Because learning changes everything.

Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 6

Making Capital Investment Decisions

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Chapter Outline
6.1 Incremental Cash Flows: The Key to Capital Budgeting
6.2 The Baldwin Company: An Example
6.3 Alternative Definitions of Operating Cash Flow
6.4 Some Special Cases of Discounted Cash Flow Analysis
6.5 Inflation and Capital Budgeting

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 6.1 Incremental Cash Flows
Cash flows matter—not accounting earnings.
Sunk costs do not matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like synergy and erosion matter.
Taxes matter: We want incremental after-tax cash flows.
Inflation matters.

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 Cash Flows—Not Accounting Income
Consider depreciation expense.
• You never write a check made out to “depreciation.”

Much of the work in evaluating a project lies in taking

accounting numbers and generating cash flows.

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 Incremental Cash Flows - I
Sunk costs are not relevant
• Just because “we have come this far” does not mean that
we should continue to throw good money after bad.

Opportunity costs do matter. Just because a project has a

positive NPV, that does not mean that it should also have
automatic acceptance. Specifically, if another project with a
higher NPV would have to be passed up, then we should not
proceed.

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 Incremental Cash Flows – II
Side effects matter.
• Erosion is a “bad” thing. If our new product causes existing
customers to demand less of our current products, we
need to recognize that.
• If, however, synergies result that create increased demand
of existing products, we also need to recognize this gain.

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 Estimating Cash Flows
Cash Flow from Operations
• Recall that: OCF = EBIT − Taxes + Depreciation.
Net Capital Spending
• Do not forget salvage value (after tax, of course).
Changes in Net Working Capital
• Recall that when the project winds down, we enjoy a return
of net working capital.

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 Interest Expense
Later chapters will deal with the impact the amount of debt a
firm has in its capital structure has on firm value.
For now, it is enough to assume that the firm’s level of debt
(and, hence, interest expense) is independent of the project
at hand.

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 The Baldwin Company – Background
• The Baldwin Company, originally established 16 years ago to
make footballs, is now a leading producer of tennis balls,
baseballs, footballs, and golf balls.
• the Baldwin Company investigated the marketing potential of
brightly colored bowling balls. Baldwin sent a questionnaire to
consumers in three markets: Philadelphia, Los Angeles, and
New Haven. The results of the three questionnaires were
much better than expected and supported the conclusion that
the brightly colored bowling balls could achieve a 10 to 15
percent share of the market.
• Some people at Baldwin complained about the cost of the test
marketing (already spent), which was $250,000
• The Baldwin Company is now considering investing in a
machine to produce bowling balls.
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 The Baldwin Company – Initial Costs
• Current market value of proposed factory site (which the
company owns): $150,000 (after tax) and could be resold at
the same price in year 5
• Cost of bowling ball machine: $100,000 (depreciated
according to 5-year MACRS). The market value of the ball
machinery at the end of year 5 is expected to be $30k
• 5 Year MACRS

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 The Baldwin Company –OCF
• Price during first year is $20;. The bowling ball market is
highly competitive, so Meadows believes that the price of
bowling balls will increase at only 2 percent per year
thereafter, as compared to the anticipated general inflation
rate of 5 percent.
• Production costs without any noncash deductions during
first year are $10 per unit and increase 10 percent per
year thereafter
• Production (in units) by year during 5-year life of the
machine: 5,000, 8,000, 12,000, 10,000, 6,000
• Meadows has determined, based on Baldwin’s taxable
income, that the appropriate incremental (marginal)
corporate tax rate in the bowling ball project is 21 percent.
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 The Baldwin Company – NWC
• Management determines that an initial investment (Year 0) in
net working capital of $10,000 is required. subsequently, net
working capital at the end of each year will be equal to 10
percent of the projected sales for that year.
• Working capital rises over the early years of the project as
expansion occurs. However, all working capital is assumed to
be recovered at the end, a common assumption in capital
budgeting. In other words, all inventory is sold by the end, the
cash balance maintained as a buffer is liquidated, and all
accounts receivable are collected.
• In the final year of the project, net working capital will decline
to zero as the project is wound down. In other words, the
investment in working capital is to be completely recovered by
the end of the project’s life
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 The Baldwin Company –
OCF(Solution)
Year 1 Year 2 Year 3 Year 4 Year 5
Units sold per year 5,000 8,000 12,000 10,000 6,000
Inflation rate 5% 5% 5% 5% 5%
Price increase per year 2% 2% 2% 2% 2%
Price per unit for Year 1 $20.00 $20.40 $20.81 $21.22 $21.65
Sales Revenues $100,000 $163,200 $249,696 $212,242 $129,892
Unit production cost for Year 1 $10.00 $11.00 $12.10 $13.31 $14.64
Increase in unit cost per year 10% 10% 10% 10% 10%
Operating cots 50,000 88,000 145,200 133,100 87,846
Tax rate 21% 21% 21% 21% 21%
Depreciation rate 20.00% 32.00% 19.20% 11.52% 11.52%
Cost of machine $100,000 $100,000 $100,000 $100,000 $100,000
Depreciation expense $20,000 $32,000 $19,200 $11,520 $11,520
OCF =(Sales-Costs)*(1-21%)
+Depreciation*tax rate $43,700.00 $66,128.00 $86,583.84 $64,941.06 $35,635.43

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 The Baldwin Company – After Tax
Salvage Value
The capital gain is $24,240 (= $30,000 – 5,760).
incremental corporate tax for Baldwin on this project is 21
percent.
So the capital gains tax due is $5,090.40 = [.21 × ($30,000 –
5,760)].
The aftertax salvage value is $30,000 – 5,090.4 =
$24,909.60.

