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Chapter10MakingCapitalInvestmentDecisions.2022/12/30Chapter10.2022/12/281ChapterOutlineProjectCashFlows:AFirstLookIncrementalCashFlowsProFormaFinancialStatementsandProjectCashFlowsMoreaboutProjectCashFlowAlternativeDefinitionsofOperatingCashFlowSomeSpecialCasesofDiscountedCashFlowAnalysis10-2.2022/12/30ChapterOutlineProjectCashFl2RelevantCashFlowsThecashflowsthatshouldbeincludedinacapitalbudgetinganalysisarethosethatwillonlyoccur(ornotoccur)iftheprojectisacceptedThesecashflowsarecalledincrementalcashflowsThestand-aloneprinciple

-analyzeeachprojectinisolationfromthefirm(onitsownmerits)byfocusingonincrementalcashflows10-3.2022/12/30RelevantCashFlowsThecashfl3AskingtheRightQuestionYoushouldalwaysaskyourself“WillthiscashflowoccurONLYifweaccepttheproject?”Iftheansweris“yes,”itshouldbeincludedintheanalysisbecauseitisincrementalIftheansweris“partofit,”thenweshouldincludethepartthatoccursbecauseoftheprojectIftheansweris“no,”itshouldnotbeincludedintheanalysisbecauseitwilloccuranyway10-4.2022/12/30AskingtheRightQuestionYous4CommonTypesofCashFlowsSunkcosts–coststhathaveaccruedinthepastOpportunitycosts–costsoflostoptionsSideeffectsPositivesideeffects–benefitstootherprojectsNegativesideeffects–coststootherprojectsChangesinnetworkingcapitalTaxes(useafter-taxcashflows)DonotconsiderFinancingCosts(partofR)10-5.2022/12/30CommonTypesofCashFlowsSunk5ProFormaStatementsandCashFlowCapitalbudgetingreliesheavilyonproformaaccountingstatements,particularlyincomestatementsComputingcashflows:OperatingCashFlow(OCF) =EBIT+depreciation–taxesOCF=Netincome+depreciation (whenthereisnointerestexpense)CashFlowFromAssets(CFFA)=OCF–netcapitalspending(NCS)–changesinNWC10-6.2022/12/30ProFormaStatementsandCash6Table10.1(p.310)

ProFormaIncomeStatementSales(50,000unitsat$4.00/unit)$200,000VariableCosts($2.50/unit)125,000Grossprofit$75,000Fixedcosts12,000Depreciation($90,000/3)30,000EBIT$33,000Taxes(34%)11,220NetIncome$21,78010-7.2022/12/30Table10.1(p.310)

ProForma7Table10.2ProjectedCapitalRequirements(balancesheet)Year0123NWC$20,000$20,000$20,000$20,000NFA90,00060,00030,0000Total$110,000$80,000$50,000$20,00010-8.2022/12/30Table10.2ProjectedCapitalR8Capitalspendingatthetimeofprojectinception(i.e.,the“initialoutlay”)includesthefollowingitems: +purchasepriceofthenewasset -sellingpriceoftheassetreplaced (ifapplicable) +costsofsitepreparation,setup, andstartup +/-increase(decrease)intax liabilityduetosaleofoldassetat other thanbookvalue

=netcapitalspending.2022/12/30Capitalspendingatthetimeo9Table10.5(p.311)ProjectedTotalCashFlowsYear0123OCF$51,780$51,780$51,780ChangeinNWC-$20,00020,000NCS-$90,000

