9
Making Chapter Capital
Investment
Decisions
0
McGraw-Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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9 -NC-1
Key Concepts and Skills
Understand how to determine the relevant
cash flows for a proposed investment
Understand how to analyze a projects
projected cash flows
Understand how to evaluate an estimated
NPV
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Chapter Outline
Project Cash Flows: A First Look
Incremental Cash Flows
Pro Forma Financial Statements and
Project Cash Flows
More on Project Cash Flows
Evaluating NPV Estimates
Scenario and Other What-If Analyses
Additional Considerations in Capital
Budgeting
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Relevant Cash Flows
The cash flows that should be included
in a capital budgeting analysis are those
that will only 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
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Asking the Right Question
You should always ask yourself Will this
cash flow change 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 is not
affected by the project
If the answer is part of it, then we should
include the part that occurs because of the
project
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Common Types of Cash Flows
Sunk costs costs that have accrued in
the past
Opportunity costs costs of lost options
Side effects externalities
Positive side effects benefits to other projects
Negative side effects costs to other projects
Changes in net working capital
Financing costs
Taxes
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Pro Forma Statements and
Cash Flow
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
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Example
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. The project
has only a 3-year life. Fixed costs for the project
will be $12,000 per year. We will need to invest
a total of $90,000 in manufacturing equipment.
W e will depreciate this amount down to 0 over
the 3-year life of the project using straight line
depreciation method. The cost of removing the
equipment will roughly equal to its actual value
in three years, so it will be essentially worthless
on a market value basis as well. The project will
require an initial investment of $20,000 in
working capital. We require a 20% return on
new products and the tax rate is 34%.
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Table 9.1 Pro Forma Income
Statement
Year 1-3
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)
EBIT
Taxes (34%)
Net Income
30,000
$ 33,000
11,220
$ 21,780
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Table 9.2 Projected Capital
Requirements
Year
0
NWC
1
2
3
$20,000
$20,000
$20,000
$20,000
Net Fixed Assets
90,000
60,000
30,000
0
Total Investment
$110,000
$80,000
$50,000
$20,000
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Table 9.5 Projected Total Cash
Flows
Year
0
2
3
21,780
NI
1
21,780
21,780
Depr.
30,000
30,000
30,000
OCF
$51,780
$51,780
$51,780
Change in
NWC
-$20,000
Capital
Spending
-$90,000
CFFA
-$110,00
$20,000
$51,780
$51,780
$71,780
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Making The Decision
Now that we have the cash flows, we can
apply the techniques that we learned in
chapter 8
Compute NPV and IRR
Should we accept or reject the project?
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The Tax Shield Approach
You can also find operating cash flows,
using the tax shield approach
OCF = (Sales costs)(1 T) +
Depreciation*T
This form may be particularly useful
when the major incremental cash flows
are the purchase of equipment and the
associated depreciation tax shield
such as when you are choosing
between two different machines
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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,
regardless of when we actually pay our suppliers
So, cash flow timing differences exist between the
purchase of inventory, revenue and costs from its
sale on the income statement, and the actual cash
collection from its sale
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Depreciation
The depreciation expense used for capital
budgeting should be the depreciation
schedule required for tax purposes
Depreciation itself is a non-cash expense;
consequently, it is only relevant because it
affects taxes
Depreciation tax shield = DxT
D = depreciation expense
T = marginal tax rate
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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)
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Example: Depreciation and
After-tax Salvage
You purchase an 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 companys marginal tax rate is 40%.
W hat is the depreciation expense each year,
and the after tax salvage in year 6, for each of
the following situations?
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Example: Straight-line
Depreciation
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
percent
D
1
.3333
.3333(110,000) =
36,663
2
.4444
.4444(110,000) =
48,884
3
.1482
.1482(110,000) =
16,302
4
.0741
BV in year 6 =
110,000 36,663
48,884 16,302
8,151 = 0
.0741(110,000) =
8,151
After-tax salvage =
17,000 - .4(17,000
0) = $10,200
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Example: Seven-Year MACRS
Year
MACRS
Percent
D
1
.1429
.1429(110,000) =
15,719
2
.2449
.2449(110,000) =
26,939
3
.1749
.1749(110,000) =
19,239
4
.1249
.1249(110,000) = =
13,739
5
.0893
.0893(110,000) 9,823
6
.0893
.0893(110,000) = 9,823
BV in year 6 =
110,000 15,719
26,939 19,239
13,739 9,823
9,823 = 14,718
After-tax salvage =
17,000 - .4(17,000
14,718) =
16,087.20
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Example: Replacement Problem
New Machine
Original Machine
Initial cost = 100,000
Annual depreciation =
9,000
Purchased 5 years ago
Book Value = 55,000
Salvage today = 65,000
Salvage in 5 years =
10,000
Initial cost = 150,000
5-year life
Salvage in 5 years = 0
Cost savings = 50,000 per
year
3-year MACRS depreciation
Required return = 10%
Tax rate = 40%
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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?
