Hervé BOISMERY

Chapter 6 -

INVESTMENT PROCESS AND PROJECT ANALYSIS

Long-term investments represent sizable outlays of funds that commit a firm to some course of actions. Consequently, the
firm needs procedures to analyze and select its long-term investments. Capital budgeting is the process of evaluating and
selecting long-term investments.

Firms typically make a variety of long-term investments, but the most common is in fixed assets, which include property,
land, plant, and equipment. These assets referred to earning assets, generally provide the basis for the firm’s earning
power and value.

1- OVERVIEW OF CAPITAL BUDGETING

Large firms evaluate dozens, perhaps even hundreds, of different ideas for new investments each year. To ensure that the
investment projects selected have the best chance of increasing the value of the firm, financial managers need tools to help
them to evaluate the merits of individual projects and to rank competing investments. Several techniques are available for
performing such analysis.

We will use one basic problem to illustrate all the techniques described in this chapter. The problem concerns Bennett
Company, a medium-sized metal fabricator that is currently contemplating two projects:

- Project A requires an initial investment of $42,000

- Project B requires an initial investment of $45,000

The projected relevant cash flows for the two projects are presented in the following table. Both projects involve one initial
cash outlay followed by annual cash inflows, a fairly typical pattern for new investments.

Project A Project B
Initial investment $ 42,000 $ 45,000
Year Operating cash flows Operating cash flows
1 $ 14,000 $ 28,000
2 $ 14,000 $ 12,000
3 $ 14,000 $ 10,000
4 $ 14,000 $ 10,000
5 $ 14,000 $ 10,000

2- PAYBACK PERIOD

The payback period is the amount of time required for the firm to recover its initial investment in a project, as calculated
from cash inflows.

1) In the case of an annuity (such as the Bennett Company’s project A), the payback period can be found by dividing
the initial investment by the annual cash inflow. For project A, which an annuity, the payback period is 3.0 years
Initial investment $ 42,000
= =
Annual cash inflow $ 14,000
2) For a mixed stream cash inflow (such as project B), the yearly cash inflows must be accumulated until the initial
investment is recovered. In year 1, the firm will recover $28,000 of its $45,000 initial investment. By the end of
year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2) will be recovered. At the end of year 3, $50,000 will
have been recovered. Only 50% of the year-3 cash inflow of $10,000 is needed to complete the payback of the
initial $45,000. The payback period for project B is therefore 2.5 years (2 years + 50% of year 3); it means 2
years and 6 months.
 2

Example 1:

John is considering investing $20,000 to obtain a 5% interest in a rental property. His good friend and real estate agent
David put the deal together and he conservatively estimates that John should receive between $4,000 and $6,000 per year
in cash from his 5% interest in the property. The deal is structured in a way that forces all investors to maintain their
investment in the property for at least ten years. John expects to remain in the 25% income-tax bracket for quite a while. To
be acceptable, John requires the investment to pay itself back in terms of after-tax cash flows in less than 7 years.

John’s calculation of the payback period on this deal begins with calculation of the range of annual after-tax cash flow.

After-tax cash flow = (1 – tax rate) X Pre-tax cash flow

(1 – 0.25) X $4,000 = $3,000

(1 – 0.25) X $6,000 = $4,500

The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 initial investment by each of the estimated
after-tax cash flows, we get the payback period:

Payback period = Initial investment / After-tax cash flow =

1) $20,000 / $3,000 = 6.67 years It means 6 years + 365 days X 0.67 = 6 years + 245 days = 6 years and 9 months
2) $20,000 / $4,500 = 4.44 years It means 4 years + 365 days X 0.44 = 4 years + 161 days = 6 years + 6 months

The investment is acceptable because the range is below the maximum payback of 7 years.

Example 2:

A weakness is that this approach fails to take fully into account the time factor in the value of money, as it can be illustrated
by the following example.

De Yarman Enterprises, a small medical appliance manufacturer, is considering two mutually exclusive projects named Gold
and Silver. The firm uses only the payback period for each project are given in the following table. Both projects have 3-year
payback periods, which would suggest that they are equally desirable. But comparison of the pattern of cash flows over the
first three years show that more of the $50,000 initial investment in project Silver is recovered sooner than is recovered for
project Gold. For example, in year 1, $40,000 of the $50,000 invested in project Silver is recovered whereas only $5,000 of
the $50,000 investment in project Gold is recovered. Given the time value of money, project Silver would clearly be
preferred over project Gold, in spite of the fact that both have identical 3-year payback periods.

Project Gold Project Silver

Initial Investment
Year Operating cash flows Operating cash flow
1 $ 5,000 $ 40,000
2 $ 5,000 $ 2,000
3 $ 40,000 $ 8,000
4 $ 10,000 $ 10,000
5 $ 10,000 $ 10,000

Payback period 3 years 3 years

 3

Example 3

AB Company, a software developer, has two investment opportunities, X and Y. The payback period for project X is 2 years;
for project Y it is 3 years.

