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Corporate Finance Twelfth Edition Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan / Joe Smolira (digital co-author)

Chapter 6 Making Capital Investment

Decisions

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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 Understand the various methods for computing operating cash flow Evaluate special cases of discounted cash flow analysis Incorporate inflation into capital budgeting

Chapter Outline

6.1 Incremental Cash Flows: The Key to Capital Budgeting

6.2 The Baldwin Company: An Example 6.3 Alternative Definitions of Operating Cash Flow 6.4 Some Special Cases of Discounted Cash Flow

Analysis 6.5 Inflation and Capital Budgeting

6.1 Incremental Cash Flows

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

Cash Flows—Not 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.

Incremental Cash Flows - I

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.

Incremental Cash Flows – II

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.

Estimating Cash Flows

Cash Flow from Operations • Recall that:

OCF = EBIT − Taxes + Depreciation Net Capital Spending • 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.

Interest Expense

Later chapters will deal with the impact the amount of debt a firm has in its capital structure has on firm value. For now, it is enough to assume that the firm’s level of debt (and, hence, interest expense) is independent of the project at hand.

6.2 The Baldwin Company – I

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

The Baldwin Company – II

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

The Baldwin Company – III ($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:

(1) Bowling ball machine –$100.00 $24.91*

(2) Accumulated depreciation $20.00 $52.00 $71.20 $82.72 94.24

(3) Adjusted basis of machine after depreciation (end of year)

80.00 48.00 28.80 17.28 5.76

(4) Opportunity cost (warehouse) –150.00 150.00

(5) Net working capital (end of year) 10.00 10.00 16.32 24.97 21.22

(6) Change in net working capital –10.00 –6.32 –8.65 3.75 21.22

(7) Total cash flow of investment [(1) + (4) + (6)]

–260.00 –6.32 –8.65 3.75 196.13

The Baldwin Company – IV

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:

(1) Bowling ball machine –$100.00 $24.91*

(2) Accumulated depreciation $20.00 $52.00 $71.20 $82.72 94.24

(3) Adjusted basis of machine after depreciation (end of year)

80.00 48.00 28.80 17.28 5.76

(4) Opportunity cost (warehouse) –150.00 150.00 (5) Net working capital (end of year) 10.00 10.00 16.32 24.97 21.22

(6) Change in net working capital –10.00 –6.32 –8.65 3.75 21.22

(7) Total cash flow of investment [(1) + (4) + (6)]

–260.00 –6.32 –8.65 3.75 196.13

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

The Baldwin Company – V

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income: (8) Sales Revenues $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.

The Baldwin Company - VI

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income: (8) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89 (9) Operating costs –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

The Baldwin Company - VII

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income: (8) Sales Revenues 100.00 163.20 249.70 212.24 129.89 (9) Operating costs –50.00 –88.00 –145.20 –133.10 –87.85 (10) Depreciation –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%

The Baldwin Company – VIII

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income: (8) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89 (9) Operating costs –50.00 –88.00 –145.20 –133.10 –87.85 (10) Depreciation –20.00 –32.00 –19.20 –11.52 –11.52 (11) Income before taxes

[(8) – (9) – (10)] $30.00 $43.20 $85.30 $67.62 $30.53

(12) Tax (21%) –6.30 –9.07 –17.91 –14.20 –6.41 (13) Net Income $23.70 $34.13 $67.38 $53.42 $24.12

Incremental Cash Flows for the Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales Revenues $100.00 $163.20 $249.70 $212.24 $129.89

(2) Operating costs –50.00 –$88.00 –145.20 –133.10 –87.85

(3) Taxes –6.30 –9.07 –17.91 –14.20 –6.41

(4) OCF (1) + (2) + (3) $43.70 $66.13 $86.59 $64.94 $35.64

(5) Total CF of Investment –$260.00 –6.32 –8.65 3.75 196.13

(6) IATCF [(4) + (5)] –$260.00 $43.70 $59.81 $77.93 $68.69 231.77

( ) ( ) ( ) ( ) ( ) 2 3 4 5

$43.70 $59.81 $77.93 $68.69 $231.77 NPV $260

1.10 1.10 1.10 1.10 1.10 = − + + + + +

NPV $78.53=

NPV of Baldwin Company

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6.3 Alternative Definitions of Operating Cash Flow

Top-Down Approach • OCF = Sales – Cash costs – Taxes • Do not subtract noncash deductions Bottom-Up Approach • Works only when there is no interest expense • OCF = Net income + Depreciation Tax Shield Approach • OCF = (Sales – Cash costs)(1 – TC) + Depreciation × TC • OCF = (Net Sales)(1 – TC) + Depreciation × TC

6.4 Some Special Cases of Discounted Cash Flow Analysis

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

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.

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)

Investments of Unequal Lives – I

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?

Investments of Unequal Lives – II

At first glance, the Cheapskate cleaner has a higher NPV.

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Investments of Unequal Lives - III

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).

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.

Cadillac EAC with a Calculator

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Cheapskate EAC with a Calculator

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6.5 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 interest rate) = (1 + Real interest rate) × (1 + Inflation rate)

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.