Chapter 6: Making

capital investment
decisions
Corporate Finance
Ross, Westerfield, and Jaffe
Outline
1. Relevant/incremental cash flows
2. An example
3. The equivalent annual cost method
TVM
• We need to evaluate a new project using the TVM technique.
• That is, we should discount future expected cash flows
(specifically, FCFs) back to present time and compare PV to
initial costs: whether NPV > 0?
• Discount cash flows, not earnings.
Relevant cash flows
• But before we do this, a few notions about cash flows need to
be addressed.
• The cash flows in the capital-budgeting time line need to be
relevant cash flows; that is they need to be incremental in
nature.
• Incremental cash flows: those cash flows that will only occur if
the project is accepted.
Ask the right question

• You should always ask yourself “Will this cash flow occur ONLY
if we accept the project?”
• If the answer is “yes”, it should be included in the analysis
because it is incremental.
• If the answer is “no”, it should not be included in the analysis
because it will occur anyway.
Sunk costs
• A sunk cost is a cost that has already occurred regardless of
whether the project is accepted.
• Example: consulting fee for evaluating a project.
• Sunk costs should not be taken into consideration when
evaluating a project.
Opportunity costs
• Opportunity costs (OCs) are the costs of giving up the second
best use of resources.
• Example: a vacant land.
• Opportunity costs should be taken into consideration when
evaluating the project.
Side effects
• Accepting a new project may have side effects.
• Erosion occurs when a new project reduces the sales and cash
flows of existing projects.
• Synergy occurs when a new project increases the sales and
cash flows of existing projects.
• Cash flows due to erosion and synergy are incremental cash
flows.
An example, I
• Baldwin Company is considering an investment project:
producing colored bowling balls.
• The estimated life of the project: 5 years.
• The cost of test marketing: $250,000.
• Would be produced in a vacant building owned by the
firm; the property can be sold for $150,000 after taxes.
• The cost of a new machine: $100,000.
• The estimated market value of the machine at the end of
5 years: $30,000.
Operating Cash Flow ( OCF)
• Net income 1 Depreciation
• OCF = (Sales - Cash costs -Depreciation) (1 – tax rate)
+Depreciation
A comprehensive example
• Suppose that we are considering a new project which
has a life of 3 years.
• The firm uses no debt; i.e., no interest expenses.
• The initial capital investment is $90,000. The firms use 3-
year straight-line depreciation to write off the $90,000
capital investment.
• Suppose that the pro forma income statements for year
1, year 2, and year 3 look the same (in real life, they are
of course unlikely to be identical).
• For each year, it looks like the following:
A comprehensive example
Sales (50,000 units at $6.00/unit) $300,000
Variable Costs ($4/unit) $200,000
Gross profit $100,000
Fixed costs $40,000
Depreciation ($90,000 / 3) $30,000
EBIT $30,000
Taxes (30%) $9,000
Net Income $ 21,000
A comprehensive example
• Operating cash flow (OCF) = EBIT + depreciation – taxes =
30,000 + 30,000 – 9,000 = 51,000.
• Suppose that the firm needs to invest $25,000 in net
working capital (NWC) and expects to recover this
investment at the end of the project.
• Suppose that in addition to the initial capital investment
and the investment in NWC, this project also require the
use of vacant facility, which the firm can lease it out for a
total of $10,000 over the 3-year period.
A comprehensive example
Year 0 1 2 3
OCF $51,000 $51,000 $51,000
NWC -$25,000 $25,000
C0 -$90,000
OC -$10,000
CF -$125,000 $51,000 $51,000 $76,000
A comprehensive example
• Suppose the WACC for the project is 10%.
• NPV = -125,000 + 51,000 / (1 + 10%) + 51,000 / (1 + 10%)2 +
76,000 / (1 + 10%)3 = $20,612.32.
• Should we accept the project ?
• Because the firm uses no debt, what is the WACC?
 An example
• Production by year for the 5-year life: 5,000 units, 8,000 units,
12,000 units, 10,000 units, and 6,000 units.
• The price of bowling balls in the first year: $20.
• The price of bowling balls will increase at 2% per year.
• No debt financing; no interest expenses.
• First-year production costs: $10 per unit.
• Production costs will increase at 10% per year.
• Incremental/marginal corporate tax rate: 34%.
• An initial investment (at year 0) in net working capital: $10,000.
• NWC at the end of each year will be equal to 10% of sales for that
year.
• NWC at the end of the project is zero
An example

