Making Capital
Investment Decisions
What finance functions add the most to
firm value?
2
What do we discount
General Rules to follow:
Only cash flows matter
2. Only examine incremental cash flow
3. Be consistent in treatment of inflation
4. Deduct taxes before discounting
1.
3
Cash Flow are what matter



Cash flow = Dollars receive – Dollars paid
Earnings are NOT cash flow
Earnings are an ACCOUNTING NUMBER
 Accountants start
with cash flow, but then adjusts for
timing, accruals, non-cash items etc.

Much of the work in evaluating a project lies in
taking accounting numbers and generating cash flows
 You
never write a check for “depreciation”
4
Incremental Cash Flows

These are cash flows that the firm only incurs
if it takes the project
 Need
to consider all incremental cash flows that
can be attributed to the project

Examples: Project Interactions, Opportunity
Costs, Overhead, Depreciation, Taxes
(including cap gains tax), and Salvage Values
5
Interactions (Side Effects)
 Affects
that the investment has on the
cash flows of the firm’s other projects
 Erosion or Cannibalism (Bad)
The
new product causes existing customers
to demand less of the company’s current
products
6
Erosion in Action

Denon is planning on introducing a Blu-Ray player,
which will likely hurt the sales of their DVD players. Are
all of the sales/profits of the Blu-Ray project incremental?
C0
C1
C2
CD Sales No DVD
800
1000
CD Sales With DVD
DVD Sales
500
400
400
800
-200
DVD Incremental CF
7
Working Capital

Money the firm has on hand that is necessary
for running the business
 Think
of the cash in a register, how effective is the
register without the cash in the drawer

If a project requires changes in working capital,
we need to account for this in our calculations
Why???
8
Opportunity Costs

Cash flows that can be realized from putting
the assets to use in different projects.
 What

could we be making?
Example: When Price Club considers stocking
a new product, what is the opportunity costs
that it should be considering?
9
Overhead

The ongoing administrative expenses a
business incurs, which cannot be attributed to
any specific business activity, but are
necessary to run the firm.
 Examples:
rent, utilities, and insurance.
 Accountants allocate overhead across projects

Are we concerned about the amount of
overhead the account’s will assign to our
project?
10
Example

A firm has only one division A, with assets of $100m
and overhead of $20m. It is planning to add another
division B. Division B will have another $50m in
assets. Due to the addition of this division, overhead
is expected to increase to $27m. The firm allocates
overheads for the two divisions based on their assets.
 What
are the allocated overhead expenses?
 What is the relevant cash flow as far as the decision to add
division B?
11
Depreciation

Allocates the cost of an asset over its expected
life, for accounting and tax purposes
 Accounts
for the decline in asset value because of
wear and tear or obsolescence
 Depreciation is based on the asset’s expected life,
not on the life of the project

LAND DOES NOT DEPRECIATE
12
Why do we care about Depreciation

Depreciation is a non-cash expense, an
accounting number, so why do we care about it?
13
The Two Depreciations

Book (Accounting) Depreciation is what
appears on financial statements
 Ex.

Straight line depreciation
Tax Depreciation is used to determine the
firms tax bill
 This
determines the Tax Shield
14
The Two EBT’s
EBDT
-Tax Dep
EBT
(Tax)
Tax Rate
Taxes Paid
-Book Dep
EBT
(Book)
-Taxes Paid
Net Income =
Book EBT –
Taxes Paid
15
Book Depreciation
This type of depreciation is used to calculate a
company’s Net Income
 Straight line Depreciation:

 (Investment
– Salvage Value) / Expected life
 Investment:
 Salvage
Value:
16
Tax Depreciation

Tax Depreciation is calculated using the
Modified Accelerated Cost Recovery System
 Tax
depreciation ignores salvage value
 MACRS allows for more depreciation early


How will this affect the PV of the tax shield?
Tax Shield = (Tax Depreciation * tax rate)
 What
is the Tax Shield?
17
Tax Depreciation Schedules by Recovery-Period Class
Year(s)
1
2
3
4
5
6
7
8
9
10
11
3-Year
5-Year
7-Year
10-Year
33.33
44.45
14.81
7.41
20.00
32.00
19.20
11.52
11.52
5.76
14.29
24.49
17.49
12.49
8.93
8.93
8.93
4.45
10.00
18.00
14.40
11.52
9.22
7.37
6.55
6.55
6.55
6.55
3.29
18
Acct & Tax Dep. Example


Purchase an asset costing $1m, which has a 5 year
expected life. After 5 years you can sell it for
scrap, $100k.
What is the yearly accounting (straight line) and
tax depreciation?
Year 1
Year 2
Year 3
Year 4
Year 5
Accting
Tax
19
Proceeds from Sale and Capital
Gains Tax
When a company sells an asset, if the price is
above the tax book value, it is subject to capital
gains
 Capital Gains Tax Obligation =
(Price- Tax Book Value) * Capital Gains Tax Rate

