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Professor John ZietlowMBA 621
Professor John ZietlowMBA 621
Cash Flow And Capital BudgetingCash Flow And Capital Budgeting
Chapter 8Chapter 8
Chapter 8: OverviewChapter 8: Overview
• 8.1 Types of Cash Flows– Cash flow vs. accounting profit– Fixed asset expenditures– Working capital expenditures– Terminal value– Incremental cash flow vs. sunk costs– Opportunity costs
• 8.2 Cash Flow for Classicaltunes.com• 8.3 Cash Flows, Discounting, and Inflation• 8.4 Special Problems in Capital Budgeting
– Equipment replacement and equivalent annual cost– Excess Capacity
• 8.5 Summary
Types of Cash FlowsTypes of Cash Flows
• First step in capital budgeting: determine the relevant CFs– The incremental after-tax cash outflow (investment) and
resulting cash flows. – Cash flows, rather than accounting values, are used.
• The cash flows of any project having simple cash flows can include three basic components: – (1) initial investment, (2) operating CFs, and (3) terminal CF – All projects have the first two components
• Initial investment includes all set up costs– Also includes incremental working capital investment
• Operating cash flows are after-tax net cash flows – using the firm’s marginal tax rate– CF, not earnings, so add depreciation back in
• The terminal CF usually related to liquidation of the project– Include disposal costs and after-tax salvage values, if any
Cash Flow Versus Accounting Profit Cash Flow Versus Accounting Profit
• Capital budgeting concerned with cash flow, not accounting profit– Most important distinction: non-cash charges
• Two ways to treat non-cash charges– Can compute net income and add depreciation back– Can compute after-tax income, then add tax savings
• Demonstrate two methods (next slide) by assuming a firm purchases a fixed asset today for $30,000– Plans to depreciate over 3 years using straight-line method– Using machine, firm will produce 10,000 units/year– Product sells for $3/unit and costs $1/unit– Firm pays taxes at a 40% marginal rate
Two Methods Of Handling Depreciation To Compute Cash Flow
Two Methods Of Handling Depreciation To Compute Cash Flow
$6,000Net income
$16,000Cash flow = NI + deprec
(4,000)Taxes (40%)
$10,000Pre-tax income
(10,000)Depreciation
$20,000Gross profits
(10,000)Cost of goods
$30,000Sales
Adding non-cash expenses back to after-tax earnings
$4,000Depreciation tax savings
$16,000Cash Flow
$12,000Aft-tax income
(8,000)Taxes (40%)
$20,000Pre-tax income
(10,000)Cost of goods
$30,000Sales
Find aft-tax profits, add back non-cash charge tax savings
Simplest and most common technique:Add depreciation back in
An Overview Of DepreciationAn Overview Of Depreciation
• Largest non-cash charge for most projects: depreciation – Firms allowed to charge off portion of asset’s cost each year
• For tax purposes, depreciation is regulated by the IR Code, as laid out most recently in the Tax Reform Act of 1986. – A firm will often use different depreciation methods for
financial reporting and tax purposes, which is quite legal.• Depreciation for tax purposes is determined by using the
modified accelerated cost recovery system (MACRS) – In US & UK, different depreciation methods can be used for
taxes and financial reporting • MACRS standards, which apply to both new and used
assets, require a taxpayer to use as an asset's depreciable life the appropriate MACRS recovery period. – There are six MACRS recovery periods--3, 5, 7, 10, 15, and
20 years--excluding real estate (not depreciable). – The first four property classes defined next slide.
