Chapter
Ten
Making Capital
Investment
Decisions
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
10.1
Relevant Cash Flows 10.1
 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
10.2
Relevant Cash Flows
 Relevant Cash Flows – any incremental changes in cash flows
related to the project
1- Depreciation is not a cash flow, but does affect taxes which are
cash flows.
2- Purchases of fixed assets represents cash outflows. They also
produce depreciation.
3- Any working capital changes associated with a capital
budgeting project must be recognized as part of the investment
at the beginning (and possibly end) of the project.
4- Ignore sunk costs.
5- Include opportunity costs.
6- Include externalities (side effects) from other parts (products)
of the firm.
7- Do not include interest expense.
10.3
Asking the Right Question
 You should always ask yourself “Will this cash flow occur (or
not 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 (or does not occur) because of the project
10.4
Common Types of Cash Flows 10.2
 Sunk costs – costs that have been incurred in the past (& thus
must be excluded from the current decision)
 Opportunity costs – cost of foregone opportunities
 Example – you purchased an asset many years ago for a
nominal sum. You now want to use that asset in a current
project. How much do you charge to the project, since you
already own the asset?
 You must charge the project with the amount you could
obtain by selling the asset to another user.
10.5
Common Types of Cash Flows
 Side effects
 Positive side effects – benefits to other projects
 Negative side effects – costs to other projects
 Issue of erosion or cannibalism
 Be sure to only include erosion due to the new project. Erosion
can also occur due to competition from other firms.
 Example: Air Canada – Tango versus the mainline fleet
 Changes in net working capital (NWC)
 Increases in NWC are a cost of the project
 Decreases in NWC are a benefit of the project
 NWC often increases initially and then decreases at the end
of the project’s life
10.6
Types of Cash Flows
 Three types of cash flows to evaluate
1- Initial Outflows ( CF0):
-
fixed assets
working capital
2- Annual Cash Flows (CF1→N):
-
income statement (no interest expense)
3- Terminal Cash Flows (CFN):
-
fixed assets
working capital
10.7
Example 1
 Your firm is contemplating the purchase of a new
$700,000 computer-based order entry system. The
system will be depreciated straight-line to zero over
its five-year life. It will be worth $160,000 at the end
of that time. You will save $300,000 before taxes per
year in order processing costs, and you will be able to
reduce working capital by $70,000 at the beginning
of the project. Working capital will revert back to
normal at the end of the project. If the tax rate is
35%, what is the IRR for this project?
10.8
Example 1 (cont.)
CF0
CF1
CF2
CF3
CF4
CF5
-630,000
244,000
244,000
244,000
244,000
278,000
IRR = 27.82%
IF I=11%
NPV = $291,976.23
10.9
Example 2
 A company is evaluating a new acquisition of a milling
machine. The machine’s price is $180,000 and it would cost
another $25,000 to modify it for special use by the firm. The
machine falls into the ACRS three-year class and it will be
sold after three years for $80,000. The machine would require
an increase in inventory of $7,500. This will be recovered
when the machine is sold. The machine would have no effect
on revenues, but it is expected to save the firm $75,000 per
year in before tax operating costs. The firm’s marginal tax rate
is 34%. Find the initial investment and all annual cash flows
associated with this project.
10.10
Example 2 (cont.)
CF0
CF1
CF2
CF3
-212,500
72,731
80,475
125,295
IRR = 13.43%
If I=10%
NPV = $14,263.34
PP = 2.47 yrs
10.11
Example 3
 Marsh Mining is considered an expansion project. The proposed project
has the following features:
- The project has an initial cost of $500,000 and this amount will be fully
depreciated using the 3-yrs MACRS class.
- If the project is undertaken, at year 0 the company will need to increase its
inventories by $50,000, and its accounts payable will rise by $10,000. This
net working capital will be recovered at the end of the project’s life of 4
years.
- If the project is undertaken, the company will realize an additional
$580,000 in sales over each of the next 4 years. The company’s operating
costs (excluding depreciation) will increase by $400,000 each year.
- The company’s tax rate is 40%.
- At the end of 4 yrs, the project will have a salvage value of $50,000.
- The project’s required rate of return (WACC) is 10%.
What is the project’s NPV?
10.12
Example 3 (cont.)
CF0
CF1
CF2
CF3
CF4
-540,000
174,660
196,880
137,640
192,820
I = 10
NPV = $16,602.19
IRR = 11.42%
10.13
Example 4
 Universal Farm Supply’s Management has observed that it can sell as
much fertilizer as it can stock and is considering the possibility of
purchasing a forklift and expanding warehouse space in order to be able to
handle and stock more fertilizer. The forklift costs $42,000 and would be
depreciated on a straight-line basis to a salvage value of zero in seven
years, even though it will last ten years. The forklift will not be sold. The
warehouse expansion would cost $100,000 and would be straight-line
depreciated to a salvage value of, and sold for $60,000 in ten years. The
expansion would allow Universal to sell 1,000,000 more pounds per year
at $0.20 per pound. The fertilizer costs Universal $0.17 per pound to
produce. This increase in sales will also require an increase in accounts
receivables of $200,000, in inventory of $50,000, and in accounts payable
of $15,000. These will be recovered at the end of ten years. Universal’s
marginal tax rate is 34%. Calculate the initial investment and the annual
cash flows associated with this project. If the required rate of return
(WACC) is 11%, calculate the project’s net present value and internal rate
of return.
10.14
Example 4 (cont.)
CF0
CF1→7
CF8→9
CF10
-197,000
23,200
21,160
136,160
I = 11
NPV = -$22,269.76
IRR = 8.78%
10.15
Common Types of Cash Flows 10.2
 Financing costs
 Are never included in the cash flows of the project
 Financing costs are captured in the discount rate
10.16
More on NWC 10.4
 Why do we have to consider changes in NWC separately?
 An investment in current assets is exactly the same as an investment in a
fixed asset (but it is harder to visualize)
 An increase in NWC requires either:
 An increase in Current Assets (a use of cash)
 A reduction in Current Liabilities (a use of cash)
 GAAP requires that sales be recorded on the income statement when
made, not when cash is received (recorded as an Account Receivable on
the B/S)
 GAAP also requires that we record cost of goods sold when the
corresponding sales are made, regardless of whether we have actually
paid our suppliers yet (costs recorded as an Account Payable on the
B/S)
 Finally, we have to buy inventory to support sales although we haven’t
collected cash yet (Both inventory and accounts payable rise)