CFFA-$110,00$51,780$51,780$71,78010-10.2022/12/30Table10.5(p.311)Projected10MakingTheDecisionNowthatwehavethecashflows,wecanapplythetechniquesthatwelearnedinChapter9UseformulasforPVofdiscountedcashflowsShouldweacceptorrejecttheproject?10-11.2022/12/30MakingTheDecisionNowthatwe11MoreonNWCWhydowehavetoconsiderchangesinNWCseparately?GAAPrequiresthatsalesberecordedontheincomestatementwhenmade,notwhencashisreceivedGAAPalsorequiresthatwerecordcostofgoodssoldwhenthecorrespondingsalesaremade,whetherwehaveactuallypaidoursuppliersyetFinally,wehavetobuyinventorytosupportsales,althoughwehaven’tcollectedcashyet10-12.2022/12/30MoreonNWCWhydowehavetoc12DepreciationThedepreciationexpenseusedforcapitalbudgetingshouldbethedepreciationschedulerequiredbytheIRSfortaxpurposesDepreciationitselfisanon-cashexpense;consequently,itisonlyrelevantbecauseitaffectstaxesDepreciationtaxshield=DTD=depreciationexpenseT=marginaltaxrate10-13.2022/12/30DepreciationThedepreciatione13ComputingDepreciationStraight-lineDepreciationD=(Initialcost–salvage)/numberofyearsVeryfewassetsaredepreciatedstraight-linefortaxpurposesMACRS(ModifiedAcceleratedCostRecoverySystem)p.316NeedtoknowwhichassetclassisappropriatefortaxpurposesMultiplypercentagegivenintablebytheinitialcostDepreciatetozeroMid-yearconvention10-14.2022/12/30ComputingDepreciationStraight14After-taxSalvageAfter-taxsalvageisthecapitalrecoverycashflowatprojectend.Ifthesalvagevalueisdifferentfromthebookvalueoftheasset,thenthereisataxeffectBookvalue=initialcost–accumulateddepreciationAfter-taxsalvage=salvage–Tax*(salvage–bookvalue)10-15.2022/12/30After-taxSalvageAfter-taxsal15Example:DepreciationandAfter-taxSalvageYoupurchaseequipmentfor$100,000,anditcosts$10,000tohaveitdeliveredandinstalled.(Whatisthecapex?)Basedonpastinformation,youbelievethatyoucanselltheequipmentfor$17,000whenyouaredonewithitin6years.Thecompany’smarginaltaxrateis40%.Whatisthedepreciationexpenseeachyearandtheafter-taxsalvageinyear6foreachofthefollowingsituations?10-16.2022/12/30Example:DepreciationandAfte16Example:Straight-lineSupposetheappropriatedepreciationscheduleisstraight-lineD=(110,000–17,000)/6=15,500everyyearfor6yearsBVinyear6=110,000–6(15,500)=17,000After-taxsalvage=17,000-.4(17,000–17,000)=17,00010-17.2022/12/30Example:Straight-lineSuppose17Example:Three-yearMACRSp.316YearMACRSpercentD1.3333.3333(110,000)=36,6632.4445.4445(110,000)=48,8953.1481.1481(110,000)=16,2914.0741.0741(110,000)=8,151BVinyear6=110,000–36,663–48,895–16,291–8,151=0After-taxsalvage=17,000-.4(17,000–0)=$10,20010-18.2022/12/30Example:Three-yearMACRSp.18Example:Seven-YearMACRSYearMACRSPercentD1.1429.1429(110,000)=15,7192.2449.2449(110,000)=26,9393.1749.1749(110,000)=19,2394.1249.1249(110,000)=13,7395.0893.0893(110,000)=9,8236.0892.0892(110,000)=9,812BVinyear6=110,000–15,719–26,939–19,239–13,739–9,823–9,812=14,729After-taxsalvage=17,000–.4(17,000–14,729)=16,091.6010-19.2022/12/30Example:Seven-YearMACRSYearM19Example:ReplacementProblemOriginalMachineInitialcost=100,000Annualdepreciation=9,000Purchased5yearsagoBookValue=55,000Salvagetoday=65,000Salvagein5years=10,000NewMachineInitialcost=150,0005-yearlifeSalvagein5years=0Costsavings=50,000peryear3-yearMACRSdepreciationRequiredreturn=10%Taxrate=40%10-20.2022/12/30