Chapter 8

Making Capital Investment Decisions

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Determine the relevant cash flows for various types of capital investments Compute depreciation expense for tax purposes Incorporate inflation into capital budgeting Employ the various methods for computing operating cash flow Apply the Equivalent Annual Cost approach

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8.1 Incremental Cash Flows 8.2 The Baldwin Company: An Example 8.3 Inflation and Capital Budgeting 8.4 Alternative Definitions of Cash Flow 8.5 Investments of Unequal Lives: The Equivalent Annual Cost Method

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Cash flows matternot accounting earnings. Sunk costs dont matter. Incremental cash flows matter. Opportunity costs matter. SEE EXAMPLE 8.3 PAGE 272 Side effects like synergy, cannibalism and erosion matter. Taxes matter: we want incremental after-tax cash flows. Inflation matters.

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When performing capital budgeting analysis:

Always base calculations on cash flow, not income
x x x x Earnings Cash Need cash for capital spending Need cash for rewarding shareholders Therefore, capital expenditure analysis must be based on cash

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Much of the work in evaluating a project lies in converting accounting income to cash flow Examples of reconciling items:
Depreciation (most common example)
x You never write a check made out to depreciation.

Amortization Deferrals and Accruals

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Remember: Incremental cash flows arise as a consequence of selecting a project Seems like a simple task
Not so, there are many pitfalls in identifying incremental cash flow

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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, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.

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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. If, however, synergies result that create increased demand of existing products, we also need to recognize that.

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Allocations
Overhead may be allocated to the new project Allocations are only relevant if the project increases or decreases the cash outlay of the entire firm

Salvage Value
Dont forget to treat salvage value (after tax, of course) as a cash inflow at the end of the project

Changes in Net Working Capital

Many projects require an increase in NWC (inventory, receivables, and other current assets) when initiated; this is a cash outlay at the beginning of the project Dont forget: To reduce NWC at the end of a project requiring increased NWC; this is a cash inflow at the end of the project
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Cash Flow from Operations

Recall that: OCF = EBIT Taxes + Depreciation

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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 (and, hence, interest expense) is independent of the project at hand.

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Costs of test marketing (already spent): $250,000 Current market value of proposed factory site (which we own): $150,000 Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year) Increase in net working capital: $10,000 Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000

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Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Annual inflation rate: 5% Working Capital: initial $10,000 changes with sales

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

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5 21.76* 94.24

Investments: (1) Bowling ball machine 100.00 (2) Accumulated 20.00 52.00 depreciation (3) Adjusted basis of 80.00 48.00 28.80 after depreciation (end of year) (4) Opportunity cost 150.00 (warehouse) (5) Net working capital 10.00 10.00 16.32 24.97 (6) Change in net 10.00 6.32 8.65 (7) Total cash flow of 260.00 6.32 8.65 [(1) + (4) + (6)]

71.20 17.28

82.72 5.76 150.00

ma

21.22 3.75 3.75

0 (end of year) 21.22 working cap 192.98 investment

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Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Investments: (1) Bowling ball machine 100.00 21.76* (2) Accumulated 20.00 94.24 depreciation (3) Adjusted basis of 80.00 48.00 machine after depreciation (end of year) (4) Opportunity cost 150.00 (warehouse) (5) Net working capital 10.00 10.00 16.32 (end of year) (6) Change in net 10.00 6.32 working capital (7) Total cash flow of 260.00 6.32 investment [(1) + (4) + (6)]

52.00 28.80

71.20 17.28

82.72 5.76 150.00

24.97 8.65 8.65

21.22 3.75 3.75

0 21.22 192.98

At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

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Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues

Year 5

100.00 163.20 249.72 212.20 129.90

Recall that production (in units) by year during the 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during the first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000[$20(1.02)2] = 12,000$20.81 = $249,720.

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Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues (9) Operating costs

Year 5

100.00 163.20 249.72 212.20 129.90 50.00 88.00 145.20 133.10 87.84

Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Production costs during the first year (per unit) are $10, and they increase 10% per year thereafter. Production costs in year 2 = 8,000[$10(1.10)1] = $88,000

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Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues (9) Operating costs (10) Depreciation 11.52

Year 5

100.00 163.20 249.72 212.20 129.90 50.00 88.00 145.20 133.10 87.84 20.00 32.00 19.20 11.52
Year 1 2 3 4 5 6 Total ACRS % 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 100.00%
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Depreciation is calculated using the Accelerated Cost Recovery System (shown at right). Our cost basis is $100,000. Depreciation charge in year 4 = $100,000(.1152) = $11,520.

