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Making Capital Investment Decision
RWJ-Chapter 10
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Project Cash Flows: A First Look
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A relevant cash flow for a project is a change in the firm’s
overall future cash flow that comes about as a direct
consequence of the decision to take that project.
The relevant cash flows are called “incremental cash flows”.
Incremental cash flow: The difference between a firm’s future
cash flows with a project and those without a project.
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Incremental Cash Flows
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Cash flows matter—not accounting earnings.
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Sunk costs don’t matter.
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Incremental cash flows matter.
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Opportunity costs matter.
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Side effects like cannibalism and erosion matter.

Taxes matter: we want incremental after-tax cash flows.
Incremental CFs are changes in firm’s cash flows that occur as a direct
consequence of accepting the project.
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Cash Flows—Not Accounting Earnings.
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Consider depreciation expense.

You never write a check made out to “depreciation”.
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Much of the work in evaluating a project lies in taking
accounting numbers and generating cash flows.
Example: A company just paid $1 million for a building, as part
of a new capital budgeting project. $1 million is a cash outflow.
Assuming straight line depreciation for 20 years, only $50,000
is considered as accounting expense in the current year.
Current earnings are reduced by $50,000; remaining 950,000
will be expensed over the following 19 years. For capital
budgeting purposes, the relevant cash flow at date 0 is the full
$1 million, not the reduction in earnings of $50,000.
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Incremental Cash Flows
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Sunk costs are not relevant
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Costs that we have already paid or have already incurred the
liability to pay. Such costs cannot be changed by the decision
today to accept or reject the project.
Example: General Milk Company is currently evaluating the
NPV of establishing a line of chocolate milk. As part of the
evaluation the company had paid a consulting firm $100,000
to perform a test-marketing analysis. This expenditure was
made last year. Is this cost relevant for capital budgeting
decision?
No!! Once the company incurred the expense, the cost
became irrelevant for any future decision (the consulting fee
must be paid whether or not the company launches the new
line).
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Incremental Cash Flows
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Opportunity costs do matter. If we are giving up a
valuable alternative when we take a particular
investment, we have to take that into consideration.
Example: Weinstein Company has an empty warehouse
in Philadelphia that can be used to store a new line of
electronic pinball machines. The company hopes to sell
these machines to northeastern customers. Should the
warehouse be considered a cost in the decision to sell
the machines?
Yes!! The company could have sold the warehouse or
rented it to an other company.
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Incremental Cash Flows
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Side effects matter.
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Erosion or cannibalism is a bad thing. If our new product
causes existing customers to demand less of current
products, we need to recognize that.
Example: A car company, IMC, is determining the NPV of a
new convertible sports car. Some of the customers who
would purchase the car are the owners IMC’s compact
sedan. Are all sales and profits from the new convertible
incremental? What if the competitor launches a convertible
car?
IMC is also contemplating the formation of a racing team.
The team is forecasted to lose money but it is likely to
generate publicity and increase cash flows elsewhere in the
firm. Should the firm consider those cash flows in their
decision?
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Allocated Costs
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Frequently a particular expenditure benefits a number of
projects. Accountants allocate this cost across the
different projects.
For example, project to open a Home Depot store might
have total advertising expense allocated to it.
If the allocated cost is an incremental cost of the project,
then it should be considered as cash outflow. So, one
must ask the question: What is the difference between
the cash flows of the entire firm with the project and the
cash flows of the entire firm without the project?
If Home Depot’s advertising expenses will increase when
the new store opens, then this is an incremental cash
flow. Otherwise it is not.
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Financing Costs
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In analyzing a proposed investment, we will NOT include
interest paid or any other financing costs such as
dividends.
Firms are interested in the cash flow generated by the
assets of the project. Therefore they typically calculate a
project’s cash flows under the assumption that the project
is financed only with equity.
Any adjustments for debt financing are reflected in the
discount rate, not the cash flows.
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Pro-Forma Financial Statements and
Project Cash Flows
 Cash
Flows from Operations
 Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
 Net
Capital Spending
 Don’t forget salvage value (after tax, of course).
 Changes
in Net Working Capital
 Increases in net working capital are viewed as
cash outflows.
 Decreases in net working capital are viewed as
cash inflows.
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Example- Pristine Urban-Tech
Zither, Inc. (PUTZ)
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Calculating Project NPV
+ Some Special Cases of Discounted Cash Flow
Analysis
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Evaluating cost-cutting proposals
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Evaluating equipment options with different lives
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Evaluating Cost-Cutting Proposals (1)
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We are considering automating some part of an existing
production process. The necessary equipment costs $80,000.
The automation will save $22,000 (before taxes). The
equipment has 5 year life and is depreciated straight-line to
zero over five years. The machine will be worth $20,000 in five
years. Should we automate?