Example:ReplacementProblemOr20ReplacementProblem–ComputingCashFlowsRememberthatweareinterestedinincrementalcashflowsIfwebuythenewmachine,thenwewillselltheoldmachineWhatarethecashflowconsequencesofsellingtheoldmachinetodayinsteadofin5years?10-21.2022/12/30ReplacementProblem–Computin21ReplacementProblem–ProFormaIncomeStatementsYear12345CostSavings50,00050,00050,00050,00050,000Depr.New49,99566,67522,21511,1150Old9,0009,0009,0009,0009,000Increm.40,99557,67513,2152,115(9,000)EBIT9,005(7,675)36,78547,88559,000Taxes3,602(3,070)14,71419,15423,600NI5,403(4,605)22,07128,73135,40010-22.2022/12/30ReplacementProblem–ProForm22ReplacementProblem–IncrementalNetCapitalSpendingYear0Costofnewmachine=150,000(outflow)After-taxsalvageonoldmachine=65,000-.4(65,000–55,000)=61,000(inflow)Incrementalnetcapitalspending=150,000–61,000=89,000(outflow)Year5After-taxsalvageonoldmachine=-10,000(outflowbecausewenolongerreceivethis)10-23.2022/12/30ReplacementProblem–Incremen23ReplacementProblem–CashFlowFromAssetsYear012345OCF46,39853,07035,28630,84626,400NCS-89,000-10,000InNWC00CFFA-89,00046,39853,07035,28630,84616,40010-24.2022/12/30ReplacementProblem–CashFlo24ReplacementProblem–AnalyzingtheCashFlowsNowthatwehavethecashflows,wecancomputetheNPVandIRREnterthecashflowsComputeNPV=54,801.74ComputeIRR=36.28%Shouldthecompanyreplacetheequipment?10-25.2022/12/30ReplacementProblem–Analyzin25OtherMethodsforComputingOCFBottom-UpApproachWorksonlywhenthereisnointerestexpenseOCF=NI+depreciationTop-DownApproachOCF=Sales–CashCosts–TaxesDon’tsubtractnon-cashdeductionsTaxShieldApproachOCF=(Sales–Costs)(1–T)+Depreciation*T10-26.2022/12/30OtherMethodsforComputingOC26Example:CostCuttingYourcompanyisconsideringanewcomputersystemthatwillinitiallycost$1million.Thesystemisexpectedtolastforfiveyearsandwillbedepreciatedusing3-yearMACRS.Thesystemisexpectedtohaveasalvagevalueof$50,000attheendofyear5.Itwillsave$300,000peryearininventoryandreceivablesmanagementcosts.Thereisnoimpactonnetworkingcapital.Themarginaltaxrateis40%.Therequiredreturnis8%.ClickontheExcelicontoworkthroughtheexample10-27.2022/12/30Example:CostCuttingYourcomp27Example:SettingtheBidPriceConsiderthefollowinginformation:Armyhasrequestedbidformultipleusedigitizingdevices(MUDDs)Deliver4unitseachyearforthenext3yearsLaborandmaterialsestimatedtobe$10,000perunitProductionspaceleasedfor$12,000peryearRequires$50,000infixedassetswithexpectedsalvageof$10,000attheendoftheproject(depreciatestraight-line)Requireinitial$10,000increaseinNWCTaxrate=34%Requiredreturn=15%10-28.2022/12/30Example:SettingtheBidPrice28Example:EquivalentAnnualCostAnalysisBurnoutBatteriesInitialCost=$36each3-yearlife$100peryeartokeepchargedExpectedsalvage=$5Straight-linedepreciationLong-lastingBatteriesInitialCost=$60each5-yearlife$88peryeartokeepchargedExpectedsalvage=$5Straight-linedepreciationThemachinechosenwillbereplacedindefinitelyandneithermachinewillhaveadifferentialimpactonrevenue.NochangeinNWCisrequired.Therequiredreturnis15%,andthetaxrateis34%.10-29.2022/12/30Example:EquivalentAnnualCos29QuickQuizHowdowedetermineifcashflowsarerelevanttothecapitalbudgetingdecision?Whatarethedifferentmethodsforcomputingoperatingcashflowandwhenaretheyimportant?Whatisthebasicprocessforfindingthebidprice?Whatisequivalentannualcostandwhenshoulditbeused?10-30.2022/12/30QuickQuizHowdowedetermine30ComprehensiveProblemA$1,000,000investmentisdepreciatedusingaseven-yearMACRSclasslife.Itrequires$150,000inadditionalinventoryandwillincreaseaccountspayableby$50,000.Itwillgenerate$400,000inrevenueand$150,000incashexpensesannually,andthetaxrateis40%.Whatistheincrementalcashflowinyears0,1,7,and8?10-31.2022/12/30ComprehensiveProblemA$1,000,31KeyConceptsandSkillsUnderstandhowtodeterminetherelevantcashflowsforvarioustypesofproposedinvestmentsUnderstandthevariousmethodsforcomputingoperatingcashflowUnderstandhowtosetabidpriceforaprojectUnderstandhowtoevaluatetheequivalentannualcostofaproject10-32.2022/12/30KeyConceptsandSkillsUnderst32Chapter10MakingCapitalInvestmentDecisions.2022/12/30Chapter10.2022/12/2833ChapterOutlineProjectCashFlows:AFirstLookIncrementalCashFlowsProFormaFinancialStatementsandProjectCashFlowsMoreaboutProjectCashFlowAlternativeDefinitionsofOperatingCashFlowSomeSpecialCasesofDiscountedCashFlowAnalysis10-34.2022/12/30ChapterOutlineProjectCashFl34RelevantCashFlowsThecashflowsthatshouldbeincludedinacapitalbudgetinganalysisarethosethatwillonlyoccur(ornotoccur)iftheprojectisacceptedThesecashflowsarecalledincrementalcashflowsThestand-aloneprinciple

-analyzeeachprojectinisolationfromthefirm(onitsownmerits)byfocusingonincrementalcashflows10-35.2022/12/30RelevantCashFlowsThecashfl35AskingtheRightQuestionYoushouldalwaysaskyourself“WillthiscashflowoccurONLYifweaccepttheproject?”Iftheansweris“yes,”itshouldbeincludedintheanalysisbecauseitisincrementalIftheansweris“partofit,”thenweshouldincludethepartthatoccursbecauseoftheprojectIftheansweris“no,”itshouldnotbeincludedintheanalysisbecauseitwilloccuranyway10-36.2022/12/30AskingtheRightQuestionYous36CommonTypesofCashFlowsSunkcosts–coststhathaveaccruedinthepastOpportunitycosts–costsoflostoptionsSideeffectsPositivesideeffects–benefitstootherprojectsNegativesideeffects–coststootherprojectsChangesinnetworkingcapitalTaxes(useafter-taxcashflows)DonotconsiderFinancingCosts(partofR)10-37.2022/12/30CommonTypesofCashFlowsSunk37ProFormaStatementsandCashFlowCapitalbudgetingreliesheavilyonproformaaccountingstatements,particularlyincomestatementsComputingcashflows:OperatingCashFlow(OCF) =EBIT+depreciation–taxesOCF=Netincome+depreciation (whenthereisnointerestexpense)CashFlowFromAssets(CFFA)=OCF–netcapitalspending(NCS)–changesinNWC10-38.2022/12/30ProFormaStatementsandCash38Table10.1(p.310)

ProFormaIncomeStatementSales(50,000unitsat$4.00/unit)$200,000VariableCosts($2.50/unit)125,000Grossprofit$75,000Fixedcosts12,000Depreciation($90,000/3)30,000EBIT$33,000Taxes(34%)11,220NetIncome$21,78010-39.2022/12/30Table10.1(p.310)