Project X Project Y
Initial investment $ 10,000 $ 10,000
Year Operating cash flows Operating cash flows
1 $ 5,000 $ 3,000
2 $ 5,000 $ 4,000
3 $ 1,000 $ 3,000
4 $ 100 $ 4,000
5 $ 100 $ 3,000

Payback period 2 years 3 years

Strict adherence to the payback period approach suggests that project X is preferable to project Y. However, if we look
beyond the payback period, we see that project X returns only an additional $1,200 ($1,000 in year 3, $100 in year 4 and 5),
whereas project Y returns an additional $7,000 ($4,000 in year 4 and $3,000 in year 5). On the basis of this information,
project Y appears preferable to X. The payback period ignores the cash inflows incurring after the end of the payback
period.

3- NET PRESENT VALUE (NPV)

The method used by most large companies to evaluate investment projects is called net present value. The intuition behind
the NPV method is simple:

- When firms make investments, they are spending money that they obtained, in one form or another, from
investors.
- Investors expect a return on the money that they give to firms.
- So a firm should undertake an investment only if the present value of the cash flow that the investment generates
is greater than the cost of making the investment in the first place.

Because the NPV method takes into account the time value of investor’s money, it is a more sophisticated capital budgeting
technique than the payback rule.

3.1- Decision Criteria

The NPV method discounts the firm’s cash flow at the firm’s cost of capital. The cost of capital represents the firm’s cost of
financing and is the minimum rate of return that a project must earn to increase firm value. Investments with rate of return
above the cost of capital will increase the value of the firm, and projects with a rate of return below the cost of capital will
decrease firm value.

The net present value (NPV) is found by subtracting a project’s initial investment CF 0 from the present value of its cash
inflows CF t discounted at a rate equal to the firm’s cost of capital.

n
CF t
NPV = ∑( t
- CF 0
t =1 1+r )
When NPV is used, both inflows and outflows are measured in terms of present dollars. For a project that has cash outflows
beyond the initial investment, the net present value of a project would be found by subtracting the present value of
outflows from the present value of inflows.
When NPV is used to make accept-reject decisions, the decision criteria are as follows:

- If the NPV is greater than $0 (NPV ≥0), the project is accepted.

- If the NPV is less than $0 (NPV¿ 0), the project is rejected.

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the
market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.

3.2- More Explanation

Suppose that you are in the real estate business. You are considering the construction of an office block. The land would
cost $50,000, and construction would cost a further $300,000. You foresee a shortage of office space and predict that a year
from now you will be able to sell the building for $400,000. Thus you would be investing $350,000 now in the expectation of
realizing $400,000 at the end of the year. Therefore, projected cash flows may be summarized as follows:

Year 0 ------------------------------------------------------------------ Year 1

-$350,000 +$400,000

You should go ahead if the present value of the $400,000 payoff is greater than the investment of $350,000.

Assume for the moment that the $400,000 payoff is a sure thing. The office building is not the only way to obtain $400,000
a year from now. You could invest in a 1-year Treasury note, in securities or in an account in a bank. Suppose this financial
investment offers interest of 7%. How much would you have to invest in it in order to receive $400,000 at the end of the
year? That’s easy: you would invest:

1
$400,000 x = $400,000 X 0.9346 = $373,832
1.07
Let’s assume that as soon as you have purchased the land and laid out the money for construction, you decide to cash in on
your project. How much could you sell it for? Since the property will be worth $400,000 in year, investors would be willing
to pay at most $373,832 for it now. That’s all it would cost them to get the same $400,000 payoff by investing in sure
securities. Of course, you could always sell tour property for less, but why sell for less than the market will bear?

Therefore, at an interest rate of 7%, the present value of the $400,000 payoff from the office building is $373,832.

The $373,832 present value is the only price that satisfies both buyer and seller. In general, the present value is the only
feasible price, and the present value of the property is also its market price or market value.

To calculate the present value, we discounted the expected future payoff by the rate of return offered by comparable
investment alternatives. The discount rate (7% in our example) is often known as the opportunity cost of capital. It is called
opportunity cost because it is the return that is being given up by investing in the project.

You committed $350,000, and therefore your net present value (NPV) is $23,832. Net present value is found by subtracting
the required initial investment from the present value of the project cash flows:

NPV = Present value (PV) – required investment = $373,832 - $350,000 = $23,832

In other words, if your office development is worth more than it costs, it makes a net contribution to value. The net present
value rule states that managers increase firm’s wealth by accepting all projects that are worth more than they cost.
Therefore, they should accept all projects with a positive net present value.

3.4- A Comment on Risk and Present Value

In our discussion of the office development, we assumed we knew the value of the completed project. Of course, you will
never be certain about the future values of office buildings. The $400,000 are the best forecast, but it is not a sure thing.
Therefore, our initial conclusion about how much investors would pay for the building is premature. Since they could

achieve $400,000 without risk by investing in $373,832 worth in Treasury securities, they would not buy your building for
that amount. You would have to cut your asking price to attract investors’ interest.

Here we can invoke a basic financial principle: A risky dollar is worth less than a safe one.