The First Four Depreciation MACRS ClassesThe First Four Depreciation MACRS Classes
Property class
Definition
3-year
Research equipment & certain tools
5-year Computers, typewriters, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets
7-year Office furniture, fixtures, most mfg equipment, railroad track, single-purpose agricultural and horticultural structures
10-year Equipment used in petroleum refining or in the manufacture of tobacco and certain food products
MACRS Recovery PeriodsMACRS Recovery Periods
• For tax purposes, assets in the first four property classes depreciated by the double-declining balance (200%) method – Also computed using the half-year convention and switching
to straight-line when advantageous.– The approximate percentages written off each year for the
first four property classes are given in Table 8.1. • Rather than using these, the firm can use either straight-line
depreciation over the asset's recovery period with the half-year convention or the alternative depreciation system. – We use MACRS figures as these generally provide for the
fastest writeoff & thus the best CF effects for profitable firms• MACRS requires use of the half-year convention, so assets
assumed to be acquired in mid-year– So only half of first year's deprec is recovered in year 1 – Final half-year of depreciation is recovered in the year
immediately following the asset's stated recovery period. – Deprec %s for an n-year asset thus given for n + 1 years
Depreciation Percentages By YearDepreciation Percentages By Year
Depreciation percentage by recovery year
Recovery year
3-year
5-year
7-year
10-year
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4 Totals 100% 100% 100% 100%
Finding Initial Cost of Fixed Asset PurchaseFinding Initial Cost of Fixed Asset Purchase
• Cap budget decisions usually entail acquiring fixed asset.– Initial cost typically measured as net cash outflow
• If new asset, net initial cost fairly simple to compute– Just purchase price plus installation costs
• If new asset purchased to replace existing asset, finding net initial cost much more complicated– Must account for purchase and installation cost of new asset– Plus after-tax inflow or outflow from old asset = sale price
net of removal costs, plus or minus tax impact of sale• Tax impact from sale of old asset depends on asset’s sale
price and book value– Sale price below book value capital loss (tax benefit)– Sale price above book value, but below purchase price
firm must pay tax on recaptured depreciation– Sale price above purchase price firm must pay tax on
recaptured depreciation plus capital gain
Calculating Net Initial Cost Of New Computers For Electrocom Mfg
Calculating Net Initial Cost Of New Computers For Electrocom Mfg
• Electrocom Mfg wants to replace computers purchased three years ago for $100,000 with newer, faster machines– Old computers have been deprec with 5-year MACRS rule– Accum deprec = $71,200 (71.20%); so book value =
$28,800• If Electrocom sells its old computers for $10,000, what is
net after-tax cash flow from sale? Assume tax rate = 40%– Capital loss, sale of old computer = book value - sale price =
$28,800 - $10,000 = $18,800 – Tax benefit of capital loss (assuming firm has other profits) =
capital loss x tax rate = $18,800 x 0.40 = $7,520– Net inflow from sale = sale price + tax benefit = $17,520
• Net initial cost of new computers thus the purchase and installation cost of new computers minus $17,520
Working Capital ExpendituresWorking Capital Expenditures
• Many cap investments require additions to working capital– Net working capital (NWC) = curr assets – curr liabilities– Increase in NWC is a cash outflow; decrease a cash inflow– Some curr assets (A/R) can be acquired thru trade credit,
but curr liab will go up if credit extended (A/P)• Demonstrate impact of WC investment on cash flow with
calendar sales booth in mall over Christmas season– Operate booth from November 1 to January 31 (close Feb1)– Order $15,000 calendars on credit, delivery by Nov 1– Must pay suppliers $5,000/month, beginning Dec 1 – Expect to sell 30% of inventory (for cash) in Nov; 60% in
Dec; 10% in Jan; close up shop Feb 1– Always want to have $500 cash on hand; invest cash Nov 1,
receive it back Jan 31.
Working Capital For Calendar Sales BoothWorking Capital For Calendar Sales Booth
($4,000)+$500+$500NAMonthly in WC
($3,000)$1,000$500$0Net WC
$5,000$10,000$15,000$0Accts payable
$0$1,500$10,500$15,000$0Inventory
$0$500$500$500$0Cash
Feb 1Jan 1Dec 1Nov 1Oct 1
($5,000)($5,000)($5,000)$0Payments
($500)Net cash flow
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
$0Sales revenue
[all cash]
Jan 1 to Jan 31
Dec 1 to Dec 31
Nov 1 to Nov 30
Oct 1 to Oct 31
Payments and
sales receipts
($500) +$4,000 ($3,000)
$0
$0
+$3,000
Terminal ValueTerminal Value
• Some investments have a well-defined life, determined by:– Physical life of a piece of equipment– Period until a patent expires– Period of time covered by a leasing or licensing agreement
• Terminal value used when evaluating an investment with indefinite life-span– 1. Construct cash-flow forecasts for 5 to 10 years– 2. Forecasts more than 5 to 10 years – high margin of error;
use terminal value instead• Terminal value – intended to reflect the value of a project at
a given future point in time– Large value relative to all the other cash flows of the project
Terminal Value of SDL AcquisitionTerminal Value of SDL Acquisition
• JDS Uniphase projections for acquisition of SDL Inc.
