FIN 2704/2704X

Week 10
Capital Budgeting – Part 2
 Learning objectives
• Understand how to determine the relevant net cash flows
for capital budgeting decisions.
• Use the relevant discount rate: Understand the role of
WACC.
• Be able to calculate projected cash flows from pro forma
financial statements.
• Understand how depreciation expenses are treated in
capital budgeting.
• Understand how capital spending is treated in capital
budgeting.
• Be able to evaluate alternative projects with “unequal lives”.
2
 NPV Analysis: Best Decision Criteria
• Last lecture, we concluded that NPV was the best capital
budgeting decision criteria to apply. Recall that NPV involves
the evaluation of various capital investment proposals by:
1. Estimating all the project’s cash inflows and outflows
2. Estimating the required rate of return
3. Computing the PV of all the cash inflows and outflows

• Evaluating the net present value of the projected cash flows

(CFs) gives management a valid criterion for choosing the
projects that promise to add the greatest value to the firm.

3
 Using NPV for Capital Budgeting
Thus, recall that NPV represents the addition to value/wealth
from undertaking a particular project/acquisition/investment.
It corresponds with the objective of maximizing value.
CF" CF# CF$
NPV = −CF! + "
+ #
+ ⋯+ $
1+r 1+r 1+r
The appropriate risk adjusted discount rate, r, when valuing
a firm’s total net cash flows and/or its project net cash flows,
is the firm’s Weighted Average Cost of Capital (WACC).
As such, the critical ingredients to capital budgeting are:
1. How to estimate the relevant project cash flows
2. How to compute the WACC. 4
Relevant Cash Flows
 Relevant Cash Flows
• A relevant cash flow for a project is a change in the firm’s overall
future cash flow that comes about as a direct consequence of the
decision to take that project. In other words, it is ____________ cash
flows that are relevant.
• Incremental cash flows is defined as the difference between a firm’s
future cash flows with a project and those without the project.
• The stand-alone principle allows us to analyze each project in
isolation from the firm simply by focusing on incremental cash flows.
• Viewing projects as “mini-firms” with their own assets, revenues and
costs allows us to evaluate the investments independently from the
other activities of the firm.
• By viewing projects as “mini-firms”, we imply that the firm as a whole
constitutes a portfolio of mini-firms (i.e. mini-projects). As a result, the
value of the firm equals the combined value of its components. 6
 Cash Flows in a Typical Project

Source: Berk (Chapter 8) 7

 Pro Forma Statements and Cash Flow
• Capital budgeting relies heavily on pro forma (i.e., projected)
accounting statements, particularly income statements.

• Also, recall how to compute CFFA:

– First, find Operating Cash Flow (OCF)
OCF = EBIT 1 − t ! + Depreciation

– Then consider net capital spending and changes in NOWC:

CFFA = OCF − NCS − Change in NOWC

CFFA is also known as Free Cash Flow and as Net Cash Flow from Operations
8
 Identifying Relevant Cash Flows
• _____ costs – costs that have already been incurred and cannot be
removed. They cannot be altered by present decisions and thus are
not relevant.

• ____________ costs – cost of next best alternative option which

must be forgone by taking the project. It is a relevant cash flow.
– E.g., Converting an old factory you own into upmarket condominiums. For
purposes of evaluating the condo project, should the factory be treated as free?
No! The relevant cash flow could be the net proceeds from the sale of the
factory/land. We forgo selling the factory/land by using it in the condo project.

• ______ effects – positive or negative spillover effects on future

cash flows. These are relevant cash flows.
– Positive side effects – benefits to other firm projects.
– Negative side effects – costs to other projects, i.e., erosion/“cannibalization”
9
 Identifying Relevant Cash Flows
• Changes in Net Operating Working Capital – these changes
are relevant as they result in cash outflows (or inflows) yet don’t
appear on the Income Statement.
– E.g., Some financing for initial inventory can be in the form of
accounts payable
• Taxes are relevant and must be considered in our analyses. All
cash flows must be measured on an ____________ basis.
• Financing Costs – interest expense, the tax effect of interest
expense, dividends paid or principal repaid are not relevant
cash flows for estimating projected cash flows and CFFAs in
projects. This is because we are looking at cash flows generated
from operations of assets (as discussed in Lecture 2) and not
from financing activities.
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Project Relevant Incremental Cash Flows
1. Net initial investment outlay
- Remember to consider impact on NOWC.