Year Units Price/unit Revenue Cost/unit Cost

1 5000 20 100000 10 50000
2 8000 20.4 163200 11 88000
3 12000 20.808 249696 12.1 145200
4 10000 21.22416 212241.6 13.31 133100
5 6000 21.648643 129891.9 14.641 87846
Depreciation
• Depreciation for tax purpose in the U.S. is based on the
Modified Accelerated Cost Recovery System (MACRS).
• See Table 6.3 (p. 176) for IRS depreciation schedule.
• For a 5-year depreciation, the depreciation schedule is: 20%
(year 1), 32% (year 2), 19.2% (year 3), 11.5% (year 4), 11.5%
(year 5), and 5.8% (year 6).
An example

Year 1 Year 2 Year 3 Year 4 Year 5

Sales 100000 163200 249696 212241.6 129891.9
Costs 50000 88000 145200 133100 87846
Dep. 20000 32000 19200 11500 11500
Income before tax 30000 43200 85296 67641.6 30545.86
Tax 10200 14688 29001 22998.14 10385.59
Net Income 19800 28512 56295 44643.46 20160.27
OCF 39800 60512 75495 56143.46 31660.27
NWC 10000 16320 24970 21224.16
After-tax salvage cash flow
• OCF = sales – costs – taxes.
• The estimated salvage market value of the machine is
30% of $100,000; that is, $30,000.
• The machine will have been depreciated to 5.8% of
$100,000 at that time; that is, $5,800.
• The taxable amount is $24,200 ($30,000 - $5,800).
• The after-tax salvage cash flow is: $30,000 – (34% ×
$24,200) = $21,772.
An example

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

OCF 39800 60512 75495 56143 31660
Capital -100000
OC -150000 150000
NWC 10000 10000 16320 24970 21224
ΔNWC -10000 0 -6320 -8650 3745 21224
Salvage 21772
Total CF -260000 39800 54192 66846 59889 224656
IRR 16%
Decision
• If the nominal discount rate (cost of equity) is less than 16%,
we accept the project.
• In other words, if the discount rate is higher than 16%, we
have a negative NPV.
NPV
• The firm uses no debt. Thus the appropriate discount rate is
the cost of equity.
• Suppose that cost of equity is 15%.
• NPV = 5473.43 (> 0).
An example

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

OCF 39800 60512 75495 56143 31660.3
Capital -100000
OC -150000 150000
NWC 10000 10000 16320 24970 21224
ΔNWC -10000 0 -6320 -8650 3745 21224.2
Salvage 21772
Total CF -260000 39800 54192 66846 59889 224656
Re 15%
NPV 5473.43
 Example : Class Tasks
• XYZ Company is considering an investment project: producing colored
bowling balls. The estimated life of the project: 5 years. The cost of test
marketing: $150,000. The firm would use a vacant building; the building
can be sold for $150,000 after taxes. The firm will buy 2 machine and cost
of each machine: $100,000 and one will be depreciated using straight line
over its useful life to zero and 2nd one will be depreciated at 25% in the
first year and 20% in 2nd year and then will be sold for 90,000 at the
beginning of 3rd year. The estimated market value of the machine at the
end of 5 years: $30,000. Production by year for the 5-year life: 6,000 units,
8,000 units, 12,000 units, 10,000 units, and 10,000 units. The price of
bowling balls in the first year: $20.The price of bowling balls will increase
at 2% per year from 3rd year. No debt financing; no interest expenses.
First-year production costs: $10 per unit. Production costs will increase at
10% per year from 2nd year. Incremental/marginal corporate tax rate:
34%. An initial investment (at year 0) in net working capital: $20, 000.NWC
at the end of each year will be equal to 10% of sales for that year .NWC at
the end of the project is zero. Cost of Equity for the project is 10%. Will
you accept the project based on either NPV or IRR
Alternative definitions of OCF
• In our previous calculation, we used the top-down approach
to compute OCF ( = sales – costs – taxes).
• Another 2 alternative methods: the bottom-up method, and
the tax shield method.
• See pp. 186-189.
The equivalent annual cost method

• This method is useful (1) when one tries to choose between 2

machines of unequal lives, or (2) whether one should replace
an existing machine with a new one.
• Whereas a general capital budgeting problem is often
computed in nominal terms, the equivalent annual cost (EAC)
method works best in real terms.
Nominal vs. real

