Chapter 10
Making Capital Investment
Decisions
10-1
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
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10-2
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Chapter Outline
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10-3
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Capital Budgeting and
Cash Flows
In the previous chapter we
focused on multiple techniques
of capital budgeting to evaluate
projects.
This chapter is all about how
each of the cash flows (CF’s) are
determined.
10-4
Project Example - Visual
R = 12%
1
$ -165,000
CF1 =
63,120
2
CF2 =
70,800
3
CF3 =
91,080
The required return for assets of this risk level
is 12% (as determined by the firm).
10-5
Chapter Outline
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10-6
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
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
10-7
Asking the Right Question
You should always ask yourself: “Will this cash
flow 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 because of the project
10-8
Common Types of Cash Flows
1. Sunk costs – costs that have accrued in
the past
2. Opportunity costs – costs of lost options
3. Changes in net working capital (NWC)
4. Financing costs
5. Taxes
10-9
Common Types of Cash Flows
6. Side effects:
• Positive side effects – benefits to other
projects
• Negative side effects – costs to other
projects
10-10
Chapter Outline
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10-11
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Pro Forma Statements and
Cash Flow
Definitions:
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation
(when there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF –
net capital spending (NCS)
– changes in NW
10-12
Project Pro Forma Income
Statement
10-13
Sales (50,000 units at
$4.00/unit)
Variable Costs ($2.50/unit)
Gross profit
Fixed costs
Depreciation ($90,000 / 3)
EBIT
Taxes (34%)
Net Income
$200,000
125,000
$ 75,000
12,000
30,000
$ 33,000
11,220
$ 21,780
Chapter Outline
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10-14
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Projected Capital Requirements
Year
0
NWC
Net FA
Total
10-15
1
2
3
$20,000 $20,000 $20,000 $20,000
90,000
60,000
30,000
0
$110,000 $80,000 $50,000 $20,000
Projected Total Cash Flows
Year
0
OCF
10-16
1
$51,780
Change
in NWC
-$20,000
Net CS
-$90,000
CFFA
-$110,00
2
$51,780
3
$51,780
20,000
$51,780
$51,780
$71,780
Project Example - Visual
R = 20%
1
$ -110,000
CF1 =
51,780
2
CF2 =
51,780
3
CF3 =
71,780
The required return for assets of this risk level
is 20% (as determined by the firm).
10-17
Using your calculator
10-18
Evaluate the Project
Enter the cash flows into the
calculator and compute NPV
and IRR:
CF0 = -110,000; C01 = 51,780; F01
= 2; C02 = 71,780; F02 = 1
NPV; I = 20;
CPT NPV = $10,648
CPT IRR = 25.8%
10-19
What’s Your Decision?
So….Deal
or No Deal?
10-20
More on NWC

Why do we have to consider changes in NWC
separately?
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10-21
GAAP requires that sales be recorded on the income
statement when made, not when the cash is received.
GAAP also requires that we record the cost of goods
sold when the corresponding sales are made, whether
we have actually paid our suppliers to date.
Finally, we have to buy inventory to support sales,
although we haven’t collected cash yet.
Depreciation
 The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
IRS for tax purposes
 Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects taxes
Calculation:
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate of the firm
10-22
Computing Depreciation
 Straight-line depreciation
D = (Initial cost – salvage) / number of years
Very few assets are depreciated using the straight-line
method for tax purposes
 MACRS
Need to know which asset class is appropriate for tax
purposes
Multiply percentage given in table by the initial cost
Depreciate to zero
Mid-year convention
10-23
After-tax Salvage
 If the salvage value is different from the
book value of the asset, then there is a
tax effect
 Book value = initial cost – accumulated
depreciation
 After-tax salvage = salvage – T*(salvage
– book value at time of sale)
10-24
After-tax Salvage Computation
1. Market Value – Book Value = gain (or loss)
2. Take gain (or loss) x (marginal tax rate)
3. Pay taxes on a gain; Receive a tax benefit on a loss
4. After-tax Salvage =
Market Value – taxes paid or
Market Value + tax benefit
10-25
Example: Depreciation and
After-tax Salvage
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.
10-26
Example: Depreciation and
After-tax Salvage
The company’s marginal tax rate is 40%.
What is the depreciation expense and the aftertax salvage in year 6 for each of the following
three scenarios (A-C)?