• Different ways to calculate terminal values – assumptions used to calculate terminal value are very important– Use final year cash flow projections and assume that all
future cash flow grow at a constant rate– Multiply final cash flow estimate by a market multiple– Use investment’s book value or liquidation value
• Estimate recovery of no more than 20 – 50 percent of original purchase cost (Asplund, 2002)
• Possibly negative terminal value if high disposal costs
$3.25 Billion$2.5 Billion$1.75 Billion$1.0 Billion$0.5 Billion
Year 5Year 4Year 3Year 2Year 1
Terminal Value of SDL Acquisition (Continued)Terminal Value of SDL Acquisition (Continued)
• If assume that cash flow continues to grow at 5% per year (g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):
• Terminal value is $68.2 billion; value of entire project is
– $42.4 billion of total $48.7 billion from terminal value
• Using price-to-cash-flow ratio of 20 for companies in the same industry as SDL to compute terminal value– Terminal Value = $3.25 x 20 = $65 billion– Caveat : market multiples fluctuate over time
7.48$1.1
2.68$
1.1
25.3$
1.1
5.2$
1.1
75.1$
1.1
1$
1.1
5.0$554321
2.68$05.010.0
41.3$or , 5
1
PVgr
CFPV t
t
Incremental Cash FlowIncremental Cash Flow
• Incremental cash flows vs. sunk costs– Cap budgeting analysis should include only incremental costs
• For example, decision to pursue MBA can be based on incremental cash flows– Norman Paul’s current salary is $60,000 per year and expect to
increase at 5% each year– Assume that Norm pays taxes at flat rate of 35%– Sunk costs: $1,000 for GMAT course and $2,000 for visiting
various programs– Room and board expenses – not incremental to the decision to
go back to school (assume the same expenses for room and board in both cases)
Incremental Cash Flow (Continued)Incremental Cash Flow (Continued)
• At end of two years assume that Norm receives a salary offer of $90,000, which increases at 8% per year– Expected tuition, fees and textbook expenses for next two years
while studying in MBA: $35,000– If Norm worked at his current job for two years, his salary would
have increased to $66,150:– Yr 2 net cash inflow: $90,000 - $66,150 = $23,850– After-tax inflow: $23,850 x (1-0.35) = $15,503– Yr 3 cash inflow:– MBA has substantial positive NPV value if 30 yr analysis period
• Unwanted incremental cash outflow – cannibalization (sales of new products may come at expense of firm’s existing products
150,66$05.1000,60$ 2
032,18$35.0105.1000,60$08.1000,90$ 3
Opportunity CostsOpportunity Costs
• Opportunity cost: cash flows from alternative investment opportunities that are forgone when one investment is undertaken– If Norm did not attend MBA, he would have earned:
• First year: $60,000 ($39,000 after taxes)• Second Year: $63,000 ($40,950 after taxes)
– Norm’s opportunity cost: $39,000 + $40,950 = $79,950• NPV of a project could fall substantially if opportunity costs
are recognized– MBA applications are countercyclical because applicants take
into consideration opportunity costs– A firm that bought land for an expansion opportunity, for
example, should factor into the NPV of firm’s expansion plans the opportunity cost of selling or leasing the land
Initial Investment for Classicaltunes.com Jazz CD Project
Initial Investment for Classicaltunes.com Jazz CD Project
• Company is considering adding jazz recordings to its offerings– Firm uses 10% discount rate to calculate NPV and 40% tax rate– The average selling price of Classicaltunes CD’s is $13.50;
price is expected to increase at 2% per year• Initial investment transactions:
– $50,000 for computer equipment (MACRS 5-year asset class) – $4,500 for inventory ($2,500 of which purchased on credit)– $1,000 increase in cash balances
• Sales expected to begin when new fiscal year begins• Expanding sales volume require increases in current assets and
additional spending on fixed assets• Any additional financing (besides trade credit) for the project
