Making Capital
Investment Decisions
Estimating Cash Flows
Special cases
Overview
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We are mainly concerned with how to arrive
at correct measure of cash flows in
numerator of NPV calculations

What are relevant and irrelevant cash
flows?
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We will also look at some special cases of
Discounted Cash Flow (DCF) methods
Special Applications of DCF
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Evaluating Cost Cutting Proposals
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Evaluating Equipment with Different Lives
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We will ignore ‘setting bid price’ example in
text
Relevant Cash Flows
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Only INCREMENTAL after-tax cash flows
are relevant:
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Incremental cash flows:
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Changes in cash flows with and without the
project
NOT the same as cash flows before and after
the project!!
Indentifying cash flows
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Look For:
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Changes in sales and operating costs
Changes in net working capital
Opportunity costs and capital spending
Effect on tax payments
Example
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Manufacturing operation that uses land that
could be sold for $100,000

With project:
(own and use land)
Without project
(sell land)
Incremental CF
(due to project)


CF = $0
CF = +$100,000
= -$100,000
Do Not Include...
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Sunk Costs and unavoidable expenses
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Depreciation
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but include effect of depreciation on taxes
Financing payments
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e.g. dividends and interest
financing is captured in denominator ‘r’
Examples: Include/Ignore?
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Market value of land and existing buildings
Costs of demolishing and clearing land
Cost of new access road put in last year
Lost earnings from other products due to
managers’ time spent on the new plant
Part of the cost of leasing the president’s airplane
Future depreciation of the new plant
Initial investment on inventories and raw materials
Payments already made for engineering of the new
plant
Definitions of Operating CF
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OCF = operating cash flow
S = sales
C = operating costs
D = depreciation
EBIT = earnings before interest and taxes
=S-C-D
T = corporate tax rate
OCF = EBIT + D - Taxes
Example:

S = $1,000
C = $600 D = $200 T = 34%
EBIT = S - C - D = 1000-600-200 = $200
Taxes = EBIT x T = 200 x .34 = $68
OCF = EBIT + D - Taxes
200 + 200 - 68 = $332
Use alternative approaches to arrive at the
same answer
Alternative Definitions of OCF

Bottoms-up approach
OCF = N.I. (without interest expense) + D

Top-down approach
OCF = S - C - Taxes
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Tax-shield approach
OCF = (S - C) x (1-T) + D x T
Notice...
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In all the alternatives of computing cash
flows, taxes must be taken into account

Payment of taxes is a cash outflow
Savings of taxes is a cash inflow

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Cash flows are computed on an after-tax
basis
Multiply by T or (1-T)?
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When you are calculating the amount of tax,
you multiply by T
When you are calculating the amount of tax
savings due to an expense (such as
depreciation expense or any other expense),
you multiply by T
When you are calculating the amount of aftertax cash flow, you multiply by (1-T)
Example
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Before Tax CF:
$1000 [= CF]
Tax @ 40%:
$400 [= CF x T]
After Tax Income: $600 [= CF x (1-T)]
Example

Taking a project increases tax deductible
expense by $1,000
How much savings in taxes does this result?
T = 40%
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Answer: 1000 x .40 = $400
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This is the amount by which the taxes are lower
Depreciation
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Depreciation is a way accountants measure
‘wear and tear’ or ‘using-up’ of assets
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It does not reflect actual cash going out
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Depreciation is a tax-deductible expense
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Tax savings due to depreciation is (D x T)
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tax savings is a cash inflow
tax savings is called depreciation tax shield
Example: Depr. Tax Shield
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The Latte Stand project requires purchasing
coffee equipment for $12,000 which will be
depreciated on a straight-line basis over 4
years to zero book value. The tax rate is
38%.

What is the annual depreciation?
What are the cash flow consequences of
depreciation?
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Note
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Equipment can be sold before it is fully
depreciated
The book value (BV) of the machine in any
year is the original cost – accumulated
depreciation
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Example. $1m machine is being depreciated
straight line over 10 years to zero book value.
What is its BV in year 6?
Accelerated Depreciation
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IRS allows a quicker schedule of
depreciation than straight-line depreciation
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This method is called Accelerated
Depreciation
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Assets are categorized in different ‘classes’
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e.g. “5-year class”
Accelerated Depreciation
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$500,000 investment is depreciated over 4
years as 3-year MACRS to zero book value

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What is the annual depreciation?
What is the annual depreciation tax shield?
Salvage Value
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The latte equipment will be sold at the end
of 4 years for $5,600.

What are the cash flows resulting from
salvage at the end of the project?
Salvage
Sale of equipment can result in
 Taxable gain if BV < MV
OR
 Taxable loss if BV > MV
OR
 Neither if BV = MV
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Gain Example
Loss Example
Book Value of Asset in
year of sale (BV)
Sale price of asset (MV)
$10,000
$10,000
$15,000
$5,000
Gain (+)/Loss (-) on sale
+$5000
-$5,000
Cash flow from tax
paid/saved on gain/loss
from sale
-$2,000
+$2,000
Here, gain on sale Here, loss on sale
to taxes being
leads to taxes
paid on the gain being saved (cash
(cash outflow)
inflow)
Net Working Capital
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Net working capital (NWC)
= S.T. Assets - S.T. Liabilities
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Businesses need NWC to conduct business
NWC ties up money (i.e. it is an investment)
What are S.T. Assets and Liabilities of a firm?
Increase in NWC is cash outflow
Decrease in NWC is cash inflow
NWC
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ST Assets
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Cash
Marketable securities
Accounts Receivables
Inventory
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ST Liabilities
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Accounts payable
Wages due
Taxes due
NWC = ST Assets - ST Liabilities
Example: NWC
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Without Project ($s)
Acct Rec’v
Inventories
Acct Pay’b
4,500
6,000
3,900
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With Project ($s)
Acct Rec’v
Inventories
Acct Pay’b
What is the change in NWC?
What is the cash inflow / outflow?
6,700
9,000
3,400
NWC at Project End
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When projects have finite life, the money
tied up in NWC becomes available when
the project ends
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Hence, one typically encounters situations
where a drop in NWC occurs at the end of
project’s life
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This results in a cash inflow
Application: Cost Cutting
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Buying a new machine press for $350,000
is estimated to result in $145,000 in annual
pre-tax savings. MACRS five-year class
depreciated to zero book value, and has sale
price of $75,000. Also required spare parts
of $17,000 and $2,500 in inventory for each
succeeding year of the project. T = 34%, r
= 15%. Buy new machine?
Equivalent Annual Cost (EAC)
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Useful:
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when alternatives have different economic lives
we will use and replace the equipment
indefinitely
Trick:
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Calculate NPV of alternatives
Use NPV as PV of annuity to calculate PMT
over the ‘n’ years of useful life
EAC Example
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Filtration Precipitation
Economic Life
5 years
8 years
Installation Cost
$1.1 mill $1.9 mill
Annual Oper. Cost $60,000 $10,000
Salvage value
$0
$0
Depreciable life
5 years
8 years
Discount rate
12%
12%
T = .34, Straight line depreciation
Notice...
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The two alternative have different lives
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Cannot directly compare them
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We usually assume that the machines are
replaced indefinitely at end of their lives
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Hence we convert NPV to Equivalent
Annual Costs (EAC)
EAC ex. continued..
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Filtr.
After tax oper. cost
-$39,600
Depr. tax shield
$74,800
Oper. Cash flow
$35,200
PV of Oper. cash flow $126,888
Investment
-$1,100,000
NPV @ 12%
-$973,112
EAC
Precip.
-$6,600
$80,750
$74,150
$368,350
-$1,900,000
-$1,531,650