20
Capital Gains Tax Example

You purchase a machine that will cost your
company $1.5m, that has a life of 5 years. You
plan to use the project for 3 years and then sell
the machine for $600k, at the end of 5 years
the machine is worth $50k. The capital gains
rate is 20%. What is the tax obligation
resulting from the sale?
21
Inflation and Capital Budgeting

Inflation: general increase in the price of good
 Alternative:
the general decline in the purchasing
power of money
 Hershey Nickel Bar:
In 1930 bar was 2 oz
 In 1968 bar was ¾ oz


Inflation is an important fact of economic life
and must be considered in capital budgeting.
22
Dealing with Inflation

KEY: Keep everything in either real or
nominal terms
Cash Flows → Real Discount Rate
 Nominal Cash Flows → Nominal Discount Rate
 Real

As long as we are consistent in our treatment
of inflation we will get the same NPV
23
Real vs. Nominal
Nominal dollars:
 Real dollars:
 Nominal rate:
 Real rate:

24
Inflation and Discount rate

The relationship between interest rates and
inflation is known as the Fisher Equation
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
25
Real vs. Nominal Rate Example 1

If you invest $10,000 at a nominal rate of 12%
APR, how much will you have in 30 years?

How much will you have in real terms if the
rate of inflation is 4% per year?
26
Real vs. Nominal Rate Example 2

Nominal Rate is 15%, inflation is 10%
Year
Real CF
Nominal CF


0
-10
-10
1
10
2
11
3
12
What is the real discount rate?
What are the nominal cash flows?
27
Depreciation & Inflation

Depreciation is always given in nominal terms
 So,
if using real cash flow and discount rates you
will need to convert nominal depreciation into real
depreciation

Generally it’s simpler to use nominal cash
flows and the nominal discount rate
28
Costs we Do NOT Care About

Sunk Costs: are expenses that have already been
paid
 Already
paid so NOT INCREMENTAL to project
 Ex: Feasibility study, R&D expenses, test marketing,
etc.


Each of theses is an independent projects, subject to NPV
Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.
29
Cost Categories
When determining whether a cost is relevant in
NPV analysis, you need to classify it
 Incremental costs, We care about these
 Opportunity costs, We care about these
 Sunk costs, We do NOT care about these

30
Estimating Cash Flows

Cash Flow from Operations
 Recall
that:
OCF = EBIT – Taxes + Depreciation
31
Other Methods for Computing OCF

Bottom-Up Approach
 Works
only when there is no interest expense
 OCF = NI + depreciation

Top-Down Approach
= Sales – Costs – Taxes
 Do not subtract non-cash deductions
 OCF

Tax Shield Approach
 OCF
= (Sales – Costs)(1 – τ) + Depreciation* τ
32
Interest Expense
 For
now, assume that debt is independent
of the project
Interest
expense is not influenced by the
project
 Later
we will deal with the impact that
debt has on firm value
33
Big Example 1
Denon is planning to introduce a DVD player. It seeks your advice on whether this
project should be taken up. The details are given below:
 The initial investment in plant and machinery is 5 million.
 The project also requires an initial Net Working Capital of 1 million which will be
recouped entirely when the project is sold off at the end of year 3.
 The revenues from the DVD player is expected to be 9, 10 and 11 million in the
first three years.
 Variable cost are expected to be 60% of sales. Fixed costs are expected to be 1
million each year.
 For simplicity, assume all assets have a life of 5 years, and assets have no salvage
value.
 The firm expects to sell off the assets after 3 years for $2m.
 DVD player sales are expected to cannibalize $1million from CD player sales
 Corporate tax rate is 35%. Capital gains tax rate is 20%. Discount rate = 10%
34
Big Example 1: Investment
Denon is planning to introduce a DVD player. It seeks your advice on whether this project should be
taken up. The details are given below:

The initial investment in plant and machinery is 5 million.

