Chapter 10
Making Capital
Investment
Decisions
Slides Prepared By:
Larbi Hammami
Desautels Faculty of
Management
McGill University
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Learning Objectives
• How to determine the relevant cash flows for a
proposed project. (L01)
• How to project cash flows and determine if a project
is acceptable. (L02)
• How to calculate operating cash flow using
alternative methods. (L03)
• How to calculate the present value of a tax shield on
CCA. (L04)
• How to evaluate cost-cutting proposals. (L05)
• How to analyze replacement decisions. (L06)
• How to evaluate the equivalent annual cost of a
project. (L07)
• How to set a bid price for a project. (L08)
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Chapter Outline
10.1 Project Cash Flows: A First Look
10.2 Incremental Cash Flows
10.3 Pro Forma Financial Statements and Project Cash
Flows
10.4 More on Project Cash Flow
10.5 Alternative Definitions of Operating Cash Flow
10.6 Applying the Tax Shield Approach to the Majestic Mulch
and Compost Company Project
10.7 Some Special Cases of Discounted Cash Flow Analysis
Summary and Conclusions
Appendix A
Appendix B
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10.1 Project Cash Flows: A First Look
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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10.1 Project Cash Flows: A First Look
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.
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10.2 Incremental Cash Flows
• Sunk costs - costs that have been incurred in the
past
• Opportunity costs - costs of lost options
• Side effects
− Positive side effects - benefits to other projects
− Negative side effects - costs to other projects
• Changes in net working capital
• Financing costs
• Inflation
• Capital Cost Allowance (CCA)
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10.3 Pro Forma Financial Statements
and Project Cash Flows
• Capital budgeting relies heavily on pro forma
accounting statements, particularly statements of
comprehensive income.
• Computing cash flows - refresher
Operating Cash Flow (OCF)
= EBIT + depreciation – taxes
Cash Flow From Assets (CFFA)
= OCF – net capital spending (NCS) – changes in
NWC
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10.3 Pro Forma Financial Statements
and Project Cash Flows
Example
ABC Corporation is considering buying a new bottling
machine for $90,000. The machine will be good for 3
years and will allow the company to process and sell
an additional 50,000 bottles per year at $4 per bottle.
Variable costs will be $2.50 per unit. Fixed costs will
be $12,000 per year. This project will require an
upfront investment in inventory of $20,000 that will be
reclaimed at the end of the project. Depreciation will be
straight line with no salvage. The tax rate is 34% and
the required return is 20%.
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10.3 Pro Forma Financial Statements
and Project Cash Flows
Example (cont.)
Pro Forma Statement of Comprehensive Income
Sales (50,000 units at $4.00/unit)
$200,000
Variable Costs ($2.50/unit)
Gross profit
Fixed costs
Depreciation ($90,000/3)
EBIT
Taxes (34%)
Net Income
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125,000
$75,000
12,000
30,000
$33,000
11,220
$21,780
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10.3 Pro Forma Financial Statements
and Project Cash Flows
Example (cont.)
Projected Capital Requirements
Year
0
1
2
3
NWC
$20,000
$20,000
$20,000
$20,000
Net Fixed
Assets
Total $’s
Invested
90,000
60,000
30,000
0
$110,000
$80,000
$50,000
$20,000
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10.3 Pro Forma Financial Statements
and Project Cash Flows
Example (cont.)
Projected Incremental Cash Flows
Year
0
1
$51,780
OCF
Change
in NWC
Capital
Spending
–$20,000
CFFA
–$110,000 $51,780
2
$51,780
3
$51,780
20,000
–$90,000
$51,780
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$71,780
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10.3 Pro Forma Financial Statements
and Project Cash Flows
Making The Decision
• Now that we have the cash flows, we can apply the
techniques that we learned in chapter 9.
• Assume the required return is 20%.
