Chapter 10
MAKING CAPITAL
INVESTMENT DECISIONS
Relevant Cash Flows
 A change in the firm’s overall future cash flow that comes
about as a direct consequence of the decision to take that
project.
 These cash flows are called incremental cash flows
 Incremental cash flows: the difference between a firm’s
future cash flows with a project and those without the
project
 Irrelevant cash flows
The stand-alone principle
 The stand-alone principle allows us to analyze each project
in isolation from the firm simply by focusing on
incremental cash flows
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
Common Types of Cash Flows
 Sunk cost: a cost that has already been incurred and can’t
be removed.
 Opportunity cost: the cost of giving up a valuable
alternative if a particular investment is undertaken.
 Side effects: a) negative impact on the cash flows of an
existing product from the introduction of a new product
(erosion)
b) Positive impact
Common Types of Cash Flows
 Net working capital:
 Financing costs:
Notes
Financial manager is interested in:
1.
Cash flows
2. When these cash flows actually occurs
3. After-tax cash flows
Note that

Incremental cash flows are after-tax cash flows

Differentiate between: after-tax cash flows, accounting
profit and net income
Pro Forma Statements and Cash Flow
 Financial statements projecting future years’ operations
 Capital budgeting relies heavily on pro forma accounting
statements, particularly income statements
 Computing cash flows – refresher

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 NWC
Example
 If Pepsi can sell 50,000 cans per year of a new product line for 4$ per
can. It costs 2.5$ per can, this product line has three- year life with a
required rate of return of 20%. There will be 12,000$ fixed costs per
year, Pepsi will need to invest a total of 90,000$ in manufacturing
equipment which will be 100 percent depreciated. In addition the
project will require an initial 20,000$ investment in networking
capital, and the tax rate is 34 percent
 Prepare a pro forma income statement
 Calculate the total investment for each year
 Calculate the total project cash flows
 Calculate the NPV
Ex 1 Page 327
 Parker & stone Inc., is looking at setting up a new manufacturing plant
in south park to produce garden tools. The company bought some land
six years ago for 6$ million in anticipation of using it as a warehouse
and distribution site, but the company has since decided to rent these
facilities from a competitor instead. If the land were sold today, the
company would net 6.4$ million. The company wants to build its
manufacturing plant on this land; the plant will cost 14.2$ million to
build, and the site requires 890,000$ worth of grading before its
suitable for construction. What is the proper cash flow amount to use as
the initial investment in fixed assets when evaluating the project? Why?
Ex 3 Page 328
 A proposed new investment has projected sales of
830,000$. Variable costs are 60 percent of sales, and fixed
costs are 181,000$; depreciation is 77,000$. Prepare a pro
forma income statement assuming a tax rate of 35 percent.
What is the projected net income?
Ex 4 Page 328
 Consider the following income statement:
sales
824,500
costs
538,900
Depreciation
126,500
EBIT
?
Taxes(34%)
?
Net income
?
Fill in the missing numbers and then calculate the OCF. What
is the depreciation tax shield?
Ex 9,10 Page 328
 Summer Tyme, Inc., is considering a new three-year expansion
project that requires an initial fixed asst investment of 3.9$
million. That fixed asset will be depreciated straight-line to zero
over the three-year tax life. After which time it will be worthless.
the project is estimated to generate 2,650,000$ in annual sales,
with the cost of 840,000$. If the tax rate is 35 percent, what is
the OCF for this project?
 Suppose that the required rate of return is 12 percent, what is the
NPV?
More on NWC
 Why do we have to consider changes in NWC separately?

