7-0

Chapter Seven

Net Present Value

and
Corporate
Finance
Ross Westerfield Jaffe
Capital Budgeting

Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-1

Chapter Outline
7.1 Incremental Cash Flows

7.2 The Majestic Mulch and Compost Company: An Example

7.3 Inflation and Capital Budgeting
7.4 Investments of Unequal Lives: The Equivalent Annual Cost
Method
7.5 Summary and Conclusions

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-2

7.1 Incremental Cash Flows

Cash flows matternot accounting earnings.

Sunk costs dont matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-3

Cash FlowsNot Accounting Earnings

Consider depreciation expense.
You never write a cheque made out to depreciation.
Much of the work in evaluating a project lies in taking
accounting numbers and generating cash flows.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-4

Incremental Cash Flows

Sunk costs are not relevant
Just because we have come this far does not mean that
we should continue to throw good money after bad.
Opportunity costs do matter. Just because a project has a
positive NPV does not mean that it should also have
automatic acceptance. Specifically if another project with a
higher NPV would have to be passed up we should not
proceed.
Side effects matter.
Erosion and cannibalism are both bad things. If our new
product causes existing customers to demand less of
current products, we need to recognize that.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-5

Estimating Cash Flows

Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT Taxes + Depreciation
Net Capital Spending
Dont forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a
return of net working capital.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-6

Interest Expense
Later chapters will deal with the impact that the amount of
debt that a firm has in its capital structure has on firm value.
For now, its enough to assume that the firms level of debt
(hence interest expense) is independent of the project at
hand.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-7

7.2 The Majestic Mulch and Compost

Company (MMCC): An Example
Costs of test marketing (already spent): $250,000.
The proposed factory site (which we own) has no resale value.
Cost of the tool making machine: $800,000 (CCA calculations are
based on a class 8, 20-percent rate).
Production (in units) by year during 8-year life of the machine:
6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, and 6,000.
Price during first year is $100; price increases 2-percent per year
thereafter.
Production costs during first year are $64 per unit and increase at
the annual inflation rate of 5-percent per year thereafter.
Fixed production costs are $50,000 each year.
Working capital: initially $40,000, then 15-percent of sales at the
end of each year. Falls to $0 by the projects end.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-8

The Worksheet for Cash Flows of the

MMCC
(All cash flows occur at the end of the year.)

Year 0
Income:
(1) Sales revenues

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

$600,000 $918,000 $1,248,480 $1,379,570 $1,298,919 $1,104,081 $900,930 $689,211

Recall that production (in units) by year during 8-year life of the machine is
given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000).

Price during first year is $100 and increases 2% per year thereafter.
Sales revenue in year 5 = 12,000[$100(1.02)4] = $1,298,919.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-9

The Worksheet for Cash Flows of the

MMCC (continued)
(All cash flows occur at the end of the year.)

Year 0
Income:
(1) Sales revenues
(2) Operating costs

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

$600,000 $918,000 $1,248,480 $1,379,570 $1,298,919 $1,104,081 $900,930 $689,211

434,000 654,800
896,720 1,013,144
983,509
866,820 736,129 590,327

Again, production (in units) by year during 8-year life of the machine is
given by: (6,000, 9,000, 12,000, 13,000, 12,000, 10,000, 8,000, 6,000).
Variable costs during first year (per unit) are $64 and (increase 5% per
year thereafter). Fixed costs are $50,000 each year.
Production costs in year 2 = 12,000[$64(1.05)4] + 50,000= $983,509.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-10

The Worksheet for Cash Flows of the

MMCC (continued)
(All cash flows occur at the end of the year.)

Year 0
Income:
(1) Sales revenues
(2) Operating costs
(3) CCA

Year 1

Year 2

Year 3

Year 5

Year 6

Year 7

Year 8

$600,000 $918,000 $1,248,480 $1,379,570 $1,298,919 $1,104,081 $900,930 $689,211

434,000 654,800
896,720 1,013,144
983,509
866,820 736,129 590,327
80,000 144,000
115,200
92,160
73,728
58,982 47,186 37,749

CCA calculations are based on

a class 8, 20% rate (shown at
right)
The machine cost $800,000.

