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Resume of Chapter 6 Making Capital Investment Decisions
Resume of Chapter 6 Making Capital Investment Decisions
Resume of Chapter 6 Making Capital Investment Decisions
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THE TOP-DOWN APPROACH: start at the top of the income statement and work our way
down to cash flow by subtracting costs, taxes, and other expenses.No need of depreciation
Because depreciation is not a cash outflow
The Operating Cash Flow (OCF): OCF= Sales−Cashcosts−Taxes
THE BOTTOM-UP APPROACH: ignoring any financing expenses, such as interest, in our
calculations of project OCF.
Project net income: Net income= EBT−Taxes
Next, depreciation is added back, giving us: OCF=Netincome+Depreciation
Expressing net income in terms of its components, we could write OCF more completely as:
OCF=(Sales−Cashcosts−Depreciation)(1−TC)+Depreciation
THE TAX SHIELD APPROACH: The tax shield approach is a variant of the top-down
approach.
OCF = Sales − Cash costs − (Sales − Cash costs − Depreciation) × TC
we can simplify it to : OCF = (Sales − Cash costs) × (1 − TC) + Depreciation × TC
This approach views OCF as having two components. The first part is what the project’s cash
flow would be if there were no depreciation expense. The second part of OCF in this
approach is the depreciation deduction multiplied by the tax rate. This is called the
depreciation tax shield.
lasts four years. There will be aftertax maintenance expenses of $100 to be paid at the end of
each of the four years.
Machin 0 1 2 3 4
e
A −$500 −$120 −$120 −$120
B −$600 −$100 −$100 −$100 −$100
Discount rate= 10%
$ 120 $ 120 $ 120
PV (Machine A)= −$ 500− − − = -$798.42
1.1 1.12 1.13
$ 100 $ 100 $ 100 $ 100
PV (Machine B)=−$ 600− − − − = -$916.99
1.1 1.12 1.13 1.14
Then we can calculate the Annuity payment per year
−$798.42 = C × PVIFA10%,3 => C= −$798.42/2.4869= -$321.6 is the equicalent annual cost
(EAC) of machine A
−$916.99 = C × PVIFA10%,4 =>C= −$916.99/2.4869= -$289,28
conclusion: Machine B is the preferred choice.
hand, real cash flow is adjusted for inflation in order to reflect the change in the value of
money over time. Because inflation can vary significantly from year to year.
Depreciation is an accounting method of allocating the cost of a tangible or physical asset
over its useful life or life expectancy. Depreciation represents how much of an asset's value
has been used up.
DISCOUNTING: NOMINAL OR REAL?
Cash flows can be expressed in either nominal or real terms.
Inflation must be handled consistently. One approach is to express both cash flows and the
discount rate in nominal terms. The other approach is to express both cash flows and the
discount rate in real terms. Because both approaches yield the same NPV calculation, the
simpler method should be used. The simpler method will generally depend on the type of
capital budgeting problem. This idea is illustrated in the two clear examples in the book.