# Making Capital Investment Decisions

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Making Capital Investment Decisions

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

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.

Project Example - Visual
\$ -165,000 1 2 3 CF1 = 63,120 CF2 = 70,800 CF3 = 91,080 Where did the figures of \$63,120, \$70,800, and \$91,080 come from? This chapter will focus on the techniques and variables that determine an estimate for future cash flows. It is important to remind students that these are estimates as they amount to future cash flows and as such have associated uncertainty (and risk) in determining the accuracy of each number – the farther out in time, the greater the uncertainty. The estimate of the cost of a project is relatively simple in that this information is available in real time and thus the accuracy of the number is almost certain. The required return for assets of this risk level is 12% (as determined by the firm).

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

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 Lecture Tip: It should be strongly emphasized that a project’s cash flows imply changes in future firm cash flows and, therefore, in the firm’s future financial statements. Examples of such relationships are given in the IM.

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 Lecture Tip: You might find it useful to clearly delineate the link between the stand-alone principle and the concept of value additivity. By viewing projects as “mini-firms,” we imply that the firm as a whole constitutes a portfolio of mini-firms. As a result, the value of the firm equals the combined value of its components. This is the essence of value additivity, and it is assumed to hold generally whether we are discussing the cash flows in a simple time-value problem, the value of a project, or the value of the firm. Note also that an understanding of this concept paves the way for the analysis of mergers and acquisitions. For a merger to “create value,” the value additivity principle must be violated. (Violations take the form of production efficiencies, economies of scale, etc.) Perhaps a key value of this approach is that it places the burden of proof on those proposing the merger, just as the capital budgeting process places the burden of proof on those proposing investment in the project.

Common Types of Cash Flows
Sunk costs – costs that have accrued in the past Opportunity costs – costs of lost options Changes in net working capital (NWC) Financing costs Taxes With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant. Personal examples of sunk costs often help students understand the issue. Ask the students to consider a hypothetical situation in which a college student purchased a computer for \$1,500 while in high school. A better computer is now available that also costs \$1,500. The relevant factors to the decision are what benefits would be provided by the better computer to justify the purchase price. The cost of the original computer is irrelevant. Opportunity costs – the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not “free.” At the very least we could sell the land; consequently, if we choose to use it, we cost ourselves the selling price of the asset. A good example of a positive side effect is when you will establish a new distribution system with this project that can be used for existing or future projects. The benefit provided to those projects needs to be considered. The most common negative side effect is erosion or cannibalism, where the introduction of a new product will reduce the sales of existing, similar products. A good real-world example is McDonald’s introduction of the Arch Deluxe sandwich. Instead of generating all new sales, it primarily reduced sales in the Big Mac and the Quarter Pounder. Additional examples are provided in a Lecture Tip in the IM. It is important to consider changes in NWC. We need to remember that operating cash flow derived from the income statement assumes all sales are cash sales and that the COGS was actually paid in cash during that period. By looking at changes in NWC specifically, we can adjust for the difference in cash flow that results from accounting conventions. Most projects will require an increase in NWC initially as we build inventory and receivables. Then, we recover NWC at the end of the project. We do not include financing costs. Students often have difficulty understanding why when it appears that we will only raise capital if we take the project. It is important to point out that because of economies of scale, companies generally do not finance individual projects. Instead, they finance the entire portfolio of projects at one time. The other reason has to do with maintaining a target capital structure over time, but not necessarily each year. Finally, financing cost is included in the required return, thus including the financing-related cash flows would be double counting. Taxes will change as the firm’s taxable income changes. Consequently, we have to consider cash flows on an after-tax basis.

Common Types of Cash Flows
6. Side effects: Positive side effects – benefits to other projects Negative side effects – costs to other projects With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant.

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

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 Operating cash flow – students often have to go back to the income statement to see that the two definitions of operating cash flow are equivalent when there is no interest expense. Lecture Tip: Students sometimes become disheartened at what they perceive as complexities in the various capital budgeting calculations. You may find it useful to remind them that, in reality, setting up timelines and performing calculations are typically the least burdensome portion of the task. Rather, the difficulties arise principally in two areas: (1) generating good investment projects and (2) developing reliable cash flow estimates for these projects. Lecture Tip: Some students may still question why we are ignoring interest, since it is clearly a cash outflow. It should be strongly emphasized that we do not ignore interest expense (or any other financing expense, for that matter); rather, we are only evaluating asset related cash flows. It should be stressed that interest expense is a financing cost, not an operating cost.

