1. Making Capital Investment Decisions
Chapter 10
Making Capital Investment Decisions

2. Relevant Cash Flows
A change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project.
These cash flows are called incremental cash flows
Incremental cash flows: the difference between a firm’s future cash flows with a project and those without the project
Irrelevant cash flows

3. The stand-alone principle
The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

4. 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

5. Common Types of Cash Flows
Sunk cost: a cost that has already been incurred and can’t be removed.
Opportunity cost: the cost of giving up a valuable alternative if a particular investment is undertaken.
Side effects: a) negative impact on the cash flows of an existing product from the introduction of a new product (erosion)
b) Positive impact

6. Common Types of Cash Flows
Net working capital:
Financing costs:

7. Notes Financial manager is interested in: Cash flows
When these cash flows actually occurs
After-tax cash flows
Note that
Incremental cash flows are after-tax cash flows
Differentiate between: after-tax cash flows, accounting profit and net income

8. Pro Forma Statements and Cash Flow
Financial statements projecting future years’ operations
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

9. Example
If Pepsi can sell 50,000 cans per year of a new product line for 4$ per can. It costs 2.5$ per can, this product line has three- year life with a required rate of return of 20%. There will be 12,000$ fixed costs per year, Pepsi will need to invest a total of 90,000$ in manufacturing equipment which will be 100 percent depreciated. In addition the project will require an initial 20,000$ investment in networking capital, and the tax rate is 34 percent
Prepare a pro forma income statement
Calculate the total investment for each year
Calculate the total project cash flows
Calculate the NPV

10. Ex 1 Page 327
Parker & stone Inc., is looking at setting up a new manufacturing plant in south park to produce garden tools. The company bought some land six years ago for 6$ million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net 6.4$ million. The company wants to build its manufacturing plant on this land; the plant will cost 14.2$ million to build, and the site requires 890,000$ worth of grading before its suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating the project? Why?

11. Ex 3 Page 328
A proposed new investment has projected sales of 830,000$. Variable costs are 60 percent of sales, and fixed costs are 181,000$; depreciation is 77,000$. Prepare a pro forma income statement assuming a tax rate of 35 percent. What is the projected net income?

12. Ex 4 Page 328 Consider the following income statement:
824,500
sales
538,900
costs
126,500
Depreciation ?
EBIT
Taxes(34%)
Net income
Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?

13. Ex 9,10 Page 328
Summer Tyme, Inc., is considering a new three-year expansion project that requires an initial fixed asst investment of 3.9$ million. That fixed asset will be depreciated straight-line to zero over the three-year tax life. After which time it will be worthless. the project is estimated to generate 2,650,000$ in annual sales, with the cost of 840,000$. If the tax rate is 35 percent, what is the OCF for this project?
Suppose that the required rate of return is 12 percent, what is the NPV?

14. 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

15. Example
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. Also assume that the only components of networking capital are account receivables and payable. The beginning and ending amount for these accounts are as follows
500
Sales
310
Costs
190
Net income
change
Ending of year
Beginning of year 30
910
880 AR 55
605
550 AP
-25
305
330
NWC

16. Depreciation
Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate

17. 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

18. Example
Consider an automobile costing 12,000$. What is the depreciation using the MACRS method?
examples
class
Equipments used in research
Three-year
Autos, computers
Five-year
Most industrial industries
Seven-year
Property class
Seven-year
Five-year
Three-year
year
14.29%
20.00%
33.33% 1
24.49 32
44.45 2
17.49
19.20
14.81 3
12.49
11.52
7.41 4
8.93 5
8.92
5.76 6 7
4.46 8

19. 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)

20. MARCS Book values Ending book value depreciation Beginning book value
Year
9,600
2,400
12,000 1 2 3 4 5 6

21. 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?
Suppose the appropriate depreciation schedule is straight-line
What is the depreciation using the MACRS method (three years)? What is the end-year book value? What is the after-tax salvage?
What is the depreciation using the MACRS method (seven years)? What is the end-year book value? What is the after-tax salvage?

22. Ex 6 Page 328
A piece of newly purchased industrial equipment costs 1,080,000$ and its classified as seven-year property under MARCS. Calculate the annual depreciation allowance and end-of-the year book values for this equipment

23. Book value versus Market value
The book value of an asset can differ substantially from its actual market value
The difference between book and market value will affect taxes

24. The Majestic Mulch and Compost Company (Example)
the company is investigating the feasibility of a new line of power mulching tools. MMCC projects unit sales as follows:
Unit sales
year
3,000 1
5,000 2
6,000 3
6,500 4 5 6
4,000 7 8

25. The Majestic Mulch and Compost Company (Example)
The new Mulcher will sell for 120$ per unit to start. After three years MMCC anticipates that the price will drop to 110$ due to competition. The company will require 20,000$ networking capital at the start. After that the networking capital will be about 15 percent of sales for that year. The variable cost per unit is 60$, and the total fixed costs are 25,000$ per year. It will cost about 800,000$ to buy the equipment and it will be worth about 20 percent of its cost in eight years. The relevant tax rate is 34 percent ant the required return is 15 percent. Based on this information, should MMCC proceed?