ProForma39Table10.2ProjectedCapitalRequirements(balancesheet)Year0123NWC$20,000$20,000$20,000$20,000NFA90,00060,00030,0000Total$110,000$80,000$50,000$20,00010-40.2022/12/30Table10.2ProjectedCapitalR40Capitalspendingatthetimeofprojectinception(i.e.,the“initialoutlay”)includesthefollowingitems: +purchasepriceofthenewasset -sellingpriceoftheassetreplaced (ifapplicable) +costsofsitepreparation,setup, andstartup +/-increase(decrease)intax liabilityduetosaleofoldassetat other thanbookvalue

=netcapitalspending.2022/12/30Capitalspendingatthetimeo41Table10.5(p.311)ProjectedTotalCashFlowsYear0123OCF$51,780$51,780$51,780ChangeinNWC-$20,00020,000NCS-$90,000

CFFA-$110,00$51,780$51,780$71,78010-42.2022/12/30Table10.5(p.311)Projected42MakingTheDecisionNowthatwehavethecashflows,wecanapplythetechniquesthatwelearnedinChapter9UseformulasforPVofdiscountedcashflowsShouldweacceptorrejecttheproject?10-43.2022/12/30MakingTheDecisionNowthatwe43MoreonNWCWhydowehavetoconsiderchangesinNWCseparately?GAAPrequiresthatsalesberecordedontheincomestatementwhenmade,notwhencashisreceivedGAAPalsorequiresthatwerecordcostofgoodssoldwhenthecorrespondingsalesaremade,whetherwehaveactuallypaidoursuppliersyetFinally,wehavetobuyinventorytosupportsales,althoughwehaven’tcollectedcashyet10-44.2022/12/30MoreonNWCWhydowehavetoc44DepreciationThedepreciationexpenseusedforcapitalbudgetingshouldbethedepreciationschedulerequiredbytheIRSfortaxpurposesDepreciationitselfisanon-cashexpense;consequently,itisonlyrelevantbecauseitaffectstaxesDepreciationtaxshield=DTD=depreciationexpenseT=marginaltaxrate10-45.2022/12/30DepreciationThedepreciatione45ComputingDepreciationStraight-lineDepreciationD=(Initialcost–salvage)/numberofyearsVeryfewassetsaredepreciatedstraight-linefortaxpurposesMACRS(ModifiedAcceleratedCostRecoverySystem)p.316NeedtoknowwhichassetclassisappropriatefortaxpurposesMultiplypercentagegivenintablebytheinitialcostDepreciatetozeroMid-yearconvention10-46.2022/12/30ComputingDepreciationStraight46After-taxSalvageAfter-taxsalvageisthecapitalrecoverycashflowatprojectend.Ifthesalvagevalueisdifferentfromthebookvalueoftheasset,thenthereisataxeffectBookvalue=initialcost–accumulateddepreciationAfter-taxsalvage=salvage–Tax*(salvage–bookvalue)10-47.2022/12/30After-taxSalvageAfter-taxsal47Example:DepreciationandAfter-taxSalvageYoupurchaseequipmentfor$100,000,anditcosts$10,000tohaveitdeliveredandinstalled.(Whatisthecapex?)Basedonpastinformation,youbelievethatyoucanselltheequipmentfor$17,000whenyouaredonewithitin6years.Thecompany’smarginaltaxrateis40%.Whatisthedepreciationexpenseeachyearandtheafter-taxsalvageinyear6foreachofthefollowingsituations?10-48.2022/12/30Example:DepreciationandAfte48Example:Straight-lineSupposetheappropriatedepreciationscheduleisstraight-lineD=(110,000–17,000)/6=15,500everyyearfor6yearsBVinyear6=110,000–6(15,500)=17,000After-taxsalvage=17,000-.4(17,000–17,000)=17,00010-49.2022/12/30Example:Straight