Not all investments are equally risky. The office development is riskier than a Treasury note or a savings account in a bank.
But it is probably less risky than investing in a start-up biotech company. Suppose you believe the office development is as
risky as an investment in the stock market and that you forecast a 12% rate of return for stock market investments. Then
12% would be the appropriate opportunity cost of capital. That is what you are giving up by not investing in comparable
securities. You can now compute the NPV in the following way:

1
PV = $400,000 X = $400,000 X 0.8929 = $357,143
1+ 0.12
NPV = PV - $350,000 = $7,143

The office building still makes a net contribution to value, but it is much smaller than our earlier calculations indicated.

Example:

What is the office development’s NPV if construction costs increase to $355,000? Assume the opportunity cost of capital is
12%. Is the development still a worth wile investment? How high can development costs be before the project is no longer
attractive? How high can development costs be before the project is no longer attractive? Now suppose that the
opportunity cost of capital is 20% with construction costs of $355,000.

Answer:

Even if construction costs are $355,000, NPV is still positive.

$ 400,000
NPV - PV = - $355,000 = $357,143 - $355,000 = $2,143
1+0.12
Therefore, the project is still worth pursuing. The project is viable as long as construction costs are less the PV of the future
CF. However, if the opportunity cost of capital is 20%, the PV of the $400,000 sales price is lower and NPV is negative.

PV = $400,000 X 1/1.20 = $333,333

NPV = PV – 355,000 = -$21,667

When the cost of capital (interest rate) increases, the NPV decreases.

3.3- Valuing Long-Lived Projects

The NPV rule works for projects of any length. For example, suppose that you have identified a possible tenant who would
be prepared to rent your office block for three years at a fixed annual rent of $16,000. You forecast that after you have
collected the third year’s rent the building could be sold for $450,000. The projected cash flows are thus the followings:

Year 0 Year 1 Year 2 Year 3

CF 0 = -$350,000 CF 1= +$16,000 CF 2 =+$16,000 CF 3 =450,000 + 16,000 = $466,000
For simplicity, we assume that these CF are certain and that the interest rate (opportunity cost of capital) is r = 7%.

Thus, we can write:

$ 16,000 $ 16,000 $ 466,000

NPV = -$350,000 + + 2 + 3 = +$59,323
1+0.07 (1+0.07) (1+0.7)

Thus, finally, constructing the office block and renting it for 3 years makes a greater addition to your wealth than selling the
office block at the end of the first year.

Example 1:

A firm is considering the purchase of an equipment which could generate sales equal to $1 million by year. This equipment
costs $8 million and is expected to last 12 years. To buy this equipment, the firm must borrow this amount of $8 million at
an interest cost of 8%, considered like the opportunity cost of capital.

CF 0= 8,000,000 CF = 1,000,000 r = 8% n = 12

NPV = - CF 0 + CF X
1
r
1−
[1
(1+r )
n
] =-8+1X
1
0.08
X
[ 1−
1
(1+0.08)
12
] = - 8 + 7.5361 = - $0.4639 million = -

$463.9 thousand

This investment is not profitable. It must be rejected.

Now let’s suppose this equipment will last 20 years.

NPV = - 8 + 1 X
1
0.08 [
X 1−
1
(1+0.8)
20
] = - 8 + 9.8181 = $1.8181 million

Under this condition, the investment is profitable.

Example 2:

Obsolete Technologies is considering the purchase of a new computer system to help handle its warehouse inventories. The
system costs $50,000, is expected to last at least 4 years, and should reduce the cost of managing inventories by $22,000 a
year. The opportunity cost of capital is 10%. Should Obsolete go ahead?

Don’t be put off by the fact that the computer system does not generate any sales. If the expected cost savings are realized,
the company’s CF will be $22,000 a year higher as a result of buying the computer. Thus we can say that the computer
increases CF by $22,000 a year of 4 years.

NPV = - 50,000 + 22,000 X

1
0.10
X
[ 1−
1
(1+0.10)
4
] = -50,000 + 22,000 X 3.1699 = $19,738

The project has a positive NPV (NPV ≥0) of $19,738. Undertaking it would increase the value of the firm by that amount.

3.4- Using the NPV Rule to Choose among Projects

The simple projects we have considered so far involve take-it-or-leave-it decisions. But almost all real-world decisions are
either-or choices. You could build 7-story office building or a 10-story one. You could heat it with oil or with natural gas.
Such choices are said to be mutually exclusive. When you need to choose among mutually exclusive projects, the decision
rule is simple: Calculate the NPV of each alternative, and chooses the highest positive-NPV project.
Example:

It has been several years since your office last upgraded its office networking software. Two competing systems have been
proposed. Both have an expected useful life of three years, at which point it will be time for another upgrade. One proposal
is for an expensive, cutting-edge system, which will cost $800,000 and increase firm CF by $350,000 a year through
increased productivity. This other proposal is for cheaper, somewhat slower system. This system would cost only $700,000
but would increase CF by only $300,000 a year. If the cost of capital is 7%, which is the better option? The following table
summarizes the CF and the NPV of the two proposals.

