Chapter 10
Making Capital
Investment Decisions
•Homework: 23, 24, 31, 32 & 34
Lecture Organization
 Identify relevant cash flows
 Construct forecasted financial statements
 Alternative definitions of OCF
 CCA versus straight-line deprecation
 Capital budgeting examples
Fundamental Principles of Project Evaluation
 Fundamental Principles of Project Evaluation:
Project evaluation - the application of one or more capital
budgeting decision rules to estimated relevant project cash
flows in order to make the investment decision.
Relevant cash flows - the incremental cash flows associated
with the decision to invest in a project.
The incremental cash flows for project evaluation consist
of any and all changes in the firm’s future cash flows that
are a direct consequence of taking the project.
Stand-alone principle - evaluation of a project based on the
project’s incremental cash flows.
Relevant Cash Flows
Honda Corp. is considering a new car model to replace the Accord
which earns 340,000 million yen a year in Accord sales
Estimates it will sell 2 million units of the new model and earn
210,000 yen on each unit (420,000 million yen in revenues)
Incremental cash flows = Cash Flow(With new car model)
- Cash Flows(Without new car model)
420,000 - 340,000 = 80,000 million yen
Stand-Alone Principle
Evaluate project on the basis of its incremental cash flows
Project = "Mini-firm"
Allows us to evaluate the investment project separately
from other activities of the firm
Cash Flows from the Project = Cash Flows from Assets
Aspects of Incremental Cash Flows
Sunk Costs
Opportunity Costs
Side Effects (Erosion)
Net Working Capital
Financing Costs
All Cash Flows should be after-tax cash flows
Sunk Costs
The Limited hires The Boston Consulting Group (BCG) to
evaluate whether a new product line should be launched. The
consulting fees are paid no matter what.
Opportunity Costs
Firm paid $300,000 land to be used for a warehouse. The
current market value of the land is $450,000.
Opportunity Cost =
Sunk Cost =
Side Effects and Erosion
A drop in Big Mac revenues when McDonald's
introduced the Arch Deluxe.
Net Working Capital
Investment in inventories and receivables.
This investment is recovered at the end of project.
Financing Costs
Interest, principal on debt and dividends.
Pro Forma Financial Statements
and DCF Valuation
Pro forma financial statements
Best current estimate of future cash flows
Exclude interest expenses and other financing costs
Use statements to obtain Project cash flow
If stand-alone principle holds:
Project Cash Flow = Cash Flow from Assets =
Operating Cash Flow - Net Capital Spending - Additions to Net
Working Capital
Depreciation
Economic and future market value are ignored.
Depreciation expense uses the cost of asset.
Care about depreciation because it affects tax bill
Use tax accounting rules for depreciation.
CCA
Straight-line
Additions to Net Working Capital
Will start with a NWC number (date 0)
NWC will change during project life (e.g. grow at a rate of 3% per
period)
NWC(year 2) = NWC(year1)*1.03
Or, NWC will equal Y% of sales each period (e.g. 15%)
NWC(year 2) = 0.15*Sales(year 2)
All NWC is recovered at the end of the project.
Inventories are run down
Unpaid bills are paid.
Bring NWC account to zero.
Ways to Capital Budgeting Problem
Date 0:
Buy the fixed asset -- Cash Outflow
Date T:
Sell the fixed asset -- Cash Inflow
If no more assets of the same class:
Record after-tax gain or loss
Example: Preparing Pro Forma Statements
 Suppose we want to prepare a set of pro forma financial
statements for a project for Norma Desmond Enterprises. In
order to do so, we must have some background information. In
this case, assume:
1. Sales of 10,000 units/year @ $5/unit.
2. Variable cost/unit is $3. Fixed costs are $5,000/year. Project
has no salvage value. Project life is 3 years.
3. Project cost is $21,000. Depreciation is $7,000/year.
4. Net working capital is $10,000.
5. The firm’s required return is 20%. The tax rate is 34%.
Example: Preparing Pro Forma Statements (continued)
Pro Forma Financial Statements
Projected Income Statements
Sales
Var. costs
$______
______
$20,000
Fixed costs
5,000
Depreciation
7,000
“EBIT”
Taxes (34%)
Net income
$______
2,720
$______
Example: Preparing Pro Forma Statements (concluded)
Projected Balance Sheets
0
1
2
3
$______
$10,000
$10,000
$10,000
NFA
21,000
______
______
0
Total
$31,000
NWC
Example: Using Pro Formas for Project Evaluation
 Let’s use the information from the previous example to
do a capital budgeting
Project operating cash flow (OCF):
EBIT
Depreciation
Taxes
OCF
$____
Example: Using Pro Formas for Project Evaluation (continued)
 Project Cash Flows
0
1
2
3
OCF
NWC Sp.
