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1、Chapter 10Making Capital Investment Decisions2024/8/26Chapter OutlineProject Cash Flows: A First LookIncremental Cash FlowsPro Forma Financial Statements and Project Cash FlowsMore about Project Cash FlowAlternative Definitions of Operating Cash FlowSome Special Cases of Discounted Cash Flow Analysi
2、s10-22024/8/26Relevant Cash FlowsThe cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is acceptedThese cash flows are called incremental cash flowsThe stand-alone principle - analyze each project in isolation from the fir
3、m (on its own merits) by focusing on incremental cash flows10-32024/8/26Asking the Right QuestionYou 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 incrementalIf the answer is “part of i
4、t,” then we should include the part that occurs because of the projectIf the answer is “no,” it should not be included in the analysis because it will occur anyway10-42024/8/26Common Types of Cash FlowsSunk costs costs that have accrued in the pastOpportunity costs costs of lost optionsSide effectsP
5、ositive side effects benefits to other projectsNegative side effects costs to other projectsChanges in net working capitalTaxes (use after-tax cash flows)Do not consider Financing Costs (part of R)10-52024/8/26Pro Forma Statements and Cash FlowCapital budgeting relies heavily on pro forma accounting
6、 statements, particularly income statementsComputing cash flows:Operating Cash Flow (OCF) = EBIT + depreciation taxesOCF = Net income + depreciation (when there is no interest expense)Cash Flow From Assets (CFFA) = OCF net capital spending (NCS) changes in NWC10-62024/8/26Table 10.1 (p. 310) Pro For
7、ma Income StatementSales (50,000 units at $4.00/unit)$200,000Variable Costs ($2.50/unit)125,000Gross profit$ 75,000Fixed costs12,000Depreciation ($90,000 / 3)30,000EBIT$ 33,000Taxes (34%)11,220Net Income$ 21,78010-72024/8/26Table 10.2 Projected Capital Requirements (balance sheet)Year0123NWC$20,000$
8、20,000$20,000$20,000NFA 90,000 60,000 30,000 0Total$110,000$80,000$50,000$20,00010-82024/8/262024/8/26Capital spending at the time of project inception (i.e., the “initial outlay”) includes the following items:+ purchase price of the new asset- selling price of the asset replaced (if applicable)+ co
9、sts of site preparation, setup, and startup+/- increase (decrease) in tax liability due to sale of old asset at other than book value= net capital spendingTable 10.5 (p. 311) Projected Total Cash FlowsYear0123OCF$51,780$51,780$51,780Change in NWC-$20,00020,000NCS-$90,000 CFFA-$110,00$51,780$51,780$7
10、1,78010-102024/8/26Making The DecisionNow that we have the cash flows, we can apply the techniques that we learned in Chapter 9Use formulas for PV of discounted cash flowsShould we accept or reject the project?10-112024/8/26DepreciationThe depreciation expense used for capital budgeting should be th
11、e depreciation schedule required by the IRS for tax purposesDepreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxesDepreciation tax shield = DTD = depreciation expenseT = marginal tax rate10-132024/8/26Computing DepreciationStraight-line DepreciationD =
12、(Initial cost salvage) / number of yearsVery few assets are depreciated straight-line for tax purposesMACRS (Modified Accelerated Cost Recovery System) p. 316Need to know which asset class is appropriate for tax purposesMultiply percentage given in table by the initial costDepreciate to zeroMid-year
13、 convention10-142024/8/26After-tax SalvageAfter-tax salvage is the capital recovery cash flow at project end.If the salvage value is different from the book value of the asset, then there is a tax effectBook value = initial cost accumulated depreciationAfter-tax salvage = salvage Tax*(salvage book v
14、alue)10-152024/8/26Example: Depreciation and After-tax SalvageYou purchase equipment for $100,000, and it costs $10,000 to have it delivered and installed. (What is the capex?)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
15、 companys 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?10-162024/8/26Example: Straight-lineSuppose the appropriate depreciation schedule is straight-lineD = (110,000 17,000) / 6 = 15,500 every year for 6
16、 yearsBV in year 6 = 110,000 6(15,500) = 17,000After-tax salvage = 17,000 - .4(17,000 17,000) = 17,00010-172024/8/26Example: Three-year MACRS p. 316YearMACRS percentD1.3333.3333(110,000) = 36,6632.4445.4445(110,000) = 48,8953.1481.1481(110,000) = 16,2914.0741.0741(110,000) = 8,151BV in year 6 = 110,
