Chapter 6
Making Capital Investment
Decisions
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
6-0
What is capital budgeting?
Should we
build this
plant?
• Chapters 5 (which we covered already), 6 and 7 focus on
capital budgeting, i.e., the decision making process for
accepting or rejecting long-term investment projects.
• Long-term decisions that involve large expenditures.
• Very important to a firm’s future.
6-1
Steps to Capital Budgeting
1.
2.
3.
4.
Estimate CFs (inflows & outflows).
Assess riskiness of CFs.
Determine the appropriate cost of capital.
Find NPV or IRR (or whatever method you
are using).
5. Accept if NPV > 0 or IRR > Required Return.
6-2
Key Concepts and Skills
• Understand how to determine the relevant
cash flows for various types of capital
investments
• Be able to compute depreciation expense for
tax purposes
• Incorporate inflation into capital budgeting
• Understand the various methods for
computing operating cash flow
• Evaluate special cases of discounted cash flow
analysis
6-3
Chapter Outline
6.1 Incremental Cash Flows
6.2 The Baldwin Company: An Example
6.3 Inflation and Capital Budgeting
6.4 Alternative Definitions of Operating Cash Flow
6.5 Some Special Cases of Discounted Cash Flow
Analysis
6-4
6.1 Incremental Cash Flows
• Cash flows matter—not accounting earnings (this is a major
difference between Corporate Finance and Financial
Accounting).
• When making a capital budgeting decision, always use cash
flows. Earnings do not represent real money! You cannot
spend out of earnings.
• Incremental cash flows matter: in calculating the NPV of a
project only cash flows that are incremental to the project
should be used. We are interested in the difference
between the cash flows with the project and the cash flows
without the project (not easy to do).
• Sunk costs do not matter. A sunk cost is a cost that has
already occurred and cannot be recovered or changed by
the decision to accept or reject the project.
6-5
Incremental Cash Flows (continued)
• Opportunity costs matter (e.g. Service Merchandise,
ToysRUs or Kmart).
• Side effects like cannibalization (e.g. iPhones
cannibalizing the sales of iPods), erosion (taking money
out of profitable areas and using it to fund projects
that may or may not be profitable in the future) and
synergy (when a new project increases the cash flows
of existing projects) matter. HP and Compaq claimed
synergies, and so did Mercedes-Benz and Chrysler.
• Taxes matter: we want incremental after-tax cash
flows.
• Inflation matters (it affects revenue and costs).
6-6
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.
6-7
Project Cash Flows
• Relevant cash flows – cash flows that occur (or don’t
occur) because a project is undertaken. Cash flows that
will occur regardless of whether or not we accept a
project aren’t relevant.
• Incremental cash flows – any and all changes in the
firm’s future cash flows that are a direct consequence
of taking the project
• The Stand-Alone Principle: Viewing projects as “minifirms” with their own assets, revenues, and costs
allows us to evaluate the investments separately from
the other activities of the firm.
6-8
Asking the Right Question
• You should always ask yourself “Will this cash
flow change 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 is not affected by the
project
– If the answer is “part of it,” then we should
include the part that occurs because of the project
6-9
Incremental Cash Flows
• 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.
6-10
Incremental Cash Flows
• Side effects matter.
– Cannibalization 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 or
cost cutting, we also need to recognize that.
6-11
Interest Expense
• Later chapters will deal with the impact that
the amount of debt that 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. The Separation Theorem dictates that
the financing and investment decisions are
separate activities.
6-12
Estimating Cash Flows
• Capital budgeting relies heavily on pro forma accounting
statements, particularly income statements.
• Net Capital Spending
– Do not forget salvage value (after tax, of course).
• Changes in Net Working Capital (increases in NWC in the early
years of the project (funded by cash generated elsewhere in
the firm→ cash outflows) and decreases in NWC at the end of
the project (cash inflows))
• Project cash flow = Project operating cash flow
- Project capital spending
- Change in project net working capital
6-13
Estimating Cash Flows (continued)
• Cash Flow from Operations
– Recall that:
OCF = EBIT + Depreciation – Current Taxes
Or OCF = NI + depreciation (because we do not consider
the interest expense). This is called the bottom-up
approach.
OCF = Sales – Costs – Taxes (do not subtract non-cash
deductions). This is called the top-down approach.
CF(A) = OCF – NCS - ΔNWC, where CF(A) is cash flow from
assets
6-14
More on NWC
• Changes in NWC reflect net increased
investment in receivables, inventory and cash
necessary to support additional sales.
• They also account for portion of this increased
investment that is funded by increases in
accounts payable (new firm short term
liabilities).
