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Chapter 10

Making Capital Investment


Decisions

Prepared by Anne Inglis, CFA

2016 McGraw-Hill Education Limited


Key Concepts and Skills
Understand how to determine the relevant cash
flows for a proposed project
Know how to project the cash flows and
determine if a project is acceptable
Understand the various methods for computing
operating cash flow
Be able to compute the CCA tax shield
Know how to evaluate cost-cutting proposals
Be able to analyze replacement decisions
Understand how to evaluate the equivalent
annual cost of a project
Know how to set a bid price for a project
2016 McGraw-Hill Education Limited 10-1
Chapter Outline
Project Cash Flows: A First Look
Incremental Cash Flows
Pro Forma Financial Statements and Project Cash Flows
More on Project Cash Flow
Alternative Definitions of Operating Cash Flow
Applying the Tax Shield Approach to the Majestic Mulch
and Compost Company Project
Some Special Cases of Discounted Cash Flow Analysis
Summary and Conclusions
Appendix A More on Inflation and Capital Budgeting
Appendix B Capital Budgeting with Spreadsheets

2016 McGraw-Hill Education Limited 10-2


LO1
Relevant Cash Flows 10.1
The cash flows that should be included in a
capital budgeting analysis are those that
will only occur (or not 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
2016 McGraw-Hill Education Limited 10-3
LO1
Asking the Right Question
You should always ask yourself Will this
cash flow occur (or not 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
If the answer is part of it, then we should
include the part that occurs (or does not occur)
because of the project
2016 McGraw-Hill Education Limited 10-4
LO1
Common Types of Cash Flows
10.2
Sunk costs costs that have been incurred in the
past
Opportunity costs costs of lost options
Side effects
Positive side effects benefits to other projects
Negative side effects costs to other projects
Changes in net working capital
Financing costs
Inflation
Capital Cost Allowance (CCA)

2016 McGraw-Hill Education Limited 10-5


LO2
Pro Forma Statements and Cash
Flow 10.3
Capital budgeting relies heavily on pro
forma accounting statements, particularly
statements of comprehensive income
Computing cash flows refresher
Operating Cash Flow (OCF) = EBIT +
depreciation taxes
Cash Flow From Assets (CFFA) = OCF net
capital spending (NCS) changes in NWC

2016 McGraw-Hill Education Limited 10-6


Example New Bottling Machine?
ABC Corporation is considering buying a new
bottling machine for $90,000. The machine will
be good for 3 years and will allow the company
to process and sell an additional 50,000 bottles
per year at $4 per bottle. Variable costs will be
$2.50 per unit. Fixed costs will be $12,000 per
year. This project will require an upfront
investment in inventory of $20,000 that will be
reclaimed at the end of the project. Depreciation
will be straight line with no salvage. The tax rate
is 34% and the required return is 20%.
10-7
LO2
Example: Pro Forma Statement
of Comprehensive Income
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780

2016 McGraw-Hill Education Limited 10-8


LO2 Example: Projected Capital Requirements

Year

0 1 2 3

NWC $20,000 $20,000 $20,000 $20,000

Net Fixed 90,000 60,000 30,000 0


Assets
Total $s $110,000 $80,000 $50,000 $20,000
Invested

2016 McGraw-Hill Education Limited 10-9


LO2
Example: Projected Incremental
Cash Flows
Year
0 1 2 3

OCF $51,780 $51,780 $51,780


Change -$20,000 20,000
in NWC

Capital -$90,000
Spending

CFFA -$110,000 $51,780 $51,780 $71,780

2016 McGraw-Hill Education Limited 10-10


LO2
Making The Decision
Now that we have the cash flows, we can
apply the techniques that we learned in
chapter 9
Assume the required return is 20%
Enter the cash flows into the calculator and
compute NPV and IRR
CF0 = -110,000; C01 = 51,780; F01 = 2; C02 =
71,780
NPV; I = 20; CPT NPV = 10,648
CPT IRR = 25.8%
Should we accept or reject the project?
2016 McGraw-Hill Education Limited 10-11
LO1
More on NWC 10.4
Why do we have to consider changes in
NWC separately?
GAAP requires that sales be recorded on the
statement of comprehensive income when
made, not when cash is received
GAAP also requires that we record cost of
goods sold when the corresponding sales are
made, regardless of whether we have actually
paid our suppliers yet
Finally, we have to buy inventory to support
sales although we havent collected cash yet