The project also requires an initial Net Working Capital of 1 million which will be recouped
entirely when the project is sold off at the end of year 3.
Year 0
Year 1
Year 2
Year 3
1.00
1.00
0.00
Total Investment
Plant & Machinery
5.00
Net Working Capital
1.00
35
Big Example 1: Operations
Denon is planning to introduce a DVD player. It seeks your advice on whether this project
should be taken up. The details are given below:
 The revenues from the DVD player is expected to be 9, 10 and 11 million in the first
three years.
 Variable cost are expected to be 60% of sales. Fixed costs are expected to be 1 million
each year.
 For simplicity, assume all assets have a life of 5 years, and assets have no salvage value.
Year 0
Year 1
Year 2
Year 3
Sales
9.00
10.00
11.00
Variable Costs (60% Sale)
5.40
6.00
6.60
Fixed Costs
1.00
1.00
1.00
EBDT
2.60
3.00
3.40
Book Dep
1.00
1.00
1.00
EBT
1.60
2.00
2.40
Profit / Loss Accounts
36
Big Example 1: Corp Taxes
Denon is planning to introduce a DVD player. It seeks your advice on whether this project


should be taken up. The details are given below:
For simplicity, assume all assets have a life of 5 years, and assets have no salvage
value.
Corporate tax rate is 35%. Capital gains tax rate is 20%. Discount rate = 10%
Year 0
Year 1
Year 2
Year 3
2.60
3.00
3.40
20.0%
32.0%
19.2%
Tax Dep
1.00
1.60
0.96
EBT (Tax)
1.6
1.40
2.44
Tax (35%)
0.56
0.49
0.85
Corp Tax
EBDT
Tax Dep %
37
Big Example 1: Capital Gains
Denon is planning to introduce a DVD player. It seeks your advice on whether this project



should be taken up. The details are given below:
The firm expects to sell off the assets after 3 years for $2m
The assets has a life of 5 years, and assets have no salvage value.
Corporate tax rate is 35%. Capital gains tax rate is 20%. Discount rate = 10%
Year 0
Year 1
Year 2
Year 3
Capital Gains Tax
Proceeds from sale
2.00
Tax Dep
BV of asset
5.00
1.00
1.60
0.96
4.00
2.40
1.44
Profit
0.56
Capital Gains Tax (20%)
0.11
38
Big Example 1: Op 2, Net Income
Denon is planning to introduce a DVD player. It seeks your advice on whether this project
should be taken up. The details are given below:
Year 0
Year 1
Year 2
Year 3
Sales
9.00
10.00
11.00
Variable Costs (60% Sale)
5.40
6.00
6.60
Fixed Costs
1.00
1.00
1.00
EBDT
2.60
3.00
3.40
Book Dep
1.00
1.00
1.00
EBT
1.60
2.00
2.40
Tax
0.56
0.49
0.85
Net Income
1.04
1.51
1.55
Profit / Loss Accounts
39
Big Example 1: C F Summary
Year 0
Year 1
Year 2
Year 3
0.00
0.00
1.00
Net Income
1.04
1.51
1.55
Book Dep
1.00
1.00
1.00
Investments
(5.00)
Change in Working Capital
(1.00)
Sale Proceeds
2.00
Capital Gains
(0.11)
Lost CD Sales
Net Cash Flow
(6.00)
NPV
(0.47)
(1.00)
(1.00)
(1.00)
1.04
1.51
4.44
40
Big Example 2: (In-Class 1, Given)
Your R&D department has come up with a innovative product. Your firm had spent $2m as R&D
expenses for this project. You are now wondering whether this product introduction will
increase shareholder wealth?

Investment of $6.0m is required immediately and another $4.0m is required at the end of year
1. The factory can start manufacturing only after this second investment is made.

Assume all assets have a life of 5 years, and depreciation starts after manufacturing begins.

You expect to sell 1m units in the first year of production, 1.5m units in the next four years.
You plan to sell the factory after that and you expect it to fetch $1m.

Selling price is expected to be $10/unit in the first year of goods sold and is expected to
increase at 5% p.a. Cost of goods sold is $6/unit in the first year of production and is expected
to increase at 4% p.a.

Assume the level of net working capital to be $1.0m in the first year of production.
Afterwards, it will increase by $1.0m each year. In the last year, the firm will be able to
liquidate its entire NWC without loss in value.

Assume corporate income tax rate to be 35% and capital gains tax rate of 20%.

This project requires a nominal discount rate of 10%.
41
Other Tricks with NPV
Optimal Timing of a Project
 Choosing between equipment with different
lives
 Replacing an Existing Machine
 Cost of Excess Capacity

42
Optimal Timing


NPV can be used to determine the optimal time to
undertake a project
Ex: You have a teak farm and you have to decide
when to harvest. The longer you wait, the bigger the
trees, and hence higher the value. However, after the
initial growth phase, the trees grow slower and
slower. The opportunity cost of capital is 10%
43
Teak Farm Example
Year
0
1
2
3
4
5
6
7
Value
100
120
140
160
180
200
220
240
20%
16.7%
14.3%
12.5%
11.1%
10%
9.1%
$109.10
$115.70
$120.21 $122.94 $124.18
$124.18
$123.16
Yr %
PV

When do we harvest the trees?