Time 0 1 2
Nominal CF -1000 600 650
Expected Inflation 5%
Real CF -1000 571.43 589.57
2 machines with unequal
lives
• Revenues per year are the same, regardless of machine.
• The nominal discount rate (NR) is 13.3%. The expected
inflation rate (E(I)) is 3%. The real discount rate (RR) is 10%.
• (1 + NR) = (1 + RR) × (1 + E(I))
• (1 + 13.3%) = (1 + 10%) × (1 + 3%).
Real cost outflows w/ real
discount rate

Time 0 Time 1 Time 2 Time 3 Time 4

Machine A 500 120 120 120
Machine B 600 100 100 100 100
Discount 10%
PV_A 798.42
PV_B 916.99
 Project Evaluation
• Your firm is contemplating the purchase of a new
$720,000 computer-based order entry system. The system
will be depreciated straight-line to zero over its five-year
life. It will be worth $75,000 at the end of that time. You
will save $260,000 before taxes per year in order
processing costs, and you will be able to reduce working
capital by $110,000 (this is a one-time reduction). If the
tax rate is 35 percent, what is the IRR for this project?
 Calculating EAC
• You are evaluating two different silicon wafer milling
machines. The Techron I costs $290,000, has a three-
year life, and has pretax operating costs of $67,000 per
year. The Techron II costs $510,000, has a fi ve-year life,
and has pretax operating costs of $35,000 per year. For
both milling machines, use straight-line depreciation to
zero over the project’s life and assume a salvage value of
$40,000. If your tax rate is 35 percent and your discount
rate is 10 percent, compute the EAC for both machines.
Which do you prefer? Why?
 Calculating a Bid Price
• Alson Enterprises needs someone to supply it with 185,000
cartons of machine screws per year to support its
manufacturing needs over the next five years, and you’ve
decided to bid on the contract. It will cost you $940,000 to
install the equipment necessary to start production; you’ll
depreciate this cost straight-line to zero over the project’s life.
You estimate that in five years, this equipment can be
salvaged for $70,000. Your fixed production costs will be
$305,000 per year, and your variable production costs should
be $9.25 per carton. You also need an initial investment in net
working capital of $75,000. If your tax rate is 35 percent and
you require a 12 percent return on your investment, what bid
price should you submit?
Comparing Mutually Exclusive
Projects
• Vandalay Industries is considering the purchase of a new
machine for the production of latex. Machine A costs
$2,900,000 and will last for six years. Variable costs are 35
percent of sales, and fixed costs are $170,000 per year.
Machine B costs $5,100,000 and will last for nine years.
Variable costs for this machine are 30 percent of sales and
fixed costs are $130,000 per year. The sales for each machine
will be $10 million per year. The required return is 10 percent,
and the tax rate is 35 percent. Both machines will be
depreciated on a straight-line basis. If the company plans to
replace the machine when it wears out on a perpetual basis,
which machine should you choose?
• The Pristine Urban-Tech Zither, Inc. (PUTZ) bought some land three
years ago for $1.4 million in anticipation of using it as a toxic waste
dump site but has recently hired another company to handle all toxic
materials. Based on a recent appraisal, the company believes it could
sell the land for $1.5 million on an aftertax basis. In four years, the land
could be sold for $1.6 million after taxes. The company also hired a
marketing firm to analyze the zither market, at a cost of $125,000. The
company will be able to sell 3,200, 4,300, 3,900, and 2,800 units each
year for the next four years, respectively. Again, capitalizing on the
name recognition of PUTZ, a premium price of $780 can be charged for
each zither. At the end of the four-year period, sales should be
discontinued. PUTZ believes that fixed costs for the project will be
$425,000 per year, and variable costs are 15 percent of sales. The
equipment necessary for production will cost $4.2 million and will be
depreciated according to a three-year MACRS schedule. At the end of
the project, the equipment can be scrapped for $400,000. Net working
capital of $125,000 will be required immediately. PUTZ has a 38 percent
tax rate, and the required return on the project is 13 percent. What is
the NPV of the project?
Replacement Decisions
• Your small remodeling business has two work vehicles.
One is a small passenger car used for job-site visits and
for other general business purposes. The other is a heavy
truck used to haul equipment. The car gets 25 miles per
gallon (mpg). The truck gets 10 mpg. You want to
improve gas mileage to save money, and you have
enough money to upgrade one vehicle. The upgrade cost
will be the same for both vehicles. An upgraded car will
get 40 mpg; an upgraded truck will get 12.5 mpg. The
cost of gasoline is $3.70 per gallon. Assuming an upgrade
is a good idea in the first place, which one should you
upgrade? Both vehicles are driven 12,000 miles per year.