26. The Majestic Mulch and Compost Company (Example)
Calculation of sales = unit price * number of units
Revenues
Unit sales
Unit price
year
360,000$
3,000
120$ 1
600,000
5,000
120 2
720,000
6,000 3
715,000
6,500
110 4
660,000 5
550,000 6
440,000
4,000 7
330,000 8

27. The Majestic Mulch and Compost Company (Example)
Calculation of depreciation= MARCS percentage * initial cost
Ending book value
depreciation
MARCS percentage
year
685,680
114,320
14.29% 1
489,760
195,920
24.49 2
349,840
139,920
17.49 3
249,920
99,920
12.49 4
178,480
71,440
8.93 5
107,120
71,360
8.92 6
35,680 7
4.46 8

28. The Majestic Mulch and Compost Company (Example)
year 8 7 6 5 4 3 2 1
330,000
440,000
550,000
660,000
715,000
720,000
600,000
36,000
revenues
180,000
240,000
300,000
360,000
390,000 VC
25,000 FC
35,680
71,440
71,360
99,920
139,920
195,920
114,320
Dep
89,320
103,560
153,640
203,560
200,080
195,080
79,080
40,680
EBIT
30,369
35,210
52,238
69,210
68,027
66,327
26,887
13,831
Tax(34%)
58,951
68,350
101,402
134,350
132,053
128,753
52,193
26,849 NI

29. The Majestic Mulch and Compost Company (Example)
Calculation of OCF = EBIT + Dep - Tax
year 8 7 6 5 4 3 2 1
89,320
103,560
153,640
203,560
200,080
195,080
79,080
40,680
EBIT
35,680
71,440
71,360
99,920
139,920
195,920
114,320
Dep
30,369
35,210
52,238
69,210
68,027
66,327
26,887
13,831
Tax(34%)
94,631
139,790
172,762
205,790
231,973
268,673
248,113
141,169
OCF

30. The Majestic Mulch and Compost Company (Example)
Calculation of NWC for each year= sales * 0.15
Change in NWC= ending NWC – Beg NWC
Cash flow
NWC
Revenues
year
20,000
360,000$ 1
600,000 2
720,000 3
715,000 4
660,000 5
550,000 6
440,000 7
330,000 8

31. The Majestic Mulch and Compost Company (Example)
year 8 7 6 5 4 3 2 1
-20,000
Initial NWC
Change in NWC
NWC recovery
Total change in NWC

32. The Majestic Mulch and Compost Company (Example)
Calculation of salvage = 0.2 * initial cost
After-tax salvage = salvage – T (salvage – BV)
year 8 7 6 5 4 3 2 1
-800,000
Initial cost
After-tax salvage
Capital spending

33. The Majestic Mulch and Compost Company (Example)
Calculation of total CF= OCF – change in NWC- NCS
year 8 7 6 5 4 3 2 1
OCF
Change in NWC
NCS
Total CF
Cumulative CF
Pv of CF

34. Other Methods for Computing OCF
If you have the following information:
Sales = 1,500$
Costs = 700$
Depreciation = 600$
Tax rate = 34%
No interest
Calculate the OCF

35. 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

36. Depreciation tax shield
The tax saving that results from the depreciation deduction
Depreciation * tax rate

37. Ex 8 Page 328
An asset used in a four-year project falls in the five-year MARCS class for tax purpose. The asset has an acquisition cost of 7,900,000$ and will be sold for 1,400,000$ at the end of the project. If the tax rate is 35 percent. What is the after tax salvage value of the asset?

38. Ex 32 Page 332
Aguilera Acoustics, Inc. (AAI), projects unit sales for a new seven-octave voice emulation implant as follows
Unit sales
year
93,000 1
105,000 2
128,000 3
134,000 4
87,000 5

39. Ex 32 Page 332
Production of the implants will require 1,800,000$ in networking capital to start and additional networking capital investments each year equal to 15 percent of the projected sales increase for the following year. Total fixed costs are 1,200,000$ per year, variable production costs are 265$ per unit, and the units priced at 380$ each. The equipment needed to begin production has an installed cost of 24,000,000$.becasue the implants are intended for professional singers, this equipment is considered industrial machinery and thus qualified as seven-year MARCS property. In five years, this equipment can be sold about 20 percent of its acquisition cost.AAI is in the 35 percent marginal tax and has a required return on all its projects of 18 percent. Based on these estimates, what is the NPV?