Capital Budgeting and Investment
Analysis by Alan Shapiro

• Shareholders are interested in how many additional dollars they will receive in the future for the dollars they lay out today
• What matters to them is not the projects total
CF per period but the incremental CFs generated by the project relative to the additional dollars they must invest today

• Incremental CFs can differ from total CFs for the following reasons:
– Cannibalization
– Sales creation
– Opportunity cost
– Sunk cost
– Transfer pricing
– Allocated overhead
– Accounting for Intangible benefits

• A new product taking sales away from the firm’s existing products.
• To the extent that sales of a new product or plant just replaced other corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales
• It is often difficult to assess the true magnitude of cannibalization because of the need to determine what would have happened to the sales in the absence of the new product introduction

• The incremental effects of cannibalization, which is the relevant measure for capital budgeting purposes equals the lost profit on lost sales that would not otherwise have been lost had the new product not been introduced.

• This is the opposite of cannibalization
• An investment created or expected to create additional sales for other products
• In calculating the project’s CFs, the additional sales and incremental CFs should be attributed to the project.

• Project costs must include the true economic cost of any source required for the project regardless of whether the firm already owns the source or has to go out and acquire it
• Opportunity cost is the cash the asset could generate for the firm should it be sold or put to some other productive use

• Sunk cost fallacy is the idea that past expenditure on a project should influence the decision whether to continue or terminate the project.
• Instead the decision should be based on future costs and benefits alone
• Example: Feasibility study

• Transfer prices is the prices at which goods and services are traded within a company
• It can significantly distort the profitability of a proposed investment
• The prices used to evaluate project inputs or outputs should be market prices where possible
• Transfer price adjustments are often made to reduce taxes

• The project should be charged only for the additional expenditures that can be attributed to the project; Those overhead expenses that are not affected by the project should not be included when estimating project CFs

• A project’s incremental CFs can be found only by subtracting worldwide corporate CFs without the investment (the base case) from post-investment corporate CFs
• What will happen if we do not make this investment?
• Do not ignore competitor behavior and assume that the base case was the status quo

• Sales could be lost any way but what if they are lost to a competitor
• If you must be the victim of cannibal, make sure the cannibal if a member of your family

• Intangibles like better quality, higher customer satisfaction, valuable learning experience, quick order processing can have tangible impact on corporate CFs
• Adopting practices, products, and technologies discovered overseas can improve a company’s competitive position worldwide

• A situation when the firm is looking at replacing an existing piece of equipment with a new piece of equipment
– Cost reduction
– Quality improvement

Data on Quantum system investment in a new extrusion press
Cost of machine
Development cost
Salvage value
Marginal tax rate
Additional sales
Net increase in Working capital
Old machine
$1,000,000
Straight line depreciation 10 years
Annual depreciation charge $100,000
Depreciated value $500,000
?
35%
New machine
$2,000,000
$750,000
5 years
-
$300,000
$500,000
35%
$150,000
$45,000

• It is the project’s net cash outlay. Includes any opportunity cost:
– The cost of acquiring and placing into service the necessary assets
– The necessary increase in working capital
– The net proceeds from the sale of existing assets in the case of a replacement decision
– The tax effects associated with the sale of existing assets and their replacement with new assets

Case
Cost of new machine
+ Inc. in WC
1 2
$2,000,000 $2,000,000
45,000 45,000
3
$2,000,000
45,000
4
$2,000,000
45,000
700,000 1,100,000 - Sales Price of old machine
= Pretax investment
+ Tax on proceeds of old machine
= Initial cost of new machine
500,000
$1,545,000 $1,645,000
0
400,000
-35,000
$1,545,000 $1,610,000
$1,345,000
70,000
$1,415,000
$945,000
210,000
$1,155,000

• Time 0, firm spends $18 million to acquire land
• Year 1, build a plant at a cost of $7 million
• Year 2, Buy and install equipment at a cost of
$20 million
• Cost of capital = 10%
• Calculate PV in millions

• What matters to investors are the incremental
CFs generated by the project
• Incremental Op CF=Change in (After tax income + Depr. - WC)
• ∆OCF = (∆REV - ∆COST - ∆DEP)(1- ∆TAX) + ∆DEP - ∆ WC
• ∆REV is the change in revenue
• ∆COST is the change in operating costs
• ∆DEP is the change in Depreciation
• ∆WC is the change in Working capital
• ∆TAX is the marginal income tax rate faced by the firm