0
1
$ -110,000
10-27
2
3
4
5
6
Sell =
$17,000
Example A: Straight-line
Suppose the appropriate depreciation schedule is
straight-line:
D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years
BV in year 6 = 110,000 – 6(15,500) = 17,000
After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000
10-28
Example A: Straight-Line
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $17,000
Capital gain/loss =
0
Taxes paid on gain/loss = ($0).40 = $0
After-tax salvage value:
17,000 - .40 (17,000 – 17,000)
= $17,000
10-29
Example B: Three-year MACRS
Year
10-30
1
MACRS
percent
.3333
2
.4445
3
.1481
4
.0741
Depreciation
per year
.3333(110,000) D1=
$36,663
.4445(110,000) D2=
$48,895
.1481(110,000) D3=
$16,291
.0741(110,000) D4=
$8,151
Example B: MACRS
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $
0
Capital gain/loss =
$17,000
Taxes paid on gain/loss = ($17,000).40
= $ 6,800
10-31
After-tax salvage value:
17,000 - .40 (17,000 – 0)
= $10,200
Example C: Seven-Year MACRS
10-32
Year
MACRS
Percent
Depreciation
Per year
1
.1429
.1429(110,000) = D1=$15,719
2
.2449
.2449(110,000) = D2=$26,939
3
.1749
.1749(110,000) = D3=$19,239
4
.1249
.1249(110,000) = D4=$13,739
5
.0893
.0893(110,000) = D5= $ 9,823
6
.0892
.0892(110,000) = D6= $ 9,812
Example C: MACRS
The company’s marginal tax rate is 40%.
Market Selling Price = $17,000
Book Value at year 6: $14,729
Capital gain /loss =
$ 2,371
Taxes paid on gain/loss = ($17,000).40
= $ 908.40
10-33
After-tax salvage value:
17,000 - .40 (17,000 – 14,729)
= $16,091.60
Chapter Outline
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10-34
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Replacement Problem
Every problem we
have presented
thus far represents
a newly purchased
asset.
10-35
What if we have an
old asset to replace
with a new asset?
Example: Replacement
Problem
 Original Machine
 Initial cost = 100,000
 New Machine
Initial cost = 150,000
5-year life
 Annual depreciation = 9,000
Salvage in 5 years = 0
 Purchased 5 years ago
Cost savings = 50,000 per
 Book Value = 55,000
year
 Salvage today = 65,000
 3-year MACRS depreciation
 Salvage in 5 years = 10,000
 Required return = 10%
 Tax rate = 40%
10-36
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
Replacement Problem
Computing Cash Flows
 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?
10-37
Replacement Problem
Pro Forma Income Statements
Year
Cost
Savings
1
2
3
4
5
50,000
50,000
50,000
50,000
50,000
New
49,995
66,675
22,215
11,115
0
Old
9,000
9,000
9,000
9,000
9,000
40,995
57,675
13,215
2,115
(9,000)
EBIT
9,005
(7,675)
36,785
47,885
59,000
Taxes
3,602
(3,070)
14,714
19,154
23,600
NI
5,403
(4,605)
22,071
28,731
35,400
Depr.
Increm.
10-38
Replacement Problem
Incremental Net Capital Spending
 Year 0
 Cost of new machine = 150,000 (outflow)
 After-tax salvage on old machine = 65,000 - .4(65,000
– 55,000) = 61,000 (inflow)
 Incremental net capital spending = 150,000 – 61,000
= 89,000 (outflow)
 Year 5
 After-tax salvage on old machine = 10,000 - .4(10,000
– 10,000) = 10,000 (outflow because we no longer
receive this)
10-39
Replacement Problem
Cash Flow From Assets
Year
0
1
2
3
46,39 53,070 35,286
8
OCF
4
5
30,846
26,400
NCS
89,000
-10,000
 In
NWC
CFF
A
0
0
10-40
46,39 53,070 35,286
89,000
8
30,846
16,400
Replacement Problem
Analyzing the Cash Flows
 Now that we have the cash flows, we
can compute the NPV and IRR
1. Enter the cash flows
2. Compute the NPV and the IRR
Compute NPV = $54,801.74
Compute IRR = 36.28%
 Should the company replace the
equipment?
10-41
Chapter Outline
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10-42
Capital Budgeting and Cash Flows
Incremental Cash Flows
Pro Forma Financial Statements
Operating Cash Flows
Replacement Decisions
Discounted Cash Flow Analysis
Other Methods for
Computing OCF
 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
10-43
Example: Cost Cutting
1.