Relevant cash flows
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Cost of the machine ($80,000)
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After-tax salvage value (20,000 x (1-0.34) = $13,200)
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Additional depreciation deduction
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Evaluating Cost-Cutting Proposals (2)
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Operating Cash Flow = EBIT – Taxes +
Depreciation
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EBIT= Sales- Costs-Depreciation
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EBIT = $22,000 – $16,000 = $6,000
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Taxes = EBIT x Tax rate = $6,000 x 0.34 = $2,040
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OCF = $6,000 - $2,040 + $16,000 = $19,960
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Cost savings increase our pretax income by $22,000. We have
to pay taxes on this amount , so our tax bill also increases.
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Evaluating Cost-Cutting Proposals (3)
NPV = $3,860 (so automate!!)
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Investments of Unequal Lives: The
Equivalent Annual Cost Method
 There
are times when application of the NPV rule
can lead to the wrong decision. Consider a factory
which must have an air cleaner. The equipment is
mandated by law, so there is no “doing without”.
 There are two choices:
 The “Cadillac cleaner”
costs $4,000 today, has
annual operating costs of $100 and lasts for 10
years.
 The “Cheapskate cleaner” costs $1,000 today, has
annual operating costs of $500 and lasts for 5
years.
 Which
one should we choose?
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EAC with a Calculator
At first glance, the Cheapskate cleaner has a lower NPV
Cadillac Air Cleaner
Cheapskate Air Cleaner
CF0
–4,000
CF0
–1,000
CF1
–100
CF1
–500
F1
10
F1
5
I
10
I
10
NPV
–4,614.46
NPV
–2,895.39
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Investments of Unequal Lives: The
Equivalent Annual Cost Method
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This overlooks the fact that the Cadillac cleaner lasts twice as
long.
When we incorporate that, the Cadillac cleaner is actually
cheaper.
+ Investments of Unequal Lives: The
Equivalent Annual Cost Method
The Cadillac cleaner time line of cash flows
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100
0
1
2
3
4
5
6
7
8
9
10
The Cheapskate cleaner time line of cash flows
over ten years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500
0
1
2
3
4
5
6
7
8
9
10
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The Equivalent Annual Cost Method
When we make a fair comparison, the Cadillac is cheaper:
Cadillac Air Cleaner
CF0
CF1
–4,000
–100
Cheapskate Air Cleaner
CF0
–1,000
CF1
–500
F1
F1
10
CF2
I
10
F1
NPV
–4,614.46
CF3
F1
4
–1,500
1
–500
5
I
NPV
10
–4,693
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Investments of Unequal Lives
 Replacement
Chain (Common Life) Method
 Repeat projects until they begin and end at
the same time—like we just did with the air
cleaners.
 Compute NPV for the “repeated projects”.
 The
Equivalent Annual Cost Method
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Investments of Unequal Lives: EAC
The Equivalent Annual Cost Method
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The Equivalent Annual Cost is the value of the level payment
annuity that has the same PV as our original set of cash flows.
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Costs should be stated in real terms.
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NPV = EAC × ArT
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Where ArT is the present value of $1 per period for T periods
when the discount rate is r.
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For example, the EAC for the Cadillac air cleaner is $750.98
The EAC for the cheapstake air cleaner is $763.80 which confirms our
earlier decision to reject it.
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Cadillac EAC with a Calculator
Use the cash flow menu to find the PV of the “lumpy” cash flows.
Then use the time value of money keys to find a payment with that
present value.
CF0
–4,000
N
10
CF1
–100
I/Y
10
F1
10
PV
I
10
PMT
NPV
–4,614.46
FV
–4,614.46
750.98
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Summary and Conclusions
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Capital budgeting must be placed on an incremental basis.
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Sunk costs are ignored
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Opportunity costs and side effects matter
When a firm must choose between two machines of unequal
lives:
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the firm can apply either the replacement chain (common life)
approach or the equivalent annual cost approach.
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The Human Factor in Capital
Budgeting
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Every project has a champion behind it. This creates a potential
for an optimistic bias in estimating the numbers. Small
adjustments to cash flow projections and the discount rates can
sway a project’s NPV from negative to positive.
One way to control for this bias is to put the responsibility for
analyzing an investment proposal under an authority
independent from the individual or group proposing the
investment.
Best financial analysts can not only provide the numbers to
highlight the value of a good investment but can also explain
why the investment makes sense.
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How Do We Estimate Project Revenues And
Expenses?
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Experience and history
 The process of estimating project revenues and expenses is
simplest for firms that consider the same kind of projects
repeatedly. (e.g. Home Depot has many stores and a rich
database of how these stores did in the past).
Market testing
 If the products and services being considered by the firm is
catering to a different market, the company might not be able to
use the experience from previous projects. Market surveys and
market testing can be useful tools in these cases. (e.g. Home
Depot opened 8 Expo stores in different parts of the country to
test the concept)
Scenario analysis
 There is considerable uncertainty introduced by external factors.
A firm can consider different scenarios and revenues and
expenses under each scenario. If probabilities are attached to
each scenario, then they can be used to find the expected
values of the project.