Why
44
Investments of Unequal Lives

There are times when application of the NPV rule can lead to the
wrong decision. Consider a factory that must have an air cleaner that
is mandated by law. Discount rate is 10% There are two choices:
 The “Cadillac cleaner” costs $4,000 today, has annual operating
costs of $100, and lasts 10 years.
 The “Cheapskate cleaner” costs $1,000 today, has annual operating
costs of $500, and lasts 5 years.
45
Comparing Investments with Different
Expected Lives
1.
Replacement Chain

Repeat projects until they begin and end at
the same time.
 Compute NPV for the “repeated projects.”
2.
The Equivalent Annual Cost Method
46
Replacement Chain Approach
The Cadillac last 10 years
 The Cheapskate last 5 years
 What is the minimum time span over, which
we can fairly compare these two?

47
Replacement Chain Approach
The Cadillac cleaner time line of cash flows:
0
1
2
3
4
5
6
7
8
9
10
The Cheapskate cleaner time line of cash flows
over ten years:
0
1
2
3
4
5
6
7
8
9
10
48
Equivalent Annual Cost (EAC)

Spread the cost of buying and maintaining a
machine over its expect life, while accounting for
time value of money
 The
payments that an annuity with the same PV and
life
 Used when the only difference is the costs
Pick
the machine with the lower EAC
 Pick the machine with the lower EAC
 The
EAC for the Cadillac is ($4,614.46)?
 The EAC for the Cheapskate is ($2,895.39)?
49
Different Lives Example (Given)

There are two machines, A and B. Both machines have the same capacity and
produce identical goods.
However, while machine A has a life of 5 years, machine B has a life of 3 years.
The initial investments are $20m and $15m respectively. There is no salvage value
for either machine.
The operating costs are $4m and $5m per year respectively.
Assume that the discount rate is 10%. Which one should you choose?

Find the Present Value of each machines total costs








(A) N = 5, I/Y = 10, PV=???, PMT = 4, FV=0:: Op PV=15.16
(A) Total PV = 15.16 + 20 = $35.16
(B) N = 3, I/Y = 10, PV=???, PMT = 5, FV=0 :: Op PV=12.43
(B) Total PV = 12.43 + 15 = $27.4
50
EAC Solution (Given)
PVA EACA EACA EACA EACA EACA
|-----------|----------|----------|----------|----------|
0
1
2
3
4
5
PVB
EACB EACB EACB
|-----------|----------|----------|
0
1
2
3
PVA = 35.16; EACA = N = 5, I/Y = 10, PV=35.16, PMT = ???, FV=0::
PMT = $9.28
PVB = 27.43; EACB = N = 3, I/Y = 10, PV=27.43, PMT = ???, FV=0::
PMT = $11.03
Choose Machine A (9.28 < 11.03)
51
Replacement Chain Machine A (Given)

How often will machine A be replaced? 2
 In


year 5, and again in year 10
PVA (Investment)=20 +20/(1.15)+20/(1.110) = 40.13
PVA (Operating Costs) =
 N=15,

I/Y=10, PV=???, PMT=4m, FV=0::PV= $30.42m
PVA = 40.13 +30.42 = $70.55m
52
Replacement Chain Machine B (Given)

How often will machine B be replaced? 4
 In


PVB (Investment) =
15+15/(1.13)+15/(1.16)+15/(1.19)+15/(1.112) = 45.88
PVB (Operating Costs) =
N

years 3, 6, 9, 12
= 15, I/Y=10, PV=???, PMT=5m,FV=0::PV= $38.03m
PVB = 45.88+38.03 = $83.91m
53
Replacement Chain Pick One (Given)

So which machine do we invest in?
A
$70.55, or B $ 83.91
 Choose A

Does it matter if we use EAC or Equal
Horizons?
 It
does not matter whether we use the
replacement chain or the EAC
54
Twist

Now, if the machines also vary in the revenue
that they will produce (possible because of
quality variations) how will we modify our
methods?
55
Equivalent Annual Revenue (EAR)

The EAR is the payment of an annuity with the
same PV and life as the investment
 Used
when the different projects produce different
revenue streams
 Spreads the machines revenue evenly over it’s life

Get the EAR just like the EAC, but now we are
using revenue so we want to pick the machine
with the higher EAR
56
Replacing an Existing Machine




The existing machine will last for 2 years. It will
produce a cash inflow of $4,000 in year 1 and $4,000
in year 2.
You can replace this with a new machine that costs
$15,000 but will produce cash inflows of $8,000 a
year for three years.
Do you go for the new machine or stay with the old
one?
Assume a 6% discount rate.
57
Machines EAR
NPVnew =
NPVold =
 EARnew =
EARold =
 Do we replace the machine? Why?

58
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?
 How should cash flows and discount rates be
matched when inflation is present?
 What is equivalent annual cost, and when
should it be used?

59