GAAP requires that sales be recorded on the income statement
when made, not when cash is received

GAAP also requires that we record cost of goods sold when the
GAAP also requires that we record cost of goods sold when the
corresponding sales are made, regardless of when we actually
pay our suppliers

Finally, we have to buy inventory to support sales, although we
haven’t collected cash yet
Example
 Suppose that during a particular year of a project we have the following
simplified income statement
Sales
500
Costs
310
Net income
190
Depreciation and taxes are zero, no fixed assets are purchased during the
year. Also assume that the only components of networking capital are
account receivables and payable. The beginning and ending amount for
these accounts are as follows
Beginning of year
Ending of year
change
AR
880
910
30
AP
550
605
55
NWC
330
305
-25
Depreciation
 Depreciation itself is a non-cash expense; consequently, it
is only relevant because it affects taxes
 Depreciation tax shield = DT

D = depreciation expense

T = marginal tax rate
Computing Depreciation
 Straight-line depreciation

D = (Initial cost – salvage) / number of years

Very few assets are depreciated straight-line for tax purposes
 MACRS

Need to know which asset class is appropriate for tax purposes

Multiply percentage given in table by the initial cost
Example
 Consider an automobile costing 12,000$. What is the depreciation using the
MACRS method?
class
examples
Three-year
Equipments used in research
Five-year
Autos, computers
Seven-year
Most industrial industries
Property class
year
Three-year
Five-year
Seven-year
1
33.33%
20.00%
14.29%
2
44.45
32
24.49
3
14.81
19.20
17.49
4
7.41
11.52
12.49
5
11.52
8.93
6
5.76
8.92
7
8.93
8
4.46
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)
MARCS Book values
Year
Beginning book value
depreciation
Ending book value
1
12,000
2,400
9,600
2
3
4
5
6
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 $17,000 when you are done with it in 6
years. The company’s marginal tax rate is 40%. What is the
depreciation expense each year and the after-tax salvage in year 6 for
each of the following situations?
 Suppose the appropriate depreciation schedule is straight-line
 What is the depreciation using the MACRS method (three years)? What
is the end-year book value? What is the after-tax salvage?
 What is the depreciation using the MACRS method (seven years)? What
is the end-year book value? What is the after-tax salvage?
Ex 6 Page 328
 A piece of newly purchased industrial equipment costs
1,080,000$ and its classified as seven-year property under
MARCS. Calculate the annual depreciation allowance and
end-of-the year book values for this equipment
Book value versus Market value
 The book value of an asset can differ substantially from its
actual market value
 The difference between book and market value will affect
taxes
The Majestic Mulch and Compost Company
(Example)
 the company is investigating the feasibility of a new line of
power mulching tools. MMCC projects unit sales as follows:
year
Unit sales
1
3,000
2
5,000
3
6,000
4
6,500
5
6,000
6
5,000
7
4,000
8
3,000
The Majestic Mulch and Compost Company
(Example)
 The new Mulcher will sell for 120$ per unit to start. After three
years MMCC anticipates that the price will drop to 110$ due to
competition. The company will require 20,000$ networking
capital at the start. After that the networking capital will be about
15 percent of sales for that year. The variable cost per unit is 60$,
and the total fixed costs are 25,000$ per year. It will cost about
800,000$ to buy the equipment and it will be worth about 20
percent of its cost in eight years. The relevant tax rate is 34
percent ant the required return is 15 percent. Based on this
information, should MMCC proceed?
The Majestic Mulch and Compost Company
(Example)
 Calculation of sales = unit price * number of units