______
Cap. Sp.
-21,000
Total
______
______
______
Example: Using Pro Formas for Project Evaluation (concluded)
 Capital Budgeting Evaluation:
NPV
=
PB
=
AAR
=
 Should the firm invest in this project? Why or why not?
Alternative Definitions of OCF
Let:
OCF = operating cash flow
S
= sales
C
= operating costs
D
= depreciation
Tc
= corporate tax rate
Alternative Definitions of OCF (concluded)
 The Tax-Shield Approach
OCF
=
(S - C - D) + D - (S - C - D) x Tc
=
(S - C) x ( 1 - Tc) + (D x Tc)
=
(S - C) x (1 - Tc) + depreciation tax shield
 The Bottom-Up Approach
OCF
=
(S - C - D) + D - (S - C - D) x Tc
=
(S - C - D) x (1 - Tc) + D
=
Net income + depreciation
 The Top-Down Approach
OCF
=
(S - C - D) + D - (S - C - D) x Tc
=
(S - C) - (S - C - D) x Tc
=
Sales - costs - taxes
Chapter 10 Quick Quiz
 Assume we have the following background information for a
project being considered by Gillis, Inc.
 Calculate the project’s NPV and payback period.
1. Required NWC investment = $40; initial capital spending =
$60; 3 year life
2. Annual sales = $100; annual costs = 50; straight line
depreciation to $0
3. Salvage value = $10; tax rate = 34%, required return = 12%

The after-tax salvage is $10 - ($___ - ___ )(.34) = $6.6

OCF = (100 - 50 - 20) + 20 - (100 - 50 - 20)(.34) = $_____
Chapter 10 Quick Quiz (concluded)
 Project cash flows are thus:
0
OCF
Add. NWC
1
2
3
$39.8
$39.8
$39.8
_____
_____
-60
_____
Cap. Sp.
_____
$39.8
NPV = $ ______
Payback period = 2.24 years
$39.8
$86.4
Example: Fairways Equipment and Operating Costs
Equipment requirements:
Ball dispensing machine
Ball pick-up vehicle
Tractor and accessories
$ 2,000
7,000
9,000
$18,000
 all depreciable equipment is Class 10, 30%
 all equipment is expected to have a salvage value of 10% of cost
after 6 years. Assume there are no more class 10 assets after the
project ends.
Balls and buckets
$ 3,000
 expenditures for balls and baskets are expected to grow to 5% per
year
 Corporate tax rate is 15%
Example: Fairways Equipment and Operating Costs (concluded)
Operating Costs (annual)
Land lease
$ 12,000
Water
1,500
Electricity
3,000
Labor
30,000
Seed & fertilizer
2,000
Gasoline
1,500
Maintenance
1,000
Insurance
1,000
Misc.