CF thousands of dollars CF 0 CF 1 CF 2 CF 3 NPV at 7%

System Faster -800 +350 +350 +350 +118.5
System Slower -700 +300 +300 +300 + 87.3

In both cases, the software system is worth more than they cost. But the faster system would make the greater
contribution to value and therefore should be your preferred choice.

3.5- More examples of Mutually Exclusive Projects

3.5.1- Long-Versus Short-Lived Equipment

Suppose the firm is forced to choose between two machines, F and G. The two machines are designed differently but have
identical capacity and do exactly the same job. Machine F costs $15,000 and will last 3 years. It costs $4,000 per year to run.
Machine G is an “economy” model costing only $10,000, but it will last only 2 years and costs $6,000 per year to run.

Because the two machines produce exactly the same product, the only way to choose between them is on the basis of cost.
Suppose we compute the present value of the costs.

Costs (thousands of dollars)

Year 0 1 2 3 PV at 6%
Machine F 15 4 4 4 $ 25.69
Machine G 10 6 6 ----- $ 21.00

4 4 4
- Cost Machine F = 15 + + 2 + = 15 + 4 X 2.6730 = $25.69
1+ 0.06 (1+0.6) (1+0.06)3
6 6
- Cost Machine G = 10 + + = 10 + 6 X 1.8334 = $21.00
1+ 0.06 (1+0.06)2

Should we take machine G, the one with the lower present value of costs? Not necessarily. All we have shown is that
machine G offers two years of service for a lower total cost than 3 years of service from machine F. But is the annual cost of
using G lower than that of F?

Suppose the financial manager agrees to buy machine F and pay for its operating costs out of her budget. She then charges
the plant manager an annual amount for use of the machine. There will be three equal payments starting in year 1.
Obviously, the financial manager has to make sure that the PV of these payments equals the PV of the costs F, $25,690.
When the discount rate is 6%, the payment stream with such a PV turns out to be $9,610 a year.

Costs (thousands of dollars)

Year 0 1 2 3 PV at 6%
Machine F 15 4 4 4 $25.69
Equivalent annual annuity 9.61 9.61 9.61 $25.69
How did we know that an annual charge of $9,610 has a present value of $25,960? The annual charge is a 3-year annuity
and set it equal to $25,690.

PV = Equivalent annual annuity X n-year annuity factor (or capitalization coefficient) = PV costs of F

PV =
a
+
a
1+ r (1+r )2 + ….+
a
( 1+ r )n
= a.
[ 1
+
1
1+r (1+r )2
+ … .+
1
(1+ r )
n
] = a. gn

PV
Present value of costs
a = = =
gn Annuity factor
$ 25,690
3− year annuity factor
=$ 25 , 90 X
1
+
1
[ +
1
( 1+0.06 ) (1+0.06) (1+0.06)
2 3 =
$ 25,690
2.6730 ] = $9,610

If we make a similar calculation of costs for machine G, we get:

Year 0 1 2 PV at 6%
Machine G 10 6 6 $21.00
Equivalent 2-year annuity 11.45 11.45 $21.00

Indeed we can write:

$ 21.00
21.00
a=
[ 1
+
1
1+ 0.06 (1+ 0.06)2 ] =
1.8334
= $11.45

We see now that machine F is better, because its equivalent annual annuity is less ($9.610 for F versus $11.45 for G). In
other words, the financial manager could afford to set a lower annual charge for the use of F.

We have thus a rule for comparing assets with different lives: select the machine that has the lowest equivalent annual
annuity.

Think of the equivalent annual annuity as the level annual charge necessary to recover the present value of investment
outlays and operating costs. The annual charge continues for the life of the equipment. Calculate the equivalent annual
annuity by dividing the present value by the annuity factor (or capitalization coefficient).

3.5.2- Equivalent Annual Annuity

You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy
the car, it will worth $500 to you in 7 years, like a “salvage value” after 7 years. The discount rate is 10%. Should you buy or
lease? What is the maximum lease payment you would be willing to pay?

The PV of the cost of purchasing is:

$ 500
PV = $15,000 - 7 = $14,743
(1+0.10)
The equivalent annual cost of purchasing the car is therefore the annuity with his present value:

Equivalent annual annuity X 7-year annuity factor at 10% = PV costs of buying = a X

1
r [
1−
1
(1+r )
n
] = a X gn
$14,743 = a X
1
0.10
1−
[ 1
(1+0.10)
7
]
Thus:

$ 14,743
PV $ 14,743
a=
gn
= 1
0.10 [
1−
1
( 1+ 0.10)
7
] =
4.8684
= $3,028

Therefore, the annual lease payment of $3,000 is less than the equivalent annual annuity of buying the car. You should be
willing to pay up to $3,028 annually to lease.

3.5.3- Another Equivalent Annual Annuity

Low-energy light-bulbs cost $3.50, have a life of 9 years, and use about $1.60 of electricity a year. Conventional light-bulbs
are cheaper to buy, for they cost only $0.50. On the other hand, they last only about a year and use about $6.00 of energy.
If the real discount is 5%, what is the relative cost of the two products?

