10

Making Capital
Investment
Decisions

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

 Project Cash Flows: A First Look

 Incremental Cash Flows (Relevant CFs)
 More on Project Cash Flows (Common
Types of Cash Flows)
 Some Special Cases of Cash Flow
Analysis (Investments with Unequal Lives)

10-2
 Project Cash Flows: A First Look
Experts in Finance, Accounting, Marketing, Production,…

Projected Income Statement FIN323: Given

CF1 CF2 CFi CFN

0 1 2 … N
CF0
NPV, IRR, PI, Payback

10-3
 Relevant Cash Flows
150

Without project R 100

With project
1000
0 1 2 … N

1400
CFIncremental = CFWith - CFWithout
“Will this cash flow occur ONLY
if we accept the project?”

Incremental CFs
All the benefits of operating railroad

 Incremental CFs only occur if the project is accepted

 Suppose that a bridge is in urgent need of repair. With the
bridge, the railroad can continue to operate; without the
bridge it can’t. What is the incremental CF? 10-4
 Example
 You bought a land for $1 million 5 years ago.
The land is worth $2 millions now.
 The cost of building a factory on the land is $3
millions.
 How much is the initial investment cost of factory?
 CF with project: - $3 Millions (build the factory)
 CF without the project: +$2 millions (sell the land)
 Incremental CF: -$5 Millions
 $1 million: sunk cost  not relevant
 $2 millions: opportunity cost  relevant

10-5
 Common Types of Cash Flows
Include: Not include:
 Opportunity costs - costs
 Sunk costs – costs that
of lost options
have accrued in the past
 Side effects
 Positive side effects – benefits  Financing costs (interest
to other projects expense)
 Negative side effects – costs
to other projects
 Changes in net working
capital
 Taxes

10-6
 7
Typical Cash Flows of a Project
Recovery of NWC

Salvage Value

Machine OCF=NI+D
purchase,
shipment Depreciation Tax
installation
R
0 1 2 … N
Tax Credit

Training expense
You plan to add a fashion product
to your current business.
Increase in NWC
What incremental CFs
do you anticipate?
 8
Review: Net working capital
How much is NWC?
Assets Liability & Equity

Cash 696 A/P 307 NWC=CA-CL

A/R 956 N/P 26 =2256-1995=261

Inventory 301 Other CL 1,662

Other CA 303 Total CL 1,995

Ex: What is the change in
Total CA 2,256 LT Debt 843 NWC if inventory, A/R and
A/P increase to 400, 1000
Net FA 3,138 C/S 2,556 and 420, respectively?
Total Assets 5,394 Total Liab. & Equity 5,394
∆NWC= ∆A/R + ∆Inventory - ∆A/P
=(400-301)+(1000-956)-(420-307)
We need to spend $30 at to =99+44-113 = 30
and will get it back
at the end of the project What does it mean if
∆NWC= 30 ?
 9
Three types of Cash Flows: CF0, OCF,
Terminal CF

Operating Cash Flows (OCF) Terminal Cash

Flow CT
OCF1 OCF2 OCFi OCFN
R
0 1 2 … N
Initial Outlay CF0
 10
#1: Estimate Initial Outlay CF0
Terminal Cash
OCFN Flow CT
OCF1 OCF2 OCFi
R
0 1 2 … N
Initial Outlay CF0

CF0 =
- Machine purchase, shipment & Installation
- Change in Working Capital
-Expense Outlays after tax (i.e. Training Expenses)
+ Sales of Old machine
- Tax on selling old machine
 11
Estimating Cash Flows
Initial Outlay

Example 1:
Gasperini Corp. is considering replacing their old
production machine with a new one. The cost of the
new machine is $48,000; installation and delivery
cost $2,000. Working Capital requirements on the
new machine are $3,000 immediately, and training
costs amount to $4,000. The old machine can be sold
for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%.
 12
Estimating Cash Flows
Initial Outlay
Cost of Machine +48,000
Installation & Shipping 2,000
Working Capital 3,000
Training (after tax) 2,400 4,000(1-0.40)
+55,400
Less: Sale of Old Machine Tax rate x (Salvage Value-Book Value)
Salvage Value 10,000 .4(10,000 – 0)
–Taxes – 4,000
– 6,000
Initial Outlay +49,400
0 1 2 3 4 5

-49,400
 13
#2: Estimate Operating CF (OCF)