Your company is considering a new computer system
that will initially cost $1 million.
2.
It will save $300,000 per year in inventory and
receivables management costs.
3.
The system is expected to last for five years and will be
depreciated using 3-year MACRS.
10-44
Example: Cost Cutting
(continued)
The system is expected to have a salvage value of
$50,000 at the end of year 5.
5. There is no impact on net working capital.
6. The marginal tax rate is 40%.
7. The required return is 8%.
4.
Task: Click on the Excel icon to work through the example
10-45
Example: Setting the Bid Price
Consider the following information:
1. The Army has requested bids for multiple
use digitizing devices (MUDDs)
2. Deliver 4 units each year for the next 3
years
3. Labor and materials estimated to be
$10,000 per unit
4. Production space leased for $12,000 per
year
10-46
Example: Setting the
Bid Price (continued)
5. Requires $50,000 in fixed assets with
expected salvage of $10,000 at the end of
the project (depreciate straight-line)
6. Requires an initial $10,000 increase in
NWC
7. Tax rate = 34%
8. Firm’s required return = 15%
Task: Click on the Excel icon
to work through the example
10-47
Example: Equivalent Annual
Cost Analysis
 Burnout Batteries
 Initial Cost = $36 each
 3-year life
 $100 per year to keep
charged
 Expected salvage = $5
 Straight-line
depreciation
10-48
 Long-lasting Batteries
 Initial Cost = $60 each
 5-year life
 $88 per year to
keep charged
 Expected salvage = $5
 Straight-line
depreciation
Example: Equivalent Annual
Cost Analysis (continued)
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 15%, and the tax
rate is 34%.
10-49
Ethics Issues
In an L.A. Law episode, an automobile
manufacturer knowingly built cars that had a
significant safety flaw. Rather than redesigning the
cars (at substantial additional cost), the
manufacturer calculated the expected costs of
future lawsuits and determined that it would be
cheaper to sell an unsafe car and defend itself
against lawsuits than to redesign the car. What
issues does the financial analysis overlook?
10-50
Quick Quiz
1. How do we determine if cash flows are relevant to the
capital budgeting decision?
2. What are the different methods for computing
operating cash flow and when are they important?
3. What is the basic process for finding the bid price?
4. What is equivalent annual cost and when should it be
used?
10-51
Comprehensive Problem
A $1,000,000 investment is depreciated using a sevenyear MACRS class life. It requires $150,000 in additional
inventory and will increase accounts payable by
$50,000. It will generate $400,000 in revenue and
$150,000 in cash expenses annually, and the tax rate is
40%. What is the incremental cash flow in years 0, 1, 7,
and 8?
10-52
Terminology
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10-53
Incremental cash flows
Sunk costs
Opportunity costs
Stand-alone (or independent) projects
Net Working Capital (NWC)
Operating Cash Flow (OCF)
Cash Flow From Assets (CFFA)
Terminology
(continued)
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10-54
Straight line depreciation
MACRS depreciation
Market value vs. book value
After-tax salvage value
Bid price
Equivalent Annual Cost (EAC)
Formulas
• Operating Cash Flow (OCF) = EBIT +
depreciation – taxes
• OCF = Net income + depreciation (when
there is no interest expense)
• Cash Flow From Assets (CFFA) = OCF – net
capital spending (NCS)
– changes in NW
• After-tax salvage = salvage –
T (salvage – book value at time of sale)
10-55
Formulas (continued)
Operating Cash Flow Formula:
Bottom-Up Approach
OCF = NI + depreciation
Top-Down Approach
OCF = Sales – Costs – Taxes
Tax Shield Approach
OCF = (Sales – Costs)(1 – T) +
Depreciation*T
10-56
Key Concepts and Skills
• Compute the relevant
cash flows for proposed
investments.
• Compare and contrast the
various methods for computing operating
cash flow.
• Compute a bid price for a project
• Compute and evaluate the equivalent
annual cost of a project
10-57
What are the most important
topics of this chapter?
1. The cash flows for a project are
computed using incremental cash
flows considering depreciation and
after-tax salvage values.
2. Straight-line and MACRS methods of
depreciation are used to compute the
depreciation of an asset.
10-58
What are the most
important topics of this
chapter?
3. Cash Flows From Assets (CFFA)
computes the annual cash flows for
capital budgeting purposes.
4. Replacement decisions involve the
cash flows of the “old” asset as well as
the “new” asset.
10-59
10-60