To answer this question, you need first to convert the initial cost of each bulb to an annual figure and then to add in the
annual energy cost. The following table sets out the calculations.

Low-Energy Bulb Conventional Bulb

1-Initial cost $ 3.50 $ 0.50
2-Estimated life, years 9 years 1 year
3-Annuity factor at 5% 7.1078 0.9254
4-Equivalent annual annuity, $= (1)/(3) $ 0.49 $ 0.52
5-Annual energy cost, $ $ 1.60 $ 6.60
6-Total annual cost,$ = (4) +(5) $ 2.09 $ 7.12
Assumption: Energy costs are incurred at the end of the year

It seems that a low-energy light-bulb provides an annual saving of about $7.12 - $2.09 = $5.03.

3.5.4- Replacing an Old Machine

Our earlier comparison of machines F and G took the life of each machine as fixed. In practice, the point at which
equipment is replaced reflects economics, not physical collapse. We usually decide when to replace. The machine will rarely
decide for us.

You are operating an old machine that will last 2 more years before it gives up the ghost. It costs $12,000 per year to
operate. You can replace it now with a new machine that costs $25,000 but is much more efficient ($8,000 per year in
operating costs) and will last for 5 years. Should you replace now or wait a year? The opportunity cost of capital or interest
rate is 6%.

Costs (thousands of dollars)

Year 0 1 2 3 4 5 PV at
6%
New machine 25 8 8 8 8 8 $58.70
Equivalent 5-year annuity = 13.93 13.93 13.93 13.93 13.93
PV/annuity factor= 58.70/ 4.2139
The CF of the new machine are equivalent to an annuity of $13,930 per year. So we can equally well ask at what point you
want to replace your old machine, which costs $12,000 a year to run, with a new one costing $13,930 a year. When the
question is posed this way, the answer is obvious. As long as your old machine costs only $12,000 a year, why replace it
with a new machine that costs $1,930 a year more?

Example: Question

Machines H and I are mutually exclusive and have the following investment and operating costs. Note that machine H lasts
for only 2 years.

Year 0 1 2 3
H $10,000 $1,100 $1,200 --------
I $12,000 $1,100 $1,200 $1,300

Calculate the equivalent annual annuity of each investment by using a discount rate of 10%. Which machine is the better
buy?

Now, suppose you have an existing machine. You can keep it going for one more year only, but it will cost $2,500 in repairs
and $1,800 in operating costs. It is worth replacing now with either H or I?

4- CAPITAL RATIONING

A firm maximizes its shareholders’ wealth by accepting every project that has a positive net present value. But this assumes
that the firm can raise the funds needed to pay for these investments. But what if there is “hard rationing”, meaning that
the firm actually cannot raise the money it needs? In that case, it may be forced to pass up positive-NPV projects.

With hard rationing you may still be interested in NPV, but you now need to select the package of projects that is within the
company’s resources and yet gives the highest NPV.

10

Let us illustrate. Suppose that the opportunity cost of capital is 10%, that the company has total resources of $20, and that
it is presented with the following proposals.

Cash Flows (millions of dollars)

Project C0 C1 C2 PV at 10% NPV

J -3 +2.2 +2.42 $4 $1
K -5 +2.2 +4.84 $6 $1
L -7 +6.6 +4.84 $10 $3
M -6 +3.3 +6.05 $8 $2
N -4 +1.1 +4.84 $5 $1

All five projects have a positive NPV. Therefore, if there were no shortage of capital, the firm would like to accept all five
proposals. But with only $20 million available, the firm needs to find the package that gives the highest possible NPV
within the budget.

The solution is to pick the projects that give the highest NPV per dollar of investment. The ratio of net present value to
initial investment is known as the profitability index.

Net present value

Profitability index =
Initial investment
Project PV Investment NPV Profitability index = NPV/Investment
 J $4 $3 $1 1/3 = 0.33
K $6 $5 $1 1/5 = 0.20
L $10 $7 $3 3/7 = 0.43
M $8 $6 $2 2/6 = 0.33
N $5 $4 $1 1/4 = 0.25

Project L offers the highest ratio of NPV to investment (0.43), and therefore L is picked first. Next come projects J and M,
which tie with a ratio of 0.33, and after them comes N. These four projects exactly use up the $20 million budget. Between
them they offer shareholders the highest attainable gain in wealth.

5- IDENTIFYING CASH FLOWS

5.1- Discount Cash Flows, Not Profits

Up to this point, we have been concerned mainly with the mechanics of discounting and with the various methods of
project appraisal. We have had almost nothing to say about the problem of what you should discount.

To calculate net present value, you need to discount cash flows, not accounting profits.

For example, suppose that you are analyzing an investment proposal. It costs $2,000 and is expected to bring in a cash flow
of $1,500 in the first year and $500 in the second. You think that the opportunity cost is 10% and so calculate the PV as
follows:

$ 1,500 $ 500
PV = + 2 = $1,776.86
1.10 (1+0.10)
The project is worth less than it costs and has a negative NPV.