2. Projected cash flows from assets (CFFA)

3. Other relevant cash flows

- E.g., opportunity costs, side effects
- Remember to consider after-tax cash flows

4. Terminal Year Cash Flows

- Net salvage value received upon termination of the project.
- Remember to include return of NOWC.
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Weighted Average Cost of Capital
(WACC)
 Weighted Average Cost of Capital (WACC)
A firm’s WACC is defined as follows:
E D
WACC = r! + r"(1 − t # )
V V
– rE is the firm’s required rate of return on equity (Computed using CAPM)
– rD is the firm’s required rate of return on debt (Computed by finding YTM of
the firm’s long-term debt)
– tC is the marginal corporate tax rate
! #
– The weights and is based on the firm’s target capital structure, e.g., if a
" "
! #
firm has a target debt-equity mix of 40%-60%, then = 60% and = 40%.
" "

– Alternatively, D, E and V are the market values of the firm’s Debt, Equity
and Total Value (where 𝑉 = 𝐷 + 𝐸), respectively.
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Weighted Average Cost of Capital (WACC)
• WACC takes into account the firm’s after-tax equity and debt
financing costs.
• Payments to equity holders are not tax-deductible and so, after-
tax, remain at rE.

• Payments to debtholders are tax deductible and so, after-tax, is

actually 𝑟! (1 − 𝑇" ) and not just rD. Thus the tax deductibility of
interest and coupon payments lowers the net cost of debt to the
firm.

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 WACC: Example
The Anyhow Company’s current capital structure comprises
1 million common shares with market price of $30 per share
and 16,000 bonds with market price of $793.70 per bond.
Going forward, however, Anyhow aims to achieve a target
capital structure of 40% debt and 60% common equity.
Its common stock has a beta of 1.6, while its bonds have a
$1,000 par value and semiannual coupons with a 3%
coupon rate with 9 years to maturity.
The risk-free rate in the market is 3% and the market return
is 11%. The marginal corporate tax rate is 30%.
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 WACC: Example
1 𝑟$ = 3% + 1.6 11% − 3% = 15.8%

2 INPUTS 18 -793.70 15 1,000

𝑟( = 3.0% × 2
N I/YR PV PMT FV
3.00
= 6.0%
OUTPUT

3 Even though we have the market value of Anyhow’s

debt and equity, we should use the target capital
structure information to compute its WACC.

4 Anyhow ) s WACC = 60% 15.8% + 40% 6.0% 1 − 30%

= 𝟏𝟏. 𝟏𝟔%
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Comprehensive Example
Project A
 Project A
• The initial investment outlay for Project A is $120,000. The
cost will be straight-line fully depreciated over its 3-year life.
• A net operating working capital of $20,000 is required
throughout the duration of the project. The net operating
working capital amount is expected to be fully recovered at
the end of the project.
• The expected incremental sales from Project A is 50,000
units per year for 3 years.
• The sale price is $4.00/unit while the variable cost is
$2.50/unit.
• The project has annual fixed costs of $12,000.
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 Project A
• The company currently has 1.24 million common shares
outstanding with market price of $2.94 per share and 3,000
bonds with market price of $1,215.30 per bond.
• Its common stock has a beta of 0.9, while its bonds have a
$1,000 par value and semiannual coupons with a 8%
coupon rate and 9 years to maturity.
• The risk-free rate in the market is 2% and the market return
is 12%.
• Marginal corporate tax rate is assumed at 34%.

