FInance Discussion Topic #2

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McGraw-Hill/Irwin

Making Capital Investment Decisions

Chapter 6

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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

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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

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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 cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.

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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.

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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.

I heard a story about an undergrad at the University of Missouri-Rolla. A student named Louis abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 Engineering Drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught us a lot about sunk costs.

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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.

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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.

Of course, amortization could be included as well; however, the formula as presented is the typical statement.

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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 firm’s level of debt (and, hence, interest expense) is independent of the project at hand.

It may be beneficial to note the separation theorem, i.e., financing and investment decisions are separate activities. Further, you can note that the discount rate captures these related issues.

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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

See the text for the details of the case.

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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

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The Baldwin Company

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

Investments:

(1) Bowling ball machine –100.00 21.76*

(2) Accumulated 20.00 52.00 71.20 82.72 94.24 depreciation

(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76 machine after
depreciation (end of year)

(4) Opportunity cost –150.00 150.00
(warehouse)

(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0 (end of year)

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

(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98 investment
[(1) + (4) + (6)]

($ thousands) (All cash flows occur at the end of the year.)

* We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is $24,240 (= $30,000 – $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,242 = [0.34 * ($30,000 – $5,760)]. The after-tax salvage value is $30,000 – 8,242 = $21,758.

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The Baldwin Company

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

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

Investments:

(1) Bowling ball machine –100.00 21.76

(2) Accumulated 20.00 52.00 71.20 82.72 94.24 depreciation

(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76 machine after
depreciation (end of year)

(4) Opportunity cost –150.00 150.00
(warehouse)

(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0

(end of year)

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

(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98 investment
[(1) + (4) + (6)]

In practice, we would want to forecast the market value of the warehouse at the time the project ends. In this case, the implicit assumption is that there is no price inflation or deflation over the period.

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The Baldwin Company

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.

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The Baldwin Company

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

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The Baldwin Company

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%

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The Baldwin Company

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

(12) Tax at 34 percent 10.20 14.69 29.00 22.99 10.38

(13) Net Income 19.80 28.51 56.30 44.63 20.15

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Incremental After Tax Cash Flows

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

-10.20

-14.69

-29.00

-22.99

-10.38

(4) OCF

(1) – (2) – (3)

39.80

60.51

75.50

56.15

31.67

(5) Total CF of Investment

–260.

–6.32

–8.65

3.75

192.98

(6) IATCF

[(4) + (5)]

–260.

39.80

54.19

66.85

59.90

224.65

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NPV of Baldwin Company

39.80

51.59

–260

CF1

CF0

NPV

54.19

CF2

66.85

CF3

59.90

CF4

224.65

CF5

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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)

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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.

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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

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6.5 Some Special Cases of Discounted Cash Flow Analysis

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

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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.

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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)

It might be helpful to point out that we are essentially working backwards through the process.

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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?

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Investments of Unequal Lives

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

–100

–4,614.46

– 4,000

–500

–2,895.39

–1,000

CF1

CF0

NPV

CF1

CF0

NPV

Cadillac Air Cleaner

Cheapskate Air Cleaner

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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).

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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.

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Cadillac EAC with a Calculator

–100

–4,614.46

–4,000

750.98

–4,614.46

CF1

CF0

NPV

PMT

I/Y

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Cheapskate EAC with a Calculator

–500

–2,895.39

–1,000

763.80

-2,895.39

CF1

CF0

NPV

PMT

I/Y

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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?

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NPV