NPV = $1,776.86 - $2,000 = - $223.14

11

The project costs $2,000 today, but accountants would not treat that outlay as an immediate expense. They would
depreciate that $2,000 over two years and deduct the depreciation from the CF to obtain accounting income. Thus an
accountant would forecast income of $500 in year and an accounting loss of $500 in year 2.

Year 1 Year 2
Cash inflow +$1,500 +$500
Less depreciation -$1,000 -$1,000
----------- -----------
Accounting income +$500 -$500

Of course, we know that is nonsense. The project is obviously a loser. We are spending money today ($2,000 cash outflow),
and we simply getting our money back later ($1,500 in year 1 and $1,500 in year 2). We are earning a zero return when we
could get a 10%return by investing our money in the capital market.

When calculating NPV, recognize investment expenditures when they occur, not later when they show up depreciation.
Projects are financially attractive because of the CF they generate, either for distribution to shareholders or for
reinvestment in the firm. Therefore, the focus of capital budgeting must be on cash flow, not profits.

Example1: Sales before Cash

Your firm’s ace computer sales man closed a $500,000 sale on December 15, just in time to count it toward his annual
bonus. How did he do it? Well, for one thing he gave the customer 180 days to pay. The income statement will recognize
the sale in December, even though cash will not arrive until June.

The accountant takes care of this timing difference by adding $500,000 to accounts receivable in December and then
reducing accounts receivable when the money arrives in June. The total of accounts receivable is just the sum of all CF due
from customers. You can think of the increase in accounts receivable as an investment- it is effectively a 180-day loan to the
customer- and therefore a cash outflow. That investment is recovered when the customer pays. Thus financial analysts
often find it convenient to calculate cash as follows:

December June
Sales $500,000 Sales 0
Less investment in accounts receivable -$500,000 Plus recovery of accounts receivable +$500,000

Cash flow 0 Cash flow $500,000

It is not always easy to translate accounting data back into actual dollars. If you are in doubt what is a CF, simply count the
dollars coming in and take away the dollars going out.

Example 2: Question

A regional supermarket chain is deciding whether to install a tewgitt machine in each of its stores. Each machine costs
$250,000. Projected income per machine is as follows:

Year 1 2 3 4 5
Sales $250,000 $300,000 $300,000 $250,000 $250,000
Operating expenses $200,000 $200,000 $200,000 $200,000 $200,000
Depreciation $ 50,000 $ 50,000 $ 50,000 $ 50,000 $ 50,000
Accounting income 0 $ 50,000 $ 50,000 0 0

Why should a store continue to operate a machine in years 4 and 5 if it produces no profits? What are the CF from investing
in a machine? Assume each tewgitt machine is completely depreciated and has no salvage value at the end of its 5-year life.

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5.2- Cash Flows and Inflation

City Consulting Services is considering moving into a new office building. The cost of 1-year lease is $8,000 paid
immediately. This cost will increase in future years at the annual inflation rate of 3%. The firm believes that it will remain in
the building for 4 years. What is the PV of its rental costs if the discount rate is 10%?

Remember:

Real rate of interest ≈ nominal rate of interest – inflation rate

1+ nominalrate of interest
The exact formula is: 1 + real interest rate =
1+ inflation rate
Year Cash Flow PV at 10% Discount Rate
0 8,000 8,000
1 8,000 x 1.03 = 8,240 8,240/1.10 = 7,491
2 8,000 x 1.032=8,467 8,487/ ( 1.10 )
2
=7,014
3
8,000 x 1.033=8,742 3
8,742/ ( 1.10 ) =6,568
$29,073
Alternatively, the real discount rate can be calculated as:

(1.10/1.03) – 1 = 0.06796 = 6.796%.

The PV of the CF can then be computed by discounting the real CF at the real discount rate as follows:

Year Real Cash Flow Present Value at 6.796% Discount Rate

0 8,000 8,000
1 8,000 8,000 / 1.06796 = 7,491
2 8,000 8,000 /(1.06796)2=7,014
3 8,000
8,000 / (1.06796)3 = 6,568
---------------------------------------
$29,073

Notice the real CF is a constant, since the lease payment increases at the rate of inflation. The PV of each CF is the same
regardless of the method used to discount it. The sum of the PV is, of course, also identical.

6- CALCULATING OPERATING CASH FLOW

In each case, operating CF consists of revenues from the sale of the new product less the costs of production and any taxes

Operating cash flow = revenues – costs – taxes

Many investments do not result in additional revenues: they are simply designed to reduce the costs of the company’s
existing operations. For example, a new computer system may provide labor savings, or a new heating system may be more
energy-efficient than the one it replaces. Such projects also contribute to the operating CF of the firm-not by increasing
revenues but by reducing costs. These cost savings therefore represent a positive CF.

Example: Operating Cash Flow of Cost-Cutting Projects

Suppose a new heating system costs $100,000 but reduces heating costs by $30,000 a year. The firm’s tax rate is 35%. The
new system does not change revenues, but thanks to the cost savings, income increases by $30,000. Therefore, incremental
operating CF is:

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- Increase in revenues (less expenses): $30,000

- Incremental tax at 35%: -$10,500
- Operating cash flow: +$19,500

Notice that because the cost savings increase profits, the company must pay more tax. The net increase in CF equals the
after-tax cost savings.