From
Pro forma Income Statement
(Projected IS)
Terminal Cash
Flow CT
OCF1 OCF2 OCFi OCFN
R
0 1 2 … N
Initial Outlay CF0
 14
Review: 3 methods to calculate OCF
1. Bottom Up
OCF=NI+ Depreciation
Sales (Revenue) 100 =26+20=46
-Costs -40
-Depreciations -20 2. Top Down
EBIT (I=0) 40 OCF=Sales-Costs-Taxes
=100-40-14=46
-Tax (35%) -14
Net Income 26
3. Tax shield
+ Depreciation +20 OCF=(S-C)(1-T)+D.T
=(100-40)(1-.35)+20*0.35=46
Operating Cash 46  EBIT=S-C-D
Flows (OCF)
 NI=EBIT*(1-T)
=(S-C-D)*(1-T)
=(S-C)*(1-T) – D*(1-T)
=(S-C)*(1-T) – D +D*T
 OCF=NI+D
=(S-C)*(1-T) +D*T
 15
Depreciation
 The depreciation expense used for capital
budgeting should be the depreciation schedule
required by the IRS (Internal Revenue Service)
for tax purposes
 Depreciation itself is a non-cash expense,
consequently, it is only relevant because it
affects taxes
 Depreciation tax shield = D*T
 16
Depreciation methods
1. Straight-line (SL)
D = (Initial cost - BVn) / number of years
Very few assets are depreciated straight-line for tax
purposes: but we use it in class for simplification

2. Modified Accelerated Cost Recovery System

(MACRS)
Determine which asset class is appropriate for tax
purposes
Multiply percentage given in Depreciation Allowance
table by the initial cost
 17
Depreciation (MACRS)

Modified ACRS Property Classes (Table 10.6)

#1st step: Asset class
Class Examples

3-year Equipment used in research

5-year Autos, computers

7-year Most industrial equipment

 18
MACRS Depreciation Allowances (Table 10.7)
Property Class
Year 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%

2 44.44 Mid-year 32.00 24.49
Conven-
3 14.82 tion 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
Depreciated
6 to zero 5.76 8.93
7 8.93
8 4.45
#2nd step: Depreciation schedule
 19
Estimating Cash Flows
Operating (Differential) Cash Flows

Example 1 (continued):
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by
$8,000/ yr. They expect to use the machine for 5 years, and
expect to sell it for $15,000 in 5 years. Assume Gasperini uses
the modified accelerated cost recovery system (MACRS) for
depreciation.

Will we look at 5-year schedule?

 20
Depreciation (MACRS)

Modified ACRS Property Classes (Table 10.6)

Class Examples

3-year Equipment used in research

5-year Autos, computers

7-year Most industrial equipment

 21
MACRS Depreciation Allowances (Table 10.7)
Property Class
Year 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%

2 44.44 32.00 24.49
3 14.82 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.93
7 What amount to be depreciated? 8.93

8 Equipment Purchase, 4.45

Shipment & Installation fees
 22
Estimating Cash Flows
Initial Outlay
Cost of Machine +48,000
Installation & Shipping 2,000
Working Capital 3,000
Training (after tax) 2,400 4,000(1-0.40)
+55,400
Less: Sale of Old Machine Tax rate x (Salvage Value-Book Value)
Salvage Value 10,000 .4(10,000 – 0)
–Taxes – 4,000
– 6,000
Initial Outlay +49,400
0 1 2 3 4 5

-49,400
 23
Estimating Cash Flows
Operating (Differential) Cash Flows
OCFt = (St - Ct)(1 -T) + DtT
Example 1 (continued):
The new machine Gasperini Corp is considering buying will increase
revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to
use the machine for 5 years, and expect to sell it for $15,000 in 5 years.
Assume Gasperini uses the modified accelerated cost recovery system
(MACRS) for depreciation.
Years 0 1 2 3 4 5 Remaining
MACRS (7yrs) 100% 14.29% 24.49% 17.49% 12.49% 8.93% 22%
D 50000 7,145 12,245 8,745 6,245 4,465 11,155
S-C 13,000 13,000 13,000 13,000 13,000
(S-C)*(1-T) 7,800 7,800 7,800 7,800 7,800
D*T (T=40%) 2,858 4,898 3,498 2,498 1,786
OCF 10,658 12,698 11,298 10,298 9,586

S-C=5000 – (-8000)=13,000
 24
Estimating Cash Flows
Operating (Differential) Cash Flows
Example 1 (continued):
The new machine Gasperini Corp is considering buying will
increase revenues by $5,000/yr and decrease costs by $8,000/ yr.
They expect to use the machine for 5 years, and expect to sell it
for $15,000 in 5 years. Assume Gasperini uses the modified
accelerated cost recovery system (MACRS) for depreciation.

0 1 2 3 4 5

-49,400 +10,658 +12,698 +11,298 +10,298 +9,586

 25
Compare SL vs. MACRS
Straight Line Method
Years 0 1 2 3 4 5 Remaining
SL (7yrs) 100% 14.29% 14.29% 14.29% 14.29% 14.29% 28.57%
D 50000 7,143 7,143 7,143 7,143 7,143 14,286
S-C 13,000 13,000 13,000 13,000 13,000
(S-C)*(1-T) 7,800 7,800 7,800 7,800 7,800
D*T (T=40%) 2,857 2,857 2,857 2,857 2,857
OCF 10,657 10,657 10,657 10,657 10,657
MACRS Method
MACRS (7yrs) 100% 14.29% 24.49% 17.49% 12.49% 8.93% 22%
D 50000 7,145 12,245 8,745 6,245 4,465 11,155
S-C 13,000 13,000 13,000 13,000 13,000
(S-C)*(1-T) 7,800 7,800 7,800 7,800 7,800
D*T (T=40%) 2,858 4,898 3,498 2,498 1,786
OCF 10,658 12,698 11,298 10,298 9,586