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Project A: Pro Forma Income Statement
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) $125,000
Gross Profit $75,000
Fixed Costs $12,000
Depreciation ($120,000 ÷ 3) $40,000
EBIT $23,000
Taxes (34%) $7,820
Net Income $15,180

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Project A: Projected Operating Cash Flow

• OCF = EBIT 1 − t # + Depreciation

= $23,000 1 − 34% + $40,000
= $55,180

• Since the projected incremental sales is constant for the 3

year period, and the depreciation is performed using
straight-line methodology, we would consequently expect
projected OCF to also be constant at $55,180 each year.

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Project A: Projected Capital Requirements
• Now consider the project’s net capital spending per year
– Recall that NCS = Change in net Vixed assets + depreciation

• Therefore:
– In Year 1: NCS = (80,000 – 120,000) + 40,000 = 0
– In Year 2: NCS = (40,000 – 80,000) + 40,000 = 0
– In Year 3: NCS = (0 – 40,000) + 40,000 = 0

• Of course we would expect net capital spending each year

for Project A to be 0 since there is no information provided of
any purchase of new equipment, sale of old equipment,
renovation works, etc.
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 Project A: Projected Total Cash Flows
Recall that Cash Inflows are represented by a “+” sign on a
timeline, while Cash Outflows are represented by a “–” sign
Year
0 1 2 3
“–” sign means
OCF $55,180 $55,180 $55,180
an outflow
Net Investment Outlay
−$120,000
(𝑁𝐶𝑆 = $120,000)
Net Investment in NOWC
(∆𝑁𝑂𝑊𝐶 = 20,000) −$20,000 $20,000

Net Cash Flow

−$𝟏𝟒𝟎, 𝟎𝟎𝟎 $55,180 $55,180 $75,180
(Sum each column)
CFFA 0 − $120,000 $55,180 $55,180 $55,180 − $0
𝑂𝐶𝐹 − 𝑁𝐶𝑆 − ∆𝑁𝑂𝑊𝐶 − $20,000 − $0 − $0 − $0 − $0 − −$20,000
= −$𝟏𝟒𝟎, 𝟎𝟎𝟎 = $𝟓𝟓, 𝟏𝟖𝟎 = $𝟓𝟓, 𝟏𝟖𝟎 = $𝟕𝟓, 𝟏𝟖𝟎
 Project A: WACC
1 𝑟$ = 2% + 0.9 12% − 2% = 11%

2 INPUTS 18 -1,215.30 40 1,000

𝑟( = 2.5% × 2
N I/YR PV PMT FV
2.50
= 5.0%
OUTPUT

3 Market Value of Equity = 1,240,000 × $2.94 = $3,645,600

Market Value of Debt = 3,000 × $1,215.30 = $3,645,900
𝐸 $3,645,600 𝐷
= = 𝟓𝟎%; = 1 − 50% = 𝟓𝟎%
𝑉 $3,645,600 + $3,645,900 𝑉

4 WACC = 50% 11% + 50% 5% 1 − 34%

= 𝟕. 𝟏𝟓% 24
 Project A: Capital Budgeting Decision
• Now that we have the net cash flows (CFFAs) and also
the WACC, we can apply the evaluation techniques that we
learned last week.

• We can find the NPV and the IRR of the cash flows:
vCompute NPV: Answer: $20,671
vCompute IRR: Answer: 14.65%

• Should we accept or reject the project? _________

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 Project A: Additional Information
1. If you had spent $50,000 last year renovating the factory building,
should you factor this into the analysis for Project A?
• No, the renovation cost is a sunk cost and should not be
considered. We only include incremental cash flows.

2. If the facility could be leased out for $15,000 per year, should you
factor this into the analysis for Project A?
• Yes, by accepting the project, the firm forgoes the annual rental.
This is an opportunity cost to be included in the analysis.
• Don’t forget that all cash flows must be after-tax!

