Scribd Logo
Upload

Welcome to Scribd!

  • 66 views

    Chap 006

    Uploaded by

    eakta
    For Capital Finance

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd

    Chap 006

    Uploaded by

    eakta
    66 views32 pages
    For Capital Finance

    Copyright

    © © All Rights Reserved

    Available Formats

    PPT, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    For Capital Finance

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    66 views32 pages

    Chap 006

    Uploaded by

    eakta
    For Capital Finance

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 32

    Chapter 6

    Making Capital Investment Decisions

    McGraw-Hill/Irwin

    Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

    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

    6-2

    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

    6-3

    6.1 Incremental Cash Flows


    Cash flows matternot accounting earnings.
    Sunk costs do not matter.
    Incremental cash flows matter.
    Opportunity costs matter.
    Side effects like cannibalism and erosion matter.
    Taxes matter: we want incremental after-tax cash
    flows.
    Inflation matters.

    6-4

    Cash FlowsNot 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.

    6-5

    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.
    6-6

    Incremental Cash Flows


    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 that.
    6-7

    Estimating Cash Flows

    Cash Flow from Operations

    Net Capital Spending

    Recall that:
    OCF = EBIT Taxes + Depreciation
    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.
    6-8

    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
    firms level of debt (and, hence, interest
    expense) is independent of the project at
    hand.
    6-9

    6.2 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: $10,000
    Production (in units) by year during 5-year life of
    the machine: 5,000, 8,000, 12,000, 10,000, 6,000

    6-10

    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.
    Annual inflation rate: 5%
    Working Capital: initial $10,000 changes with
    sales
    6-11

    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

    6.32

    8.65

    3.75

    21.22

    6.32

    8.65

    3.75

    192.98
    6-12

    The Baldwin Company


    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

    6.32

    8.65

    3.75

    21.22

    6.32

    8.65

    3.75

    192.98

    At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

    6-13

    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.

    6-14

    The Baldwin Company


    Year 0
    Year 1
    Income:
    (8) Sales Revenues
    (9) Operating costs

    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

    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
    6-15

    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%
    6-16

    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

    6-17

    Incremental After Tax Cash Flows

    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.

    39.80

    $39.80 $54.19 $66.85 $59.90 $224.65


    NPV $260

    2
    3
    4
    (1.10) (1.10) (1.10) (1.10)
    (1.10) 5
    NPV $51.59

    6-18

    NPV of Baldwin Company


    CF0
    CF1
    F1
    CF2
    F2
    CF3

    260
    39.80

    F3
    CF4

    1
    F4
    54.19
    1
    66.85

    CF5
    F5

    1
    59.90
    1

    I
    NPV

    10
    51.59

    224.65
    1
    6-19

    7.3 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)

    6-20

    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.

    6-21

    6.4 Other Methods for Computing OCF

    Bottom-Up Approach
    Works only when there is no interest expense
    OCF = NI + depreciation

    Top-Down Approach
    OCF = Sales Costs Taxes
    Do not subtract non-cash deductions

    Tax Shield Approach

    OCF = (Sales Costs)(1 T) + Depreciation*T


    6-22

    6.5 Some Special Cases of


    Discounted
    Cash
    Flow
    Analysis

    Cost-Cutting Proposals
    Setting the Bid Price
    Investments of Unequal Lives

    6-23

    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.

    6-24

    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)
    6-25

    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?
    6-26

    Investments of Unequal Lives


    Cadillac Air Cleaner
    CF0

    4,000

    Cheapskate Air Cleaner


    CF0

    1,000

    CF1

    100

    CF1

    500

    F1

    10

    F1

    10

    10

    NPV
    4,614.46
    NPV
    2,895.39
    At first glance, the Cheapskate cleaner has a higher NPV.
    6-27

    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).

    6-28

    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.

    6-29

    Cadillac EAC with a Calculator


    CF0

    4,000

    10

    CF1

    100

    I/Y

    10

    F1

    10

    PV

    4,614.46

    10

    PMT

    750.98

    NPV

    4,614.46

    FV
    6-30

    Cheapskate EAC with a Calculator


    CF0

    1,000

    CF1

    500

    I/Y

    10

    F1

    PV

    -2,895.39

    10

    PMT

    763.80

    NPV

    2,895.39

    FV
    6-31

    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?
    How should cash flows and discount rates be
    matched when inflation is present?
    What is equivalent annual cost, and when should it
    be used?

    6-32

    You might also like