6-15
Tax Shield Approach
• You can also find operating cash flows using the tax shield
approach
• OCF = (Sales – costs)*(1 – T) + Depreciation*T
• OCF has two components:
• First component: Project’s cash flow if there were no
depreciation expense.
• Second component: Depreciation deduction multiplied by
the tax rate. It is called depreciation tax shield.
• This form may be particularly useful when the major
incremental cash flows are the purchase of equipment and
the associated depreciation tax shield – such as when you
are choosing between two different machines
6-16
Depreciation and the Tax Shield
Approach
• Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects
taxes
• The depreciation expense used for capital
budgeting should be the depreciation schedule
required by the IRS for tax purposes
• Depreciation tax shield = (Depreciation
expense)x(Marginal Tax Rate)
• Particularly useful when using accelerated
depreciation.
6-17
Computing Depreciation
• Straight-line depreciation:
•
– (Initial Cost – Salvage Value) / Number of Years
– Salvage value=what we think the asset will be worth when we
dispose it.
– Very few assets are depreciated straight-line for tax purposes
MACRS (Modified Accelerated Cost Recovery System)
– Need to know which asset class is appropriate for tax purposes
– Multiply percentage given in table by the initial cost
– Depreciate to zero
– Half year convention(e.g., for a 3-year-class property, the
recovery period begins in the middle of the year the asset is
placed in service and ends three years later. The effect of the
half-year convention is to extend the recovery period out one
more year, so 3-year-class property is depreciated over 4 years. )
6-18
MACRS Property Classes
6-19
After Tax Salvage
• 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
• After tax salvage = salvage – T(salvage – book
value)
6-20
Example: Straight Line Depreciation
You purchase equipment for $100,000 and it
costs $10,000 to have it delivered and installed.
Based on past information, you believe that you
can sell the equipment for $17,000 when you
are done with it in 6 years. The company’s
marginal tax rate is 40%. What is the
depreciation expense each year, and the after
tax salvage in year 6, assuming that the
appropriate depreciation schedule is straightline?
6-21
Straight Line Depreciation (continued)
 Depreciation=
 = ($110,000 – 17,000) / 6 = $15,500 every year
for 6 years
 Book value in year 6 =
 = $110,000 – 6(15,500) = $17,000
 After-tax salvage =
 = $17,000 - .4(17,000 – 17,000) = $17,000
6-22
Example: Depreciation of a Vehicle
• Consider an automobile costing $12,000. How
is it depreciated? MACRS, 5 year.
6-23
Depreciation of a Vehicle (continued)
• Suppose I want to sell the car after 5 years and it will be worth
25 percent of the purchase value. Also assume tax rate of
34%
• 0.25*12,000 = $3,000 = salvage
• Taxes paid = T(salvage – book value)
• What is book value after 5 years?
• $12,000-2,400-3,840-2,304-1,382-1,382=$692
• (Hint: it should be approximately equal to the 6th year
depreciation that fully depreciates the vehicle, that is,
$691.20)
• Taxes paid = 0.34(3,000 – 692) = 0.34*2,308 ≈ 785
• I over depreciated the car by $2,308. So I need to pay the
taxes on this difference.
• Therefore, after-tax cash flow from salvage is:
• $3000 – 785 = $2,215
6-24
6.2 The Baldwin Company
• Capital budgeting example.
• Sports equipment manufacturer (mostly golf
balls)
• Project: Colored bowling balls
• Questionnaires in test markets (Phil., LA, New
Haven): 10-15% of market share
• Need new machine, use existing (vacant)
building that otherwise could be sold.
• 5 year horizon (life of machine, after which
salvage value of $30,000)
6-25
The Baldwin Company
 Costs of test marketing (already spent): $250,000
 Current market value of proposed factory site (which
we own): $150,000
 Cost of bowling ball machine: $100,000 (depreciated
according to MACRS 5-year)
 Increase in net working capital (purchase raw material
before production→investment in inventory, cash
buffer against unforseen expenditures, cash from
sales will be received later→accounts receivable):
$10,000
 All working capital is assumed to be recovered at the
end (typical assumption in capital budgeting): all
inventory is sold; cash buffer is liquidated; all accounts
receivable are collected.
 Production (in units) by year during 5-year life of the
machine: 5,000, 8,000, 12,000, 10,000, 6,000
6-26
The Baldwin Company
Price during first year is $20; price increases
2% per year thereafter.
Production costs during first year are $10 per
unit and increase 10% per year thereafter.