17、000 36,663 48,895 16,291 8,151 = 0After-tax salvage = 17,000 - .4(17,000 0) = $10,20010-182024/8/26Example: Seven-Year MACRSYearMACRS PercentD1.1429.1429(110,000) = 15,7192.2449.2449(110,000) = 26,9393.1749.1749(110,000) = 19,2394.1249.1249(110,000) = 13,7395.0893.0893(110,000) = 9,8236.0892.0892(11
18、0,000) = 9,812BV in year 6 = 110,000 15,719 26,939 19,239 13,739 9,823 9,812 = 14,729After-tax salvage = 17,000 .4(17,000 14,729) = 16,091.6010-192024/8/26Example: Replacement ProblemOriginal MachineInitial cost = 100,000Annual depreciation = 9,000Purchased 5 years agoBook Value = 55,000Salvage toda
19、y = 65,000Salvage in 5 years = 10,000New MachineInitial cost = 150,0005-year lifeSalvage in 5 years = 0Cost savings = 50,000 per year3-year MACRS depreciationRequired return = 10%Tax rate = 40%10-202024/8/26Replacement Problem Computing Cash FlowsRemember that we are interested in incremental cash f
20、lowsIf we buy the new machine, then we will sell the old machineWhat are the cash flow consequences of selling the old machine today instead of in 5 years?10-212024/8/26Replacement Problem Pro Forma Income StatementsYear12345Cost Savings50,00050,00050,00050,00050,000Depr. New49,99566,67522,21511,115
21、0 Old9,0009,0009,0009,0009,000Increm.40,99557,67513,2152,115(9,000)EBIT9,005(7,675)36,78547,88559,000Taxes3,602(3,070)14,71419,15423,600NI5,403(4,605)22,07128,73135,40010-222024/8/26Replacement Problem Incremental Net Capital SpendingYear 0Cost of new machine = 150,000 (outflow)After-tax salvage on
22、old machine = 65,000 - .4(65,000 55,000) = 61,000 (inflow)Incremental net capital spending = 150,000 61,000 = 89,000 (outflow)Year 5After-tax salvage on old machine = -10,000 (outflow because we no longer receive this)10-232024/8/26Replacement Problem Cash Flow From AssetsYear012345OCF46,39853,07035
23、,28630,84626,400NCS-89,000-10,000 In NWC00CFFA-89,00046,39853,07035,28630,84616,40010-242024/8/26Replacement Problem Analyzing the Cash FlowsNow that we have the cash flows, we can compute the NPV and IRREnter the cash flowsCompute NPV = 54,801.74Compute IRR = 36.28%Should the company replace the eq
24、uipment?10-252024/8/26Other Methods for Computing OCFBottom-Up ApproachWorks only when there is no interest expenseOCF = NI + depreciationTop-Down ApproachOCF = Sales Cash Costs TaxesDont subtract non-cash deductionsTax Shield ApproachOCF = (Sales Costs)(1 T) + Depreciation*T10-262024/8/26Example: C
25、ost CuttingYour company is considering a new computer system that will initially cost $1 million. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5.It will save $300,000 per year in
26、 inventory and receivables management costs. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%.Click on the Excel icon to work through the example10-272024/8/26Example: Equivalent Annual Cost AnalysisBurnout BatteriesInitial Cost = $36 each3-year life
27、$100 per year to keep chargedExpected salvage = $5Straight-line depreciationLong-lasting BatteriesInitial Cost = $60 each5-year life$88 per year to keep chargedExpected salvage = $5Straight-line depreciationThe machine chosen will be replaced indefinitely and neither machine will have a differential
28、 impact on revenue. No change in NWC is required.The required return is 15%, and the tax rate is 34%.10-292024/8/26Quick QuizHow do we determine if cash flows are relevant to the capital budgeting decision?What are the different methods for computing operating cash flow and when are they important?W
29、hat is the basic process for finding the bid price?What is equivalent annual cost and when should it be used?10-302024/8/26Comprehensive ProblemA $1,000,000 investment is depreciated using a seven-year MACRS class life. It requires $150,000 in additional inventory and will increase accounts payable
30、by $50,000. It will generate $400,000 in revenue and $150,000 in cash expenses annually, and the tax rate is 40%. What is the incremental cash flow in years 0, 1, 7, and 8?10-312024/8/26Key Concepts and SkillsUnderstand how to determine the relevant cash flows for various types of proposed investmentsUnderstand the various methods for computing operating cash flowUnderstand how to set a bid price for a projectUnderstand how to evaluate the equivalent annual cost of a project10-322024/8/26
