Making capital

investment decision

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Project Cash Flows: A First Look
incremental cash flows: The difference between a
firm’s future cash flows with
a project and those without the project
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.
Stand-alone principle: The assumption that evaluation of
a project may be based on the project’s incremental cash
flows.
Sunk costs
Sunk cost : A cost that has already been incurred and
cannot be removed and therefore should not be considered
in an investment decision
Opportunity costs
 Opportunity costs (OCs) are the costs of giving up the
second best use of resources.
opportunity cost The most valuable
alternative that is given up if a particular investment is
undertaken.
Opportunity costs should be taken into consideration
when evaluating the project.
Side effects
 Accepting a new project may have side effects.
 Erosion occurs when a new project reduces the sales
and cash flows of existing projects.
 Synergy (extra energy) occurs when a new project
increases the sales and cash flows of existing projects.
 Cash flows due to erosion and synergy are incremental
cash flows.
Net working capital
 A project will require that the firm invest in net working
capital
For example, a project will need an initial investment in
inventories and 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
Net working capital
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 and
recovers it towards the end.
 Financing cost
In analyzing a proposed investment, we will not
include interest paid or any other financing costs
such as dividends or principal repaid, because we
are interested in the cash flow generated by the
assets of the project.
When valuing a project, ignore how the project is
financed.
you must separate financing and investment
decisions.
Other issues
 First, we are only interested in measuring
cash flow when it actually occurs, not when it accrues in
an accounting sense.
Example
A project costs $2,000 and is expected to last 2
years, producing cash income of $1,500 and
$500 respectively. The cost of the project can be
depreciated at $1,000 per year. Given a 10%
required return, compare the NPV using cash
flow to the NPV using accounting income.
Cash Flow vs. Accounting Income
Cash Flow vs. Accounting Income
 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
Common Types of Cash Flows
 Sunk costs – costs that have accrued 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
 Taxes

14
Exercise Questions
A cost that has already been paid, or the liability to
pay has already been incurred, is a(n):
a. Salvage value expense.
b. Net working capital expense.
c. Sunk cost.
d. Opportunity cost.
 You bought some real estate 6 years ago for $25,000,
and you are thinking of using this land for the
construction of a new warehouse as part of a production
expansion project.
 You include the $25,000 purchase cost of the land as an
initial cost in the capital budgeting process. By doing so,
you are making the mistake of in the
decision-making process.

a. including erosion costs

b. including opportunity costs
c. including sunk costs
d. including net working capital changes
e. including financing costs
You do NOT consider the $25,000 purchase cost of the
land as an initial cost in the capital budgeting process. You
also ignore the fact that the land now can be sold at
$28,000. By doing so, you are making the mistake of
______in the decision-making process.

a. excluding erosion costs

b. excluding opportunity costs
c. excluding sunk costs
d. including opportunity costs
e. including sunk costs
You correctly do NOT consider the $25,000 purchase cost of the
land as an initial cost in the capital budgeting process. You also
correctly consider the fact that the land now can be sold at
$30,000. But you forget to consider the fact that the new
warehouse will attract more customer in the region and your other
business (retailing, for example) will be positively affected. By
doing so, you are making the mistake of ____in the decision-
making process.
a. excluding erosion costs
b. excluding opportunity costs
c. excluding sunk costs
d. excluding incidental effects
e. excluding financing costs
If two projects are independent, then:

a. Accepting one automatically implies rejection of the

other.
b. If one is undertaken, the other must be undertaken as
well.
c. Both will be undertaken, assuming each has a positive
NPV and the firm’s capital budget can afford to include
both projects.
d. All of the above
Incremental cash flows refer to:

a. The difference between after-tax cash flows

and before-tax accounting profits.
b. The additional cash flows that will be generated
if a project is undertaken.
c. The cash flows of a project, minus financing
costs.
d. The cash flows that are foregone if a firm does
not undertake a project.
 Which of the following should be included in an
analysis of a new project?
a. Any sales from existing products that would be
lost if customers were expected to purchase a new
product instead.
b. All financing costs.
c. All sunk costs.
d. All of the above.
e. None of the above.
Adams Audio is considering whether to make an investment
in a new type of technology.
Which of the following factors should the company
consider when it decides whether to undertake the
investment?
a. The company has already spent $3 million researching
the technology.
b. The new technology will affect the cash flows produced
by its other operations.
c. If the investment is not made, then the company will be
able to sell one of its laboratories for $2 million.
d. Statements b and c should be considered.
e. All of the statements above should be considered.
Pro Forma Financial Statements
and Project Cash Flows

Pro forma refers to a report of the company's earnings

that excludes unusual or nonrecurring transactions

Pro forma financial statements: Financial statements

projecting future years’ operations
Projected Income Statement
Sales: Year 1: 1000S$
Projected Capital Requirements
Calculating Cash Flows
 Think of cash flows as coming from three elements
Total cash flow
= cash flows from capital investments
+ cash flows from changes in working capital
+ operating cash flows
= capital spending
+ Change in NWC
+ operating cash flow
Calculating Cash Flows
 Cash Flow from Capital Investments
• Almost every project requires some sort of initial
investment. This is often capitalized from an
accounting perspective. In finance, the investment
represents a negative cash flow or cash outflow.

.
Calculating Cash Flows
 Cash Flow from Investment in working capital

An increase in working capital implies a negative cash

flow; a decrease implies a positive cash flow.

The cash flow is measured by the change in working

capital, not the level of working capital
.
 Cash flow from operations
Method 1: Top-down approach
Cash flow from operation= revenues-cash expenses –
taxes paid
Method 2: Bottom – up approach
Cash flow from operation= net profit + depreciation
Method 3: Tax-shield approach
Cash flow from operation= (revenues – cash
expenses)*(1- tax rate) + ( depreciation*tax rate)
More about Project Cash Flow
DEPRECIATION: Modified ACRS
Depreciation (MACRS)

accelerated cost recovery system (ACRS) A

depreciation method under U.S. tax law allowing for the
accelerated write-off of property under various
classifications
A nonresidential real property, such as an
office building, is depreciated over 31.5
years using straight-line depreciation.
 A residential real property, such as an
apartment building, is depreciated straight-
line over 27.5 years. Remember that land
cannot be depreciated
DEPRECIATION: Modified ACRS
Depreciation (MACRS)
AN EXAMPLE: THE MAJESTIC MULCH AND
COMPOST COMPANY (MMCC)
 MMCC is investigating the feasibility of a new line of power mulching
tools aimed at the growing number of home composters.
 The new power mulcher will sell for $120 per unit to start. When the
competition catches up after three years, however, MMCC anticipates
that the price will drop to $110. The power mulcher project will require
$20,000 in net working capital at the start. Subsequently, total net
working capital at the end of each year will be about 15 percent of sales
for that year. The variable cost per unit is $60, and total fixed costs are
$25,000 per year.

It will cost about $800,000 to buy the equipment
necessary to begin production. This investment is
primarily in industrial equipment, which qualifies as
seven-year MACRS property. The equipment will
actually be worth about 20 percent of its cost in eight
years, or .20 * $800,000 = $160,000. (=> taxafter
salvage = 160000*(1-0.34) = 105,600.
The relevant tax rate is 34 percent,
and the required return is 15 percent.
Based on this information, should MMCC proceed?
Run a coffee shop at NVT street
Year 1:
Unit price: 25,000 VND
Sales (1000 unit)
Variable costs:
+ Coffee: 100,000VND/kg = 1,000 units
+ Sugar: 50,000/kg = 2,000 units
+ Other expenses: 1000 VND/unit

Fixed costs:
FC = 5,000,000 VND
Depreciation: 1,000,000

Year 2 increases by 10% of year 1

Year 3 increases by 10% of year 2
Year 4 increases by 10% of year 3
Year 5 increases by 10% of year 4.

 Require:
1/ EBIT
2/ Net income with Tax of 25%
3/ Operating CF
4/ Change in NWC = -5000; capital spending: 100,000,000
rate of return 15%
NVP? IRR? PB? discounted PB
  Y1 Y1 Y2 Y2 Y3 Y3   Y4 Y5 Y5

Unit price   25,000   27,500   30,250   33,275   36,603

Sales
units   1,000   1,100   1,210   1,331   1,464

Revenue   25,000,000   30,250,000   36,602,500   44,289,025   53,589,720

VC/unit 1,125 1,125,000 1,238 1,361,250 1,361 1,647,113 1,497 1,993,006 1,647 2,411,537

Coffee 100 100,000 110 121,000 121 146,410 133 177,156 146 214,359

Sugar 25 25,000 28 30,250 30 36,603 33 44,289 37 53,590

Other
exp 1,000 1,000,000 1,100 1,210,000 1,210 1,464,100 1,331 1,771,561 1,464 2,143,589

Total FC   6,000,000   6,500,000   7,050,000   7,655,000   8,320,500

FC   5,000,000   5,500,000   6,050,000   6,655,000   7,320,500

Depre   1,000,000   1,000,000   1,000,000   1,000,000   1,000,000

EBIT   17,875,000   22,388,750   27,905,388   34,641,019   42,857,683

Taxes
25%   4,468,750   5,597,188   6,976,347   8,660,255   10,714,421
Net
income   13,406,250   16,791,563   20,929,041   25,980,764   32,143,262
 Some Special Cases of Discounted Cash Flow Analysis
 EVALUATING COST-CUTTING PROPOSALS
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
straightline basis over that period. It will actually be worth $20,000 in
five years. Should we automate? The tax rate is 34 percent, and the
discount rate is 10 percent.
Automate: “to use machines and computers instead of people to do a job or
task”
Operating income = $22,000
Depreciation = $80,000/5= $16,000
EBIT= $ 6,000
Tax = 0.34* $6,000= $2,040
EAT= $3,960
OCF= EAT+ Depreciation= $19,960
Aftertax salvage value = $20,000 * (1-0.34)= $13,200
There are no working capital consequences no changes in net
working capital
Practice:
We are considering the purchase of a $200,000 computer-
based inventory management system. It will be depreciated
straight-line to zero over its four-year life. It will be worth
$30,000 at the end of that time. The system will save us
$60,000 before taxes in inventory-related costs.
The relevant tax rate is 39 percent. Because the new setup is
more efficient than our existing
one, we will be able to carry less total inventory and thus free
up $45,000 in net working capital. What is the NPV at 16
percent?
At 16 percent, the NPV is - $12,768, so the investment is not
attractive
EVALUATING EQUIPMENT OPTIONS WITH DIFFERENT LIVES

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. We are
considering which of two stamping mechanisms to buy.
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 taxes, which one should we go with if we use a 10 percent
discount rate?
equivalent annual cost (EAC)The present value of a
project’s costs calculated on an annual basis