Working Capital: initial $10,000 changes with
sales (analyst gives you figures)
Costs, revenues are in nominal $, and required
nominal return is 10%
6-27
The Baldwin Company
Year 0
Income:
(8) Sales Revenues
Year 1
Year 2
Year 3
Year 4 Year 5
100.00 163.20 249.70 212.24 129.89
Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
6-28
The Baldwin Company
Year 0
Income:
(8) Sales Revenues
(9) Operating costs
Year 1
Year 2
Year 3
Year 4 Year 5
100.00
50.00
163.20
88.00
249.70 212.24 129.89
145.20 133.10 87.85
Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
6-29
The Baldwin Company
Year 0
Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation
Year 1
Year 2
Year 3
Year 4 Year 5
100.00 163.20 249.70 212.24 129.89
50.00 88.00 145.20 133.10 87.85
20.00 32.00 19.20 11.52 11.52
Depreciation is calculated using the Modified
Accelerated Cost Recovery System (shown at
right).
Our cost basis is $100,000.
Depreciation charge in year 4
= $100,000×(.1152) = $11,520.
Year
ACRS %
1
20.00%
2
32.00%
3
19.20%
4
11.52%
5
11.52%
6
5.76%
Total 100.00%
6-30
The Baldwin Company
Year 0
Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation
(11) Income before taxes
[(8) – (9) - (10)]
(12) Tax at 34 percent
(13) Net Income
Year 1
Year 2
Year 3
Year 4 Year 5
100.00 163.20 249.70 212.24 129.89
50.00 88.00 145.20 133.10 87.85
20.00 32.00 19.20 11.52 11.52
30.00 43.20 85.30 67.62 30.53
10.20
19.80
14.69
28.51
29.00
56.30
22.99
44.63
10.38
20.15
Note: Assume 34% tax rate
6-31
The Baldwin Company: Incremental
After Tax Cash Flows: OCF
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
(1) Sales
Revenues
(2) Operating
costs
(3) Taxes
$100.00
$163.20
$249.70
$212.24
$129.89
-50.00
-88.00
-145.20
133.10
-87.85
-10.20
-14.69
-29.00
-22.99
-10.38
(4) OCF
(1) – (2) – (3)
39.80
60.51
75.50
56.15
31.67
OCF = Sales – Costs – Taxes (top-down approach)
6-32
The Baldwin Company: Cash Flows
from Investment
•
•
•
•
Three kinds:
1) the bowling ball machine
2) the warehouse
3) changes in net working capital
6-33
The Baldwin Company: Cash Flows
from Investment
• 1) the bowling ball machine
• Recall:
– $100,000 investment
– MACRS depreciation
– $30,000 salvage
• Imply depreciated value, end of year 5 =
$5760 (see next slide…)
6-34
The Baldwin Company: Cash Flows
from Investment
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Investments:
(1) Bowling ball machine
–100.00
(2) Accumulated
depreciation
(3) Adjusted basis of
machine after
depreciation (end of year)
Year 1
Year 2
Year 3
Year 4 Year 5
20.00
52.00
71.20
82.72
21.76*
94.24
80.00
48.00
28.80
17.28
5.76
6-35
The Baldwin Company: Cash Flows
from Investment
• 1) the bowling ball machine
• Recall:
– $100,000 investment
– MACRS depreciation
– $30,000 salvage
• Imply depreciated value, end of year 5 = $5760
• Therefore, year 5 taxes = .34 x (30,000-5760) = $8242
• Therefore, year 5 cash flow = $30,000 - $8242 =
$21,758
6-36
The Baldwin Company: Cash Flows
from Investment
•
•
•
•
•
Next:
2) the warehouse
Recall
$150,000 opportunity cost
Assume same sale value in 5 years (no
inflation!)
6-37
The Baldwin Company
Year 0
Investments:
(1) Bowling ball machine
(4) Opportunity cost
(warehouse)
Year 1
Year 2
Year 3
Year 4 Year 5
–100.00
21.76
–150.00
150.00
At the end of the project, the warehouse is unencumbered, so we can sell it if we want
to.
