IBA, Main Campus

Financial Management
Capital Budgeting
Making Capital Investment Decisions
Ch 10 - Ross, Westerfield & Jordan

by

M. Yousuf Saudagar
ysaudagar@iba.edu.pk

1
 Learning today
• So far, we’ve covered various parts of the capital budgeting decision.

• Our task in these sessions is to start bringing these pieces together.

• In particular, we will se you how to “spread the numbers” for a

proposed investment or project & based on those numbers, make an
initial assessment about whether the project should be undertaken.

• In the discussion that follows, we focus on the process of setting up a

discounted cash flow analysis.

• From our earlier sessions, we know that the projected future cash
flows are the key element in such an evaluation.

• Accordingly, we emphasize working with financial and accounting

information to come up with these figures.

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 Learning today
• This chapter follows up on our previous one by delving more deeply
into capital budgeting. We have two main tasks:

1. In evaluating a proposed investment, we pay special attention to

deciding what information is relevant to the decision at hand and
what information is not.

First, recall that in the last chapter, we saw that cash flow estimates
are the critical input into a net present value analysis, but we didn’t
say much about where these cash flows come from; so we will now
examine this question in some detail.

2. Our second goal is to learn how to critically examine NPV

estimates(estimates such as Cashflows or discount rate).

In particular, how to evaluate the sensitivity of NPV estimates to

assumptions made about the uncertain future.
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 Learning today
• After studying this chapter, you should understand:

a) How to determine the relevant cash flows for a proposed

project.

b) How to determine if a project is acceptable.

c) How to set a bid price for a project.

d) How to evaluate the equivalent annual cost of a project.

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 RELEVANT & irrelevant CASH FLOWS
{{{
• The effect of taking a project is to change the firm’s overall cash flows
today and in the future.(preferably to increase the value or wealth)

• To evaluate a proposed investment, we must consider the changes in

the firm’s cash flows(in other words, we need to know which
factors, if changed, would increase cashflows and thereby add
value) and then decide whether they add value to the firm.

• The first and most important step is to decide which cash flows are
relevant.(in short, which cash flows should we be focusing on)

• A relevant cash flow for a project is a change in the firm’s overall

future cash flow that comes about as a direct consequence of the
decision to take that project.

• Because the relevant cash flows are defined in terms of changes in, or
increments to, the firm’s existing cash flow, they are called the
incremental cash flows associated with the project. 5
 incremental CASH FLOWS
• The concept of incremental cash{{{flow is central to our analysis, so we
state a general definition and refer back to it as needed:

• The incremental cash flows for project evaluation consist of any and
all changes in the firm’s future cash flows that are a direct
consequence of taking the project.

• Incremental cash flows are:

• The difference between a firm’s future cash flows with a project and
those without the project.

• This definition of incremental cash flows has an obvious & important

corollary:

• Any cash flow that exists regardless of whether or not a project is

undertaken is not relevant or irrelevant cash flows.
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 THE STAND-ALONE PRINCIPLE

• In practice, it would be cumbersome to actually calculate the future

total cash flows to the firm with and without a project, especially for
a large firm. Fortunately, it is not really necessary to do so.

• Once we identify the effect of undertaking the proposed project on

the firm’s cash flows, we need focus only on the project’s resulting
incremental cash flows. This is called the stand-alone principle .

• The stand-alone principle says is that once we have determined the

incremental cash flows from undertaking a project, we can view that
project as a kind of “mini-firm” with its own future revenues and
costs, its own assets, and, of course, its own cash flows.

• We will then be primarily interested in comparing the cash flows

from this mini-firm to the cost of acquiring it. An important
consequence of this approach is that we will be evaluating the
proposed project purely on its own merits, in isolation from any other
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activities or projects.
 some pitfalls in Incremental Cash Flows
• We are concerned here with only cash flows that are incremental and
that result from a project.

