10-0 Making Capital Investment Decisions Chapter 10 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Outline Relevant and Irrelevant Cash Flows How to Evaluate a Project Capital Budgeting Example Special Types of Projects 1

Relevant Cash Flows Incremental cash flows: cash flows that will only occur if the project is accepted. - Opportunity Costs - Side Effects - Change in NWC - Taxes 2

Irrelevant Cash Flows Sunk costs Financing costs 3

How to Evaluate a Project 1. Calculate the Pro Forma Income Statements 2. Compute CF from Assets Cash Flow From Assets = OCF – net capital spending – changes in NWC where: operating cash flow (OCF) = EBIT + depr – taxes net capital spending includes: - initial investment + after tax salvage value at the end change in NWC: always adds up to 0 3. Apply the Evaluation Criteria NPV, IRR, etc. 4

Capital Budgeting Example Project X  you expect to sell 500 stereo amplifiers in year 1 at $8,000 each, unit sales grow at 10% per year  variable cost = $5,000/unit  fixed costs = $610,000/year  Initial investment = $1,100,000 (use straight line depreciation)  The project has a 4-year life  In 4 years the equipment sells for $550,000  The initial investment in NWC = $900,000  Tax rate = 34% If the required rate of return = 20%, should you accept the project? 5

Special Types of Projects Cost Cutting evaluate: after-tax cost saving + depreciation tax shield instead of OCF Setting the Bid Price find the OCF that sets the NPV = 0, then find the NI, sales, and finally the unit price Equivalent Annual Cost (EAC) use for evaluating projects of different economic lives EAC=PMT in an annuity where the PV is the NPV of the projects CFs 6