After-tax Opportunity Cost = $15,000 1 − 34% = $𝟗, 𝟗𝟎𝟎

26
 Project A: Projected Total Cash Flows
Factoring in after-tax Opportunity Cost

Year
0 1 2 3

OCF $55,180 $55,180 $55,180

Net Investment Outlay

−$120,000
(𝑁𝐶𝑆 = $90,000)
Net Investment in NOWC
(∆𝑁𝑂𝑊𝐶 = 20,000) −$20,000 $20,000

After-tax Opp Cost –$9,900 –$9,900 –$9,900

Net Cash Flow

−$𝟏𝟒𝟎, 𝟎𝟎𝟎 $45,280 $45,280 $65,280
(Sum each column)

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Project A: Final Capital Budgeting Decision
• We can find the NPV and the IRR of the cash flows:
vCompute NPV: Answer: –$5,238
vCompute IRR: Answer: 5.2%

• Should we accept or reject the project? _________

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Other Considerations:
Depreciation Expense and
Net Salvage Value
 Depreciation Expense ≠ Cash Flow
• In finance, costs and benefits associated with a capital
budgeting project are measured in terms of cash flows
rather than accounting earnings.
• In Accounting, upfront cash outflows to purchase and set
up equipment are not recognized as expenses in year 0.
Instead, the cash outlay appears as a ______________
expense over the course of the equipment’s useful life.
• However, depreciation expenses do not correspond to
actual cash outflows.
• This accounting treatment and tax effect of capital
expenditures is one of several key reasons that accounting
earnings do not accurately capture actual cash flows.
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 Depreciation: Be Sure to Reflect Taxes
• Depreciation itself is a non-cash expense.
• Consequently, it is only relevant because it affects taxes,
i.e. it results in ______ taxes payable (Greater depreciation
expense à Lower EBIT à Less taxes payable)
• Taxes are a relevant cash flow. As such, depreciation
expense indirectly affects cash flows through the
depreciation tax shield it creates

Depreciation Tax Shield = D×t D

where D is depreciation expense and t # is marginal corporate tax rate

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Depreciation Expense for Capital Budgeting
The depreciation expense used for capital budgeting should
be calculated based on the depreciation schedule required
for ______ purposes, i.e. not for accounting purposes
– Firms may choose different depreciation methodologies for
tax and accounting reporting purposes.
– Straight-line full depreciation is commonly used.
– Although we will not consider it in this module, accelerated
depreciation is an alternative: for example, depreciation
schedule for different assets are provided under MACRS
(Modified Accelerated Cost Recovery System) that is
commonly used in the U.S.

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 Computing Depreciation Expense
Using straight-line full depreciation methodology:

Inital Investment Cost

𝐀𝐧𝐧𝐮𝐚𝐥 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐄𝐱𝐩𝐞𝐧𝐬𝐞 =
Number of Useful Years

𝐀𝐜𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐞𝐝 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐄𝐱𝐩𝐞𝐧𝐬𝐞

= Annual Depreciation Expense × Number of years in use

𝐁𝐨𝐨𝐤 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀𝐬𝐬𝐞𝐭

= Initial Cost − Accumulated Depreciation Expense

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 Net Salvage Value
• Salvage Value refers to the _________ value the firm expects to receive
for an asset should it choose to sell it.
• If the salvage value (S) is different from the book value (B) of the asset at
the time of sale, then there is an effect on taxes.

Net Salvage Value = S − t % (S − B)

• If 𝑆 > 𝐵, then there is “excess depreciation”, and this must be
“recaptured” when the asset is sold. In other words, because we had
enjoyed a depreciation tax shield on the asset thus far, if there is now
“excess depreciation”, the authorities would want to get the “excess tax
shield” back. Hence, we pay 𝑡& (𝑆 − 𝐵) in taxes when we sell this asset.
• If 𝑆 < 𝐵, then this is treated as a loss for tax purposes. In this case, the
authorities would allow us a “tax credit” and we get to save on taxes.
Hence, we add 𝑡& 𝑆 − 𝐵 , which is the amount of tax savings as a direct
result of this sale, to the salvage value, S, to get the net salvage value.
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 Example: Depreciation Expense
and Net Salvage Value
• You purchase equipment for $100,000 and it costs $20,000
to have it delivered and installed.
• The equipment has a useful life of 6 years.
• Based on past information, you believe that you can sell the
equipment for $50,000 when you are done with it in 4 years’
time.
• The company’s marginal corporate tax rate is 40%.
• What is the depreciation expense each year and the Net
Salvage Value in year 4?