• Looking back at our general definition, we might think it would be

easy to decide whether a cash flow is incremental. Even so, in a few
situations it is easy to make mistakes.
• Here, we describe some common pitfalls & how to avoid them:
1. Sunk Costs
2. Opportunity Costs
3. Side Effects
4. Net Working Capital
5. Financing Costs
6. Actual Vs Accruals
7. After Tax 8
 SUNK COSTS

• A sunk cost is a cost we have already paid or have already incurred

the liability to pay. Such a cost cannot be changed by the decision
today to accept or reject a project. Put another way, the firm will
have to pay this cost no matter what.

• Based on our definition of incremental cash flow, such a cost is clearly

not relevant to the decision at hand. So, we will always be careful to
exclude sunk costs from our analysis.

• For example, suppose General Milk Company hires a financial

consultant to help evaluate whether a line of chocolate milk should
be launched. When the consultant turns in the report, General Milk
objects to the analysis because the consultant did not include the
hefty consulting fee as a cost of the chocolate milk project.

• Who is correct? The consulting fee is a sunk cost: It must be paid

whether or not the chocolate milk line is actually launched 9
 OPPORTUNITY COSTS
• An opportunity cost is slightly different from out-of-pocket-cost; it
requires us to give up a benefit.

• Suppose a firm already owns some of the assets a proposed project

will be using e.g. we might be thinking of converting an old cotton
mill(Asset/Plant) we bought years ago for $100,000 into up-market
condominiums.

• If we undertake this project, there will be no direct cash outflow

because we already own it.

• For purposes of evaluating the condo project, should we then treat

the mill as “free”?

• The answer is no.

• The mill is a valuable resource used by the project. We can sell it.
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 OPPORTUNITY COSTS
• There is another issue here.

• Once we agree that the use of the mill has an opportunity cost, how
much should we charge the condo project for this use?

• Given that we paid $100,000, it might seem that we should charge

this amount to the condo project. Is this correct? No, it is not.

• The fact that we paid $100,000 is irrelevant (sunk cost). The fact we
could have sold it for 105,000 (opportunity cost)

• That cost is sunk.

• At a minimum, the opportunity cost that we charge the project is

what the mill would sell for today because this is the amount we give
up by using the mill instead of selling it.
Hence, our opportunity cost here is the amount that we could have
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earned—not paid—if we had sold the mill instead of investing in the
 SIDE EFFECTS
• Remember that the incremental cash flows for a project include all
the resulting changes in the firm’s future cash flows.

• It would not be unusual for a project to have side, or spillover, effects,

both good and bad.

• For example, in 2008, the time between the theatrical release of a

feature film and the release of the DVD had shrunk to 98 days
compared to 200 days in 1998.

• Of course, retailers cheered the move because it was credited with

increasing DVD sales.

• A negative impact on the cash flows of an existing product from the

introduction of a new product is called erosion . (products must be
mutually exclusive)

• In this case, the cash flows from the new line should be adjusted 12
 SIDE EFFECTS
• It is important to recognize that any sales lost as a result of launching
a new product might be lost anyway because of future competition.

• Erosion is relevant only when the sales would not otherwise be lost.

• Side effects show up in a lot of different ways. For example, one of

Walt Disney Company’s concerns when it built Euro Disney was that
the new park would drain visitors from the Florida park, a popular
vacation destination for Europeans.

• There are beneficial spillover effects, of course.

• When the price of a printer that sold for $500 to $600 in 1994
declined to below $100 by 2009, HP realized that the big money is in
the consumables that printer owners buy to keep their printers going,
such as ink-jet cartridges, laser toner cartridges, and special paper.

• The profit margins for these products are substantial. 13

 NET WORKING CAPITAL

• Normally a project will require that the firm invest in net working
capital in addition to long-term assets.

• For example, a project will generally need some amount of cash on

hand to pay expenses.

• In addition, a project will need an initial investment in inventories &

accounts receivable (to cover credit sales).

• Some of the financing for this will be in the form of amounts owed to
suppliers (accounts payable), but the firm will have to supply the
balance.

• This balance represents the investment in net working capital.

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 NET WORKING CAPITAL

• It’s easy to overlook an important feature of net working capital in

capital budgeting.