Sales
Costs
Depreciation
Profit Before
Tax
Tax @ 35%
Profit After Tax
Depreciation
Cash Flow
Before
5,000,000
4,000,000
500,000
500,000
175,000
325,000
500,000
825,000
After
5,150,000
3,820,000
800,000
530,000
185,500
344,500
800,000
1,144,500
Increments
150,000
-180,000
300,000
30,000
10,500
19,500
300,000
319,500
Cash Flows
+$150,000
+$180,000
-
-
-10,500
-
-
+$319,500

• Because depreciation is a noncash charge, its only significance lies in the fact that it reduces or shields taxable income and therefore reduces taxes
• The value of Tax shield provided by depreciation charge of DEP in year t equals
DEP*TAX
• TAX is the firm’s marginal income tax rate

2
3
4
5
Year
1
6
Totals
2
3
4
5
6
1
Year by Year Depreciation Tax shield under MACRS
Year Dep Base X Dep factor =Dep writeoff X marginal
Tax rate
= Dep Tax shield
2,000,000 0.2
400,000 0.35
140,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
0.32
0.192
0.1152
0.1152
0.0576
Totals
640,000
384,000
230,400
230,400
115,200
2,000,000
0.35
0.35
0.35
0.35
0.35
0.35
224,000
134,000
80,640
80,640
40,320
700,000
Dep Tax shield
140,000
224,000
134,000
80,640
80,640
40,320
700,000
-Lost Dep write-off =Incremental Tax shield
35,000 105,000
35,000
35,000
35,000
35,000
189,000
99,400
45,640
45,640
-
175,000
40,320
525,000

• What really matters is the incremental depreciation tax shield
• Because Quantum Systems losses $100,000 in annual depreciation when the old machine is scrapped, incremental depreciation in each of the first five years is actually $100,000 less than the calculations indicate

• As a result, the annual net Tax shield provided by new machine is $35,000 ($100,000*0.35) less than the gross tax shield it provided or
0.35 DEP - $35,000
• If it buys the new machine, Quantum systems will have annual incremental after tax revenue plus cost reductions equals to
[(150,000 + 180,000)*(1-0.35)] = $214,500

• Incremental Operating CF in year t will be
• $214,500 + 0.35 ∆DEPt
• ∆DEPt is the incremental depreciation charge in year t and 0.35 ∆DEP is the value of the incremental depreciation tax shield provided by the new machine

3
4
1
2
5
6
Year
Incremental revenues and cost reduction (After tax)
= Incremental
Operating CF
214,500
214,500
214,500
214,500
-
214,500
+ Incremental
Depreciation tax shield
105,000
189,000
99,400
45,640
45,640
40,320
319,500
403,500
313,900
260,140
260,140
40,320

• We left out financing costs when estimating
Operating CFs
• Usually in the form of dividends and interest
• The reason for this omission is that the cost of capital for the project already incorporates the cost of these funds
• No double counting

• The terminal value of any asset is equal to the present value of future cash flows generated by the asset, whether it be the scrap value of the extrusion press or the revenue produced by a product
• In addition, it is assumed that any working capital investment will be recaptured at the termination of the project
• It includes any additional expenses required to meet environmental regulations

• Salvage value end of Yr 5 is $500,000
• Book value is $115,200
• Taxable gain = 500,000 – 115,200 = $384,800
• Taxes owed = 384,800*0.35 = $134,680
• After tax Salvage value = $500,000 - $134,680
• Recapture of working capital = $45,000
• Terminal value=$365,320+$45,000 = $410,320

• Old machine can be sold for $700,000
• Initial cash outflow of $1,415,000
• Discount rate of 15%
• Assume a ZERO terminal value
• NPV = -$347,604
• The terminal value must be greater than
347,604 * (1.15) 5 = $699,155 for the machine to have positive NPV

Year
0
1
2
3
4
5
Cash Flow
-1,415,000
319,500
403,500
313,900
260,140
260,140
Present Value
Factor @15%
1.0000
0.8696
0.7561
0.6575
0.5718
0.4972
Total
Present value
-1,415,000
277,826
305,104
206,394
148,736
129,336
- 347,604

