=$13,739
5 .0893 .0893(110,000) = D5= $ 9,823
6 .0892 .0892(110,000) = D6= $ 9,812
10-33
 Example C: MACRS
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $14,729
Capital gain /loss = $ 2,371

Taxes paid on gain/loss = ($17,000).40

= $ 908.40

After-tax salvage value:

17,000 - .40 (17,000 – 14,729)
10-34
= $16,091.60
 Chapter Outline
• Capital Budgeting and Cash Flows
• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-35
 Replacement Problem

Every problem we
have presented What if we have an
thus far represents old asset to replace
a newly purchased with a new asset?
asset.

10-36
 Example: Replacement
Problem
Original Machine New Machine
Initial cost = 100,000 Initial cost = 150,000
Annual depreciation = 9,000 5-year life
Purchased 5 years ago Salvage in 5 years = 0
Book Value = 55,000 Cost savings = 50,000 per

Salvage today = 65,000

year
3-year MACRS depreciation
Salvage in 5 years = 10,000
 Required return = 10%
 Tax rate = 40%

10-37
 Replacement Problem
Computing Cash Flows
 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?
10-38
 Replacement Problem
Pro Forma Income Statements
Year 1 2 3 4 5
Cost 50,000 50,000 50,000 50,000 50,000
Savings

Depr.
New 49,995 66,675 22,215 11,115 0
Old 9,000 9,000 9,000 9,000 9,000
Increm. 40,995 57,675 13,215 2,115 (9,000)
EBIT 9,005 (7,675) 36,785 47,885 59,000
Taxes 3,602 (3,070) 14,714 19,154 23,600
NI 5,403 (4,605) 22,071 28,731 35,400
10-39
 Replacement Problem
Incremental Net Capital Spending
Year 0
 Cost of new machine = 150,000 (outflow)
 After-tax salvage on old machine = 65,000
- .4(65,000 – 55,000) = 61,000 (inflow)
 Incremental net capital spending = 150,000 – 61,000
= 89,000 (outflow)

Year 5
 After-tax salvage on old machine = 10,000
- .4(10,000 – 10,000) = 10,000 (outflow because we
no longer receive this)

10-40
 Replacement Problem
Cash Flow From Assets
Year 0 1 2 3 4 5
OCF 46,398 53,070 35,286 30,846 26,400

NCS -89,000 -10,000

 In 0 0
NWC

CFFA -89,000 46,398 53,070 35,286 30,846 16,400

10-41
 Replacement Problem
Analyzing the Cash Flows
Now that we have the cash flows, we
can compute the NPV and IRR
1. Enter the cash flows
2. Compute the NPV and the IRR
Compute NPV = $54,801.74
Compute IRR = 36.28%
Should the company replace the
equipment?
10-42
 Chapter Outline

• Capital Budgeting and Cash Flows

• Incremental Cash Flows
• Pro Forma Financial Statements
• Operating Cash Flows
• Replacement Decisions
• Discounted Cash Flow Analysis

10-43
 Other Methods for
Computing OCF
Bottom-Up Approach
Works only when there is no interest expense
OCF = NI + depreciation

Top-Down Approach
OCF = Sales – Costs – Taxes
Don’t subtract non-cash deductions

Tax Shield Approach

OCF = (Sales – Costs)(1 – T) + Depreciation*T

10-44
 Example: Cost Cutting
1. Your company is considering a new computer system
that will initially cost $1 million.

2. It will save $300,000 per year in inventory and

receivables management costs.

3. The system is expected to last for five years and will be

depreciated using 3-year MACRS.

10-45
 Example: Cost Cutting
(continued)
4. The system is expected to have a salvage value of
$50,000 at the end of year 5.
5. There is no impact on net working capital.
6. The marginal tax rate is 40%.
7. The required return is 8%.

Task: Click on the Excel icon to work through the

example

10-46
 Example: Setting the Bid
Price
Consider the following information:
1. The Army has requested bids for multiple
use digitizing devices (MUDDs)
2. Deliver 4 units each year for the next 3
years
3. Labor and materials estimated to be
$10,000 per unit
4. Production space leased for $12,000 per
year

10-47
 Example: Setting the
Bid Price (continued)
5. Requires $50,000 in fixed assets with
expected salvage of $10,000 at the end of
the project (depreciate straight-line)
6. Requires an initial $10,000 increase in
NWC
7. Tax rate = 34%
8. Firm’s required return = 15%

Task: Click on the Excel icon

to work through the example
10-48
 Example: Equivalent Annual
Cost Analysis
Long-lasting Batteries
Burnout Batteries
Initial Cost = $60 each
Initial Cost = $36
5-year life
each
3-year life $88 per year to
$100 per year to keep keep charged
charged Expected salvage = $5
Expected salvage = $5 Straight-line
Straight-line depreciation
10-49
depreciation
 Example: Equivalent Annual
Cost Analysis (continued)
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 15%, and the tax
rate is 34%.

10-50
 Ethics Issues
In an L.A. Law episode, an automobile
manufacturer knowingly built cars that had a
significant safety flaw. Rather than redesigning the
cars (at substantial additional cost), the
manufacturer calculated the expected costs of
future lawsuits and determined that it would be
cheaper to sell an unsafe car and defend itself
against lawsuits than to redesign the car. What
issues does the financial analysis overlook?

10-51
 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?

10-52
 Comprehensive Problem

A $1,000,000 investment is depreciated using a seven-

year MACRS class life. It requires $150,000 in
additional inventory and will increase accounts
payable by $50,000. It will generate $400,000 in
revenue and $150,000 in cash expenses annually, and
the tax rate is 40%. What is the incremental cash flow
in years 0, 1, 7, and 8?

10-53
 Terminology
• Incremental cash flows
• Sunk costs
• Opportunity costs
• Stand-alone (or independent) projects
• Net Working Capital (NWC)
• Operating Cash Flow (OCF)
• Cash Flow From Assets (CFFA)

10-54
 Terminology
(continued)
• Straight line depreciation
• MACRS depreciation
• Market value vs. book value
• After-tax salvage value
• Bid price
• Equivalent Annual Cost (EAC)

10-55
 Formulas
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation (when
there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF –
net capital spending (NCS)
– changes in NW

• After-tax salvage = salvage –

T (salvage – book value at time of sale)
10-56
 Formulas (continued)
Operating Cash Flow Formula:

Bottom-Up Approach
OCF = NI + depreciation
Top-Down Approach
OCF = Sales – Costs – Taxes
Tax Shield Approach
OCF = (Sales – Costs)(1 – T) +
Depreciation*T
10-57
 Key Concepts and Skills

• Compute the relevant

cash flows for proposed
investments.
• Compare and contrast the
various methods for computing operating
cash flow.
• Compute a bid price for a project
• Compute and evaluate the equivalent
annual cost of a project
10-58
 What are the most
important topics of this
chapter?
1. The cash flows for a project are
computed using incremental cash
flows considering depreciation and
after-tax salvage values.

2. Straight-line and MACRS methods of

depreciation are used to compute the
depreciation of an asset.

10-59
 What are the most
important topics of this
chapter?

3. Cash Flows From Assets (CFFA)

computes the annual cash flows for
capital budgeting purposes.

4. Replacement decisions involve the

cash flows of the “old” asset as well as
the “new” asset.

10-60
 Questions?
10-61