• As a project winds down, inventories are sold, receivables are

collected, bills are paid, and cash balances can be drawn down.

• These activities free up the net working capital originally invested.

• So the firm’s investment in project net working capital closely

resembles a loan.

• The firm supplies working capital at the beginning when it puts up a

project and recovers it toward the end when it winds up.

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 FINANCING COSTS

• In analyzing a proposed investment, we will not include interest paid

or any financing costs e.g. dividends or principal repaid(kyun k hum
sirf aur sirf initial cost of acquiring project dekh rahe h. Interest
wagera management k operations me aajata h. Imagine the example
of person who invested his own money.because we are interested in
the cash flow generated by the assets of the project.

• As we saw earlier, interest paid, is a component of cash flow to

creditors, not cash flow from assets.(we would only record cash
inflows and outflows from the assets)

• More generally, our goal in project evaluation is to compare the cash

flow from a project to the cost of acquiring that project in order to
estimate NPV.

• The particular mixture of debt & equity a firm actually chooses to use
in financing a project is a managerial variable & primarily determines
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how project cash flow is divided between owners & creditors.
 OTHER ISSUES - Actual Vs Accruals & After Tax
• There are some other things to watch out for.

Actual Vs Accruals:
• First, we are interested only in measuring cash flow.
• Moreover, we are interested in measuring it when it actually occurs,
not when it accrues in an accounting sense.
After-tax Cash Flow:
• Second, we are always interested in after-tax cash flow because taxes
are definitely a cash outflow.
• In fact, whenever we write incremental cash flows , we mean after-
tax incremental cash flows.

• Remember, however, that after-tax cash flow and accounting profit,

or net income, are entirely different things. (because the accounting
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profit also includes receivables)
 Pro Forma Financial Statements and Project Cash Flows
• The first thing we need when we begin evaluating a proposed
investment is a set of pro forma, or projected, financial statements.
Given these, we can develop the projected cash flows. Once we have
the cash flows, we can estimate the value of the project using the
techniques we described in the previous sessions.
• Pro forma financial statements are a convenient and easily
understood means of summarizing much of the relevant information
for a project. To prepare these statements, we will need estimates of:
a) Quantities such as unit sales
b) The selling price per unit
c) The variable cost per unit, and
d) Total fixed costs.
We will also need to know:
e) The total investment required
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 Illustration –finding net income
• Suppose we think we can sell 50,000 cans of shark attractant per year
at a price of $4 per can.
• It costs us $2.50 per can to make the attractant
• New product such as this one typically has only a three-year life.
• We require a 20% return on new products.
• Fixed costs for the project will be $12,000 per year, including rent on
the production facility,.
• Further, we will need to invest $90,000 in manufacturing equipment.
• For simplicity, we will assume that this $90,000 will be 100%
depreciated over the three-year life of the project.
• Furthermore, the cost of removing the equipment will roughly equal
its actual value in three years, so it will be essentially worthless on a
market value basis as well.
• Finally, the project will require an initial $20,000 investment in net
working capital, and the Tax rate is 34%. 19
 Projected Income Statement & Capital Requirements

(Outstanding)

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 PROJECT CASH FLOWS
• At this point, we need to start converting this accounting information
into cash flows.

• To develop the cash flows from a project, we need to recall that cash
flow from assets has three components:
1. Operating cash flow
2. Capital spending, and
3. Changes in net working capital.
• To evaluate a project or mini-firm, we need to estimate each of these.

• Once we have estimates of the components of cash flow, we will

calculate cash flow for our mini-firm just as we did earlier for an
entire firm.

• Project cash flow = Project operating cash flow - Project change in

net working capital - Project capital spending 21
 Project Operating Cash Flow
• Operating cash flow = EBIT + Depreciation - Taxes
• To illustrate the calculation we’ll use the projections from the project.