• We subtract $45,000 in recaptured WC which leaves after tax salvage value of $654,156
• Sale price – Tax on Sale = Sale price – (Sale price – BV) * Tax Rate
• Given a BV of $115,200
• Gives us a Sale price of $944,366
• The value of the new machine at end of 5 years must exceed $944,366 to make it worthwhile for the company to replace its old machine today

• Today, the project will require capital equipment with an installed cost of $6 million
• During year 7, the plant will be sold for $1 million
• Depreciation on a straight line
• Zero Salvage value
• Required return of 20%

Smith corporation new product financial forecasts (in thousands$)
Period
Sales
0 1 2
500 5,500
Operating expenses
800 3,410
Product production
3,000
Depreciation 0
1,000
1,000 1,000
Profit before
Taxes
-3,000 -2,300 1,090
Taxes @35% -1,050 -805 382
Profit after taxes
Level of WC
-1,950 -1,495 709
250 660
3
8,000
4,960
1,000
2,040
714
1,326
960
4 5
14,000 7,000
8,680 4,340
1,000
1,660
1,512
2,808
1,680
1,000
1,660
581
1,079
840
6
4,000
2,480
1,000
520
182
338
480

2
3
4
5
0
1
6
7
Smith corporation summary of CFs for new product introduction
Year Capital
Equipment
Profit After
Tax + Dep
Change in
Working
Capital
Total Cash
Flow
PV @ 20%
-
-
-
-
-
-6,000
-
650
-1,950
-495
1,709
2,326
3,808
2,079
1,338
-250
-410
-300
-720
840
360
480
-7,950
-745
1,299
2,026
3,088
2,919
1,698
1,130
NPV =
-7,950
-621
902
1,172
1,489
1,173
569
315
- 2, 950

• Taxable gain of $1 million
• Taxes of $350,000
• An increase in WC is a use of cash which is cash outflow
• Decrease in WC are a source of cash

• Terminal values:
– The salvage value of the equipment (after tax)
– Recovery of project’s working capital
– CFs beyond the initial evaluation period
TV n

CF k
 n
 g
1

Smith corporation New product #2 financial forecasts
Period
Sales
Cost of goods sold
Selling/Admin expenses
Depreciation
Profit before tax
Tax @35%
Profit after tax
Level of working capital
0 1 5 6
2,500 10,000 16,500 21,000 23,000 25,000
1,625
3,000 3,000 3,000 3,000
750 750
-3,000 -2,875 -250
-1,050 -1,006 -88
-1,950 -1,869 -163
750
2
6,500
3,000
3
10,725
750
2,025
709
1,316
4,950
4
13,650
3,000
750
3,600
1,260
2,340
6,300
-
14,950
3,000
5,050
1,768
3,283
6,900
-
16,250
3,000
5,750
2,013
3,738
7,500

4
5
6
0
1
2
3
Year
Total CF PV @ 24%
-
-
-
-
-
-
Capital
Equipment
-3,000
Profit After
Tax + Dep
-1,950
-1,119
588
2,066
3,090
3,283
3,738
-
Working capital
-750
-2,250
-1,950
-1,350
-600
-600
-4,950
-1,869
-1,663
116
1,740
2,683
3,138
NPV=
-4,950
-1,507
-1,081
61
736
915
863
- 4,963

Smith Corporation TV sensitivity analysis
6
7
8
4
5
Growth rate(%)
3
Terminal value
15,391,143
16,317,600
17,341,579
18,479,333
19,750,941
21,181,500
PV of TV
4,233,902
4,488,758
4,770,441
5,083,422
5,433,225
5,826,753
Project NPV
(729,098)
(474,242)
(192,559)
120,422
470,225
863,753

• Several factors contribute to the tendency that accepted projects do less well than expected
• Overoptimism
• Lack of consistency
• Natural Bias
• Postinvestment audit

• Project sponsors are generally optimistic about the prospects of the projects they advocate
• Spent great deal of time and effort
• Emotionally involved in the acceptance of the project
• Optimistic rather than realistic
• Greatly underestimated costs and inflated benefits

• Estimates of project CFs are likely to be biased upwards, resulting in an overstated expected
NPV
• Tend to ignore the consequences of future competitive entry into their markets.
• Successful products are likely to attract competitors who will drive down prices and returns
• Revising upwards or downwards if someone is known to be overly optimistic or pessimistic

• When estimating cash flows, it is necessary to be consistent with the information contained in the discount rate
• Projected inflation-adjusted price increases should NOT exceed real interest rates
• Prices of Oil (Commodity) cannot be expected to rise by more than the real interest rate plus storage costs
• Arbitrage opportunity?!