CCA charge in year 5

=$368,640(.20) = $73,728.

McGraw-Hill Ryerson

Year 4

Annual CCA
Beginning
Ending
Year
UCC
CCA
UCC
1
$400,000 $80,000 $320,000
2
720,000 144,000 576,000
3
576,000 115,200 460,800
4
460,800 92,160 368,640
5
368,640 73,728 294,912
6
294,912 58,982 235,930
7
235,930 47,186 188,744
8
188,744 37,749 150,995
2003 McGrawHill Ryerson Limited

7-11

The Worksheet for Cash Flows of the

MMCC (continued)
(All cash flows occur at the end of the year.)

Year 0
Income:
(1) Sales revenues
(2) Operating costs
(3) CCA
(4) EBIT
[(1) (2) - (3)]
(5) Taxes at 40%
(6) Net Income

McGraw-Hill Ryerson

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

$600,000 $918,000 $1,248,480 $1,379,570 $1,298,919 $1,104,081 $900,930 $689,211

434,000 654,800
896,720 1,013,144
983,509
866,820 736,129 590,327
80,000 144,000
115,200
92,160
73,728
58,982
47,186
37,749
86,000 119,200
236,560
274,266
241,682
178,278 117,615
61,136
34,400
51,600

47,680
71,520

94,624
141,936

109,707
164,560

96,673
145,009

71,311
106,967

47,046
70,569

24,454
36,682

2003 McGrawHill Ryerson Limited

7-12

The Worksheet for Cash Flows of the

MMCC (continued)
(All cash flows occur at the end of the year.)

Year 0
Investments:
(7) NWC (year end)
(8) Change in NWC
(9) Equipment
(10) Aftertax salvage
(11) Total cash flow
of investment
[(8) + (9) + (10)]

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

$ 40,000 $90,000 $137,700 $187,272 $206,936 $194,838 $165,612 $135,139 $ 0

(40,000) (50,000) (47,700) (49,572) (19,664) 12,098
29,226
30,473 135,139
(800,000)
150,000
(840,000) (50,000) (47,700) (49,572) (19,664) 12,098
29,226
30,473 285,139

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-13

Incremental After Tax Cash Flows

(IATCF) of the MMCC
(All cash flows occur at the end of the year.)
Year 0
(1) Sales
revenues
(2) Operating
costs
(3) Taxes

Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
$600,000 $918,000 $1,248,480 $1,379,570 $1,298,919 $1,104,081 $900,930 $689,211
$434,000 $654,800 $ 896,720 $1,013,144 $ 983,509 $ 866,820 $736,129 $590,327
34,400

47,680

94,624

109,707

96,673

71,311

47,046

24,454

(4) OCF
131,600 215,520
[(1) - (2) - (3)]
(5) Total CF of (840,000) (50,000) (47,700)
Investment
(6) IATCF
(840,000) 81,600 167,820
[(4) + (5)]

257,136

256,720

218,737

165,949

117,755

74,430

(49,572)

(19,664)

12,098

29,226

30,473

285,139

207,564

237,056

230,835

195,175

148,228

359,570

NPV@10%

$500,135

NPV@10%

$188,042

NPV@15%

$2,280

NPV@20%

($137,896)

IRR

15.07%

McGraw-Hill Ryerson

If the projects
discount rate is
above 15.07%,
it should not be
accepted (since
NPV > 0).
2003 McGrawHill Ryerson Limited

7-14

7.3 Inflation and Capital Budgeting

Inflation is an important fact of economic life and must be
considered in capital budgeting.
Consider the relationship between interest rates and inflation,
often referred to as the Fisher relationship:
(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)
For low rates of inflation, this is often approximated as
Real Rate Nominal Rate Inflation Rate
While the nominal rate in the U.S. has fluctuated with
inflation, most of the time the real rate has exhibited far less
variance than the nominal rate.
When accounting for inflation in capital budgeting, one must
compare real cash flows discounted at real rates or nominal
cash flows discounted at nominal rates.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-15