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 PROJECTED TOTAL CASH FLOW AND VALUE
Now that we have cash flow projections, we are ready to apply the various
criteria we discussed in the last chapter.
2 3
1. NPV(@r 20%) = -110,000+51,780/1.2+51,780/1.2+71,780/1.2=10,648

Thus, the project creates over $10,000 in value and should be accepted.
Also, the return on this investment obviously exceeds 20% (because the
NPV is positive at 20%).

2. IRR With trial & error, we find that the IRR = 25.8%.

3. Payback period = 2.1 years.

4. AAR = average net income divided by average book value. The net income
= $21,780. The average of 4 book values for total investment is ($110 + 80
+ 50 + 20)/4 = $65 or $21,780/65,000 = 33.51%.

We’ve seen that the return on this investment (the IRR) is about 26%. The
fact that the AAR is larger illustrates again why the AAR cannot be 23
 A CLOSER LOOK AT NET WORKING CAPITAL
• In calculating OCF, we did not consider the fact that some of our sales might be on
credit. Also, we may not have actually paid some of the costs shown. In either case, the
cash flow in question would not yet have occurred.
• We show here that these possibilities are not a problem as long as we don’t forget to
include changes in net working capital. Let’s assume simplified IS:

• Depreciation and taxes are zero. No fixed assets are purchased during the year. Also, we
assume that the only components of net working capital are accounts receivable and
payable.

• Notice that net working capital actually declined by $25

• Total cash flow = Operating cash flow - Change in NWC – Cap. spending 24
 Concept
• We can also ask what were cash revenues & what were cash costs?
• To determine cash revenues, we need to look closely at net working capital.
• Cash Inflow: During the year, we had sales of $500. However, accounts
receivable rose by $30 over the same time period. Thus the $30 increase tells us
that sales exceeded collections by $30. In other words, we haven’t yet received
the cash from $30 of the $500 in sales. As a result, our cash inflow is $500 - 30 =
$470.
• Cash outflows: Costs is $310 on the income statement, but accounts payable
increased by $55 during the year. This means that we have not yet paid $55 of
the $310, so cash costs for the period are just $310 - 55 = $255.
Putting this information together, we se that cash inflows less cash outflows are:
$470 - 255 = $215, just as we had before.
Cash flow = Cash inflow - Cash outflow
= ($500–30) - (310-55) = 215; ($500 - 310) - (30 - 55) = 215
Operating cash flow - Change in NWC = $190 - ( -25) = $215
• This example illustrates that including net working capital changes in our
calculations has the effect of adjusting for the discrepancy between accounting
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sales and costs and actual cash receipts and payments.
 example
• For the year just completed, the CWT Inc. reports sales of $998 and costs of
$734. You have collected following information:

• Based on these figures 1) What are cash inflows? 2) Cash outflows? 3) What
happened to each account? 4) What is net cash flow?
• Sales were $998, but receivables rose by $10. So cash collections were $10 less
than sales, or cash sales were $988.
• Costs were $734, but inventories fell by $20. This means that we didn’t replace
$20 worth of inventory, so costs are actually overstated by this amount.
• Also, payables fell by $30. This means that we actually paid our suppliers $30
more than we received from them, resulting in a $30 understatement of costs.
• Adjusting for these, we calculate that cash costs are $734 - 20 + 30 = $744.
• Net cash flow is $988 - 744 = $244.
• Net working capital increased by 20 overall. We can check our answer by noting
that the original accounting sales less costs $998 -734 = $264. In addition, CWT
spent $20 on net working capital, so the net result is a cash flow of $264 - 20 =
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$244, as we calculated.
DEPRECIATION, accelerated cost recovery system (ACRS)

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 EXAMPLE: THE MAJESTIC MULCH AND COMPOST COMPANY
• MMCC is investigating the feasibility of a new line of power mulching tools for
growing number of homes. MMCC projects unit sales as follows:

• The new product will sell for $120 per unit to start. When the competition catches
up after 3 years, MMCC anticipates that the price will drop to $110.
• Project will require $20,000 in net working capital at start. Subsequently, total net
working capital at the end of each year will be 15% of sales for that year.
• The variable cost per unit is $60, and total fixed costs are $25,000 per year.
• It will cost $800,000 to buy the equipment necessary to begin production.
• This investment is an industrial equipment & qualifies as seven-year MACRS.
• The equipment will actually be worth 20% of its cost in eight years or $160,000.
• The relevant tax rate is 34% & the required return is 15%.
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Based on this information, should MMCC proceed?
 Operating Cash Flows
There is a lot of information that we need to organize. The first thing
we can do is calculate projected sales.

