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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

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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

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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

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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 (CFs) are determined.

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10-5 Project Example - Visual R = 12% $ -165, CF 1 = 63,120 CF 2 = 70,800 CF 3 = 91,080 The required return for assets of this risk level is 12% (as determined by the firm).

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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

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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

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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

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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

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

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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

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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

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10-13 Project 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 costs12,000 Depreciation ($90,000 / 3)30,000 EBIT$ 33,000 Taxes (34%)11,220 Net Income$ 21,780

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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

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10-15 Projected Capital Requirements Year 0123 NWC$20,000 Net FA 90,000 60,000 30,000 0 Total$110,000$80,000$50,000$20,000

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10-16 Projected Total Cash Flows Year 0123 OCF$51,780 Change in NWC -$20,00020,000 Net CS-$90,000 CFFA-$110,00$51,780 $71,780

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10-17 Project Example - Visual R = 20% $ -110, CF 1 = 51,780 CF 2 = 51,780 CF 3 = 71,780 The required return for assets of this risk level is 20% (as determined by the firm).

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10-18 Using your calculator

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10-19 Evaluate the Project Enter the cash flows into the calculator and compute NPV and IRR: CF 0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1 NPV; I = 20; CPT NPV = $10,648 CPT IRR = 25.8%

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10-20 Whats Your Decision? So….Deal or No Deal?

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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 havent collected cash yet.

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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

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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

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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)

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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

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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.

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10-27 Example: Depreciation and After-tax Salvage The companys 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,

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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, (17,000 – 17,000) = 17,000

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10-29 Example A: Straight-Line The companys 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, (17,000 – 17,000) = $17,000

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10-30 Example B: Three-year MACRS YearMACRS percent Depreciation per year (110,000) D 1 = $36, (110,000) D 2 = $48, (110,000) D 3 = $16, (110,000) D 4 = $8,151

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10-31 Example B: MACRS The companys 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, (17,000 – 0) = $10,200

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10-32 Example C: Seven-Year MACRS YearMACRS Percent Depreciation Per year (110,000) = D 1 =$15, (110,000) = D 2 =$26, (110,000) = D 3 =$19, (110,000) = D 4 =$13, (110,000) = D 5 = $ 9, (110,000) = D 6 = $ 9,812

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10-33 Example C: MACRS The companys 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 = $ After-tax salvage value: 17, (17,000 – 14,729) = $16,091.60

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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

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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?

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10-36 Example: Replacement Problem 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 New Machine 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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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?

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10-38 Replacement Problem Pro Forma Income Statements Year12345 Cost Savings 50,000 Depr. New49,99566,67522,21511,1150 Old9,000 Increm.40,99557,67513,2152,115(9,000) EBIT9,005(7,675)36,78547,88559,000 Taxes3,602(3,070)14,71419,15423,600 NI5,403(4,605)22,07128,73135,

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10-39 Replacement Problem Incremental Net Capital Spending Year 0 Cost of new machine = 150,000 (outflow) After-tax salvage on old machine = 65, (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, (10,000 – 10,000) = 10,000 (outflow because we no longer receive this)

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10-40 Replacement Problem Cash Flow From Assets Year OCF 46, ,07035,28630,84626,400 NCS - 89, ,000 In NWC 00 CFF A - 89,000 46, ,07035,28630,84616,400

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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, Compute IRR = 36.28% Should the company replace the equipment?

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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

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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 Dont subtract non-cash deductions Tax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation*T

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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.

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10-45 Example: Cost Cutting (continued) 4. The system is expected to have a salvage value of $50,000 at the end of year 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

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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

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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. Firms required return = 15% Task: Click on the Excel icon to work through the example

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10-48 Example: Equivalent Annual Cost Analysis Burnout Batteries Initial Cost = $36 each 3-year life $100 per year to keep charged Expected salvage = $5 Straight-line depreciation Long-lasting Batteries Initial Cost = $60 each 5-year life $88 per year to keep charged Expected salvage = $5 Straight-line depreciation

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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%.

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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?

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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?

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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?

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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)

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

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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)

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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

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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

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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?

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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?

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