(1 – 0.35) X $30,000 = $19,500

Here is another matter that you need to look out for when calculating CF. When the firm calculates its taxable income, it
makes a deduction for depreciation. The depreciation charge is an accounting entry. It affects the tax that the company
pays, but it is not a cash expense and should not be deducted when calculating operating cash flow. Remember that you
want discount cash flows, not profits.

When you work out a project’s CF, there are three possible ways to deal with depreciation.

- Method 1: Dollars in Minus Dollars Out

Take only the items from the income statement that represent actual CF. This means that you start with cash revenues and
subtract cash expenses and taxes paid. You do not, however, subtract a charge for depreciation because this does not
involve cash going out the door. Thus:

Operating cash flow = revenues – cash expenses – taxes

- Method 2: Adjusted Accounting Profits

Alternatively, you can start with after-tax accounting profits and add back any depreciation deduction. This gives:

Operating cash flow = after-tax profit + depreciation

- Method 3: Add Back Depreciation Tax Shield

Although the depreciation is not a cash expense, it does affect the firm’s tax payment, which certainly is a cash item. Each
additional dollar of depreciation reduces taxable income by 1$. So, if the firm’s tax bracket is 35%, tax payments fall by
$0.35, and CF increases by the same amount. Financial managers often refer to this tax saving as the depreciation tax
shield. It equals the product of the tax rate and the depreciation charge:

Depreciation tax shield = tax rate X depreciation

This suggests a third way to calculate operating CF. First, calculate net profit, assuming zero depreciation. This is equal to:

(revenues – cash expenses) x (1 – tax rate) + (tax rate x depreciation)

The following example confirms that the three methods all give the same figure for operating CF.

Example:

A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year. The
firm’s tax bracket is 35%. Net income is calculated as follows:

Revenues 1,000
-Cash expenses 600
-Depreciation expense 200
= Profit before tax 200
-Tax at 35% 70
= Net profit 130

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Methods 1,2 and 3 all show that operating cash flow is $330.

- Method 1: Operating cash flow = revenues – cash expenses - taxes = 1,000 – 600 – 70 = $330
- Method 2: Operating cash flow = net profit + depreciation = 130 + 200 = $330
- Method 3: Operating cash flow = (revenues – cash expenses) x (1 – tax rate) + (depreciation x tax rate) =
(1,000 - 600) x (1 – 0.35) + (200 x 0.35) = $330

10- BREAK-EVEN ANALYSIS AND NPV

For many projects, the make-or-break variable is sales volume. Therefore, managers most often focus on the break-even
level of sales. However, you might also look at other variables, for example at how high costs could be therefore the project
goes into the red.
As it turns out, “losing money” can be defined in more than one way. Most often, the break-even condition is defined in
terms of accounting profits. More properly, however, it should be defined in terms of NPV. We will start with accounting
break-even, show that it can lead you astray, and then show how NPV break-even can be used as an alternative.

10.1- Accounting Break-Even Analysis

The accounting beak-even point is the level of sales at which profits are zero or, equivalently, at which total revenues equal
total costs. As we have seen, some costs are fixed regardless of the level of output. Other costs vary with the level of
output.

When you first analyzed a superstore project, you came up with the following estimates:

- Sales: $16 million

- Variable costs: $13 million
- Fixed costs: $2 million
- Depreciation: $0.45 million

Notice that variable costs are 81.25% of sales. So for each additional dollar of sales, costs increase by only $0.8125. We can
easily determine how much business the superstore needs to attract to avoid losses. If the store sells nothing, the income
statement will show fixed costs of $2 million and depreciation of $450,000. Thus there will be an accounting loss before tax
of $2.45 million. Each dollar of sales reduces this loss by $1.00 – $0.8125 = $0.1875. Therefore, to cover fixed costs plus
depreciation, you need sales of 2.45 million/0.1875 = $13.067 million. At this sales level, the firm will break even. More
generally, we can write:

¿ costs including depreciation

Break-even level of revenues = each additional dollar of sales ¿ =
Additional profit ¿
¿ costs including depreciation
Contributionmargin %

Item $ Thousands
Revenues 13,067
Variable costs 10,617
Fixed costs 2,000
Depreciation 450
Pretax profit 0
Taxes 0
Profit after taxes 0

Is a project that breaks even in accounting terms an acceptable investment? No, of course.

A project that simply breaks even on an accounting basis gives you your money back but does not cover the opportunity
cost of the capital tied up in the project. A project that breaks even in accounting terms will surely have a negative NPV.