Example of Capital Budgeting under Inflation

Canadian Electronics Inc. (CEI) has an investment opportunity to produce a
new stereo colour TV.
The required investment on January 1 of this year is $32 million. CCA
calculations are based on a class 8, 20% rate. The firm is in the 34% tax
bracket.
This investment will have no resale value at the end of the project (in four
years).
The price of the product on January 1 will be $400 per unit. The price will stay
constant in real terms.
Labour costs will be $15 per hour on January 1. The will increase at 2% per
year in real terms.
Energy costs will be $5 per TV; they will increase 3% per year in real terms.
The inflation rate is 5%.
Revenues are received and costs are paid at year-end.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-16

Example of Capital Budgeting under Inflation

Year 1

Year 2

Year 3

Year 4

Physical
Production
(units)

100,000

200,000

200,000

150,000

Labour Input
(hours)

2,000,000

2,000,000

2,000,000

2,000,000

Energy input,
physical units

200,000

200,000

200,000

200,000

The riskless nominal discount rate is 4%.

The real discount rate for costs and revenues is 8%. Calculate the
NPV.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-17

Present Value of the Tax Shield on CCA

The PV of CCA tax shield is a perpetuity, with an adjustment
for
the 1st year 50-percent rule
the sale of the asset at the time when the project is
terminated
The PV of CCA tax shield is given by:

C d Tc 1 0.5k S d Tc
1
PVCCA Tax Shield

n
k d
1 k
k d
1 k

S = Min[resale value of assets, original price of assets]

C = original price of the assets
d = depreciation rate that applies to the asset class
d = discount rate
n = the time when assets are sold
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-18

Example of Capital Budgeting under Inflation

The depreciation tax shield is a risk-free nominal cash flow, and
is therefore discounted at the nominal riskless rate.
Cost of investment today: C = $32,000,000
Project life: n = 4 years
Class 8 depreciation rate: d = 20%
Asset resale value: S = 0
Finally: k = 0.04 and TC = 0.34
The PV of CCA tax shield is given by:

PVCCA Tax Shield

32,000,000 .2 .34 1 (.5 .04 0 .2 .34

1

4
.04 .2
1.04
.04 .2 1.04
$8,892,308
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-19

Example of Capital Budgeting under Inflation

Risky Real Cash Flows
Price: $400 per unit with zero real price increase
Labour: $15 per hour with 2% real wage increase
Energy: $5 per unit with 3% real energy cost increase
Year 1 After-tax Real Risky Cash Flows:
After-tax revenues =
$400 100,000 (1-.34) = $26,400,000
After-tax labour costs =
$15 2,000,000 1.02 (1-.34) = $20,196,000
After-tax energy costs =
$5 2,00,000 1.03 (1-.34) = $679,800
After-tax net operating CF =
$26,400,000 - $20,196,000 - $679,800 =$5,524,200
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-20

Example of Capital Budgeting under Inflation

Year One After-tax revenues = $400 100,000 (1-.34) = $26,400,000
Year One After-tax labour costs = $15 2,000,000 1.02 (1-.34) = $20,196,000
Year One After-tax energy costs = $5 2,00,000 1.03 (1-.34) = $679,800

Year One After-tax net operating CF =$5,524,200

$5,524,200

$31,499,886

$31,066,882

$17,425,007

-$32,000,000

$5,524,200 $31,499,886 $31,066,882 $17,425,007

2
3
(1.08)
(1.08)
(1.08)
(1.08) 4
$69,590,868

PVrisky CFs $32m

PVrisky CFs

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-21

Example of Capital Budgeting under Inflation

The project NPV can now be computed as the sum of the PV
of the cost, the PV of the risky cash flows discounted at the
risky rate, and the PV of the risk-free CCA tax shield cash
flows discounted at the risk-free discount rate.
NPV = -$32,000,000 + $69,590,868 + $8,892,308 = $46,483,176

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-22

7.4 Investments of Unequal Lives: The

Equivalent Annual Cost Method
There are times when application of the NPV rule can lead to
the wrong decision. Consider a factory that must have an air
cleaner. The equipment is mandated by law, so there is no
doing without.
There are two choices:
The Cadillac cleaner costs $4,000 today, has annual
operating costs of $100 and lasts for 10 years.
The cheaper cleaner costs $1,000 today, has annual
operating costs of $500 and lasts for five years.
Which one should we choose?