35
 Example: Depreciation Expense
and Net Salvage Value
𝐀𝐧𝐧𝐮𝐚𝐥 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐄𝐱𝐩𝐞𝐧𝐬𝐞
$100,000 + $20,000 $120,000
= = = $𝟐𝟎, 𝟎𝟎𝟎
6 6

𝐀𝐜𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐞𝐝 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐄𝐱𝐩𝐞𝐧𝐬𝐞

= $20,000 × 4 = $𝟖𝟎, 𝟎𝟎𝟎

𝐁𝐨𝐨𝐤 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀𝐬𝐬𝐞𝐭

= $120,000 − $80,000 = $𝟒𝟎, 𝟎𝟎𝟎

𝐍𝐞𝐭 𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞

= $50,000 − 40% $50,000 − $40,000
= $50,000 − 40% $10,000 = $𝟒𝟔, 𝟎𝟎𝟎
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 Other Considerations:
Alternative Formulae for OCF
 Alternative Methods for Computing OCF
OCF = EBIT 1 − t # + Depreciation
We can always find OCF with the above formula. The alternative methods
below will also give us the same result for OCF, subject to conditions.

1. Bottom-Up Approach (usable only when there is no interest expense)

Ø Net Income = EBIT − Taxes = Sales − Costs − Depreciation − Taxes
Ø Taxes = t ' × EBIT = t ' × (Sales − Costs − Depreciation)
Ø OCF = Net Income + Depreciation

2. Top-Down Approach (usable only when there is no interest expense)

Ø OCF = Sales − Costs − Taxes
o where Costs excludes depreciation & Taxes is taken from the Income Statement

3. Tax-Shield Approach (usable even when there is interest expense)

Ø OCF = Sales − Costs 1 − t ' + Depreciation×t '
o Depreciation results in more cash remaining in the firm as it reduces the cash
tax payment.
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Recall Project A: Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) $125,000
Gross Profit $75,000
Fixed Costs $12,000
Depreciation ($120,000 ÷ 3) $40,000
EBIT $23,000
Taxes (34%) $7,820
Net Income $15,180

39
 Alternative Methods for Computing OCF
OCF = EBIT 1 − t # + Depreciation
= $23,000 1 − 34% + $40,000 = $𝟓𝟓, 𝟏𝟖𝟎

1. Bottom-Up Approach (no interest expense à get same answer)

OCF = Net Income + Depreciation
= $15,180 + $40,000 = $𝟓𝟓, 𝟏𝟖𝟎
2. Top-Down Approach (no interest expense à get same answer)
OCF = Sales − Costs − Taxes
= $200,000 − $137,000 − $7,820 = $𝟓𝟓, 𝟏𝟖𝟎
3. Tax-Shield Approach (always get the same answer)
OCF = Sales − Costs 1 − t # + Depreciation×t #
= $200,000 − $137,000 1 − 34% + $40,000×34%
= $41,580 + $13,600 = $𝟓𝟓, 𝟏𝟖𝟎 40
Other Considerations:
Replacement Projects
 Replacement Projects
For a replacement rather than a new project, how would the
analysis change?

• Remember that we are interested in incremental cash flows

• Let’s assume that if we buy any new equipment, we will sell the
current equipment at the same time.

• The incremental cash flows in this case would be the difference

in all cash flows between the old machine and the new machine.

• If we could have salvaged the current equipment at the end of its

life, then our projected cash flow estimates for the replacement
project must reflect all the cash flow consequences of selling
the current equipment today instead of at the end of its life.
42
Replacement Projects: Net Salvage Value
• If the current machine is sold today, the firm will not receive
the net salvage value at the end of the machine’s life (as it
otherwise would have).

• Not receiving the net salvage value of the replaced

equipment is an ______________ cost of the replacement
project.

• Thus it is important to factor the net salvage value cash

inflow to be received upon sale of the current equipment
while also taking into account that this results in forfeiting
the net salvage value of the equipment some time in
the future.
43
Replacement Projects: Relevant Depreciation
• The relevant annual depreciation expense would be the
change in annual depreciation expense from switching
equipment, i.e. the new equipment’s depreciation expense
less the old equipment’s depreciation expense.

