Chapter 10 Making Capital Investment Decisions. A change in the firm’s overall future cash flow that comes about as a direct consequence of the decision

Chapter 10

Making Capital Investment Decisions

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

Relevant Cash Flows

The stand-alone principle allows us to

analyze each project in isolation from the

firm simply by focusing on incremental cash

flows

The stand-alone principle

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

Asking the Right Question

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:

Common Types of Cash Flows

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

Notes

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

Pro Forma Statements and Cash Flow

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

Example

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 1 Page 327

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 3 Page 328

Consider the following income statement:

Ex 4 Page 328

824,500 sales

538,900 costs

126,500 Depreciation

? EBIT

? Taxes(34%)

? Net income

Fill in the missing numbers and then calculate the OCF.

What is the depreciation tax shield?

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?

Ex 9,10 Page 328

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

More on NWC

Suppose that during a particular year of a project we have the following simplified income statement

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

Example

500 Sales

310 Costs

190 Net income

change Ending of year Beginning of year

30 910 880 AR

55 605 550 AP

-25 305 330 NWC

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

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

Computing Depreciation

Consider an automobile costing 12,000$. What is the depreciation using the MACRS method?

Exampleexamples class

Equipments used in research Three-year

Autos, computers Five-year

Most industrial industries Seven-year

Property class

Seven-year Five-year Three-year year

14.29% 20.00% 33.33% 1

24.49 32 44.45 2

17.49 19.20 14.81 3

12.49 11.52 7.41 4

8.93 11.52 5

8.92 5.76 6

8.93 7

4.46 8

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)

After-tax Salvage

Ending book value

depreciation

Beginning book value

Year

9,600 2,400 12,000 1

2

3

4

5

6

MARCS Book values

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?

Example: Depreciation and After-tax Salvage

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

Ex 6 Page 328

The book value of an asset can differ

substantially from its actual market value

The difference between book and market

value will affect taxes

Book value versus Market value

the company is investigating the feasibility

of a new line of power mulching tools. MMCC

projects unit sales as follows:

The Majestic Mulch and Compost Company(Example)

Unit sales year

3,000 1

5,000 2

6,000 3

6,500 4

6,000 5

5,000 6

4,000 7

3,000 8

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?


Calculation of sales = unit price * number of

units


Revenues Unit sales Unit price year

360,000$ 3,000 120$ 1

600,000 5,000 120 2

720,000 6,000 120 3

715,000 6,500 110 4

660,000 6,000 110 5

550,000 5,000 110 6

440,000 4,000 110 7

330,000 3,000 110 8

Ending book value

depreciation MARCS percentage

year

685,680 114,320 14.29% 1

489,760 195,920 24.49 2

349,840 139,920 17.49 3

249,920 99,920 12.49 4

178,480 71,440 8.93 5

107,120 71,360 8.92 6

35,680 71,440 8.93 7

0 35,680 4.46 8


Calculation of depreciation= MARCS percentage * initial cost

year

8 7 6 5 4 3 2 1

330,000 440,000 550,000 660,000 715,000 720,000 600,000 36,000 revenues

180,000 240,000 300,000 360,000 390,000 360,000 300,000 180,000 VC

25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 FC

35,680 71,440 71,360 71,440 99,920 139,920 195,920 114,320 Dep

89,320 103,560 153,640 203,560 200,080 195,080 79,080 40,680 EBIT

30,369 35,210 52,238 69,210 68,027 66,327 26,887 13,831 Tax(34%)

58,951 68,350 101,402 134,350 132,053 128,753 52,193 26,849 NI


Calculation of OCF = EBIT + Dep - Tax


year

8 7 6 5 4 3 2 1

89,320 103,560 153,640 203,560 200,080 195,080 79,080 40,680 EBIT

35,680 71,440 71,360 71,440 99,920 139,920 195,920 114,320 Dep

30,369 35,210 52,238 69,210 68,027 66,327 26,887 13,831 Tax(34%)

94,631 139,790 172,762 205,790 231,973 268,673 248,113 141,169 OCF

Calculation of NWC for each year= sales * 0.15

Change in NWC= ending NWC – Beg NWC


Cash flow NWC Revenues year

20,000 0

360,000$ 1

600,000 2

720,000 3

715,000 4

660,000 5

550,000 6

440,000 7

330,000 8

year

8 7 6 5 4 3 2 1 0

-20,000 Initial NWC

Change in NWC

NWC recover

y

Total change in NWC


year8 7 6 5 4 3 2 1 0

-800,000 Initial cost

After-tax salvage

Capital spendin

g


Calculation of salvage = 0.2 * initial costAfter-tax salvage = salvage – T (salvage – BV)

Calculation of total CF= OCF – change in NWC- NCS


year

8 7 6 5 4 3 2 1 0

OCF

Change in NWC

NCS

Total CF

Cumulative CF

Pv of CF

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

Other Methods for Computing OCF

The tax saving that results from the

depreciation deduction

Depreciation * tax rate

Depreciation tax shield

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 8 Page 328

Aguilera Acoustics, Inc. (AAI), projects unit

sales for a new seven-octave voice

emulation implant as follows

Ex 32 Page 332

Unit sales year

93,000 1

105,000 2

128,000 3

134,000 4

87,000 5

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?

Ex 32 Page 332

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Chapter 10 Making Capital Investment Decisions. A change in the firm’s overall future cash flow that comes about as a direct consequence of the decision