Chapter 9 Making Capital Investment Decisions

Introduction
The cash flows that should be included in a capital budgeting analysis are those that will only
occur if the project is accepted
These cash flows are called incremental cash flows
The stand-alone principle allows us to analyze each project in isolation from the firm simply by
focusing on incremental cash flows
Cash flow estimation is the most important step in the capital budgeting. It is also the most
difficult. In large firms, many departments are involved:
Marketing
Engineering
Operations
Accounting
Personnel
Because of its difficulty, forecast errors can be large thus making poor projects can appear to be
good and good project appear poor. It does not matter what type of analytical technique is used,
if the cash flows contain large errors, poor decisions can be made.
The role of financial staffs in the forecasting process
Coordinating the efforts of the other departments
Ensuring all participants use a consistent set of economic assumptions
Assure there are no biases inherent in the forecast
Too estimate cash flows; we must identify the relevant cash flows. We want to use cash flows
not accounting income.
The incremental cash flows, for project evaluation, consist of any and all changes in a firms
future cash flows that are a direct consequence of taking the project.
Sunk Costs
Opportunity Costs
Turning a building we own into a condo complex. The opportunity costs would be the
market value of the building.
Fin 311 Chapter 9 Lecture Notes
Page 1

Externalities or Side effects

Erosion:

Opening a new branch for a bank.

Synergy
Shipping and Installation Costs
Changes in Net Working Capital
Normally, a new project will require some investment in new inventory and accounts like
that. This increases net working capital and should be considered in the analysis.
Financing Costs
Not considered in cash flows.
Other Issues
When the flows actually occur
After-tax cash flows

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Fin 311 Chapter 9 Lecture Notes

A company is considering a new project that will last for five years. The equipment necessary
for production will cost $400,000 and will be depreciated on a straight-line basis to a zero
salvage value. The project will generate sales of $300,000 per year. Variable costs are 40
percent of sales and fixed costs are $30,000. The project will require an initial investment of
$50,000 in net working capital. The tax rate is 30 percent and the required return is 12 percent.
What is the payback period, NPV, and IRR?
Initial Investment
Equip:

-400,000

NWC

-50,000

Net Investment (CF0) -$450,000

OCF
Sales $300,000

Remember:

VC

120,000

OCF = EBIT + Dep - Taxes

FC

30,000

OCF = 70,000 + 80,000 21,000

Dep

80,000

OCF = 129,000

EBT

$70,000

Tax

21,000

NI

$49,000

Another way:
OCF = NI + Dep
OCF = 49,000 + 80,000
OCF = 129,000

Non-OCF or Terminal Year CF

After-Tax Salvage Value

Return of NWC

50,000

Non-OCF

50,000

NPV/IRR Calculation
CF0

-450,000

CF1

129,000

F1 4

CF2

129,000 + 50,000 = 179,000

F2 1

12%

CPT NPV
CPT IRR
Payback

$43,387.47
15.65%
3.49 years

Fin 311 Chapter 9 Lecture Notes

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Here is another way to approach this problem. It is called the Tax Shield approach and is used to
calculate the OCF.
OCF = [Sales Costs](1 TC) + Depreciation(TC)
OCF = [(P)Q (VC)Q FC](1 TC) + Depreciation(TC)
Initial Investment
Equip:

-400,000

NWC

-50,000

Net Investment (CF0) -$450,000

OCF
OCF = [Sales - Costs](1 TC) + Depreciation(TC)
OCF1 5 = (300,000 (0.40)(300,000) 30,000)(1 0.30) + (80,000)(0.30)
OCF1 5 = 129,000
Non-OCF or Terminal Year CF
After-Tax Salvage Value

Return of NWC

50,000

Non-OCF

50,000

NPV/IRR Calculation
CF0

-450,000

CF1

129,000

F1 4

CF2

129,000 + 50,000 = 179,000

F2 1

12%

CPT NPV
CPT IRR
Payback

$43,387.47
15.65%
3.49 years

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Fin 311 Chapter 9 Lecture Notes