Next, we compute the depreciation on the $800,000 investment

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 Operating Cash Flows
With this information, we can prepare the income statements

From here, computing the operating cash flows is straightforward.

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 Change in Net Working Capital
• Now that we have the operating cash flows, we need to determine changes
in NWC which is assumed to change as sales change.
• Recalling that NWC starts out at $20,000 and then rises to 15% of sales, we
can calculate the amount of NWC for each year as

• Total change in NWC for each year are shown below:

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 Capital Spending
• Finally, we have to account for the long-term capital invested. MMCC
invests $800,000 at year 0. This equipment will be worth $160,000 at
the end & will have BV = 0. This $160,000 excess of MV over BV is
taxable, so the after-tax proceeds will be $160,000 x (1 - .34) =
$105,600.

• Total Cash Flow: We now have all the cash flow pieces, put them
together
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Valuation:

33
 Valuation:
Conclusion:

• There is no further analysis to be done.

• MMCC should begin production and marketing immediately.

• It is important to remember that the result of our analysis is an

estimate of NPV & we’ll usually have less than complete confidence in
our projections.

• This means we have more work to do.

• We need to spend some time evaluating the quality of our estimates.

• Thus we need to do some sensitivity analyses before we actually

proceed for implementation of the decision

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mutually exclusive projects with unequal LIVES

NPV = 28.93

NPV = 35.66

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EVALUATING OPTIONS WITH DIFFERENT LIVES – LCM approach

NPV = 72.59

NPV = 62.45

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 EVALUATING OPTIONS WITH DIFFERENT LIVES – Eqv Ann Cost approach
• Here the problem we consider involves choosing among different
possible systems, equipment setups, or procedures.
• Our goal is to choose the most cost-effective option. As discussed
under LCM, the approach we consider here is necessary only when
two special circumstances exist.
1. First, the possibilities under evaluation have different economic
lives.
2. Second, and just as important, we will need whatever we buy
indefinitely. As a result, when it wears out, we will buy another
one.
• We can illustrate this problem with a simple example. Imagine we are
in the business of manufacturing stamped metal subassemblies.
• Whenever a stamping mechanism wears out, we have to replace it
with a new one to stay in business.
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• We are considering which of two stamping mechanisms to buy.
 EVALUATING OPTIONS WITH DIFFERENT LIVES – Eqv Ann Cost approach
• Machine A costs $100 to buy and $10 per year to operate. It wears
out and must be replaced every two years.
• Machine B costs $140 to buy and $8 per year to operate. It lasts for
three years and must then be replaced.
• Ignoring tax which one should we choose using 10% discount rate?
• In comparing the two machines, we notice that the first is cheaper to
buy, but it costs more to operate and it also wears out more quickly.
How can we evaluate these trade-offs?
• We can start by computing the present value of the costs for each:
2
• Machine A: PV -$100 - 10/1.1 - 10/1.1 = -$117.36
2 3
• Machine B: PV -$140 - 8/1.1 - 8/1.1 - 8/1.1 = -$159.89
• Notice that all the numbers here are costs, so they all have negative
signs. 38
 EVALUATING OPTIONS WITH DIFFERENT LIVES - EAC approach
• If we stopped here, it might appear that A is more attractive because the
PV of the costs is less.
• Actually, all we have really discovered so far is that A effectively provides
two years’ worth of stamping service for $117.36, whereas B effectively
provides three years’ worth of same service for $159.89.
• These costs are not comparable because of different service periods.
• We need to work out a cost per year for these two alternatives.
• To do this, we ask: What amount, paid each year over the life of the
machine, has the same PV of costs? This amount is called the
equivalent annual cost (EAC) .
• Calculating EAC involves finding unknown payment amount e.g. for
machine A, we need to find 2 year ordinary annuity with PV of $117.36
at 10%.
• Similarly , for B we need to find 3 year ordinary annuity with PV
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of
$159.89 at 10%
 EVALUATING OPTIONS WITH DIFFERENT LIVES - EAC approach
• In IBF, we learnt that Annuity PV Factor
2