6-38
The Baldwin Company: Cash Flows
from Investment
• Finally:
• 3) changes in net working capital (given to you
by analyst)
6-39
The Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Year 1
Investments:
(1) Bowling ball machine
–100.00
(2) Accumulated
20.00
depreciation
(3) Adjusted basis of
80.00
machine after
depreciation (end of year)
(4) Opportunity cost
–150.00
(warehouse)
(5) Net working capital
10.00 10.00
(end of year)
(6) Change in net
–10.00
working capital
(7) Total cash flow of
–260.00
investment
[(1) + (4) + (6)]
Year 2
Year 3
Year 4 Year 5
52.00
71.20
82.72
21.76*
94.24
48.00
28.80
17.28
5.76
150.00
16.32
24.97
21.22
0
–6.32
–8.65
3.75
21.22
–6.32
–8.65
3.75
192.98
6-40
The Baldwin Company
• Adding it all together… and discounting at,
say, 10% cost of capital…
6-41
Incremental After Tax Cash Flows
(IATFC)
Year 0
(1) Sales
Revenues
(2) Operating
costs
(3) Taxes
(4) OCF
(1) – (2) – (3)
(5) Total CF of
Investment
(6) IATCF
[(4) + (5)]
Year 1
Year 2
Year 3
Year 4
Year 5
$100.00
$163.20
$249.70
$212.24
$129.89
-50.00
-88.00
-145.20
-133.10
-87.85
-10.20
-14.69
-29.00
-22.99
-10.38
39.80
60.51
75.50
56.15
31.67
–6.32
–8.65
3.75
192.98
54.19
66.85
59.90
224.65
–260.
–260.
NPV  $260 
NPV  $51.59
39.80
$39.80 $54.19 $66.85 $59.90 $224.66




2
3
4
(1.10) (1.10) (1.10) (1.10)
(1.10)5
6-42
NPV of Baldwin Company
CF0
CF1
F1
CF2
F2
CF3
–260
39.80
F3
CF4
1
F4
54.19
CF5
1
59.90
I
1
NPV
10
51.59
224.65
1
66.85
F5
1
6-43
Baldwin Company: What have we
done?
• Incremental cash flows, sunk costs do not
matter ($250,000 on test marketing),
opportunity costs (of warehouse) do matter
• Separation of financing from project
evaluation (interest is not considered here)
• How to estimate cash flows – as distinct from
accounting values (such as depreciation)
6-44
6.3 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 Rate) = (1 + Real Rate) × (1 + Inflation Rate)
Hence,
Real Interest Rate =
1+Nominal Interest Rate
−1
1+Inflation Rate
6-45
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.
6-46
Inflation and Capital Budgeting
• The approximation
Real Rate  Nominal Rate – Inflation Rate
• Is pretty good when inflation is low.
• Example 1: Country X has nominal interest rates of 10% and
inflation of 3%. What is real rate of interest?
• Truth: Real rate = [(1+nominal)/(1+infl.)]-1
• = (1.1/1.03)-1 = 6.8%
• Approximation: Real rate = Nominal – infl. = 7%
• However, example 2: Country Y has nominal interest rates
of 400% and inflation of 350%. What is real rate of
interest?
• Truth: Real rate = [(1+nominal)/(1+infl.)]-1
• = (5/4.5)-1 = 11.11%
• Approximation: Real rate = Nominal – infl. = 50%
6-47
6.5 Some Special Cases of Discounted
Cash Flow Analysis
• Cost-Cutting Proposals
• Investments of Unequal Lives
6-48
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.
6-49
Investments of Unequal Lives
• 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% discount rate, which one
should we choose?
6-50
Investments of Unequal Lives
Cadillac Air Cleaner
CF0
– 4,000
Cheapskate Air Cleaner
CF0
–1,000
CF1
–100
CF1
–500
F1
10
F1
5
I
10
I
10
NPV
–4,614.46
NPV
The Cheapskate cleaner has a higher NPV.
–2,895.39
6-51
Investments of Unequal Lives
• 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 (i.e., has a higher NPV).
6-52
Equivalent Annual Cost (EAC)
• This approach puts costs on a per year basis.
• The EAC is the value of the level payment annuity
that has the same PV as our original set of cash
flows.
• Find NPV, then compute payment PMT, where NPV
is the PV, N=number of years and I/Y=rate
– 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 (because it has higher costs).
6-53
Cadillac EAC with a Calculator
CF0
–4,000
CF1
N
10
–100
I/Y
10
F1
10
PV
–4,614.46
I
10
PMT
750.98
NPV
–4,614.46
FV
6-54
Cheapskate EAC with a Calculator
CF0
–1,000
CF1
N
5
–500
I/Y
10
F1
5
PV
-2,895.39
I
10
PMT
763.80
NPV
–2,895.39
FV
6-55
Replacement Chain Method
• Repeat projects until they have the same life.
• Given that Cadillac cleaner lasts twice as long, assume
that Cheapskate cleaner is purchased again in 5 years.
What is the NPV of the Cheapskate cleaner then?
• However, if one machine, say, 7 years and the other
machine lasted, say, 8 years,…
• …to get equal horizons the first machine should be
replicated 8 times and the second machine 7 times to
get 56 years for both (complicated).
• The EAC method is applicable to a more robust set of
circumstances.
6-56