Ch. 10: Making Capital Investment Decisions

Relevant Cash Flows

• We are interested in incremental cash flows.
  • These are the cash flows that will only occur if the project is accepted
  • We will treat each project in isolation from the current operations of the firm
    • This is known as the stand-alone principle.
    • Think of the project in question as a mini-firm.
  • Focus on:
    • cash flows
    • timing (when you get the money, not when it accrues)
    • cash flows net of taxes (taxes are a cash outflow)
• Ask the question: “Will this cash flow occur only if we accept the project?”
  • If you answer “yes,” then include the cash flow.
  • If you answer “no,” then don’t include the cash flow.
  • If you answer “partly,” then include the part that occurs because of the project.
• Common Pitfalls
  • Sunk Costs
    • a cost that has already been incurred
    • not an incremental cash flow
  • Opportunity Costs
    • most valuable alternative (cost of lost options)
    • include as an incremental cash flow
  • Side Effects (spillovers)
    • Positive
    • Negative: “erosion” (cash flows of existing projects are reduced)
    • include as an incremental cash flow
  • Net Working Capital
    • inventories
    • accounts receivable (sales on credit)
    • accounts payable (supplies on credit)
    • include as an incremental cash flow
  • Financing Costs
    • not an incremental cash flow
    • analyze separately
    • included in required rate of return (cost of capital)
  • Taxes
    • represent a cash outflow
    • include as an incremental cash flow

Pro Forma Statements

• Financial statements projecting future years’ operations
• How do we get from accounting statements to cash flows?
  • Operating Cash Flow (OCF) = EBIT + Depreciation - Taxes = Net Income + Depreciation
  • Cash Flow from Assets (CFFA) = OCF - Net Capital Spending - Changes in NWC
• Example - Shark Repellant
  • See Table 10.1
  • See Table 10.2
  • OCF = $51,780, Capital Spending in Year 0 = $90,000, NWC Outflow in Year 0 = $20,000, Return of NWC in Year 3 = $20,000
  • NPV = $10,648 at required rate of return of 20 percent; Payback Period = 2.1 years

Details

• Net Working Capital
  • GAAP requires that sales be recorded on the income statement when made, not when the cash is received.
  • GAAP also requires that we record the cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers to date.
  • Finally, we have to buy inventory to support sales, although we haven’t collected cash yet.
• Depreciation
  • Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes.
  • Straight-line: D = (Initial cost – salvage) / number of years
  • MACRS: See Tables 10.6 and 10.7
• After-tax Salvage
  • 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 at time of sale)
  • Taxes can be positive or negative
  • Example: Purchase price = $110,000, Salvage Value in Year 6 = $17,000, MTR = 40 percent
    • Straight-line: After-tax salvage = $17,000
    • 3-year MACRS: After-tax salvage = $10,200
    • 7-year MACRS: BV in Year 6 = $14,729, After-tax salvage = $16,091.60

Alternative Definitions of OCF

• Bottom-up: OCF = NI + Depreciation (only valid if no interest expense)
• Top-down: OCF = Sales - Costs - Taxes
• Tax Shield
  • OCF = (1-T)(Sales - Costs) + T*Depreciation
  • Depreciation Tax Shield

Examples

• Cost Cutting
  • $80,000 in equipment. Save $22,000 per year (before taxes). Straight-line depreciation to zero in 5 years. Salvage of $20,000. Tax rate is 34 percent, and the discount rate is 10 percent.
  • After-tax Salvage = $13,200, OCF = $19,960, NPV = $3,860
• Setting the Bid Price
  • A local distributor has requested bids for 5 specially modified trucks each year for the next four years. Each truck costs $14,000 in materials plus facilities must be leased for $24,000 per year. We need $60,000 of new equipment. Depreciate to zero over four years (straight-line). Salvage value is $5,000. We need $40,000 in working capital. Tax rate is 39 percent. What price should we bid for a 20 percent return?
  • OCF = $30,609, NI = $15,609, Sales = $134,589 or $26,918 per truck
• Evaluating Equipment Options with Different Lives
  • Machine A costs $100 to buy and $10 per year to operate. It wears out and must be replaced every two years. Machine B costs $140 to buy and $8 per year to operate. It lasts for three years and much then be replaced. Ignoring taxes, which one should we choose if we use a 10 percent discount rate?
  • Machine A: NPV = $–117.36; Machine B: NPV = $–159.89
  • Equivalent Annual Cost: annuitize cost to annual basis
  • Machine A: EAC = $–67.62; Machine B: EAC = $–64.29