Capital Investment Decisions

• Chapter focuses on making capital investment decisions.

Outcomes

• Determine relevant cash flows for various proposed investments.
• Use various methods for computing operating cash flow.
• Evaluate projects with unequal lives.

Chapter Outline

• Project cash flows are examined for a first look.
• Incremental cash flows are assessed.
• Pro forma financial statements and project cash flows are used.
• Project cash flow is explored in more detail.
• Alternative definitions of operating cash flow are provided.
• Special cases of discounted cash flow analysis are explored.

Relevant Cash Flows

• Capital budgeting analysis includes cash flows that occur only if the project is accepted.
• These cash flows are called incremental cash flows
• The stand-alone principle isolates a project to focus on its incremental cash flows.
• Project cash flows imply changes in future firm cash flows and financial statements.

Common Types of Cash Flows

• Sunk costs are costs that have accrued in the past.
• Opportunity costs are costs of lost options.
• Side effects can be positive (benefits to other projects) or negative (costs to other projects).
• Negative side effects include cannibalization, where a new product reduces sales of an existing one. For example, a foldable phone reducing iPad sales.
• Changes in net working capital are relevant.
• Financing costs are not included.
• Taxes are a relevant cash flow.

Pro Forma or Projected Statements and Cash Flow

• Capital budgeting relies heavily on pro forma accounting statements, particularly income statements.
• Operating Cash Flow (OCF) = EBIT – taxes + depreciation (or Net Income + depreciation if no interest payment)
• OCF = Net Income + Depreciation (if no interest).
• OCF = (sales - cost) (1-T) + Dep * T, where T is the tax rate.
• OCF = sales - costs - taxes.
• Total Cash Flow = – net capital spending (NCS) + OCF - changes in NWC.

Other Methods of Computing OCF

• Bottom-Up Approach: OCF = EBIT(1 - Tax) + depreciation.
• Tax Shield Approach: OCF = (Sales – Costs)(1 – Tax) + Depreciation*Tax.
• Top-Down Approach: OCF = Sales – Costs – Taxes, does not subtract non-cash deductions.

Example Project

• Project requires an initial investment of $90,000 and NWC of $20,000.
• Expected project life is 3 years.
• Expected sales are 50,000 units at $4/unit.
• Expected variable cost is $2.5 per unit.
• Expected fixed cost is $12,000.
• Straight line depreciation is used, with a tax rate of 34%.

Projected Income Statement (accounting concepts)

• Sales revenue totals $200,000.
• Variable costs total $125,000.
• Gross profit is $75,000.
• Fixed costs are $12,000.
• Depreciation expense is $30,000.
• Earnings Before Income Tax (EBIT) totals $33,000.
• Taxes are $11,220.
• Net income is $21,780.
• The project requires an investment of $90,000 and NWC of $20,000.

Projected Total Cash Flows

• Capital spending is -$90,000 in year 0.
• Operating cash flow is $51,780 in years 1-3.
• Changes in NWC are -$20,000 in year 0 and $20,000 in year 3.
• Total project cash flow is -$110,00 in year 0, $51,780 in years 1-2, and $71,780 in year 3.

Making the Decision

• Apply techniques to cash flows learned in Chapter 9.
• Enter cash flows into a calculator to compute NPV and IRR.
• NPV = 10,648
• IRR = 25.8%
• If the discount rate is 20%, the project should be accepted.

Depreciation

• Depreciation is a non-cash expense that affects taxes.
• Depreciation tax shield = Depreciation x Tax Rate.

Computing Depreciation

• Straight-line depreciation = (Initial cost – salvage value *) / number of years.
• In some examples, salvage value is not deducted to simplify tax impact.
• MACRS uses percentages in a table based on the asset class.
• Need to know the correct asset class for tax purposes.
• Multiply the percentage by the initial cost.
• Depreciate to zero.

After-tax Salvage

• If salvage value differs from book value, there is a tax effect.
• Book value = initial cost – accumulated depreciation.
• After-tax salvage = salvage – Tax (salvage – book value); can be given as After tax salvage = Salvage (1 - Tax) only if the book value is zero.
• Salvage value is the estimated resale value at the end of its useful life.
• If expected salvage value is considered in depreciation, there's no tax implication upon sale.

Straight-Line Depreciation and After-Tax Salvage Example

• Equipment is purchased for $90,000, with $10,000 delivery and installation fees, totaling $100,000.
• The equipment can be sold for $17,000 in 5 years.
• The company’s marginal tax rate is 40%.
• With straight line depreciation and a zero salvage value:
• Annual depreciation is $20,000: Depreciation = 100,000 / 5
• Book Value in year 5 = 100,000 – 5(20,000) = 0
• After-tax salvage = salvage - Tax (salvage - book value)= 17,000 - 0.4(17,000 – 0).

Replacement Problem

• Original Machine: Initial cost $100,000, annual depreciation $9,000, purchased 5 years ago, current book value $55,000, salvage value now $65,000, salvage value in 5 years $10,000.
• New Machine: Initial cost $150,000, 5-year life, straight-line depreciation $30,000, salvage value in 5 years $17,000.
• Cost savings of $50,000 per year, required return 10%, tax rate 40%.
• Old machine is sold when the new one is purchased.
• Incremental cash flows represent the changes from the old to new situations.