• Enter the cash flows into the calculator and compute
NPV and IRR
− CF0 = –110,000; C01 = 51,780; F01 = 2;
C02 = 71,780
− NPV; I = 20; CPT NPV = 10,648
− CPT IRR = 25.8%
• Should we accept or reject the project?
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10.4 More on Project Cash Flow
More on NWC
Why do we have to consider changes in NWC
separately?
− GAAP requires that sales be recorded on the
statement of comprehensive income when made,
not when cash is received.
− 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.
− Finally, we have to buy inventory to support sales
although we haven’t collected cash yet.
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10.4 More on Project Cash Flow
Example
• CWT Corp. reported sales of $998 and costs of
$734. We have the following info:
Beginning
Ending
Accounts receivable
$100
$110
Inventory
100
80
Accounts payable
100
70
Net working capital
$100
$120
• What are the cash inflows? Cash outflows? What is
net cash flow?
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10.4 More on Project Cash Flow
Example (cont.)
• Cash Inflows = Sales – Increase in A/R
= 998 – (110 – 100) = 988
• Cash Outflows = Costs – Increase in A/P + Increase
in Inventory
= 734 – (70 – 100) + (80 – 100)
= 744
• Net Cash Flow = Cash Inflow – Cash Outflow
= 988 – 744 = 244
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10.4 More on Project Cash Flow
Example (cont.)
Or alternatively:
• Change in NWC = Increase in A/R + Increase in
Inventory – Increase in A/P
= 10 + (–20) – (–30) = 20
• Net Cash Flow = Sales – Costs – Change in NWC
= 998 – 734 – 20 = 244
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10.4 More on Project Cash Flow
Capital Cost Allowance (CCA)
• CCA is depreciation for tax purposes.
• The depreciation expense used for capital budgeting
should be calculated according to the CCA schedule
dictated by the tax code.
• Depreciation itself is a non-cash expense,
consequently, it is only relevant because it affects
taxes.
• Depreciation tax shield = D*T
D = depreciation expense
T = marginal tax rate
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10.4 More on Project Cash Flow
Computing Depreciation
• Need to know which asset class is appropriate for tax
purposes.
• Straight-line depreciation:
D = (Initial cost – salvage)/number of years
− Very few assets are depreciated straight-line for tax
purposes
• Declining Balance
− Multiply the percentage given in CCA table by 1.5 in year
1, then multiply by the un-depreciated capital cost (UCC).
− Can use PV of CCA Tax Shield Formula.
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10.4 More on Project Cash Flow
IdTc 1 + 1.5r Sn dTc
1
PV tax shield on CCA =
×
−
×
d+r
1+r
d + r (1 + r)n
Where:
I = Total Capital Investment
d = CCA tax rate
Tc = Corporate Tax Rate
r = discount rate
Sn = Salvage value in year n
n = number of periods in the project
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10.4 More on Project Cash Flow
Example
• 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%.
If the applicable CCA rate is 20% and the required
return on this project is 10%, what is the present
value of the CCA tax shield?
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10.4 More on Project Cash Flow
Example (cont.)
• The delivery and installation costs are capitalized in
the cost of the equipment
PV tax shield on CCA
110,000 × 0.2 × 0.4 1 + 1.5 × 0.1 17,000 × 0.2 × 0.4
1
=
×
−
×
0.2 + 0.1
1 + 0.1
0.2 + 0.1
(1 + 0.1)6
= $28,386.51
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10.5 Alternative Definitions of
Operating Cash Flow
• 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
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10.6 Applying the Tax-Shield
Approach to the MMCC Project
• Under the top-down and bottom-up approach,
project cash flows are calculated for each year
separately with non-cash items such as depreciation
added back each year.
− This requires a yearly calculation of CCA.
• The tax-shield approach simplifies the process with
a formula that calculates the present value of the
future tax shield on CCA.
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10.6 Applying the Tax-Shield
Approach to the MMCC Project
• The tax-shield formula allows for:
− adjusting for the 150 percent rule in the year of
addition;
− adjusting for CCA claims in perpetuity; and
− accounting for the disposal of the asset at the end
of the project.