year
Unit price
Unit sales
Revenues
1
120$
3,000
360,000$
2
120
5,000
600,000
3
120
6,000
720,000
4
110
6,500
715,000
5
110
6,000
660,000
6
110
5,000
550,000
7
110
4,000
440,000
8
110
3,000
330,000
The Majestic Mulch and Compost Company
(Example)
Calculation of depreciation= MARCS percentage * initial cost
year
MARCS percentage
depreciation
Ending book value
1
14.29%
114,320
685,680
2
24.49
195,920
489,760
3
17.49
139,920
349,840
4
12.49
99,920
249,920
5
8.93
71,440
178,480
6
8.92
71,360
107,120
7
8.93
71,440
35,680
8
4.46
35,680
0
The Majestic Mulch and Compost Company
(Example)
year
1
2
3
4
5
6
7
8
revenues
36,000
600,000
720,000
715,000
660,000
550,000
440,000
330,000
VC
180,000
300,000
360,000
390,000
360,000
300,000
240,000
180,000
FC
25,000
25,000
25,000
25,000
25,000
25,000
25,000
25,000
Dep
114,320
195,920
139,920
99,920
71,440
71,360
71,440
35,680
EBIT
40,680
79,080
195,080
200,080
203,560
153,640
103,560
89,320
Tax(34%)
13,831
26,887
66,327
68,027
69,210
52,238
35,210
30,369
NI
26,849
52,193
128,753
132,053
134,350
101,402
68,350
58,951
The Majestic Mulch and Compost Company
(Example)
 Calculation of OCF = EBIT + Dep - Tax
year
1
2
3
4
5
6
7
8
EBIT
40,680
79,080
195,080
200,080
203,560
153,640
103,560
89,320
Dep
114,320
195,920
139,920
99,920
71,440
71,360
71,440
35,680
Tax(34%)
13,831
26,887
66,327
68,027
69,210
52,238
35,210
30,369
OCF
141,169
248,113
268,673
231,973
205,790
172,762
139,790
94,631
The Majestic Mulch and Compost Company
(Example)
 Calculation of NWC for each year= sales * 0.15
 Change in NWC= ending NWC – Beg NWC
year
Revenues
0
NWC
20,000
1
360,000$
2
600,000
3
720,000
4
715,000
5
660,000
6
550,000
7
440,000
8
330,000
Cash flow
The Majestic Mulch and Compost Company
(Example)
year
0
Initial
NWC
Change
in NWC
NWC
recovery
Total
change
in NWC
-20,000
1
2
3
4
5
6
7
8
The Majestic Mulch and Compost Company
(Example)
Calculation of salvage = 0.2 * initial cost
After-tax salvage = salvage – T (salvage – BV)
year
0
Initial
cost
After-tax
salvage
Capital
spending
800,000
1
2
3
4
5
6
7
8
The Majestic Mulch and Compost Company
(Example)
 Calculation of total CF= OCF – change in NWC- NCS
year
0
OCF
Change
in NWC
NCS
Total CF
Cumulat
ive CF
Pv of CF
1
2
3
4
5
6
7
8
Other Methods for Computing OCF
 If you have the following information:
 Sales = 1,500$
 Costs = 700$
 Depreciation = 600$
 Tax rate = 34%
 No interest
 Calculate the OCF
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
Depreciation tax shield
 The tax saving that results from the depreciation deduction
 Depreciation * tax rate
Ex 8 Page 328
 An asset used in a four-year project falls in the five-year
MARCS class for tax purpose. The asset has an acquisition
cost of 7,900,000$ and will be sold for 1,400,000$ at the
end of the project. If the tax rate is 35 percent. What is the
after tax salvage value of the asset?
Ex 32 Page 332
 Aguilera Acoustics, Inc. (AAI), projects unit sales for a new
seven-octave voice emulation implant as follows
year
Unit sales
1
93,000
2
105,000
3
128,000
4
134,000
5
87,000
Ex 32 Page 332
 Production of the implants will require 1,800,000$ in networking capital to
start and additional networking capital investments each year equal to 15
percent of the projected sales increase for the following year. Total fixed
costs are 1,200,000$ per year, variable production costs are 265$ per unit,
and the units priced at 380$ each. The equipment needed to begin
production has an installed cost of 24,000,000$.becasue the implants are
intended for professional singers, this equipment is considered industrial
machinery and thus qualified as seven-year MARCS property. In five years,
this equipment can be sold about 20 percent of its acquisition cost.AAI is in
the 35 percent marginal tax and has a required return on all its projects of
18 percent. Based on these estimates, what is the NPV?