Computing Cash Flows for Replacement Machine

• Focus is on incremental cash flows.
• Buying the new machine involves selling the old one.
• Cash flow consequences of selling the old machine today versus in 5 years need considering.

Incremental Net Capital Spending

• Buy the new machine which is an outflow of $150,000
• Selling the old machine results in inflow: 65,000 - 0.4(65,000 - 55,000) = 61,000
• Net capital spending is therefore: 150,000-61,000 = $89,000; an outflow

Incremental OCF

• Cost Savings is $50,000
• Incremental Depreciation:
  • New = $30,000
  • Old = $9,000
  • Difference = $21,000
• Results in:
  • EBIT = $29,000
  • Taxed amount = $11,600
  • NI = $17,400
• OCF = $38,400

Incremental Terminal CF

• Net Salvage Value on New Machine = 17,000 - 0.4(17,000 - 0) = $10,200
• Net Salvage Value on Old Machine = 10,000 - 0.4(10,00 - 10,000) = $10,000
  • This is an opportunity cost because there is no longer the ability ti get $10,000 because it was sold today
• Terminal CF = $200

Incremental CF on a Timeline

• Year 0: Net Capital Spending = -$89,000
• Years 1-5: Operating Cash Flow = $38,400 per year + Terminal CF of $200 in Year 5.

Analyzing the Cash Flows

• Now that we have the cash flows, we can compute the NPV and IRR
• Enter cash Flows
  • Compute NPV = $56,690 at 10%
  • Compute IRR = 32.66%
• Should the company replace the equipment?

Cost Cutting Exercise

• A company considers a new computer system costing $1 million, saving $300,000 annually.
• System lasts five years, depreciated on a 4-year straight-line basis.
• Salvage value of $50,000 at the end of year 5, no impact on NWC, tax rate 40%, required return 8%.
• Calculate projected cash flows and note that we are to assume a zero salvage value for depreciation

Exercise Key Figures

• Initial Cost: $1,000,000
• Savings: $300,000
• Tax Rate: 40%
• Expected Salvage: $50,000
• Discount Rate: 8%
• Straight-Line Depreciation Schedule: 25% per year for 4 years, resulting in $250K depreciation expense.
• Cash Flow from Assets: -$1,000,000 in year 0, then $280,000 annually for 4 years, $ 210,000 in year 5
• Net Present Value: $70,317.99
• Internal Rate of Return: 10.72%

MACRS Depreciation and After-tax Salvage Example

• Equipment is purchased for $100,000, with $10,000 delivery and installation, totaling $110,000.
• It can be sold for $17,000 in 6 years, marginal tax rate 40%.
• Determine depreciation expense and after-tax salvage under 3-year and 7-year MACRS.

Three-Year MACRS Example

• Three-Year MACRS: Year 1: Depreciation = .3333(110,000) = 36,663 Year 2: Depreciation = .4445(110,000) = 48,895 Year 3: Depreciation = .1481(110,000) = 16,291 Year 4: Depreciation = .0741(110,000) = 8,151
• BV in year 6
  • 110,000 – 36,663 – 48,895 - 16,291 – 8,151 = 0
• After-tax salvage = 17,000 - .4(17,000 – 0) = $10,200

Seven-Year MACRS Example

• 7-Year MA CRS Year 1: Depreciation = .1429(110,000) = 15,719 Year 2: Depreciation = .2449(110,000) = 26,939 Year 3: Depreciation = .1749(110,000) = 19,239 Year 4: Depreciation = .1249(110,000) = 13,739 Year 5: Depreciation = .0893(110,000) = 9,823 Year 6: Depreciation = .0892(110,000) = 9,812
• The BV in year 6 = 110,000 - 15,719 - 26,939 - 19,239 - 13,739 - 9,823 - 9,812 = stops in year 6
• After-tax salvage = 17,000 - .4(17,000 - 14,729) =

Projects with Unequal Lives

• A firm is planning to expand and needs to select one of two machines with different economic lives. Replacement of machines is necessary.
• Choose between mutually exclusive machines with different lives when replacement is needed.

Unequal Lives Example

• S and L are mutually exclusive and will continue to be replaced, which is better? Use r= 10%
  • Project S has NPV = 4.132
  • Project L has NPV = 6.190
• NPV of L > NPV of S
  • IF there is no replacement L would be better

Replacement Chain

• Projects with Unequal Lives:
  • A project S with replication, which is better?
    • The NPV of S is greater than the NPV of L

Equivalent Annual Annuity (EAA)

• You Need to find the two year annuity factor is = 1.735537, so 4.321/1.7355 = 2.38 ==EAA of S

Project L:

• You Need to find the four year annuity factor = 3.1699, so 6.19/3.1699 = 1.953 = EAA of L

EAA Analysis

• EAA of S is greater than EAA of L and so selects S
• Replacement chains (NPV using common life) - anmd EAA always lead to the same decision

Additional EAA Examples

• Burnout Batteries