• Average error associated with the CF forecasts
• Projects with overestimated CFs are more likely to be chosen than those whose CFs are underestimated
• The actual NPVs of projects undertaken will be generally lower than their predicted NPVs even if the underlying CF estimates are themselves unbiased

• Once an investment has been made, it is largely a sunk cost and should not influence future decisions
• Management should conduct a postinvestment audit that compares actual results with exante budgeted figures
• The firm can learn from its mistakes and its successes
• Firm can include correction factors in future investment analysis

• Help the firm improve its capital budgeting process and come up with better projects
• The firm can learn how to structure projects better
• The firm can repeat its successes and avoid future mistakes

• Depreciation is the annual income tax deduction that allows a business to recover the cost or other basis of certain property over the time it uses the property
• A business can depreciate most types of tangible property (except land) such as buildings, machinery, vehicles, furniture and equipment

• The 200% declining balance method. Also known as double declining balance method
• The 150% declining balance method
• The straight line method
• Modified Accelerated Cost Recovery System
(MACRS)
• MACRS assumes that the property is depreciable for half of the taxable year in which it is placed in service

6
7
8
2
3
4
5
Year
1
3-Year
33.33%
44.45%
14.81%
7.41%
5-Year
20%
32%
19.2%
11.52%
11.52%
5.76%
7-Year
14.29%
24.49%
17.49%
12.49%
8.93%
8.92%
8.93%
4.46%

Incorporating inflation in Capital budgeting
• The nominal interest rate already incorporates the expected rate of inflation
• Fisher equation:
• R = a + i + ai
• R is nominal return
• A is real return
• I is expected inflation rate
• We must nominal CFs to account for the impact of expected inflation on anticipated revenues and costs

• Contractual CFs are those fixed in nominal dollar terms
• Contractual CFs arise from such commitments as debt, longterm leases, labor contracts, rents, and AR, AP.
• NonContractual means that they fluctuate inline with changing market conditions
• Noncontractual CFs move in line with inflation

• Contractual CFs:
– Depreciation tax shield
– Working capital recaptured
• Noncontractual CFs:
– Cost savings
– Additional revenues to be received from investing in the new extrusion press
– Investment in WC is equal to 30% of sales.
Therefore, it will rise with sales

• 7% rate of inflation
• Adjust incremental sales and cost savings for inflation
• Expected 1 st year revenues = 150,000*1.07
• Expected 1 st year cost savings=180,000*1.07
• With 35% marginal corporate tax rate
• After tax, the nominal increase will be
– 10,500*0.65 = $6,825
– 12,600*0.65=$8,190

• Additional investment in working capital of
10,500*0.30= $3,150
• The depreciation charge is fixed in nominal terms and so remains the same regardless of the rate of inflation
• The incremental project CF in the 1 st year resulting from adjustment for inflation is
6,825+8,190+3,150 = $11,865

Project analysis incorporating 7% inflation
0 Year
Sales
Cost savings
Incremental depreciation
Pretax incremental profit
Tax @35%
Profit after tax
Operating CF
WC 0.3*Sales
Change in WC
Initial Invest
Net CF
PV @15%
NPV
-1,415
-1,415
-1,415
-$210,178
1 2 3
160.5
171.7
183.8
192.6
206.1
220.5
300 540 284
53.1
-162.2
120.3
18.6
-56.8
42.1
34.5
-105.4
78.2
334.5
434.6
362.2
48.2
51.5
55.1
3.2
3.4
3.6
331.4
431.2
358.6
288.1
326.1
235.8
4
196.6
235.9
130.4
302.2
105.8
196.4
326.8
59
3.9
322.9
184.6
5
210.4
252.5
130.4
332.4
116.4
216.1
346.5
63.1
4.1
342.4
170.2

• The current tax system taxes nominal income rather than real income
• Because the tax shield associated with the depreciation charge is fixed in nominal terms, the real value declines as the rate of inflation rises
• The net effect of combining inflation with a tax system geared toward nominal instead of real gains or losses is to reduce the real CF associated with depreciable assets

• This distorts investment decisions by reducing the attractiveness of capital intensive projects, especially those with long economic lives, relative to other projects as well as relative to consumption.
• The end result is more consumption and less investment