• 2 year annuity PV factor = (1 – 1/1.10 )/.10 = 1.7355

• For machine A, then, we have: PV of costs = -$117.36 = EAC x 1.7355
• Equivalent Annual Cost (EAC) = -$117.36/1.7355 = -$67.62
3
• For machine B, life is 3 yrs, so we first need the 3 year annuity factor:
• 3 year annuity factor = (1 – 1/1.10 )/.10 = 2.4869
• PV of costs = -$159.89 = EAC x 2.4869
• EAC = -$159.89/2.4869 = -$64.29
• Based on this analysis, we should purchase B because it effectively costs
$64.29 per year versus $67.62 for A. So B is cheaper. In this case, the
longer life and lower operating cost are more than enough to offset the 40
higher initial purchase price
real options

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real options

42
real options

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 Production flexibility option

Solution

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 Abandonment Option

• An abandonment option is the ability to discontinue a project if

the operating cash flow turns out to be lower than expected.

• It reduces the risk of project and increases its value.

• Instead of total abandonment, some options allow a company

to reduce capacity or temporarily suspend operations.

• Smart managers negotiate the right to abandon if a project

turns out to be unsuccessful as a condition for undertaking the
project.

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 Abandonment Option

Solution 1

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Solution 2
Solution 2s

47
 Sensitivity Analysis
• Sensitivity analysis measures the percentage change in NPV that
results from a given percentage change in input variable
• All the input variables can be changed to alter the calculated project
cash flows and thus the NPV and other capital budgeting decision
criteria may be applied. We could increase or decrease
a) the projected unit sales,
b) the sales price,
c) the variable and/or
d) the fixed costs,
e) the initial investment cost,
f) the net working capital requirements,
g) the salvage value,
h) the tax rate OR
i) Any other variable
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 Sensitivity analysis
• Such changes can be made easily in an Excel model, making it
possible to immediately see the resulting changes in the decision
criteria.
• This is called sensitivity analysis
• Ask yourself a series of “what if” questions: “What if unit sales fall
from 550 to 385?” What if market forces us to price the product at
$8.12, not $11.60?” “What if variable costs are higher?”

• Sensitivity analysis provides answers to such questions.

• Each variable is increased or decreased by a specified %age from its

expected value, holding other variables constant at base-case levels.

• Then the NPV is calculated using the changed input.

• Finally, the resulting set of NPVs is plotted to show how sensitive NPV
is to changes in the different variables.
Input Variables

NPV = $36
 Interpreting Sensitivity Analysis
• The slopes of the lines in the graph and the ranges in the table indicate
how sensitive NPV is to each input.
• The larger the range, the steeper the variable’s slope and the more
sensitive the NPV is to this variable.
• NPV is extremely sensitive to changes in the sales price; fairly sensitive
to changes in variable costs, units sold, and fixed costs; and not
especially sensitive to changes in the equipment’s cost and the WACC.
• We should try to obtain accurate estimates of the variables that have
the greatest impact on the NPV (i.e. steep slope & high range).
• Even though NPV may be highly sensitive to certain variables, if those
variables are not likely to change much from their expected values, then
the project may not be very risky in spite of its high sensitivity.
• If we were comparing two projects, then the one with the steeper
sensitivity lines would be riskier, because relatively small changes in the
input variables would produce large changes in the NPV
 Using Tornado Diagrams for Sensitivity Analysis
• It is another way to present results from sensitivity analysis.
• First rank the range of possible NPVs for each of the input variables
& place the widest at the top and smallest at the bottom.
 Scenario Analysis
• In sensitivity analysis, we change one variable at a time.