1,000
$53,000
Working Capital
Initial requirement = $3,000
Working capital requirements
are expected to grow at 5%
per year for the life of the
project
Example: Fairways Revenues, Depreciation, and Other Costs
Projected Revenues
Year
Buckets
Revenues
1
20,000
$60,000
2
20,750
62,250
3
21,500
64,500
4
22,250
66,750
5
23,000
69,000
6
23,750
71,250
Example: Fairways Revenues, Depreciation, and Other Costs (continued)
Cost of balls and buckets
Year
Cost
1
$3,000
2
3,150
3
3,308
4
3,473
5
3,647
6
3,829
Example: Fairways Revenues, Depreciation, and Other Costs (concluded)
CCA for the six year life of the project
Year
Beg. UCC
CCA
Ending UCC
1
9000
2700
6300
2
15300
4590
10710
3
10710
3213
7497
4
7497
2249
5248
5
5248
1574
3674
6
3674
1102
2572
Example: Fairways Pro Forma Income Statement
Year
1
2
3
4
5
6
$60,000
62,250
64,500
66,750
69,000
71,250
3,000
3,150
3,308
3,473
3,647
3,829
Fixed costs
53,000
53,000
53,000
53,000
53,000
53,000
Depreciation
2,700
4,590
3,213
2,249
1,574
EBIT
1,300
1,510
4,979
8,028
10,779
195
227
747
1,204
1,617
1105
1,283
4,232
6,824
9,162
Revenues
Variable costs
Taxes
Net income
$
Example: Fairways Projected Increases in NWC
Projected increases in net working capital
Year
Net working capital
Increase in NWC
0
3,000
____
1
3,150
150
2
3,308
158
3
3,473
165
4
3,647
174
5
3,829
182
6
4,020
____
Example: Fairways Cash Flows
 Operating cash flows:
Year
0
EBIT
$
0
+ Depreciation
$
0
- Taxes
$
0
Operating
= cash flow
$
0
1
1,300
2,700
195
3,805
2
1,510
4,590
227
5,873
3
4,979
3,213
747
7,445
4
8,028
2,249
1,204
9,073
5
10,779
1,574
1,617
10,736
6
______
_____
______
_______
Example: Fairways Cash Flows (concluded)
 Total cash flow from assets:
- Increases
in NWC
Capital
- spending
Total
= cash flow
0
$ ______
$18,000
-$_____
1
3,805
150
0
3,655
2
5,873
158
0
5,715
3
7,445
165
0
7,280
4
9,073
174
0
8,899
5
10,736
182
0
10,554
6
______
_____
______
______
Year
0
Operating
cash flow
$
Present Value of the Tax Shield on CCA
Let:
C
= total capital cost added to
the pool (initial UCC)
d
=
CCA rate for the asset class
k
=
discount rate
S
=
salvage value of asset
Tc
=
corporate tax rate
n
=
asset life in years
Notes for Present Value of CCA Tax Shield (CCATS)
Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal
Consider a $10,000 machine that will reduce pretax operating costs
by $3,000 per year over a 5-year period. Assume no changes
in net working capital and a scrap value of $1,000 after five years.
The equipment is in class 8 with a CCA rate of 20%. The marginal tax
rate is 34% and the appropriate discount rate is 10%.
(Assume there are other class 8 assets in use after 5 years.)
Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal (concluded)
Example 2: Straight-line Depreciation and Cost-Cutting Proposal
Redo the previous example with straight-one deprecation.
Consider a $10,000 machine that will reduce pretax operating costs
by $3,000 per year over a 5-year period. Assume no changes
in net working capital and a scrap value of $1,000 after five years.
For simplicity, assume straight-line depreciation. The marginal tax
rate is 34% and the appropriate discount rate is 10%.
Example 2: Straight-line Depreciation and Cost-Cutting Proposal (concluded)
Example: Setting the Bid Price
The Army is seeking bids on Multiple Use Digitizing Devices (MUDDs). The contract calls for
4 units per year for 3 years. Labour and material costs are estimated at $10,000 per MUDD.
Production space can be leased for $12,000 per year. The project will require $50,000 in new
equipment which is expected to have a salvage value of $10,000 after 3 years. Making MUDDs
will require a $10,000 increase in net working capital. Assume a 34% tax rate and a required
return of 15%. Use straight-line depreciation.
Increases
in NWC
Capital
spending
Total
= cash flow
0
______
______
_______
1
OCF
0
0
OCF
2
OCF
0
0
OCF
3
OCF
______
______
OCF + ______
Year
0
Operating
cash flow
$
Example: Setting the Bid Price (concluded)
Evaluating equipment with different economic lives
Machine A
Machine B
Costs
$100
$140
Annual
Operating
Costs
$10
$8
Replace
Every 2 years
Every 3 years
Equivalent Annul Cost (EAC)
PV(Costs) = EAC*(Annuity Factor)
EAC = PV(Costs)/Annuity Factor
Example: Equivalent Annual Cost Analysis
 Two types of batteries are being considered for use in
electric golf carts at City Country Club. Burnout brand
batteries cost $36, have a useful life of 3 years, will cost
$100 per year to keep charged, and have a salvage value of
$5. Longlasting brand batteries cost $60 each, have a life of
5 years, will cost $88 per year to keep charged, and have a
salvage value of $5. Assume straight-line depreciation.
Example: Equivalent Annual Cost Analysis (concluded)