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Evaluating Cost Cutting Proposal
• Your company is considering a new production system
that will initially cost $1 million. It will save $300,000 a
year in inventory and receivables management costs.
The system is expected to last for five years and will be
depreciated at a CCA rate of 20%. 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%.
• Click on the Excel icon to work through the example.
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Replacement Problem
• New Machine
• Original Machine
− Initial cost = $150,000
− Initial cost = $100,000
− 5-year life
− CCA rate = 20%
− Salvage in 5 years = 0
− Purchased 5 years ago
− Cost savings =$50,000
− Salvage today = $65,000
per year
− Salvage in 5 years = $10,000
− CCA rate = 20%
• Required return = 10%
• Tax rate = 40%
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Replacement Problem (cont.)
• 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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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Replacement Problem (cont.)
• If we sell the old equipment today, then we will
receive $65,000 today. However, we will also NOT
receive $10,000 in 5 years.
• The appropriate number to use in the NPV analysis
is the net salvage value.
• Always consider after-tax cash flows.
• You can use your calculator for the cash flows and
salvage, but there are no short cuts for finding the
PV of the CCA tax shield.
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Replacement Problem (cont.)
• Net present value of the project is:
NPV = −150,000 + 65,000 + 50,000(1 − 0.4)
1
1. 15 − 10,000
0.10
1.105
1−
65,000
150,000××0.2
0.2××0.4
0.4 11++0.5
0.5××0.1
0.1
−
×
+
× 1.10
0.10
++0.20
0.10
0.20
1.10
NPV = $45,806.54
• Therefore, the old equipment should be replaced.
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Equivalent Annual Cost
• Machine B
• Machine A
− Initial Cost = $100,000
− Initial Cost = $150,000
− Pre-tax operating cost
− Pre-tax operating cost
= $57,500
= $65,000
− Expected life is 6 years
− Expected life is 8 years
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 10%, the applicable CCA rate is 20% and the tax
rate is 40%.
Which machine should you buy?
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10.7 Some Special Cases of
Discounted Cash Flow Analysis
Example - Setting the Bid Price
• Consider the example in the textbook:
− Need to produce 5 modified trucks per year for 4 years.
− We can buy the truck platforms for $10,000 each.
− Facilities will be leased for $24,000 per year.
− Labour and material costs are $4,000 per truck.
− Need $60,000 investment in new equipment, depreciated at 20%
(CCA class 8).
− Expect to sell equipment for $5,000 at the end of 4 years.
− Need $40,000 in net working capital.
− Tax rate is 43.5%.
− Required return is 20%.
− Spreadsheet:
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Summary and Conclusions
• You should know:
− How to determine the relevant incremental cash flows
that should be considered in capital budgeting
decisions.
− How to calculate the CCA tax shield for a given
investment.
− How to perform a capital budgeting analysis for:
• Replacement problems
• Cost cutting problems
• Bid setting problems
• Projects of different lives
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Appendix 10A
Impact of Inflation
• The interest rate used in the capital budgeting
analysis can be in either nominal or real terms
Real Rate = Nominal Rate – Expected Inflation
• Also, cash flows can be either nominal or real.
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Appendix 10A
How to handle inflation
• Key - Be consistent
− Nominal cash flows must be discounted by the
nominal discount rate.
− Real cash flows must be discounted by the real
discount rate.
• NPV is the same under the two different
approaches.
• Use the approach that is simpler for the information
that you’re given.
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Appendix 10B
Capital Budgeting with Spreadsheets
• Spreadsheets are almost essential for capital
budgeting, especially when using pro forma
statements.
• Since spreadsheets completely integrate the
different tables needed for the capital budgeting
analysis, changing on variable instantly recalculates
the results for the entire spreadsheet.
• Very useful for sensitivity analysis calculations.
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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?
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