from funds generated by classical-music CD side of the business
Projections for Jazz CD ProposalProjections for Jazz CD Proposal
6543210Year
24,000
$14.91
22,000
$14.61
25,00016,00010,0004,0000Units
$15.20$14.33$14.05$13.77$13.50Price per unit
37393
25208
35772
98374
259349
357722
27565
23872
35363
86800
234682
321482
49903155191649-13043-10000Pretax profit
1851214280138001800010000Depreciation
38008297991966482620SG&A Expense
1064225959735114 13219 0Gross profit
273657 169623105341418610Cost of goods sold
380080229221140454550800Revenue
Abbreviated Project Income Statement
Projections for Jazz CD Proposal (Continued)Projections for Jazz CD Proposal (Continued)
6543210Year
28057
120646
39840
105160
145000
80806
47696
29810
3300
25214
122903
50048
79952
130000
72855
42864
26790
3200
29810179781101643202500Accounts Payable
11717986585561324593445500Total assets
3132833920232003200040000Net P&E
12367256080418002800010000Accumulated Depreciation
15500090000650006000050000Gross P&E
858515266532932139345500 Current Assets
50677305631872773444500Inventory
31673191021170545900Accounts Receivable
35003000250020001000Cash
Abbreviated Project Balance Sheet
Annual Cash Flow EstimatesAnnual Cash Flow Estimates
Annual Cash Flow Estimates for Classicaltunes.com
-3291-5109-12953-12771-12302-6614-3000Change in working capital
-10000-15000-40000-25000-5000-10000-50000New Fixed Assets
6543210Year
27535
47644
-12542
40411
35163-14180-2512-6440-49000Net cash flow
484542359114790101744000Operating cash flow
Year Zero Cash FlowYear Zero Cash Flow
• Initial cash outlay of $50,000 for computer equipment• Even though sales begin when new fiscal year begins, half-year
of MACRS depreciation can be taken in year zero:– 20% x $50,000 = $10,000; non cash expense– Depreciation expense can be deducted from the firm’s classical-
music CD profits. The company saves $4,000 (40% x $10,000) in taxes
• Changes in working capital are result of following transactions:– Purchase of $4,500 in inventory and $1000 cash balance– Accounts payable of $2,500 partially finance the $5,500 outlay
• Net Cash Flow: Increase in gross fixed assets - $50,000
Change in working capital - $3,000 Tax savings + $4,000
Net cash flow - $49,000
Year One Cash FlowYear One Cash Flow
• Purchase of additional $10,000 in fixed assets• 2nd year depreciation expenses for MACRS 5-year asset class
is 32%. An additional 20% depreciation deduction for assets purchased this year– 32% x $50,000 + 20% x $10,000= $18,000– Non cash expense; has to be added back when computing cash
flow for the year• Net working capital for year one is:
– NWC = Current Assets – Current Liabilities = $13,934 - $4,320 = $9,614
– Increase in NWC; cash outflow of $6,614
614,6$000,3$614,9$ NWC– NWC NWC 0year 1year
Year One Cash Flow (Continued)Year One Cash Flow (Continued)
• Pretax loss of $13,043 in year 1 of Jazz CD project generates tax savings for other operations of Classicaltunes.com– Tax savings = 40% x $13,043 = $5,217
• Net operating cash inflow = pretax loss + tax savings + depreciation– Operating cash inflow = -$13,043 + $5,217 + $18,000 = $10,174
• Net cash flow:
Increase in gross fixed assets - $10,000 Change in working capital - $6,614 Operating cash inflow + $10,174
Net cash flow - $6,440
Year Two Cash FlowYear Two Cash Flow
• Purchase of additional $5,000 in fixed assets– Assets purchased at the onset of the project – allowable
depreciation of 19.2% (19.2% x $50,000 = $9,600)– An additional 32% depreciation deduction for assets purchased
in year 1 and 20% depreciation of assets purchased this year– Total depreciation = $9,600 + 32% x $10,000 + 20% x $5,000=
$4,200 = $13,800• Changes in working capital are result of following transactions:
– Increases in current assets:• $500 increase in cash balance• $7,115 increase in accounts receivables• $11,383 increase in inventory
– Increase in current liabilities:• $6,696 increase in account payables
– Change in NWC = $18,998 - $6,696 = $12,302 (cash outflow)