2016 McGraw-Hill Education Limited 10-12


LO1
NWC Example
CWT Corp. reported sales of $998 and
costs of $734. We have the following info:
Beginning Ending
Accounts receivable $100 $110
Inventory 100 80
Accounts payable 100 70
Net working capital $100 $120

What are the cash inflows? Cash


outflows? What is net cash flow?

10-13
LO1
NWC Example - continued
Cash Inflows = Sales Increase in A/R =
998 (110 100) = 988
Cash Outflows = Costs Increase in A/P +
Increase in Inventory = 734 (70 100) +
(80 100) = 744
Net Cash Flow = Cash Inflow Cash
Outflow = 988 744 = 244

10-14
LO1
NWC Example - continued
Or alternatively:
Change in NWC = Increase in A/R +
Increase in Inventory Increase in A/P =
10 + (-20) (-30) = 20
Net Cash Flow = Sales Costs Change
in NWC = 998 734 20 = 244

10-15
LO4
Capital Cost Allowance (CCA)
CCA is depreciation for tax purposes
The depreciation expense used for capital
budgeting should be calculated according
to the CCA schedule dictated by the tax
code
Depreciation itself is a non-cash expense,
consequently, it is only relevant because it
affects taxes
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate
2016 McGraw-Hill Education Limited 10-16
LO4
Computing Depreciation
Need to know which asset class is appropriate
for tax purposes
Straight-line depreciation
D = (Initial cost salvage) / number of years
Very few assets are depreciated straight-line for tax
purposes
Declining Balance
Multiply percentage given in CCA table by the un-
depreciated capital cost (UCC)
Half-year rule
Can use PV of CCA Tax Shield Formula:
2016 McGraw-Hill Education Limited 10-17
LO4
PV of CCA Tax Shield Formula
IdTc 1 0.5r S n dTc 1
PV tax shield on CCA
d r 1 r d r (1 r ) n

Where:
I = Total Capital Investment
d = CCA tax rate
Tc = Corporate Tax Rate
r = discount rate
Sn = Salvage value in year n
n = number of periods in the project

2016 McGraw-Hill Education Limited 10-18


Example: Depreciation and
LO4
Salvage
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 companys marginal tax rate is
40%. If the applicable CCA rate is 20%
and the required return on this project is
10%, what is the present value of the CCA
tax shield?
2016 McGraw-Hill Education Limited 10-19
LO4
Example: Depreciation and Salvage
continued
The delivery and installation costs are
capitalized in the cost of the equipment
110,000 0.20 0.40 1 0.5 0.10
PV tax shield on CCA
0.20 0.10 1 0.10

17,000 0.20 0.40 1



0.20 0.10 (1 0.10) 6

25,441.05

2016 McGraw-Hill Education Limited 10-20


LO3
Other Methods for Computing
OCF 10.5
Bottom-Up Approach
Works only when there is no interest expense
OCF = NI + depreciation
Top-Down Approach
OCF = Sales Costs Taxes
Dont subtract non-cash deductions
Tax Shield Approach
OCF = (Sales Costs)(1 T) +
Depreciation*T
2016 McGraw-Hill Education Limited 10-21
LO4
Salvage Value versus UCC 10.6

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LO5
Example: Cost Cutting 10.7
Your company is considering a new production
system that will initially cost $1 million. It will
save $300,000 a year in inventory and
receivables management costs. The system is
expected to last for five years and will be
depreciated at a CCA rate of 20%. The system is
expected to have a salvage value of $50,000 at
the end of year 5. There is no impact on net
working capital. The marginal tax rate is 40%.
The required return is 8%.
Click on the Excel icon to work through the
example 10-23
2016 McGraw-Hill Education Limited
LO6
Example: Replacement Problem
Original Machine New Machine
Initial cost = 100,000 Initial cost = 150,000
CCA rate = 20% 5-year life
Purchased 5 years ago Salvage in 5 years = 0
Salvage today = Cost savings = 50,000
65,000 per year
Salvage in 5 years = CCA rate = 20%
10,000 Required return =
10%
Tax rate = 40%

2016 McGraw-Hill Education Limited 10-24


Example: Replacement Problem
LO6
continued
Remember that we are interested in
incremental cash flows
If we buy the new machine, then we will
sell the old machine
What are the cash flow consequences of
selling the old machine today instead of in
5 years?