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10.2- NPV Break-Even Analysis

Example 1:

A manager who calculates an accounting-based measure of break-even may be tempted to think that any project that earns
this figure will help shareholders. But projects that break even on an accounting basis are really making a loss-they are
failing to cover the costs of capital employed. Managers who accept such projects are not helping their shareholders.
Therefore, instead of asking what sales must be to produce an accounting profit, it is more useful to focus on the point at
which NPV switches from negative to positive. This is called NPV break-even point.
The CF of the superstore project in each year will depend on sales as follows:

1) Variable costs 81.25% of sales

2) Fixed costs $2 million
3) Depreciation $450,000
4) Pretax profit (0.1875 x sales) - $2.45 million
5) Tax (at 40%) 0.40 x (0,1875 x sales - $2.45)
6) Profit after tax 0.60 x (0.1875 x sales - $2.45)
7) Cash flows (3+6) $450,000 + 0.6 x (0.1875 x sales - $2.45 million) =
0.1125 x sales - $1.02

This CF will last for 12 years. So to find its PV we multiply by the 12-annuity factor. With a discount rate of 8%, the PV of $1
a year for each of 12 years is $7.536. Thus the PV of the CF is:

PV (CF) = (0.1125 x sales) x

1 1−
0.08 [ 1
1+ 0.08 ¿
12 ¿ ]
=¿ (0.1125 x sales - $1.02 million) x 7.536

The project breaks even in PV terms (that is, has zero NPV) if the PV of these CF is equal to the initial $5.4 million
investment. Therefore, break-even occurs when:

PV (cash flows) = CF. gn=¿ investment

7.536 x (0.1125 x sales - $1.02 million) = 0.8478 x sales - $7.69 million = $5.4 million

Sales = (5.4 + 7.69)/0.8478 = $15.4 million

Therefore, the store needs sales of $15.4 million a year for the investment to have a zero NPV. This is more than 18% higher
than the point at which the project has zero profit.

Question:

What would be the NPV break-even level of sales if the capital investment was only $5 million?

Example 2:

We have said that projects that break-even on an accounting basis are really making a loss. Here is a dramatic example.
Lophead Aviation is contemplating investment in a new passenger aircraft, code-named the Trinova. Lophead’s financial
staff has gathered together the following estimates:

1) The cost of developing the Trinova is forecast at $900 million, and this investment can be depreciated in six equal
annual amounts.
2) Production of the plane is expected to take place at a steady annual rate over the following 6 years.
3) The average price of the Trinova is expected to be $15.5 million.
4) Fixed costs are forecast at $175 million by year.
5) Variable costs are forecast at $8.5 million a plane.
6) The tax rate is 50%
7) The cost of capital is 10%.

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Lophead’s financial manager has used this information to construct a forecast of the profitability of the Trinova program.

How many aircrafts does Lophead need to sell to break-even? The answer depends on what it meant by break-even. In
accounting terms the venture will break even when net profit is zero. In this case, according to the row 7 of the following
table:

(3.5 x planes sold) – 162.5 = 0 Planes sold = 162.5/3.5 = 46.4

Thus Lophead needs to sell about 46 planes a year, or a total of 280 planes over 6 years to show a profit. With a price of
$15.5 million a plane, Lophead will break-even in accounting terms with annual revenues of 46.4 x $15.5 million = $719
million.

Forecast profitability for production of the Trinova airliner (figures in millions of dollars)

Year 0 Year 1 - 6
Investment $900
1) Sales 15.5 x planes sold
2) Variable costs 8.5 x planes sold
3) Fixed costs 175
4) Depreciation 900/6 = 150
5) Pretax profit (1 – 2 – 3 – 4) (7 x planes sold) – 325
6) Taxes at 50% (3.5 x planes sold) – 162.5
7) Net profit (5 – 6) (3.5 x planes sold) – 162.5
8) Net cash flow (4+7) -$900 (3.5 x planes sold) – 12.5

We would have arrived at the same answer if we had used our formula to calculate the break-even level of revenues.
Notice that the variable cost of each plane is $8.5 million, which is 54.8% of the $15.5 million sale price. Therefore, each
dollar of sales increases pretax profits by $1 - $0.548 = $0.452. Now we use the formula for the accounting break-even
point:

¿ costs including depreciation

Break-even revenues = each additional dollar of sales ¿ = $325 million /
Additional profit ¿
0.452 = $719 million

If Lophead sells about 46 planes a year, it will recover its original investment, but it will not earn any return on the capital
tied up in the project. Companies that earn a zero return on their capital can expect some unhappy shareholders.
Shareholders will be content only if the company’s investments earn at least the cost of the capital invested. True break-
even occurs when the projects have zero economic value added.

How many planes must Lophead sell to break even in terms of NPV? Development of the Trinova costs $900 million. If the
cost of capital is 10%, the 6-year annuity factor is 4.3553:

gn =
1
r[1−
1
(1+r )
n
] =
1
0.10[1−
1
(1+0.10)
6
] = 4.3553

Thus we can now find the annual plane sales necessary to break even in terms of NPV:

NPV = −C 0 + gn (net cash flow) = - 900 + (4.3553) [ 3.5 x planes sold−12.5 ] = 0

Planes sold = 954.44/15.2436 = 62.6 ≈ 63 planes by year.

Thus, while Lophead will break even in terms of accounting profits with sales of 47 planes a year (282 in total), it needs to
sell 63 a year (or about 378 in total) to also recover the opportunity cost of the capital invested in the project and break
even in terms of NPV.