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Chapter 10
Making Capital
Investment Decisions

Tang Vu Hung BS - NEU.

Key Concepts and Skills

• Understand how to determine the relevant
cash flows for various types of proposed
investments
• Understand the various methods for
computing operating cash flow
• Understand how to set a bid price for a
project
• Understand how to evaluate the equivalent
annual cost of a project
10-1

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
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Capital Budgeting Decisions

• involves large amounts

• resources committed for a long time

• cannot be reversed easily

• involves substantial risk

8-3

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

10-4

Asking the Right Question

• Any and all changes in the firm’s future cashflows that
are a direct consequence of undertaking the project
• 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 10-5

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Types of Cash Flows

• Sunk costs – costs that have accrued in the past

• Opportunity costs – costs of lost options
• Side effects
• Positive side effects – benefits to other projects
• Negative side effects – costs to other projects
• Changes in net working capital
• Financing costs
• Taxes & Others
10-6

Sunk Costs / Past Costs

• Cost already paid or incurred liability to pay

• Decision to accept/reject project will NOT
change cost
• Cost cannot be removed
• Cost is irrelevant to analysis
DO NOT include

8-7

Opportunity costs

• The cost of giving up another opportunity

• Example: a project may require the use of a
building that could otherwise be sold or
leased to someone else.
DO include

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BEWARE! of Side -Effects

• Are changes that may not at first appear to have
anything to do with the project under evaluation
• Increased or decreased sales of existing products
because the company begins selling a new
product
• Remember do not include changes if they would
have happened anyway.
DO include
8-9

Changes in net working capital

• A project requires the firm invest in net
working capital in addition to long - term
assets.
• Cash ouflows at the beginning and cash
intflows at the end.

8-10

Financing Costs

• Financing costs
- dividends to shareholders
- interest to debt holders

• The required rate of return reflects all

sources of funds used by the company
DO NOT include

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Taxes

• Since most business are subject to tax, to

ignore it would give a misleading result
• Tax payable is calculated on taxable income
- tax is a cash outflow
- tax may be lagged 1 period
- resultant analysis is more reliable

8-12

Gain /Loss on Disposal of Assets

• If the salvage value > • If the salvage value <

book value book value
- a profit/gain is made on - the ensuing loss on
disposal disposal is a tax
- the profit/gain is subject deduction
to tax - CASH INFLOW as tax
- CASH OUTFLOW for benefit is received
tax paid
8-13

Depreciation

• Depreciation is a non-cashdeduction
• It does not directly cause an inflow or outflow
of cash
• Tax Implications of Depreciation
- depreciation will impact on tax payable as it is
a taxdeductible expense
- depreciation expense will result in a tax
benefit (CASH INFLOW)

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Pro Forma Statements and CF

• Capital budgeting relies heavily on pro forma
accounting statements, particularly income
statements
• Computing cash flows – refresher
• 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 NWC
10-15

Table 10.1 (p302)

Summary:
• Expect to sell 50,000 products per year
• $4/product
• $2.50/product
• Fixed costs: $12,000
• Fixed Assets: 90,000
• 3 years life, straight - line
• NWC: $20,000
• Required return 20%
• t = 34% 8-16

Table 10.1 Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000

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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Table 10.2 Projected Capital

Requirements

Year

0 1 2 3

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

NFA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000

10-18

Table 10.5 Projected Total CFs

Year
0 1 2 3

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

Change -$20,000 20,000
in NWC
NCS -$90,000

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

10-19

Making The Decision

• Now that we have the cash flows, we can apply
the techniques that we learned in Chapter 9
• 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
• CPT IRR = 25.8%
• Should we accept or reject the project?

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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 cash is
received
• GAAP also requires that we record cost of goods
sold when the corresponding sales are made,
whether we have actually paid our suppliers yet
• Finally, we have to buy inventory to support sales,
although we haven’t collected cash yet
10-21

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
• Depreciation tax shield = D.T
• D = depreciation expense
• T = marginal tax rate
10-22

Computing Depreciation

• Straight-line depreciation
• D = (Initial cost – salvage) / number of years
• Very few assets are depreciated straight-line 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

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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)

10-24

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. 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?

10-25

Example: 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

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Example: Three-year MACRS

Year MACRS D BV in year 6 =

percent 110,000 – 36,663 –
48,895 – 16,291 –
1 .3333 .3333(110,000) =
8,151 = 0
36,663
2 .4445 .4445(110,000) =
48,895 After-tax salvage
3 .1481 .1481(110,000) = = 17,000 -
16,291 .4(17,000 – 0) =
$10,200
4 .0741 .0741(110,000) =
8,151
10-27

Example: Seven-Year MACRS

Year MACRS D BV in year 6 =

Percent
110,000 – 15,719 –
1 .1429 .1429(110,000) = 26,939 – 19,239 –
15,719
13,739 – 9,823 –
2 .2449 .2449(110,000) =
26,939 9,812 = 14,729
3 .1749 .1749(110,000) =
19,239 After-tax salvage
4 .1249 .1249(110,000) = = 17,000 –
13,739 .4(17,000 –
5 .0893 .0893(110,000) = 9,823 14,729) =
16,091.60
6 .0892 .0892(110,000) = 9,812

10-28

Example: Replacement Problem

• Original Machine • New Machine
• Initial cost = 100,000 • Initial cost = 150,000
• Annual depreciation • 5-year life
= 9,000 • Salvage in 5 years = 0
• Purchased 5 years • Cost savings = 50,000
ago per year
• 3-year MACRS
• Book Value = 55,000 depreciation
• Salvage today = • Required return = 10%
65,000 • Tax rate = 40%
• Salvage in 5 years =
10,000

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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?
10-30

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

10-31

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)
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Replacement Problem – CF 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

10-33

Replacement Problem – Analyzing the Fs

• Now that we have the cash flows, we can

compute the NPV and IRR
• Enter the cash flows
• Compute NPV = 54,801.74
• Compute IRR = 36.28%
• Should the company replace the
equipment?
10-34

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

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Example: Cost Cutting

• Your company is considering a new computer system
that will initially cost $1 million. It will save $300,000
per year in inventory and receivables management
costs. The system is expected to last for five years
and will be depreciated using 3-year MACRS. The
system is expected to have a salvage value of
$50,000 at the end of year 5. There is no impact on
net working capital. The marginal tax rate is 40%.
The required return is 8%.
• Click on the Excel icon to work through the example

10-36

Example: Setting the Bid Price

• Consider the following information:
• Army has requested bid for multiple use digitizing
devices (MUDDs)
• Deliver 4 units each year for the next 3 years
• Labor and materials estimated to be $10,000 per
unit
• Production space leased for $12,000 per year
• Requires $50,000 in fixed assets with expected
salvage of $10,000 at the end of the project
(depreciate straight-line)
• Require initial $10,000 increase in NWC
• Tax rate = 34%
• Required return = 15% 10-37

Example: Equivalent Annual Cost

Analysis
• Burnout Batteries • Long-lasting Batteries
• Initial Cost = $36 each • Initial Cost = $60 each
• 3-year life • 5-year life
• $100 per year to keep • $88 per year to keep
charged charged
• Expected salvage = $5 • Expected salvage = $5
• Straight-line • Straight-line
depreciation depreciation
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%.
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Quick Quiz

• How do we determine if cash flows are relevant

to the capital budgeting decision?
• What are the different methods for computing
operating cash flow and when are they
important?
• What is the basic process for finding the bid
price?
• What is equivalent annual cost and when
should it be used?
10-39

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?

10-40

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?
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Chapter

End of Chapter

Tang Vu Hung BS - NEU.

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