2016 McGraw-Hill Education Limited 10-25


LO6
Example: Replacement Problem
continued
If we sell the old equipment today, then we
will receive $65,000 today. However, we
will also NOT receive $10,000 in 5 years
The appropriate number to use in the NPV
analysis is the net salvage value
Always consider after-tax cash flows
You can use your calculator for the cash
flows and salvage, but there are no short
cuts for finding the PV of the CCA tax
shield 10-26
2016 McGraw-Hill Education Limited
LO6
Example: Replacement Problem
continued
Net present value of the project is:
1
1 5 10,000
NPV 150,000 65,000 50,000(1 0.4) 1.1 5
0 .10 1.10

65,000 0.2 0.4 1 0.5 0.1 10,000 0.2 0.4 1



0.10 0.20 1.10 0.10 0.20 1.105

150,000 0.2 0.4 1 0.5 0.1



0.10 0.20 1.10

NPV 45,806.54

Therefore, the old equipment should be


replaced.
2016 McGraw-Hill Education Limited 10-27
LO7
Example: Equivalent Annual Cost
Analysis
Machine A Machine B
Initial Cost = $150,000 Initial Cost = $100,000
Pre-tax operating cost Pre-tax operating cost
= $65,000 = $57,500
Expected life is 8 years Expected life is 6 years

The machine chosen will be replaced indefinitely and neither


machine will have a differential impact on revenue. No change
in NWC is required.
The required return is 10%, the applicable CCA rate is 20%
and the tax rate is 40%.
Which machine should you buy?
2016 McGraw-Hill Education Limited 10-28
LO8
Example: Setting the Bid Price
Consider the example in the textbook:
Need to produce 5 modified trucks per year for 4 years
We can buy the truck platforms for $10,000 each
Facilities will be leased for $24,000 per year
Labour and material costs are $4,000 per truck
Need $60,000 investment in new equipment,
depreciated at 20% (CCA class 8)
Expect to sell equipment for $5,000 at the end of 4
years
Need $40,000 in net working capital
Tax rate is 43.5%
Required return is 20%
2016 McGraw-Hill Education Limited 10-29
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 the basic process for finding the
bid price?
What is equivalent annual cost and when
should it be used?
2016 McGraw-Hill Education Limited 10-30
Summary 10.8
You should know:
How to determine the relevant incremental cash flows
that should be considered in capital budgeting
decisions
How to calculate the CCA tax shield for a given
investment
How to perform a capital budgeting analysis for:
Replacement problems
Cost cutting problems
Bid setting problems
Projects of different lives

2016 McGraw-Hill Education Limited 10-31


Appendix A Impact of Inflation
The interest rate used in the capital
budgeting analysis can be in either
nominal or real terms
Real Rate = Nominal Rate Expected Inflation
Also, cash flows can be either nominal or
real

2016 McGraw-Hill Education Limited


10-32
How to handle inflation
Key Be consistent
Nominal cash flows must be discounted by the
nominal discount rate
Real cash flows must be discounted by the
real discount rate
NPV is the same under the two different
approaches
Use the approach that is simpler for the
information that youre given
2016 McGraw-Hill Education Limited
10-33
Appendix B Capital Budgeting
with Spreadsheets
Spreadsheets are almost essential for
capital budgeting, especially when using
pro forma statements
Since spreadsheets completely integrate
the different tables needed for the capital
budgeting analysis, changing on variable
instantly recalculates the results for the
entire spreadsheet
Very useful for sensitivity analysis
calculations
2016 McGraw-Hill Education Limited 10-34