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 costs 12,000 Depreciation (\$90,000 / 3) 30,000 EBIT \$ 33,000 Taxes (34%) 11,220 Net Income \$ 21,780 This is an example of a projected income statement for a project that has a life of three years with a constant sales and variable cost figure.

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

Projected Capital Requirements
Year 1 2 3 NWC \$20,000 Net FA 90,000 60,000 30,000 Total \$110,000 \$80,000 \$50,000 Ask the students why net fixed assets is decreasing each year. The accounting concept of depreciation is the key here. It is important that they understand why this is happening when they go to compute the net capital spending in the next slide.

Projected Total Cash Flows
Year 1 2 3 OCF \$51,780 Change in NWC -\$20,000 20,000 Net CS -\$90,000 CFFA -\$110,00 \$71,780 OCF = EBIT + depreciation – taxes = 33, ,000 – 11,220 = 51,780; or OCF = NI + depreciation = 21, ,000 = 51,780 Note that in the Table in the book, the negative signs have already been carried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending. Change in NWC = We have a net investment in NWC in year 0 of 20,000; we get the investment back at the end of the project when we sell our inventory, collect on our receivables and pay off our payables. Students often forget that we get the investment back at the end. Capital Spending – remember that Net capital spending = change in net fixed assets + depreciation. So in year one NCS = (60,000 – 90,000) + 30,000 = 0; The same is true for the other years. Lecture Tip: Capital spending at the time of project inception (i.e., the “initial outlay”) includes the following items: + purchase price of the new asset - selling price of the asset replaced (if applicable) + costs of site preparation, setup, and startup +/- increase (decrease) in tax liability due to sale of old asset at other than book value = net capital spending

Project Example - Visual
\$ -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).

Evaluate the Project CPT NPV = \$10,648 CPT IRR = 25.8%
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 = % You can also use the formulas to compute NPV and IRR; just remember that the IRR computation is trial and error. Click on the excel icon to go to an embedded spreadsheet that illustrates how the pro formulas and cash flows can be set-up. It also computes the NPV and IRR.

What’s Your Decision? So….Deal or No Deal?
Deal! The NPV is greater than \$0 and the IRR of 25.8% is greater than the firm’s required rate of return of 20%. Thus, we have NO conflict between NPV and IRR.

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. The first two items mean that our operating cash flow does not include the impact of accounts receivable and accounts payable on cash flow. The third item is very much like the purchase of fixed assets. We have to buy the assets (have the cash outflow) before we can generate sales. By looking at changes in NWC, we can incorporate the increased investment in receivables and inventory that are necessary to support additional sales. Because we look at changes in NWC, and not just current assets, we also incorporate the increase in our payable accounts that partially pays for the investment in inventory and receivables. The NWC discussion is very important and should not be overlooked by students. It may be helpful to reemphasize the point of NWC and operating cash flow through accounting entries, which is done in a Lecture Tip in the IM.

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 Students should be familiar with depreciation techniques from their accounting class(es) but a quick review of straight line, double declining, sum-of-the-years-digits, and MACRS might be in order. We will focus on just straight line and MACRS in this discussion.

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 The MACRS percentages are given in the textbook. Lecture Tip: Ask the students why a company might prefer accelerated depreciation for tax purposes to the simpler straight-line depreciation. An example is given in the IM. Another example is provided that reexamines the Majestic Mulch case from the text assuming straight-line, illustrating that the NPV is lower under this circumstance.

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)

After-tax Salvage Computation
Market Value – Book Value = gain (or loss) Take gain (or loss) x (marginal tax rate) Pay taxes on a gain; Receive a tax benefit on a loss After-tax Salvage = Market Value – taxes paid or Market Value + tax benefit Students can easily appreciate this concept if it is exemplified with the sale of a used car in terms of what they paid for it and what they can sell it for. If they have put effort into modifying the car they could possibly sell it for more than they purchased and thus, a gain. The gain is what they must pay in taxes (based on what US state they live in).

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.

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 5 4 3 2 1 It is important to point out to the students that the \$17,000 is in cash and is available to the company. The only problem is that it is six years away and thus we need to use the time value of money if we are going to compute the project’s value using NPV, IRR or MIRR.

