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10-1
Making Capital Investment Decisions
Chapter 10
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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
Chapter Outline
• Capital Budgeting and Cash Flows
• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis
10-4
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.
10-5
Project Example - Visual
R = 12%
$ -165,000
1 2 3
CF1 = 63,120
CF2 = 70,800
CF3 = 91,080
The required return for assets of this risk level is 12% (as determined by the firm).
10-6
Chapter Outline
• Capital Budgeting and Cash Flows
• Incremental Cash Flows• Pro Forma Financial Statements• Operating Cash Flows• Replacement Decisions• Discounted Cash Flow Analysis
10-7
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
10-8
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
5. Taxes
10-10
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
FlowDefinitions:
• 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 $4.00/unit)
$200,000
Variable Costs ($2.50/unit) 125,000Gross profit $ 75,000Fixed costs 12,000Depreciation ($90,000 / 3) 30,000EBIT $ 33,000Taxes (34%) 11,220Net Income $ 21,780
10-14
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 $20,000
Net FA 90,000 60,000 30,000 0
Total $110,000 $80,000 $50,000 $20,000
10-16
Projected Total Cash Flows
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in NWC
-$20,000 20,000
Net CS -$90,000
CFFA -$110,00 $51,780 $51,780 $71,780
10-17
Project Example - Visual
R = 20%
$ -110,000
1 2 3
CF1 = 51,780
CF2 = 51,780
CF3 = 71,780
The required return for assets of this risk level is 20% (as determined by the firm).
10-18
Using your calculator
10-19
Evaluate the ProjectEnter the cash flows into the calculator and compute NPV and IRR:
CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1NPV; I = 20;
CPT NPV = $10,648CPT IRR = 25.8%
10-20
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
DepreciationThe 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 = DTD = depreciation expenseT = marginal tax rate of the firm
10-23
Computing Depreciation
Straight-line depreciationD = (Initial cost – salvage) / number of years
Very few assets are depreciated using the straight-line method for tax purposes
MACRSNeed 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)?
$ -110,000
6
Sell = $17,000
543210
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 = $17,000Book Value at year 6: $17,000Capital 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 percent
Depreciation 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= $8,151
10-31
Example B: MACRS The company’s marginal tax rate
is 40%.
Market Selling Price = $17,000Book Value at year 6: $ 0Capital gain/loss = $17,000
Taxes paid on gain/loss = ($17,000).40 = $ 6,800
After-tax salvage value: 17,000 - .40 (17,000 – 0)
= $10,200
10-32
Example C: Seven-Year MACRS
Year MACRS Percent
Depreciation 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 = $17,000Book Value at year 6: $14,729Capital 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)
= $16,091.60
10-34
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 thus far represents a newly purchased asset.
What if we have an old asset to replace with a new asset?
10-36
Example: Replacement Problem
Original MachineInitial cost = 100,000Annual depreciation =
9,000Purchased 5 years
agoBook Value = 55,000Salvage today =
65,000Salvage in 5 years =
10,000
New MachineInitial cost = 150,0005-year lifeSalvage in 5 years =
0Cost savings =
50,000 per year3-year MACRS
depreciationRequired 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 Savings
50,000 50,000 50,000 50,000 50,000
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 35,40010-38
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 NWC
0 0
CFFA
-89,000
46,398
53,070 35,286 30,846 16,400
10-41
Replacement Problem Analyzing the Cash
FlowsNow that we have the cash flows, we can compute the NPV and IRR1. Enter the cash flows2. Compute the NPV and the IRRCompute NPV = $54,801.74Compute 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 ApproachWorks only when there is no interest
expenseOCF = NI + depreciation
Top-Down ApproachOCF = Sales – Costs – TaxesDon’t subtract non-cash deductions
Tax Shield ApproachOCF = (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
Burnout BatteriesInitial Cost = $36 each
3-year life$100 per year to keep charged
Expected salvage = $5
Straight-line depreciation
Long-lasting BatteriesInitial Cost = $60 each
5-year life$88 per year to keep chargedExpected salvage = $5
Straight-line depreciation
10-49
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 ApproachOCF = NI + depreciation
Top-Down ApproachOCF = Sales – Costs – Taxes
Tax Shield ApproachOCF = (Sales – Costs)(1 – T) + Depreciation*T
10-57
Key Concepts and Skills
• Compute the relevant cash flows for proposedinvestments.
• 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
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.
What are the most important topics of this chapter?
10-59
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.
What are the most important topics of this chapter?
10-60
Questions?