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 The Baldwin Company – Investments
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:

(1) Bowling ball −$100.00 $24.91*

machine
(2) Opportunity cost −150.00 150.00
(warehouse)

(3) Net working 10.00 10.00 16.32 24.97 21.22

capital (end of year)

(4) Change in net −10.00 −6.32 −8.65 3.75 21.22

working capital
(5) Total cash flow of −260.00 −6.32 −8.65 3.75 196.1
investment [(1) + 3
(2) + (4)]

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 Incremental Cash Flows for the Baldwin
Company

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

(1) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89

(2) Operating costs −50.00 −$88.00 −145.20 −133.10 −87.85

(3) Taxes −6.30 −9.07 −17.91 −14.20 −6.41

(4) OCF (1) + (2) + $43.70 $66.13 $86.59 $64.94 $35.64

(3)
(5) Total CF of −$260.00 −6.32 −8.65 3.75 196.13
Investment
(6) IATCF [(4) + (5)] −$260.00 $43.70 $59.81 $77.93 $68.69 231.77

$43.70 $59.81 $77.93 $68.69 $231.77

NPV  $260   2
 3
 4

1.10 1.10 1.10 1.10 1.105
NPV  $78.53

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 NPV of Baldwin Company

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 6.3 Alternative Definitions of Operating
Cash Flow
Top-Down Approach
• OCF = Sales − Cash costs − Taxes.
• Do not subtract noncash deductions.
Bottom-Up Approach
• Works only when there is no interest expense.
• OCF = Net income + Depreciation.
Tax Shield Approach
• OCF = (Sales − Cash costs)(1 − TC) + Depreciation × TC.

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 6.4 Some Special Cases of Discounted
Cash Flow Analysis
Cost-Cutting Proposals
Setting the Bid Price
Investments of Unequal Lives

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 Cost-Cutting Proposals
Cost savings will increase pretax income
• But, we have to pay taxes on this amount.
Depreciation will reduce our tax liability
Does the present value of the cash flow associated with the
cost savings exceed the cost?
• If yes, then proceed.

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 Setting the Bid Price
Find the sales price that makes NPV = 0
Step 1: Use known changes in NWC and capital to estimate
“preliminary” NPV
Step 2: Determine what yearly OCF is needed to make
NPV = 0
Step 3: Determine what NI is required to generate the OCF
• OCF = NI + Depreciation.
Step 4: Identify what sales (and price) are necessary to
create the required NI
• NI = (Sales − Costs − Depreciation)*(1 − T)

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 Investments of Unequal Lives – I
There are times when application of the NPV rule can lead to
the wrong decision. Consider a factory that must have an air
cleaner that is mandated by law. There are two choices:
• The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100, and lasts 10 years.
• The “Cheapskate cleaner” costs $1,000 today, has annual
operating costs of $500, and lasts 5 years.

Assuming a 10 percent discount rate, which one should we

choose?

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 Investments of Unequal Lives – II

At first glance, the Cheapskate cleaner has a higher N PV.

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 Investments of Unequal Lives - III
This overlooks the fact that the Cadillac cleaner lasts twice
as long.
When we incorporate the difference in lives, the Cadillac
cleaner is actually cheaper (that is, has a higher NPV).

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 Equivalent Annual Cost (EAC)
The EAC is the value of the level payment annuity that has
the same PV as our original set of cash flows.
• For example, the EAC for the Cadillac air cleaner is
$750.98.
• The EAC for the Cheapskate air cleaner is $763.80, thus
we should reject it.

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 Cadillac EAC with a Calculator

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 Cheapskate EAC with a Calculator

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 6.5 Inflation and Capital Budgeting
Inflation is an important fact of economic life and must be
considered in capital budgeting.
Consider the relationship between interest rates and inflation,
often referred to as the Fisher equation:
(1 + Nominal interest rate) = (1 + Real interest rate) × (1 +
Inflation rate)

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 Inflation and Capital Budgeting
For low rates of inflation, this is often approximated:

Real Rate  Nominal Rate – Inflation Rate

While the nominal rate in the U.S. has fluctuated with

inflation, the real rate has generally exhibited far less
variance than the nominal rate.
In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows discounted at
nominal rates.

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 Quick Quiz
How do we determine if cash flows are relevant to the capital
budgeting decision?
What are the different methods for computing operating cash
flow, and when are they important?
What is equivalent annual cost, and when should it be used?
How should cash flows and discount rates be matched when
inflation is present?

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