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 Straight –line depreciation’s formula is the total depreciable basis minus the salvage value (if there is any) divided by the accounting life of the asset. The depreciation is \$110,000 – 17,000 divided by the number of years, 6 = \$15,500/year

Example A: Straight-Line
The company’s marginal tax rate is 40%. Market Selling Price = \$17,000 Book Value at year 6: \$17,000 Capital gain/loss = Taxes paid on gain/loss = (\$0).40 = \$0 After-tax salvage value: 17, (17,000 – 17,000) = \$17,000 Straight –line depreciation’s formula is the total depreciable basis minus the salvage value (if there is any) divided by the accounting life of the asset. The depreciation is \$110,000 – 17,000 divided by the number of years, 6 = \$15,500/year The book value in year 6 is the asset’s depreciable basis minus the accumulated depreciation \$110,000 - \$15,500 x 6 years = \$110,000 - \$93,000 = \$17,000

Example B: Three-year MACRS
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 The figures for MACRS are from the GAAP and not produced by the managers of a single firm. Note that with MACRS you do not subtract the expected salvage from the initial cost. Also note that the MACRS % is multiplied by the initial cost every year. For some reason, students want to multiply by the book value.

Example B: MACRS The company’s marginal tax rate is 40%.
Market Selling Price = \$17,000 Book Value at year 6: \$ 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 BV in year 6 = 110,000 – 36,663 – 48,895 – 16,291 – 8,151 = 0 Alternatively: MV of \$17,000 – taxes paid of \$6,800 = after-tax salvage value = \$10,200

Example C: Seven-Year MACRS
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 BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,812 = 14,729

Example C: MACRS The company’s 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 BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,812 = 14,729 Alternatively: MV of \$17,000 – taxes paid of \$ = after-tax salvage value = \$16,091.60

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

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?

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%

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?

Replacement Problem Pro Forma Income Statements
Year 1 2 3 4 5 Cost Savings 50,000 Depr. New 49,995 66,675 22,215 11,115 Old 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 10-38

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) The year 5 cash flow is the most difficult for students to grasp. It is important to point out that we are looking for ALL changes in cash flow associated with selling the machine today instead of in 5 years. If we do not sell the machine today, then we will have after-tax salvage of 10,000 in 5 years. Since we do sell the machine today, we LOSE the 10,000 cash flow in 5 years.

Replacement Problem Cash Flow From Assets
Year 1 2 3 4 5 OCF 46,398 53,070 35,286 30,846 26,400 NCS -89,000 -10,000  In NWC CFFA 16,400 The negative signs in the CFFA equation were once again carried through the table. That way outflows are in the table as negative and inflows are positive.

Replacement Problem Analyzing the Cash Flows
Now that we have the cash flows, we can compute the NPV and IRR Enter the cash flows Compute the NPV and the IRR Compute NPV = \$54,801.74 Compute IRR = 36.28% Should the company replace the equipment? Replace the equipment: NPV>0 and the IRR of 36.28%>the required return of 10%. If students are having difficulties using their financial calculators for this problem, go back to chapter 9 and see the example using both the HP 12c and TI BA II plus calculators for NPV.

Chapter Outline Capital Budgeting and Cash Flows
Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis

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

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. There are two worksheets. The first allows you to enter the information and work the example during class. The second provides the solutions. You may go directly to this one if you do not wish to show the students how to set up the spreadsheet during class time. The example is an additional one to that provided in the textbook.

Example: Cost Cutting (continued)
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%. Task: Click on the Excel icon to work through the example There are two worksheets. The first allows you to enter the information and work the example during class. The second provides the solutions. You may go directly to this one if you do not wish to show the students how to set up the spreadsheet during class time. The example is an additional one to that provided in the textbook.

Example: Setting the Bid Price
Consider the following information: The Army has requested bids 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 Click on the worksheet to see the solution to the problem. If you wanted to set up a separate spreadsheet using Solver, you certainly could.

Example: Setting the Bid Price (continued)
Requires \$50,000 in fixed assets with expected salvage of \$10,000 at the end of the project (depreciate straight-line) Requires an initial \$10,000 increase in NWC Tax rate = 34% Firm’s required return = 15% Task: Click on the Excel icon to work through the example Click on the worksheet to see the solution to the problem. If you wanted to set up a separate spreadsheet using Solver, you certainly could.

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

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%.

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?

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?

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? Annual depreciation expense: Year 1: x \$1million = \$142,900 Year 7: x \$1million = \$89,300 Year 8: x \$1million = \$44,600 Time 0 cash flow = -\$1million investment – (\$150,000 - \$50,000) = -\$1,100,000 Time 1 and 7 cash flow = (\$400,000 - \$150,000) x (1 - .4) + (.4 x \$89,300) = \$185,720 Time 8 cash flow = (\$400,000 - \$150,000) x (1 - .4) + (.4 x \$44,600) + \$100,000 NWC = \$267,840 (assumes zero salvage value)

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)

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

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)

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

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

What are the most important topics of this chapter?
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?
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.

Questions?