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Replacement Problem Pro
Forma Income Statements
Year
Cost
Savings
1
2
3
4
5
50,000
50,000
50,000
50,000
50,000
49,995
66,660
22,230
11,115
0
9,000
9,000
9,000
9,000
9,000
Depr.
New
Old
Increm.
40,995
57,660
13,230
2,115
(9,000)
EBIT
9,005
(7,660)
36,770
47,885
59,000
Taxes
3,602
(3,064)
14,708
19,154
23,600
NI
5,403
(4,596)
22,062
28,731
35,400
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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 Cash
Flow From Assets
Year
0
NI
1
2
3
4
5
5,403
-4,596
22,062
28,731
Depr.
40,995
57,660
13,230
2,115
35,400
-9,000
OCF
46,398
53,064
35,292
30,846
26,400
NCS
-89,000
-10,000
In
NWC
0
0
CFFA
-89,000
46,398
53,064
35,292
30,846
16,400
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Replacement Problem Analyzing
the Cash Flows
Now that we have the cash flows, we can
compute the NPV and IRR
Discount the cash flows at 10%
NPV = ?
IRR = ?
Should the company replace the
equipment?
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Evaluating NPV Estimates
The NPV estimates are just that
estimates
A positive NPV is a good start now we
need to take a closer look
Forecasting risk how sensitive is our NPV
to changes in the cash flow estimates, the
more sensitive, the greater the forecasting
risk
Sources of value why does this project
create value?
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Scenario Analysis
What happens to the NPV under different
cash flows scenarios?
At the very least look at:
Best case revenues are high and costs are
low
Worst case revenues are low and costs are
high
Measure of the range of possible outcomes
Best case and worst case are not
necessarily probable; they can still be
possible
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Sensitivity Analysis
What happens to NPV when we vary
one variable at a time
This is a subset of scenario analysis
where we are looking at the effect of
specific variables on NPV
The greater the volatility in NPV in
relation to a specific variable, the larger
the forecasting risk associated with that
variable and the more attention we want
to pay to its estimation
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New Project Example
Consider the project discussed in the
text
The initial cost is $200,000 and the
project has a 5-year life. There is no
salvage. Depreciation is straight-line, the
required return is 12% and the tax rate
is 34%
The base case NPV is $15,567
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Summary of Scenario Analysis
Scenario
Net
Income
Cash Flow
NPV
IRR
Base
case
$19,800
$59,800
$15,567
15.1%
Worst
Case
-15,510
24,490
-111,719
-14.4%
59,730
99,730
159,504
40.9%
Best Case
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Summary of Sensitivity Analysis
Scenario
Unit
Sales
Cash
Flow
NPV
IRR
Base
case
6,000
59,800
15,567
15.1%
Worst
case
5,500
53,200
-8,226
10.3%
Best case
6,500
66,400
39,357
19.7%
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Making A Decision
Beware of Paralysis of Analysis
At some point, you have to make a
decision
If the majority of your scenarios have
positive NPVs, then you can feel
reasonably comfortable about accepting
the project
If you have a crucial variable that leads
to a negative NPV with a small change
in the estimates, then you may want to
forgo the project
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Managerial Options
Capital budgeting projects often provide
other options that we have not yet
considered
Contingency planning
Option to expand
Option to abandon
Option to wait
Strategic options
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Capital Rationing
Capital rationing occurs when a firm or
division has limited resources
Soft rationing the limited resources are
temporary, often self-imposed
Hard rationing capital will never be available
for this project
The profitability index is a useful tool when
faced with soft rationing
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Quick Quiz
How do we determine if cash flows are
relevant to the capital budgeting
decision?
What is scenario analysis and why is it
important?
What is sensitivity analysis and why is it
important?
What are some additional managerial
options that should be considered?
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A firm is considering an investment in a new machine
with a price of $320,000 to replace its existing machine.
The current machine has a book value of $10,000 which
will be depreciated down to a value of zero over the next
2 years. It has market values of $90,000 today and
$20,000 in 4 years from today. The new machine is
expected to have a four year life and will be depreciated
down to a value of zero over 4 years using straight line
depreciation method. If the firm replaces the old
machine with the new one, it expects to save $80,000 in
production costs each year over the next 4 years. At the
end of the 4th year, new machine can be sold for
$50,000. If the firm purchases the new machine, it will
also need an investment of $50,000 in net working
capital. The required return on the investment is 18%
and the tax rate is 40%
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Comprehensive Problem
A $1,000,000 investment is depreciated
using a seven-year MACRS class life. It
requires $100,000 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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