Year 0 Year 1 Year 2 Year 3 Year 4 Income: (8) Sales Revenues (9) Operating costs (10) Depreciation 11.52 (11) Income before taxes 30.54 [(8) (9) - (10)] (12) Tax at 34 percent (13) Net Income

Year 5

100.00 163.20 249.72 212.20 129.90 50.00 88.00 145.20 133.10 87.84 20.00 32.00 19.20 11.52 30.00 10.20 19.80 14.69 28.51 43.20 29.01 56.31 85.32 22.98 44.60 67.58 10.38 20.16

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Year 0 (1) Sales Revenues (2) Operating costs (3) Taxes (4) OCF (1) (2) (3) (5) Total CF of Investment (6) IATCF [(4) + (5)]

Year 1 $100.00 -50.00 -10.20 39.80

Year 2 $163.20 -88.00 -14.69 60.51 6.32

Year 3 $249.72 -145.20 -29.01 75.51 8.65 66.86

Year 4 $212.20 133.10 -22.98 56.12 3.75 59.87

Year 5 $129.90 -87.84 -10.38 31.68 192.98 224.66

260. 260. 39.80

54.19

NPV ! $260  NPV ! $51.588

$39.80 $54.19 $66.86 $59.87 $224.66     2 3 4 (1.10) (1.10) (1.10) (1.10) (1.10)5

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CF0 CF1 F1 CF2 F2 CF3

260 39.80 1 54.19 1

F3 CF4 F4 CF5 F5

1 59.87 1 224.66 1 I NPV 10 51.588

66.86
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Inflation is an important fact of economic life and might be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher equation:
(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)

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For low rates of inflation, this is often approximated: Real Rate $ Nominal Rate Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, the real rate has generally exhibited far less variance than the nominal rate. In capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.

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Bottom-Up Approach
Works only when there is no interest expense OCF = NI + depreciation

Top-Down Approach
OCF = Sales Costs Taxes Dont subtract non-cash deductions

Tax Shield Approach

OCF = (Sales Costs)(1 T) + Depreciation*T

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There are times when application of the NPV rule can lead to the wrong decision. Consider a factory that must have an air cleaner that is mandated by law. There are two choices:
The Cadillac cleaner costs $4,000 today, has annual operating costs of $100, and lasts 10 years. The Cheapskate cleaner costs $1,000 today, has annual operating costs of $500, and lasts 5 years.

Assuming a 10% discount rate, which one should we choose?

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Cadillac Air Cleaner

CF0 CF1 F1 I NPV
4,000

Cheapskate Air Cleaner

CF0 CF1 F1 I NPV

1,000 500 5 10
2,895.39

100

10 10
4,614.46

At first glance, the Cheapskate cleaner has a higher NPV.

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This overlooks the fact that the Cadillac cleaner lasts twice as long. When we incorporate that, the Cadillac cleaner is actually cheaper (i.e., has a higher NPV). Two methods exist to analyze this situation further : Replacement Chain
x Repeat projects until they begin and end at the same time. x Compute NPV for the repeated projects.

The Equivalent Annual Cost Method

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The Cadillac cleaner time line of cash flows:

-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -100

10

The Cheapskate cleaner time line of cash flows over ten years:
-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

10

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Cadillac Air Cleaner

CF0 CF1 F1 I NPV

Cheapskate Air Cleaner

CF0 CF1 F1

4,000 100 10 10
4,614

1,000 500 4 1,500 1 500 5

I NPV

CF2 F2 CF3 F3

10
4,693
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EAC is the annual annuity payment implied by a projects NPV In other words:
if the present value of an annuity is set equal to the project NPV and an annual payment is computed using the same term and rate as the NPV; then, the payment is the EAC

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The EAC for the Cadillac filter is $750.98 The EAC for the Cheapskate filter is $763.98 In general, select the EAC with the lower cost. This suggests a decision to reject the Cheapskate filter which had the more attractive raw NPV

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Net Present Value

Equivalent Annual Cost

CF0 CF1 F1 I NPV

4,000
100

N I/Y PV PMT FV

10 10 4,614.46 750.98

10 10
4,614.46

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Net Present Value

Equivalent Annual Cost

CF0 CF1 F1 I NPV

1,000 500 5 10
2,895.39

N I/Y PV PMT FV

5 10 -2,895.39 763.80

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How 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? How should cash flows and discount rates be matched when inflation is present? What is equivalent annual cost, and when should it be used?

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