Aunt Sallys Sauces is considering expansion into a new line of all natural tomato sauces. Sally
paid $50,000 for a marketing study that determined sales for the product will be $650,000 per
year for five years. Equipment will cost $500,000 and will be depreciated on a straight-line
manner to zero over the five-year life of the project. The equipment will have a salvage value of
$50,000 in five years. Annual fixed costs are projected at $80,000 per year and variable costs are
60 percent of sales. Net working capital in the amount of $75,000 is needed at the beginning of
the project. The tax rate is 40 percent and the required return is 15 percent. What is the payback
period, NPV, and IRR?
Initial Investment
Equip:

-500,000

NWC

-75,000

Net Investment (CF0) -$575,000

OCF
OCF = [(P)Q (VC)Q FC](1 TC) + Depreciation(TC)
OCF1 5 = (650,000 (0.60)(650,000) 80,000)(1 0.40) + (100,000)(0.40)
OCF1 5 = 148,000
Non-OCF or Terminal Year CF
After-Tax Salvage Value

30,000

Return of NWC

75,000

Non-OCF

SV - (SV BV)TC = 50,000 - ($50,000 0)(.40)

105,000

NPV/IRR Calculation
CF0

-575,000

CF1

148,000

F1 4

CF2

148,000 + 105,000 = 253,000

F2 1

15%

CPT NPV
CPT IRR
Payback

-$26,667.49
13.17%
3.89 years

Fin 311 Chapter 9 Lecture Notes

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Replacement Analysis
A firm is considering an investment in a new machine with a price of $23 million to replace its
existing machine. The current machine has a book value of $6 million, and a market value of
$10.5 million. The new machine is expected to have a four-year life, and the old machine has
four years left in which it can be used. If the firm replaces the old machine with the new
machine, it expects to save $5 million in operating costs each year over the next four years. Both
machines will have no salvage value in four years. If the firm purchases the new machine, it will
also need an investment of $400,000 in net working capital. The required return on the
investment is 10 percent, and the tax rate is 40 percent. What is the NPV and IRR of the decision
to replace the old machine?
Initial Investment
Buy new machine Keep old machine Incremental analysis
Purchase new machine
$23,000,000
$23,000,000
Net working capital
400,000
400,000
Sell (buy) old machine
$10,500,000
10,500,000
Taxes on old machine
1,800,000
1,800,000
Total
$23,400,000
$8,700,000
$14,700,000
or
New Equip:
Old EquipAT:
NWC

-23,000,000
8,700,000

SV - (SV BV)TC = 10.5 - ($10.5 6)(.40)

-400,000

Net Investment (CF0) -$14,700,000

OCF
Buy new machine Keep old machine Incremental analysis
Operating expense
$5,000,000
$5,000,000
Depreciation
5,750,000
$1,500,000
4,250,000
EBT
$750,000
$1,500,000
$750,000
Taxes
300,000
600,000
300,000
Net income
$450,000
$900,000
$450,000
OCF
$5,300,000
$600,000
$4,700,000
or
OCF = [Sales - Costs](1 TC) + Depreciation(TC)
OCF1 4 = (0 (-5,000,000))(1 0.40) + (5,750,000 1,500,000)(0.40)
OCF1 4 = 4,700,000

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Fin 311 Chapter 9 Lecture Notes

Non-OCF or Terminal Year CF

After-Tax Salvage Value

Return of NWC

400,000

Non-OCF

400,000

NPV/IRR Calculation
Year
0
1
2
3
4
NPV
IRR

Buy new machine Keep old machine Incremental analysis

Cash flow
Cash flow
Cash flow
$23,400,000
$8,700,000
$14,700,000
5,300,000
600,000
4,700,000
5,300,000
600,000
4,700,000
5,300,000
600,000
4,700,000
5,700,000
600,000
5,100,000
$6,326,507.75
-3.09%

