Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-1 Chapter Eight Making Capital Investment Decisions

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-2 Chapter Organisation 8.1Project Cash Flows: A First Look 8.2Incremental Cash Flows 8.3Project Cash Flows 8.4More on Project Cash Flows 8.5Some Special Cases of Discounted Cash Flow Analysis 8.6Summary and Conclusions

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-3 Chapter Objectives Identify incremental cash flows relevant to investment evaluation. Calculate depreciation expense for tax purposes. Apply incremental analysis to project evaluation. Determine how to set the bid price and how to value options. Compare mutually-exclusive projects using annual equivalent costs.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-4 Incremental Cash Flows Any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project. The only relevant cash flows in capital project evaluation. Stand-alone principle: we can evaluate the project on its own.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-5 Types of Cash Flows Sunk costs  a cost that has already been incurred and cannot be removed  incremental cash flow Opportunity costs  the most valuable alternative that is given up by the investment = incremental cash flow Side effects  erosion = incremental cash flow

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-6 Types of Cash Flows (continued) Financing costs  incorporated in discount rate  incremental cash flow Always use after-tax incremental cash flow

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-7 Investment Evaluation Step 1 Calculate the taxable income. Step 2 Calculate the cash flows. Step 3 Discount the cash flows. Step 4 Decision.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-8 Example—Investment Evaluation Purchase price $ Salvage value $1000 at end of Year 3 Net cash flowsYear 1 $ Year 2 $ Year 3 $ Tax rate is 30% Depreciation 20% reducing balance Required rate of return 12%

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-9 Solution—Depreciation Schedule

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-10 Solution—Taxable Income

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-11 Solution—Cash Flows Year 0Year 1Year 2Year 3 Tax paid(6 780)(5 484)1 764 Net cash flow Salvage value1 000 Outlay(42 000) Cash flow(42 000)

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-12 Solution—NPV and Decision Decision: NPV > 0, therefore ACCEPT.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-13 Interest As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return). Interest costs should not therefore be included as an explicit cash flow. Interest costs are included in the required rate of return (discount rate) used to evaluate the project.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-14 Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes. Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes. Prime cost vs diminishing value methods Depreciation tax shield = DT -D = depreciation expense -T = marginal tax rate

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-15 Disposal of Assets If the salvage value > book value, a profit/gain is made on disposal. This profit/gain is subject to tax (excess depreciation in previous periods). If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods).

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-16 Capital Gains Capital gains made on the sale of assets such as rental property are subject to taxation. Capital losses are not a tax deduction but can be offset against future capital gains.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-17 Example—Incremental Cash Flows A firm is currently considering replacing a machine purchased two years ago with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below:

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-18 Solution—Taxable Income

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-19 Solution—Cash Flows

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-20 Solution—NPV and Decision Decision: NPV < 0, therefore REJECT.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-21 Setting the Bid Price How to set the lowest price that can be profitably charged. Cash outflows are given. Determine cash inflows that result in zero NPV at the required rate of return. From cash inflows, calculate sales revenue and price per unit.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-22 Setting the Option Value Option value = Asset value × Probability of the Value – Present value of the exercise price × Probability the exercise price will be paid.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-23 Annual Equivalent Cost (AEC) When comparing two mutually-exclusive projects with different lives, it is necessary to make comparisons over the same time period. AEC is the present value of each project’s costs to infinity calculated on an annual basis. Select the project with the lowest AEC.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-24 Example—AEC Project A costs $3000 and then $1000 per annum for the next four years. Project B costs $6000 and then $1200 for the next eight years. Required rate of return for both projects is 10 per cent. Which is the better project?

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-25 Solution—Project A

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-26 Solution—Project B

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 8-27 Solution—Interpretation Project A is better because it costs $1946 per year compared to Project B’s $2325 per year.