• This gives the ______________ depreciation expense.

• “Incremental” does not mean it will always be higher!

Incremental depreciation expense could also be negative if
the depreciation expense of the new equipment is less than
the depreciation expense of the current equipment.

44
 Example: Replacement Project
Current Machine
v Initial cost = $240,000
v 8-year useful life
v Purchased 3 years ago
v Salvage today = $65,000
v Salvage in 5 years = $10,000
if don’t replace
current machine
Opportunity cost
New Machine
v Initial cost = $125,000
v 5-year useful life
v Salvage in 5 years = $15,000
v Cost savings = $16,000/year
• Required return = 10%
• Tax rate = 40%
45
Replacement Project: Pro Forma Income Statements
Year 1 - 5
Cost Savings $16,000
$125,000
= $25,000
Depreciation 5
New Machine $25,000 $240,000
= $30,000
Old Machine $30,000 8

Incremental –$5,000
• Relevant
EBIT $21,000 • Can be negative!
Taxes (40%) $8,400
Net Income $12,600

What is the relevant OCF? $12,600 − $5,000 = $𝟕, 𝟔𝟎𝟎 46

Replacement Project: Incremental Net Capital Spending
• Year 0
Ø Cost of new machine = $125,000 (outflow)
Ø Book Value of current machine = $240,000 − 3 $30,000 = $150,000
Ø Net Salvage Value of current machine
= $65,000 − 0.4 $65,000 − $150,000 = $99,000 (inflow)
à Net capital spending = $125,000 − $99,000 = $26,000 (outflow)

• Year 5 (Additional Cash Consequences)

Ø Net Salvage Value on new machine
= $15,000 − 0.4 $15,000 − $0 = $9,000 (inflow)
Ø Net Salvage Value of current machine
= $10,000 − 0.4 $10,000 − $0 = $6,000 (outflow)
Note: If we do not sell the machine today, then we will have after-tax salvage of $6,000 in 5
years. Since we sell the machine today, we will lose the $6,000 cash flow in 5 years.
47
 Replacement Project: Net Cash Flows
Year
In $ 0 1 2 3 4 5
OCF 7,600 7,600 7,600 7,600 7,600

Investment −26,000

NSV (new) 9,000

Opp C (current) −6,000

DNOWC 0 0
NCF −𝟐𝟔, 𝟎𝟎𝟎 7,600 7,600 7,600 7,600 10,600

48
Replacement Project: Capital Budgeting Decision
• Now that we have the cash flows, we can compute the
NPV and IRR
Ø NPV = $4,673
Ø IRR = 16.49%

• Should the company replace the equipment? _______

49
Other Considerations:
Unequal Lives Projects
Mutually Exclusive Unequal Life Projects
• Suppose our firm is planning to expand and we have to select 1
out of 2 machines. However, they differ in terms of useful life.
• How do we decide which machine to select?

The after-tax cash flows are:

Year Machine 1 Machine 2
0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000
► Assume a required return of 14%
51
 Example 1: Unequal Life Projects
Step 1:
Calculate NPV

• NPV1 = $1,432
• NPV2 = $1,664

• So, does this mean #2 is better?

• Not Necessarily – the two NPVs can’t be compared
simply as they are because the two machines have
unequal useful lives

52
 Example 1: Unequal Life Projects
Step 2:
Calculate Equivalent Annual Annuities (EAA)
(also called Replacement Chains)

• If we assume that each machine will be replaced an

infinite number of times into the future, then we can
convert each NPV to an annuity.

• We can then compare the projects’ EAAs to determine

which is the better machine.

53
 Example 1: Unequal Life Projects
How to compute EAA?

Machine 1: Machine 2:
INPUTS INPUTS
N I/YR PV PMT FV N I/YR PV PMT FV
OUTPUT -617 OUTPUT -428

What does this tell us?