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-23

7.4 Investments of Unequal Lives: The

Equivalent Annual Cost Method
At first glance, the cheap cleaner has the lower NPV (r = 10%):
10

$100
NPVCadillac $4,000
4,614.46
t
t 1 (1.10)
5

NPVcheap

$500
$1,000
2,895.39
t
t 1 (1.10)

This overlooks the fact that the Cadillac cleaner lasts twice as
long.
When we incorporate that, the Cadillac cleaner is actually
cheaper.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-24

7.4 Investments of Unequal Lives: The

Equivalent Annual Cost Method
The Cadillac cleaner time line of cash flows:
-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -100

10

10

$100
NPVCadillac $4,000
4,614.46
t
t 1 (1.10)

The cheaper cleaner time line of cash flows over 10 years:

-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

10

NPVcheap

$500 $1,000 10 $500

$1,000

$4,693.20
t
5
t
(1.10) t 6 (1.10)
t 1 (1.10)

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-25

Investments of Unequal Lives

Replacement Chain
Repeat the projects forever, find the PV of that
perpetuity.
Assumption: Both projects can and will be repeated.
Matching Cycle
Repeat projects until they begin and end at the same
timelike we just did with the air cleaners.
Compute NPV for the repeated projects.
The Equivalent Annual Cost Method

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-26

Investments of Unequal Lives: EAC

The Equivalent Annual Cost Method
Applicable to a much more robust set of circumstances
than replacement chain or matching cycle.
The Equivalent Annual Cost is the value of the level
payment annuity that has the same PV as our original set
of cash flows.
NPV = EAC ArT
For example, the EAC for the Cadillac air cleaner is
$750.98
10

10
$100
$750.98
$4,000
4,614.46
t
t
t 1 (1.10)
t 1 (1.10)

The EAC for the cheaper air cleaner is $763.80

which confirms our earlier decision to reject it.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-27

Example of Replacement Projects

Consider a Belgian Dentists office; he needs an autoclave to
sterilize his instruments. He has an old one that is in use, but
the maintenance costs are rising and so he is considering
replacing this indispensable piece of equipment.
New Autoclave
Cost = $3,000 today,
Maintenance cost = $20 per year
Resale value after 6 years = $1,200
NPV of new autoclave (at r = 10%):
6

$20
$1,200
$2,409.74 $3,000

t
(1.10) 6
t 1 (1.10)

EAC of new autoclave = -$553.29

$553.29
$2,409.74
t
(
1
.
10
)
t

1
McGraw-Hill Ryerson
6

2003 McGrawHill Ryerson Limited

7-28

Example of Replacement Projects

Existing Autoclave
Year
0
Maintenance
0
Resale
900
Total Annual Cost

1
200
850
340

2
275
775
435

3
325
700
478

4
450
600
620

5
500
500
660

Total Cost for year 1 = (900 1.10 850) + 200 = $340

Total Cost for year 2 = (850 1.10 775) + 275 = $435
Total Cost for year 3 = (775 1.10 700) + 325 = $478
Total Cost for year 4 = (700 1.10 600) + 450 = $620
Total Cost for year 5 = (600 1.10 500) + 500 = $660

Note that the total cost of keeping an autoclave for the first year
includes the $200 maintenance cost as well as the opportunity cost of
the foregone future value of the $900 we didnt get from selling it in
year 0 less the $850 we have if we still own it at year 1.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-29

Example of Replacement Projects

New Autoclave

EAC of new autoclave = -$553.29

Existing Autoclave
Year
0
1
2
3
Maintenance
0
200
275
325
Resale
900
850
775
700
Total Annual Cost
435
478
340

4
450
600
620

5
500
500
660

We should keep the old autoclave until its cheaper to buy

a new one.

Replace the autoclave after year 3: at that point the new

one will cost $553.29 for the next years autoclaving and
the old one will cost $620 for one more year.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

7-30

7.5 Summary and Conclusions

Capital budgeting must be placed on an incremental basis.
Sunk costs are ignored
Opportunity costs and side effects matter
Inflation must be handled consistently
Discount real flows at real rates
Discount nominal flows at nominal rates
When a firm must choose between two machines of unequal
lives:
the firm can apply either the matching cycle approach
or the equivalent annual cost approach

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited