BF3326 Corporate Finance: Deciding Capital Investment

BF3326 Corporate Finance
Deciding Capital Investment

Necessary Information
• Understand how to determine the relevant cash flows for
various types of proposed investments
• Understand the various methods for computing operating

cash flow
• Understand how to set a bid price for a project
• Understand how to evaluate the equivalent annual cost of a

project
What to look at?
• Project Cash Flows: A First Look
• Incremental Cash Flows

• Pro Forma Financial Statements and Project Cash Flows
• Alternative Definitions of Operating Cash Flow
• Some Special Cases of Discounted Cash Flow Analysis

Relevant Cash Flows
• 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
Asking the Right Question
You should always ask yourself “Will this cash flow 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
because of the project
Common Items 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
Relevant costs
Three years ago, the Jamestown Co. purchased some land for $1.24 million.
Today, the land is valued at $1.32 million. Six years ago, the company
purchased some equipment for $189,000. This equipment has a current
book value of zero and a current market value of $39,900.
What value should be assigned to the land and the equipment if the
Jamestown Co. opts to use both for a new project?
Relevant costs
Relevant cost = $1,320,000 + $39,900

= $1,359,900
Relevant Revenue
The Blue Shoe currently sells 13,000 pairs of athletic shoes and 4,500
pairs of dress shoes every year. The athletic shoes sell for an average
price of $79 a pair while the average price for the dress shoes is $49. The
company is considering expanding their offerings to include sandals at
an average price of $29 a pair. The Blue Shoe estimates that the addition
of sandals to their lineup will reduce their dress shoe sales by 1,000
pairs and increase their athletic shoes sales by 800 pairs. The Blue Shoe
expects to sell 4,500 pairs of sandals if they decide to carry them.
What amount should the Blue Shoe use as the annual estimated sales
revenue when they analyze the addition of sandals to their lineup?
Relevant Revenue
𝐴𝑡ℎ𝑙𝑒𝑡𝑖𝑐 shoes 800 × $79 = $ 63,200

Dress shoes −1,000 × $49 = −$ 49,000
Sandals 4,500 × $29 = $130,500
Total = $144,700
Net working capital
The Fritz Co. is considering a new project and asked the chief accountant to
review potential changes to the net working capital accounts should the project
be adopted. The accountant’s report is as follows:
Current Projected
Accounts receivable $ 89,430 $110,000
Inventory $ 99,218 $ 75,000
Accounts payable $ 58,640 $ 50,000
What amount should be included in the initial cash flow of the project for net
working capital?
Net working capital
Current Projected Cash flow

Accounts receivable $ 89,430 $110,000 -$20,570
Inventory $ 99,218 $ 75,000 $24,218
Accounts payable $ 58,640 $ 50,000 -$ 8,640
Total -$ 4,992
Pro Forma Statements and Cash Flow
Capital budgeting relies heavily on pro forma accounting

statements, particularly income statements
• Computing cash flows – refresher
– Operating Cash Flow (OCF) = EBIT + depreciation – taxes

– OCF = Net income + depreciation (when there is no interest expense)
– Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) –
changes in NWC
Pro Forma Income Statement
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
Projected Capital Requirements
Year
0 1 2 3
Net Working Capital $20,000 $20,000 $20,000 $20,000
Net Fixed Assets 90,000 60,000 30,000 0
Total $110,000 $80,000 $50,000 $20,000

Projected Total Cash Flows
Year
0 1 2 3
Operating Cash Flow $51,780 $51,780 $51,780

Change in Net Working -$20,000 20,000
Capital
Net Capital Standing -$90,000
Cash Flow from Assets -$110,00 $51,780 $51,780 $71,780

Making The Decision
Now that we have the cash flows, we can apply the

techniques Investment appraisal techniques.
Enter the cash flows into the calculator and compute NPV
and IRR
– CF0 = -110,000; C01 = 51,780; C02 = 51,780 C03 = 71,780;
– I = 20;
– Find NPV
Should we accept or reject the project?
Net Working Capital
Why do we have to consider changes in NWC separately?
– GAAP requires that sales be recorded on the income statement when

made, not when cash is received
– GAAP also requires that we record cost of goods sold when the
corresponding sales are made, whether or not we have actually paid our
suppliers yet
– Finally, we have to buy inventory to support sales, although we haven’t
collected cash yet
Depreciation
• The depreciation expense used for capital budgeting should
be the depreciation schedule required by the IRS for tax
purposes
• 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
Computing Depreciation
• Straight-line depreciation
– D = (Initial cost – salvage) / number of years
– Very few assets are depreciated straight-line for tax purposes
• MACRS
– Need to know which asset class is appropriate for tax purposes
– Multiply percentage given in table by the initial cost
– Depreciate to zero
– Mid-year convention
After-Tax Salvage
• If the salvage value is different from the book value of the asset,
then there is a tax effect
• Book value = initial cost – accumulated depreciation
• After-tax salvage = salvage – Tax (salvage – book value)

Depreciation and After-tax 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 company’s marginal tax rate is 40%. What is the
depreciation expense each year and the after-tax salvage in year 6
for each of the following situations?
- Straight Line
- 3 Years MACRS
- 7 Years MACRS
Straight-line
Suppose the appropriate depreciation schedule is straight-line
– Depreciation = (110,000 – 17,000) / 6 = 15,500 every year for 6 years
– Book Value in year 6 = 110,000 – 6(15,500) = 17,000
– After-tax salvage = 17,000 - 0.4(17,000 – 17,000) = 17,000

Three-year MACRS
Yea MACR Depreciation
r S
percent
Book Value in year 6
1 .3333 .3333(110,000) = 36,663
= 110,000 – 36,663 – 48,895 – 16,291 – 8,151
2 .4445 .4445(110,000) = 48,895 =0
3 .1481 .1481(110,000) = 16,291 After-tax salvage

= 17,000 - 0.4(17,000 – 0)
4 .0741 .0741(110,000) = 8,151
= $10,200
Seven-Year MACRS
Year MACRS Depreciation
Book Value in year 6
Percent
1 .1429 .1429(110,000) = 15,719 = 110,000 – 15,719 – 26,939 – 19,239 –
13,739 – 9,823 – 9,812
2 .2449 .2449(110,000) = 26,939 = 14,729
3 .1749 .1749(110,000) = 19,239

After-tax salvage
4 .1249 .1249(110,000) = 13,739 = 17,000 – 0.4(17,000 – 14,729)
5 .0893 .0893(110,000) = 9,823 = 16,091.60
6 .0892 .0892(110,000) = 9,812

Investment Decision - Replacement Problem
Original Machine New Machine

– Initial cost = 100,000 – Initial cost = 150,000
– Annual depreciation = 9,000 – 5-year life
– Purchased 5 years ago – Salvage in 5 years = 0
– Book Value = 55,000 – Cost savings = 50,000 per year
– Salvage today = 65,000 – 3-year MACRS depreciation
– Salvage in 5 years = 10,000
Required return = 10%

Tax rate = 40%
Investment Decision - Replacement Problem
Constructing the Cash Flow
• 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?
Pro Forma Income Statements
Year 1 2 3 4 5
Cost Savings 50,000 50,000 50,000 50,000 50,000
Depr.
New 49,995 66,675 22,215 11,115 0
Old 9,000 9,000 9,000 9,000 9,000
Increm. 40,995 57,675 13,215 2,115 (9,000)
EBIT 9,005 (7,675) 36,785 47,885 59,000
Taxes 3,602 (3,070) 14,714 19,154 23,600
Net Income 5,403 (4,605) 22,071 28,731 35,400
Incremental Net Capital Spending
Year 0
– Cost of new machine = 150,000 (outflow)
– After-tax salvage on old machine = 65,000 - 0.4(65,000 – 55,000)
= 61,000 (inflow)
– Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow)
Year 5
– After-tax salvage on old machine = 10,000 - 0.4(10,000 – 10,000) = 10,0
00 (outflow because we no longer receive this)
Cash Flow From Assets
Year 0 1 2 3 4 5
OCF 46,398 53,070 35,286 30,846 26,400
NCS -89,000 -10,000
 In 0 0
NWC
CFFA -89,000 46,398 53,070 35,286 30,846 16,400
Replacement Problem – Making the Decision
Now that we have the cash flows, we can compute the

NPV and IRR
– Enter the cash flows

– Compute NPV
– Compute IRR
Should the company replace the equipment?

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
– Don’t subtract non-cash deductions
Tax Shield Approach
– OCF = (Sales – Costs)(1 – T) + Depreciation*T

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BF3326 Corporate Finance

Deciding Capital Investment

• Understand the various methods for computing operating

• Understand how to set a bid price for a project

• Understand how to evaluate the equivalent annual cost of a

• Project Cash Flows: A First Look

• Incremental Cash Flows

• Alternative Definitions of Operating Cash Flow

• Some Special Cases of Discounted Cash Flow Analysis

• The cash flows that should be included in a capital budgeting

• These cash flows are called incremental cash flows

• The stand-alone principle allows us to analyze each project in

– If the answer is “yes,” it should be included in the analysis because it

– If the answer is “no,” it should not be included in the analysis because

• Sunk costs – costs that have accrued in the past

Relevant cost = $1,320,000 + $39,900

𝐴𝑡ℎ𝑙𝑒𝑡𝑖𝑐 shoes 800 × $79 = $ 63,200

Current Projected Cash flow

Capital budgeting relies heavily on pro forma accounting

• Computing cash flows – refresher

– Operating Cash Flow (OCF) = EBIT + depreciation – taxes

Net Working Capital $20,000 $20,000 $20,000 $20,000

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

Total $110,000 $80,000 $50,000 $20,000

Operating Cash Flow $51,780 $51,780 $51,780

Cash Flow from Assets -$110,00 $51,780 $51,780 $71,780

Now that we have the cash flows, we can apply the

Why do we have to consider changes in NWC separately?

– GAAP requires that sales be recorded on the income statement when

• Depreciation itself is a non-cash expense; consequently, it is

• Depreciation tax shield = DT

• Book value = initial cost – accumulated depreciation

• After-tax salvage = salvage – Tax (salvage – book value)

– Depreciation = (110,000 – 17,000) / 6 = 15,500 every year for 6 years

– Book Value in year 6 = 110,000 – 6(15,500) = 17,000

– After-tax salvage = 17,000 - 0.4(17,000 – 17,000) = 17,000

2 .4445 .4445(110,000) = 48,895 =0

3 .1481 .1481(110,000) = 16,291 After-tax salvage

3 .1749 .1749(110,000) = 19,239

5 .0893 .0893(110,000) = 9,823 = 16,091.60

6 .0892 .0892(110,000) = 9,812

Original Machine New Machine

Required return = 10%

Constructing the Cash Flow

• Remember that we are interested in incremental cash

– Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow)

OCF 46,398 53,070 35,286 30,846 26,400

NCS -89,000 -10,000

Now that we have the cash flows, we can compute the

– Enter the cash flows

Should the company replace the equipment?

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