This tells us that:
NPV1 is equivalent to receiving $617 per year forever.
NPV2 is equivalent to receiving $428 per year forever.
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 Example 1: Unequal Life Projects
• If we assume that the machines are replaced infinitely,
why do we convert NPV to annuities and not perpetuities?
Next Next Equivalent
Year Machine 1 Machine 1 Machine 1 CF Stream
𝑁𝑃𝑉0 𝑵𝑷𝑽𝟎
0 (45,000) = $1,432 = $𝟏, 𝟒𝟑𝟐
1 20,000 617
2 20,000 𝑁𝑃𝑉3 617 𝑵𝑷𝑽𝟑
3 20,000 (45,000) = $1,432 617 = $𝟏, 𝟒𝟑𝟐
4 20,000 617
5 20,000 𝑁𝑃𝑉6 617 𝑵𝑷𝑽𝟔
6 20,000 (45,000) = $1,432 617 = $𝟏, 𝟒𝟑𝟐
7 20,000 617
8 Replacement 20,000 617
9 Chains 20,000 617
⋮ ⋮ ⋮ 55
 Example 1: Unequal Life Projects
Step 3: Apply Appropriate Decision Rule

Decision Rule:

Select the highest EAA à We would choose machine #1.

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 Example 2: Unequal Life Projects
Machine A Machine B
• Initial Cost = $5,000,000 • Initial Cost = $6,000,000
• Pre-tax operating cost • Pre-tax operating cost
= $500,000 = $450,000
• 5-year useful life • 8-year useful life
• Salvage value of $400,000 • Salvage value of $700,000
after 5 years after 8 years

• The machine chosen will be replaced indefinitely and neither

machine will have a differential impact on revenue. No change in
NOWC is required.
• The required return is 9% and the tax rate is 40%.
• Which machine would you choose?
57
 Example 2: Unequal Life Projects
Machine A:
t=0 t = 1 to 4 t=5
Initial costs -5m
OCF (0-500k)*(1-0.4) + 1000K*0.4 100,000 100,000
NSV 400K – 40%(400K – 0) 240,000
NCF -5m 100,000 340,000

Enter cashflows into <CF> function of calculator, I = 9% and

compute NPV, you should get –$4,455,051.34.
To find EAA:
INPUTS 5 9 –4,455,051.34
N I/YR PV PMT FV
OUTPUT 1,145,360.10
58
 Example 2: Unequal Life Projects
Machine B:
t=0 t = 1 to 7 t=8
Initial costs -6m
OCF (0-450k)*(1-0.4) + 750K*0.4 30,000 30,000
NSV 700K – 40%(700K – 0) 420,000
NCF -6m 30,000 450,000

Enter cashflows into <CF> function of calculator, I = 9% and

compute NPV, you should get –$5,623,171.59.
To find EAA:
INPUTS 8 9 –5,623,171.59
N I/YR PV PMT FV
OUTPUT 1,015,963.03
59
 Example 2: Unequal Life Projects
Machine A Machine B
–$1,145,360.10 –$1,015,963.03

This is a cost. So you should select the one with the less
negative EAA (still the higher EAA), or interpreted as the
lower Equal Annual Cost (EAC)

à We will choose Machine B.

Note that only incremental cash flows are required. Since

revenue/sales information are the same for both machines,
they are irrelevant and can be left out.
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 Overall Summary
• A relevant cash flow for a project is a change in the firm’s overall future
cash flow that comes about as a direct consequence of the decision to
take that project, i.e. incremental cash flows.
• Examples of relevant cash flows are opportunity costs and side effects.
Sunk costs are not relevant cash flows.
• The appropriate discount rate to use for capital budgeting decisions is
the Weighted Average Cost of Capital (WACC). The WACC factors in the
after-tax cost of equity and after-tax cost of debt.
• Depreciation expense is a non-cash expense. However, it impacts
capital budgeting decisions because of the depreciation tax shield.
• Net capital spending is the amount spent on new investment minus the
amount received (Net Salvage Value) from selling old equipment/assets.
• The Equivalent Annual Annuity method (also called Replacement
Chains) is used to compare projects of unequal useful lives.
61