Ch 10 - Making Capital Investment Decisions

8/9/2019 Ch 10 - Making Capital Investment Decisions

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Making Capital Investment Decisions

Chapter 10

Making Capital

Investment Decisions


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Capital budgeting concepts

Relevant cash fows

Incremental cash fows ater tax eectshave been considered.

he !stand"alone# principle

$ach pro%ect can be eval&ated in isolation.

'&nk costs(ave alread) been inc&rred* so the) areirrelevant.


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Capital budgeting concepts(contd.)

+pport&nit) costs

'omething that we give &p b) &ndertaking apro%ect " can be di,c&lt to identi).

'ide eects

he impact a pro%ect has on other activities

o the -rm* e.g. Coke Diet Coke.


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/et working capital

0dditional &nds re1&ired at the

beginning o a pro%ect to p&rchaseinventor) and -nance acco&ntsreceivable 2 &s&all) recovered at

the end o the pro%ect.


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3inancing costs4e will ignore these or now 2

pro%ect acceptance or re%ectionsho&ld be driven b) the assets* not-nancing eects.


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Straightline depreciation

Depreciation expense 5

6initial cost 2 salvage

val&e78estimated lie


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!"ample o# straightlinedepreciation

$xample9 comp&te the ann&aldepreciation expense or a machine

that has an estimated &se&l lie o :)ears* a ;ero salvage val&e* and aninitial cost o *>>>*>>>.

depreciation expense 5 6M " >78:5


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$orking %ith M&C'Sschedules

Ignore salvage val&e

A )r convention


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!"ample o# %orking %ithM&C'S schedules

$xample9 the B"ear M0CR' sched&le

ear Depreciation

= BB.BB

? ::.::

B =:.E?

: F.:=


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ook value and market value

0re &s&all) dierent


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!"ample o# book value andmarket value

$xample9 comp&te the -rst")eardepreciation expense and the book val&eat the end o ear = or a machine in the

B"ear M0CR' class that has an initialcost o *>>>*>>>.

Depr. $xp. 5 .BBBBGM 5


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he concept o# estimatingsalvage values

4hat )o& think )o& co&ld sell thee1&ipment or when the pro%ect is

over.


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Calculating ta"es

ax 5 tax rate x 6salvage val&e 2book val&e7


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!"ample o# calculating ta"es

$xample9 what is the relevant taxpa)ment i a machine is sold or

>*>>> when the book val&e is*>>> and the tax rate is :>J

ax 5 .:> G 6>*>>> " *>>>75 >>


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a" shields

+cc&r when e1&ipment is sold orless than book val&e.


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terta" salvage value

0ter"tax salvage val&e 5$stimated salvage val&e " tax


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!"ample o# a#terta" salvagevalue

$xample9 what is the ater"tax salvageval&e o a machine that is sold or>*>>> when the book val&e is*>>> and the tax rate is :>J

0ter"tax salvage val&e

5 >*>>>"K.:>G6>*>>>"*>>>7L5 < =>E*>>>


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!stimating pro*ect cash+o%s

ro%ect cash fow5 operating cash fow 2 change in

/4C 2 capital spending

+perating cash fow5 $HI N depreciation 2 taxes

'cenario and sensitivit) anal)sis


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!"ample o# estimatingpro*ect cash +o%s

$xample9 the hiladelphia ret;el Compan)is considering an investment in a newpret;el twister. he machine will cost

*>>>* and will be depreciated on astraight"line basis to ;ero over two )ears.It will generate additional sales o *>>>per )ear and expenses o >> per)ear. he pro%ect will re1&ire an additionalinvestment in working capital o >>*which will be reed &p at the end o thepro%ect. he tax rate is :>.


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!"ample o# estimatingpro*ect cash +o%s (contd.)

6=7 $stimate the pro%ectOs cash fowsand comp&te the / at a

disco&nt rate o =?.


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0 1 2Investment (20)000

NWC (*)000 *)000

Sales *0)000 *0)000

Expenses *)000 *)000

Gross Profit 1*)000 1*)000

Depreciation 10)000 10)000

EBIT *)000 *)000

Taxes 2)000 2)000

Net Income )000 )000

+ Depreciation 10)000 10)000

per Cas! flo" 1)000 1)000

Pro#ect C$ ,2*)000- 1)000 1.)000

NP% & 12' /*

I 1*'


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6?7 Recomp&te the / i the machine issold or >> ater two )ears.

0ter"tax salvage val&e5 B>>>"K.:>6B>>>">7L 5 =E>>

$ect on / 5 N=E>>8=.=?? 5 =:B@

/ew / 5 P@F N =:B@ 5 ?BP?


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&dditional considerations incapital budgeting

Managerial optionsextra fexibilit) can onl) help a

pro%ect

Capital rationing

res&lts rom a shortage o &nds


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Managerial options

he option to expand 6i things gowell7

he option to abandon 6i things gopoorl)7

he option to wait 6conditions ma)

improve7 'trategic options


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Capital rationing

'ot rationingd&e to b&dget allocation within the

-rm* b&t external -nancing isavailable

(ard rationingno external or internal capital isavailable

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Ch 10 - Making Capital Investment Decisions