InitialCos ts  BookValue
Depreciati on SL 
Number .of .Year
50,000  0
Depreciation SL   7,143
7
 26
#3: Terminal Cash Flow CT

Operating Cash Flows (OCF) Terminal Cash

Flow CT
OCF1 OCF2 OCFi OCFN
R
0 1 2 … N
Initial Outlay CF0
 27
Estimating Cash Flows
Terminal Cash Flow
Recover Working Capital
Sell Machine
Pay Taxes or receive tax credit if Selling price <>BV

If the salvage value is different from the book value

of the asset, then there is a tax effect
Book value = initial cost – accumulated depreciation
Tax=(Tax rate)*(salvage – book value)
After-tax salvage = salvage – Tax
 28
Estimating Terminal Cash Flows
Example 1 (continued):
Gasperini Corp. is considering replacing their old production machine with
a new one. The cost of the new machine is $48,000; installation and
delivery cost $2,000. Working Capital requirements on the new machine
are $3,000 immediately, and training costs amount to $4,000. The old
machine can be sold for $10,000; its book value is zero. Gasperini has a
marginal tax rate of 40%. The new machine Gasperini Corp is considering
buying will increase revenues by $5,000/yr and decrease costs by $8,000/
yr. They expect to use the machine for 5 years, and expect to sell it for
$15,000 in 5 years. Assume Gasperini uses MACRS

Recover Working Capital +3,000

Sell “New” Machine 15,000 .4(15,000-11,155)
Tax on Sale -1,538
Terminal Cash Flow +16,462
 29
Compute Project’s NPV
Cash Flows from Project
0 1 2 3 4 5

-49,400 +10,658 +12,698 +11,298 +10,298 +9,586

+16,462

Initial Outlay
Operating Cash Flows Terminal Cash Flow

If the required rate of the above project is 11%, compute its NPV?
CFo=-49,400, CF1=10,658, CF2=12,698, CF3=11,298, CF410,298, CF5=26,048
I = 11%  NPV=+1,010.62 > 0  Accept

How about IRR? IRR =11.71%

 Example 2: Mutually Exclusive
Investments with Unequal Lives
12,000 12,000 12,000 12,000 12,000 12,000
Machine 1 14%
0 1 2 3 4 5 6
-45,000 Can we compare
“NO”
their NPV directly?
 Their economic lives
are different!
20,000 20,000 20,000
Machine 2 14%
0 1 2 3
-45,000 #1: Bring them to the same life
#2: Compare Value per Year (EAC)
10-30
 #1: Replacement Chain method
12,000 12,000 12,000 12,000 12,000 12,000
Machine 1 14%
0 1 2 3 4 5 6
-45,000 Repeat projects using
a replacement chain
to equalize life spans

20,000 20,000 20,000 20,000 20,000 20,000

Machine 2 14%
0 1 2 3 4 5 6
-45,000 NPV2 > NPV1
-45,000
 Select Machine 2

PA 1: Cf0=-45,000;Cf1=12,000;N=6, i=14% NPV1 =1,664.01

PA 2: Cf0=-45,000;Cf1=20,000;Cf2=-25,000;Cf3=20,000;N=6
10-31
i=14%  NPV2 =2,399.63
 #2: Equivalent Annual Cost (EAC)
12,000 12,000 12,000 12,000 12,000 12,000
Machine 1 14%
0 1 2 3 4 5 6
-45,000 Calculate NPV and Spread it over
the life of the project

20,000 20,000 20,000

Machine 2 14%
0 1 2 3
-45,000

10-32
 #2: Equivalent Annual Cost (EAC)
NPV=1,664.01 12,000 12,000 12,000 12,000 12,000
12,000
Machine 1 14% EAC=427.91

0 1 2 3 4 5 6
#1: Calculate NPV =1,664.01
-45,000
#2: Spread NPV  EAC1 = 427.91 (~AW)

EAC1=427.91 < EAC2=617.08

NPV=1,432.64
20,000 20,000 20,000  Select machine 2!
Machine 2 14% EAC=617.08
0 1 2 3
-45,000 #1: Calculate NPV =1,432.64
#2: Spread NPV  EAC2 = 617.08 (~AW)

10-33
 Summary: Typical Cash Flows of a Project
Net sale of old Recovery of NWC
machine (S*old)
(-∆NWC)
Machine
purchase,
Net Salvage Value
shipment
(SVNew*)
installation
OCF=(S-C)*(1-T) + D*T
(CNEW)
R
0 1 2 … N
SV*=SV – T*(SV-BV)
Net Training expense
(C*Training) C*Training=CTraining*(1-T)
∆NWC= ∆A/R + ∆Inven - ∆AP …
Increase in NWC SL: D=CNEW/n (Law  n)
(∆NWC)
MACRS: Dep. Schedule

10-34
 10
End of Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.