-lineSuppose49Example:Three-yearMACRSp.316YearMACRSpercentD1.3333.3333(110,000)=36,6632.4445.4445(110,000)=48,8953.1481.1481(110,000)=16,2914.0741.0741(110,000)=8,151BVinyear6=110,000–36,663–48,895–16,291–8,151=0After-taxsalvage=17,000-.4(17,000–0)=$10,20010-50.2022/12/30Example:Three-yearMACRSp.50Example:Seven-YearMACRSYearMACRSPercentD1.1429.1429(110,000)=15,7192.2449.2449(110,000)=26,9393.1749.1749(110,000)=19,2394.1249.1249(110,000)=13,7395.0893.0893(110,000)=9,8236.0892.0892(110,000)=9,812BVinyear6=110,000–15,719–26,939–19,239–13,739–9,823–9,812=14,729After-taxsalvage=17,000–.4(17,000–14,729)=16,091.6010-51.2022/12/30Example:Seven-YearMACRSYearM51Example:ReplacementProblemOriginalMachineInitialcost=100,000Annualdepreciation=9,000Purchased5yearsagoBookValue=55,000Salvagetoday=65,000Salvagein5years=10,000NewMachineInitialcost=150,0005-yearlifeSalvagein5years=0Costsavings=50,000peryear3-yearMACRSdepreciationRequiredreturn=10%Taxrate=40%10-52.2022/12/30Example:ReplacementProblemOr52ReplacementProblem–ComputingCashFlowsRememberthatweareinterestedinincrementalcashflowsIfwebuythenewmachine,thenwewillselltheoldmachineWhatarethecashflowconsequencesofsellingtheoldmachinetodayinsteadofin5years?10-53.2022/12/30ReplacementProblem–Computin53ReplacementProblem–ProFormaIncomeStatementsYear12345CostSavings50,00050,00050,00050,00050,000Depr.New49,99566,67522,21511,1150Old9,0009,0009,0009,0009,000Increm.40,99557,67513,2152,115(9,000)EBIT9,005(7,675)36,78547,88559,000Taxes3,602(3,070)14,71419,15423,600NI5,403(4,605)22,07128,73135,40010-54.2022/12/30ReplacementProblem–ProForm54ReplacementProblem–IncrementalNetCapitalSpendingYear0Costofnewmachine=150,000(outflow)After-taxsalvageonoldmachine=65,000-.4(65,000–55,000)=61,000(inflow)Incrementalnetcapitalspending=150,000–61,000=89,000(outflow)Year5After-taxsalvageonoldmachine=-10,000(outflowbecausewenolongerreceivethis)10-55.2022/12/30ReplacementProblem–Incremen55ReplacementProblem–CashFlowFromAssetsYear012345OCF46,39853,07035,28630,84626,400NCS-89,000-10,000InNWC00CFFA-89,00046,39853,07035,28630,84616,40010-56.2022/12/30ReplacementProblem–CashFlo56ReplacementProblem–AnalyzingtheCashFlowsNowthatwehavethecashflows,wecancomputetheNPVandIRREnterthecashflowsComputeNPV=54,801.74ComputeIRR=36.28%Shouldthecompanyreplacetheequipment?10-57.2022/12/30ReplacementProblem–Analyzin57OtherMethodsforComputingOCFBottom-UpApproachWorksonlywhenthereisnointerestexpenseOCF=NI+depreciationTop-DownApproachOCF=Sales–CashCosts–TaxesDon’tsubtractnon-cashdeductionsTaxShieldApproachOCF=(Sales–Costs)(1–T)+Depreciation*T10-58.2022/12/30OtherMethodsforComputingOC58Example:CostCuttingYourcompanyisconsideringanewcomputersystemthatwillinitiallycost$1million.Thesystemisexpectedtolastforfiveyearsandwillbedepreciatedusing3-yearMACRS.Thesystemisexpectedtohaveasalvagevalueof$50,000attheendofyear5.Itwillsave$300,000peryearininventoryandreceivablesmanagementcosts.Thereisnoimpactonnetworkingcapital