Chapter 10 Making Capital Investment Decisions 10-1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • • • • • • 10-2 Capital Budgeting and Cash Flows Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis Chapter Outline • • • • • • 10-3 Capital Budgeting and Cash Flows Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis Capital Budgeting and Cash Flows In the previous chapter we focused on multiple techniques of capital budgeting to evaluate projects This chapter is all about how each of the cash flows (CF’s) are determined 10-4 Project Example - Visual R = 12% $ -165,000 CF1 = 63,120 CF2 = CF3 = 70,800 91,080 The required return for assets of this risk level is 12% (as determined by the firm) 10-5 Chapter Outline • • • • • • 10-6 Capital Budgeting and Cash Flows Incremental Cash Flows Pro Forma Financial Statements Operating Cash Flows Replacement Decisions Discounted Cash Flow Analysis Relevant Cash Flows • The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted • These cash flows are called incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows 10-7 Asking the Right Question 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 10-8 Common Types of Cash Flows Sunk costs – costs that have accrued in the past Opportunity costs – costs of lost options Changes in net working capital (NWC) Financing costs Taxes 10-9 Common Types of Cash Flows Side effects: 10-10 • Positive side effects – benefits to other projects • Negative side effects – costs to other projects Example: Setting the Bid Price Consider the following information: The Army has requested bids for multiple use digitizing devices (MUDDs) 10-46 Deliver units each year for the next years Labor and materials estimated to be $10,000 per unit Production space leased for $12,000 per year Example: Setting the Bid Price (continued) Requires $50,000 in fixed assets with expected salvage of $10,000 at the end of the project (depreciate straight-line) Requires an initial $10,000 increase in NWC Tax rate = 34% Firm’s required return = 15% Task: Click on the Excel icon to work through the example 10-47 Example: Equivalent Annual Cost Analysis  Burnout Batteries Long-lasting Batteries  Initial Cost = $36 each  Initial Cost = $60 each  3-year life  5-year life  $100 per year to keep  $88 per year to charged 10-48  keep charged  Expected salvage = $5  Expected salvage = $5  Straight-line depreciation  Straight-line depreciation Example: Equivalent Annual Cost Analysis (continued) The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue No change in NWC is required The required return is 15%, and the tax rate is 34% 10-49 Ethics Issues In an L.A Law episode, an automobile manufacturer knowingly built cars that had a significant safety flaw Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car What issues does the financial analysis overlook? 10-50 Quick Quiz 10-51 How 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? What is the basic process for finding the bid price? What is equivalent annual cost and when should it be used? Comprehensive Problem A $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 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? 10-52 Terminology • • • • • • • 10-53 Incremental cash flows Sunk costs Opportunity costs Stand-alone (or independent) projects Net Working Capital (NWC) Operating Cash Flow (OCF) Cash Flow From Assets (CFFA) Terminology (continued) • • • • • • 10-54 Straight line depreciation MACRS depreciation Market value vs book value After-tax salvage value Bid price Equivalent Annual Cost (EAC) Formulas • 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 NW • After-tax salvage = salvage – T (salvage – book value at time of sale) 10-55 Formulas (continued) Operating Cash Flow Formula: Bottom-Up Approach OCF = NI + depreciation Top-Down Approach OCF = Sales – Costs – Taxes Tax Shield Approach OCF = (Sales – Costs)(1 – T) + Depreciation*T 10-56 Key Concepts and Skills • Compute the relevant cash flows for proposed investments • Compare and contrast the various methods for computing operating cash flow • • Compute a bid price for a project Compute and evaluate the equivalent annual cost of a project 10-57 What are the most important topics of this chapter? The cash flows for a project are computed using incremental cash flows considering depreciation and after-tax salvage values Straight-line and MACRS methods of depreciation are used to compute the depreciation of an asset 10-58 What are the most important topics of this chapter? Cash Flows From Assets (CFFA) computes the annual cash flows for capital budgeting purposes Replacement decisions involve the cash flows of the “old” asset as well as the “new” asset 10-59 Questions? 10-60 [...]... expense) • Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NW 10-12 Project Pro Forma Income Statement Sales (50,000 units at $4.00/unit) Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT Taxes (34%) Net Income 10-13 $200,000 $ 33,000 11,220 $ 21,780 Chapter Outline • • • • • • 10-14 Capital Budgeting and Cash Flows... consequently, it is only relevant because it affects taxes Calculation: Depreciation tax shield = DT D = depreciation expense T = marginal tax rate of the firm 10-22 Computing Depreciation  Straight-line depreciation D = (Initial cost – salvage) / number of years Very few assets are depreciated using the straight-line method for tax purposes  MACRS Need to know which asset class is appropriate for... cost Depreciate to zero Mid-year convention 10-23 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) 10-24 After-tax Salvage Computation 1.Market Value – Book Value = gain (or loss) 2.Take gain (or loss) x (marginal... 3 $51,780 20,000 NWC 10-16 Net CS -$90,000 CFFA -$110,00 $51,780 $51,780 $71,780 Project Example - Visual R = 20% 1 $ -110,000 CF1 = 51,780 2 3 CF2 = CF3 = 51,780 71,780 The required return for assets of this risk level is 20% (as determined by the firm) 10-17 Using your calculator 10-18 Evaluate the Project Enter the cash flows into the calculator and compute NPV and IRR: CF0 = -110,000; C01 = 51,780;... Why do we have to consider changes in NWC separately?  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 10-21... when you are done with it in 6 years 10-26 Example: Depreciation and After-tax Salvage The company’s marginal tax rate is 40% What is the depreciation expense and the after-tax salvage in year 6 for each of the following three scenarios (A-C)? 0 $ -110,000 1 2 3 4 5 6 Sell = $17,000 10-27 Example A: Straight-line Suppose the appropriate depreciation schedule is straight-line: D = (110,000 – 17,000) / 6 ... “part of it,” then we should include the part that occurs because of the project 10-8 Common Types of Cash Flows Sunk costs – costs that have accrued in the past Opportunity costs – costs of lost... In the previous chapter we focused on multiple techniques of capital budgeting to evaluate projects This chapter is all about how each of the cash flows (CF’s) are determined 10-4 Project Example... Forma Income Statement Sales (50,000 units at $4.00/unit) Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT Taxes (34%) Net Income