Year Two Cash Flow (Continued)Year Two Cash Flow (Continued)
• Pretax profit in year two is $1,649– The company must pay taxes of $660 (40% x $1,649); cash
outflow• Net operating cash inflow = pretax profit + tax + depreciation
– Operating cash inflow = $1,649 - $660 + $13,800 = $14,789
• Net cash flow:
Increase in gross fixed assets - $5,000 Change in working capital - $12,302 Operating cash inflow + $14,790
Net cash flow - $2,512
Terminal Value for Jazz CD InvestmentTerminal Value for Jazz CD Investment
• If assume that cash flow continue to grow at 2% per year (g = 2%, r = 10%,)
• Second approach used by Classicaltunes.com to compute terminal value for the project – use the book value at end of year six:– Plant and Equipment (P&E) at end of year six is $31,328– The firm liquidates total current assets and pays off current
debts
$85,850 - $29,810 = $56,040– Terminal value = $31,328 + $56,040 = $87,368
325,448$02.010.0
866,35$or ,
866,35$163,35$02.11
61
1
PVgr
CFPV
CFgCF
tt
tt
NPV for Jazz CD ProjectNPV for Jazz CD Project
• Using assumption that cash flow grow at a steady rate past year 6
• Using book value assumption for terminal value
• NPV is positive with both methods – investing in Jazz CD project increases shareholders wealth
862,213$1.1
325,448$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV
111,10$1.1
368,87$
1.1
163,35$
1.1
535,27$1.1
562,12$
1.1
180,14$
1.1
513,2$
1.1
440,6$000,49$
665
4321
NPV
Nominal and Real ReturnNominal and Real Return
• Nominal return vs. real return– Nominal return reflects the actual dollar return; real return
measures the increase in purchasing power gained by holding a certain investment
• Common in capital budgeting is the use of market rates of return at the time of the analysis– Market interest rates have embedded an assumption about
inflation– In this case, use nominal cash flows to reflect the same inflation
rate as that embedded in discount rate
1inf1
nom1rate real or,
rate), real(1rate)inflation (1rate) nominal1(
Inflation RulesInflation Rules
• Inflation Rule 1 – if nominal rate used to discount cash flow of a project, the embedded inflation expectation in the nominal rate must be used to construct the cash flows– In analysis of Jazz CD’s investment, assumption that price of a
CD increases by 2% per year on average– Revenues expressed in nominal terms– Discount rate used (10%) must reflect current market returns to
account for inflation rate• Inflation Rule 2 – when project cash flows are stated in real rather
than nominal terms, the appropriate discount rate is the real rate– Cash flows projections for Classicaltunes.com could be
expressed in real terms– Use current price for CDs of $13.50, current-year labor costs,
current-year prices for fixed assets for projections of cash flows
Real-Term Cash Flows for Jazz CD Investment
Real-Term Cash Flows for Jazz CD Investment
• To obtain cash flow in real terms – discount nominal cash flow at inflation rate– First year cash flow of -$6,440 restated in real terms
314,6$02.01
440,6$
3516327535-12542-14180-2512-6440-49000Nominal cash flow
1Discount factor
Real-Term Cash Flow Estimates for Classicaltunes.com
6543210Year
24939-11587 31224-13362-2415-6314-49000Real-term cash flow
02.1 202.1 302.1 402.1 502.1 602.1
NPV of Jazz CD ProjectNPV of Jazz CD Project
• Real rate for Classicaltunes.com
• NPV of the project – discount real-term cash flow at real rate
0784.0102.01
10.011
inf1
nom1rate Real
862,213$0784.1
100,398224,310784.1
939,24
0784.1
587,11
0784.1
362,13
0784.1
415,2
0784.1
314,6000,49
6
5432
NPV
Discounting real cash flows at real interest rate yields the same NPVas discounting nominal cash flows at nominal rate
Capital Budgeting and InflationCapital Budgeting and Inflation
NPV Overstated
NPV UnderstatedNominal Discount Rate
Real Discount Rate
Nominal Cash Flows Real Cash Flows
• If discount nominal cash flows at real discount rate:
overstated NPV $213,862 552,248$0784.1
325,448$163,35$0784.1
535,27$
0784.1