• However, it is useful to know what would happen to the project’s

NPV if several of the inputs turn out to be better or worse than
expected, and this is what we do in a scenario analysis.

• Scenario analysis allows us to assign probabilities to the base case,

the best case, and the worst case; then we can find the expected
value of the project’s NPV.

• Always ask marketing, engineering, and other operating managers to

specify a worst-case scenario (low unit sales, low sales price, high
variable costs, and so on) and a best-case scenario.
Scenario Analysis
 Interpretation of Scenario Analysis
• If the project is highly successful, then low initial investment,
high sales price, high unit sales, and low production costs
would combine to result in a very high NPV, $13,379.
• However, if things turn out badly, then the NPV would be a -
$5,847 (negative).
• If bad conditions materialize, the project will not bankrupt the
entire company—this is just one project for a large company.
• However, losing $5,847,000 would certainly hurt the
company’s value and the reputation of the managers.
• Thus wide range of possibilities, and especially the large
potential negative value, suggests that project is a risky.
 Expansion Projects Vs Replacement Projects
• Two types of projects can be distinguished:

1) Expansion projects, where firm makes an additional production.

2) Replacement projects, where firm replaces existing assets,

generally to reduce costs.

• In expansion projects, the cash expenditures on buildings,

equipment, and required working capital are all incremental, as are
the sales revenues and operating costs associated with the project.

• In replacement projects the incremental costs are not so obvious e.g

the fuel bill for a more efficient new truck might be $10,000 per year
versus $15,000 for the old truck, therefore $5,000 fuel savings would
be an incremental cash inflow associated with the replacement
decision.
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 Analysis of Expansion Project – A Case study
• Now we’ll see how Cash Flows are estimated for an expansion project. Let’s
look at the following Case Study:
• The project is a new type of solar water heater, which will be manufactured
under a 4-year license. It’s not clear how well the water heater will work,
how strong demand for it will be, how long it will be before the product
becomes obsolete, or whether the license can be renewed after the initial 4
years”. Still, the water heater is hoped to be quite profitable, though it could
also fail.

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58
 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• One decision we frequently face is whether to upgrade existing
facilities to make them more cost-effective.
• The issue is whether the cost savings are large enough to justify the
necessary capital expenditure.
• For example, suppose we are considering automating some part of an
existing production process.
• The necessary equipment costs $80,000 to buy and install.
• The automation will save $22,000 per year (before taxes) by reducing
labor and material costs.
• For simplicity, assume that the equipment has a five-year life and is
depreciated to zero on a straight line basis over that period.
• It will actually be worth $20,000 in 5 years.
• Should we automate? Tax rate is 34%, and the discount rate is 10%.
59
 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• As always, the first step in making such a decision is to identify the
relevant incremental cash flows.
• First, determining the relevant capital spending is easy enough. The
initial cost is $80,000. The after-tax salvage value is $20,000 x (1 .34)
= $13,200 because the book value will be zero in five years.
• Second, there are no working capital consequences here, so we
don’t need to worry about changes in net working capital.
• Third, Operating cash flows. Buying the new equipment affects our
operating cash flows in two ways. First, we save $22,000 before taxes
every year. In other words, the firm’s operating income increases by
$22,000, so this is the relevant incremental project operating income.
Second, we have an additional depreciation. In this case, depreciation
is $80,000/5 = $16,000 per year. Because the project has an operating
income of $22,000 (the annual pretax cost saving) and a depreciation
deduction of $16,000, taking the project will increase the firm’s EBIT
by $22,000 - 16,000 = $6,000, so this is the project’s EBIT. 60
 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• Finally, because EBIT is rising for the firm, taxes will increase. This
increase in taxes will be $6,000 x .34 = $2,040. With this information, we
can compute operating cash flow in the usual way:

• We can now finish our analysis. Based on our discussion, here are the
relevant cash flows:

• At 10%, it’s straightforward to verify that the NPV here is $3,860, so

we should go ahead and automate. 61