$6,798,080.73
-37.07%

$471,572.98
11.46%

or
CF0

-14,700,000

CF1

4,700,000

F1 3

CF2

4,700,000 + 400,000 = 5,100,000

F2 1

10%

CPT NPV

$471,572.98

CPT IRR

11.46%

Fin 311 Chapter 9 Lecture Notes

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Expansion Project using MACRS Depreciation

A company is considering a new project that will generate sales of $1.6 million, $2 million, $1.9
million, and $1.4 million over the next four years. The variable costs are 30 percent of sales and
fixed costs are $400,000. The equipment necessary for the project costs $1.5 million and will be
depreciated on a 3-year MACRS schedule. The equipment will be worth $100,000 in four years.
The project will require an immediate investment in net working capital of $350,000. The tax
rate is 40 percent and the required return is 11 percent. What is the payback period, NPV, and
IRR?
Initial Investment
Equipment

-$1,500,000

NWC

Depreciation Calculations

-350,000

Year Factor

Depreciation

Net Investment (CF0) -$1,850,000

1 0.3333

499,950

2 0.4444

666,600

3 0.1482

222,300

4 0.0741

111,150

100%

1,500,000

OCF
OCF = [(P)Q (VC)Q FC](1 TC) + Depreciation(TC)
OCF1 = (1,600,000 (0.30)(1,600,000) 400,000)(1 0.40) + (499,950)(0.40) = 631,980
OCF2 = (2,000,000 (0.30)(2,000,000) 400,000)(1 0.40) + (666,600)(0.40) = 866,640
OCF3 = (1,900,000 (0.30)(1,900,000) 400,000)(1 0.40) + (222,300)(0.40) = 646,920
OCF4 = (1,400,000 (0.30)(1,400,000) 400,000)(1 0.40) + (111,150)(0.40) = 392,460
Non-OCF or Terminal Year CF
After-Tax Salvage Value

60,000

Return of NWC

350,000

Non-OCF

410,000

SV - (SV BV)TC = 100,000 - ($100,000 0)(.40)

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Fin 311 Chapter 9 Lecture Notes

NPV/IRR Calculation
CF0

-1,850,000

CF1

631,980

F1 1

CF2

866,640

F2 1

CF3

646,920

F3 1

CF4

392,460 + 410,000 = 802,460

F4 1

11%

CPT NPV
CPT IRR

424,363.40
21.11%

Fin 311 Chapter 9 Lecture Notes

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Replacement Project using MACRS Depreciation

Original Machine

New Machine

Purchased 5 years ago

5-year life

Initial cost

100,000

3-year MACRS
depreciation

Annual depreciation

9,000

Initial cost

150,000

Book Value today

55,000

Cost savings

50,000 per year

Salvage today

65,000

Salvage in 5 years

Salvage in 5 years

10,000

Required return = 10%

Tax rate = 40%
Initial Investment
Equip (New)

-150,000

Equip (Old)AT

+61,000

= 65,000 (0.4)((65,000
55,000)

Net Investment (CF0) -$89,000

OCF
OCF1 = (0 - (-50,000))(1 0.40) + [(0.33)(150,000) 9,000](0.40) = 46,200
OCF2 = 30,000 + [(0.45)(150,000) 9,000](0.40) = 53,400
OCF3 = 30,000 + [(0.15)(150,000) 9,000](0.40) = 35,400
OCF4 = 30,000 + [(0.07)(150,000) 9,000](0.40) = 30,600
OCF5 = 30,000 + ( 9,000)(0.40) = 26,400
Non-OCF or Terminal Year CF
SVOld

-10,000

Total: -10,000

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Fin 311 Chapter 9 Lecture Notes

NPV Calculation
CF0

-89,000

CF1

46,200

F1 1

CF2

53,400

F2 1

CF3

35,400

F3 1

CF4

30,600

F4 1

CF5

26,400 10,000 = 16,400

F5 1

10%

CPT NPV
CPT IRR

$54,812.10
36.28%

Fin 311 Chapter 9 Lecture Notes

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Strategic Options
Option to expand
Option to wait
Option to abandon
Strategic options Sticking our toe in the water

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Fin 311 Chapter 9 Lecture Notes