562,12$
0784.1
180,14$
0784.1
513,2$
0784.1
440,6$000,49$
6
54321
NPV
• If discount real cash flows at nominal discount rate:
detatsrednu NPV 862,213$ 138,183$1.1
100,398224,311.1
939,24
1.1
587,11
1.1
362,13
1.1
415,2
1.1
314,6000,49
6
5432
NPV
Equipment ReplacementEquipment Replacement
• A firm must purchase an electronic control device– First alternative – cheaper device, higher maintenance costs,
shorter period of utilization– Second device – more expensive, smaller maintenance costs,
longer life span• Expected cash outflows
– Maintenance costs – constant over time – use real discount rate of 7% for NPV
• Cash outflow device A < cash outflow device B select A
-15001500150012000A120012001200120014000B
43210Device
$15,936A$18,065B
NPVDevice
Equipment Replacement (Continued)Equipment Replacement (Continued)
Year A B
0 12,000 14,0001 1,500 1,2002 1,500 1,2003 13,500 1,2004 1,500 15,2005 1,500 1,2006 13,500 1,2007 1,500 1,2008 1,500 15,2009 13,500 1,200
10 1,500 1,20011 1,500 1,20012 1,500 1,200
NPV(7%) $48,233 $42,360
• Previous approach ignores the fact that device A will be replaced in year 4– Different approach – use cash flows for 12 years select B
Equivalent Annual Cost (EAC)Equivalent Annual Cost (EAC)
• EAC method approximates NPV for operating device with NPV of annuity– 1. Compute NPV for operating devices A and B for their lifetime
• NPV device A = $15,936• NPV device B = $18,065
– 2. Compute annual expenditure to make NPV of annuity equal to NPV of operating device
• Device A
• Device B
$6,072 X 07.107.107.1
936,15$321
XXX
$5,333Y 07.107.107.107.1
065,18$4321
YYYY
Equivalent Annual Cost (Continued)Equivalent Annual Cost (Continued)
• The firm chooses device B – replacing device B every four years is equivalent to a perpetuity of $5,333– The firm assumes that will keep using device B for a long period
of time• Assume the firm will use in three years new, less expensive
technology that makes current technology obsolete– In this case, choose the device that has the smallest cash outflow
for three years – choose A (assume salvage value zero)
926,15$07.1
500,1
07.1
500,1
07.1
500,1000,12$
321ANPV
674,18$07.1
200,1
07.1
200,1
07.1
200,1000,14$
321BNPV
Excess CapacityExcess Capacity
• Excess capacity – not a free asset as traditionally regarded by managers– Company has excess capacity in a distribution center warehouse– In two years the firm will invest $2,000,000 to expand the
warehouse as new stores are built in the region• The firm could lease the excess space for $125,000 per year for
the next two years– Expansion plans should begin immediately in this case to hold
inventory for stores that will come on line in a few months– Incremental cost – investing $2,000,000 at present vs. two years
from today– Incremental cash inflow - $125,000
Excess Capacity (Continued)Excess Capacity (Continued)
• NPV of leasing excess capacity (assume 10% discount rate)
• NPV negative – reject to lease excess capacity at $125,000 per year
• The firm could compute the value of the lease that would allow to break even
– X = $181,818– Leasing the excess capacity for a price above $181,818 would
increase shareholders wealth
471,108$1.1
000,000,2
10.1
000,125000,000,2000,125
2NPV
01.1
000,000,2
10.1000,000,2
2
XXNPV
The Human Face of Capital BudgetingThe Human Face of Capital Budgeting
• NPV of a project is based on a number of assumptions– Managers must be aware of optimistic bias in these assumptions
made by supporters of the project• Companies should have control measures in place to remove
bias– Analysis of an investment done by a group independent of
individual or group proposing the project– Analysts of the project must have a sense of what is reasonable
when forecasting a project’s profit margin and its growth potential• Another side of determining which projects receive funding –
storytelling– Best analysts not only provide numbers to highlight a good
investment, but also can explain why this investment makes sense