0. Making Capital Investment Decisions
Chapter 8
Making Capital Investment Decisions

1. Key Concepts and Skills
Determine the relevant cash flows for various types of capital investments
Compute depreciation expense for tax purposes
Incorporate inflation into capital budgeting
Employ the various methods for computing operating cash flow
Apply the Equivalent Annual Cost approach

2. Incremental Cash Flows
Cash flows matter—not accounting earnings.
Incremental cash flows matter.
Sunk costs don’t matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after- tax cash flows.
Inflation matters.
STAND ALONE PRINCIPLE – view the Project as a mini-firm.

3. Cash Flow: The Basis of Capital Budgeting Decisions
When performing capital budgeting analysis:
Always base calculations on cash flow, not income
Earnings ≠ Cash
Need cash for capital spending
Need cash for rewarding shareholders
Therefore, capital expenditure analysis must be based on cash
Much of the work in evaluating a project lies in converting accounting income to cash flow (e.g., Depreciation)

4. Incremental Cash Flows
Remember: Incremental cash flows arise as a consequence of selecting a project
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.

5. Sunk Costs vs. Opportunity Costs
Last year, you purchased a plot of land for $2.5 million.
Currently, its market value is $2.0 million.
You are considering placing a new retail outlet on this land.
How should the land cost be evaluated for purposes of projecting the cash flows that will become part of the NPV analysis?

6. Incremental Cash Flows
Side effects matter.
Erosion and cannibalism are both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that.
For example, erosion: cash flow transferred from existing operations to the new project.
Starbucks introduction of “Via”
Apple offering an iPad3/4 or Mini-iPad.
If, however, synergies result that create increased demand of existing products, we also need to recognize that.

8. Incremental Cash Flows
Allocations
Overhead may be allocated to the new project
Allocations are only relevant if the project increases or decreases the cash outlay of the entire firm
Salvage Value
Don’t forget to treat salvage value (after tax, of course) as a cash inflow at the end of the project
Changes in Net Working Capital
Many projects require an increase in NWC (inventory, receivables, and other current assets) when initiated; this is a cash outlay at the beginning of the project
Don’t forget: To reduce NWC at the end of a project requiring increased NWC; this is a cash inflow at the end of the project

9. Taxes and capital budgeting – Depreciation and Salvage value
Accountants charge depreciation to spread a fixed asset’s costs over time to match its benefits
Capital budgeting analysis focuses on cash inflows and outflows when they occur
Non-cash expenses affect cash flow through their impact on taxes
Compute after-tax net income and add depreciation back
Ignore depreciation expense but add back its tax savings
For capital budgeting analysis, it is the depreciation method for tax purposes that matters

10. How much depreciation can be taken?
Modified Accelerated Cost Recovery System (ACRS): 1986 Tax Reform Act allows firms to "front-load" depreciation charges.
Modified ACRS Property Classes:
3 year (short lived equipment, including research)
5 year (autos, computers, etc.)
7 year (most industrial equipment)

12. Salvage Value and Taxes on Sale of Fixed Assets
Tax = [Selling price - Book value]x[Tax rate]
Example 1. Selling price = $100,000, Book value = $80,000.
Tax = [100, ,000][.40] = $8,000
Total Cashflow from sale of asset: $100,000- $8,000=$92,000
Example 2. Selling price = $50,000, Book value = $80,000.
Tax = [50, ,000][.40] = -$12,000
Total Cashflow from sale of asset: $50,000+$12,000=$62,000

13. Estimating Net Cash Flows – also known as Free Cash Flows or Cash Flows from Assets
Operating Cash Flow
Recall that:
OCF = EBIT – Taxes + Depreciation
Net Capital Spending or Capital Expenditures
Don’t 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.

14. Alternative 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
(R-E-D) *(1-t) + D = OCF

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

16. 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)
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.

17. The Baldwin Company – Section 8.2 of RWJJ
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.

18. 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

19. The Baldwin Company
($ 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 – * (2) Accumulated depreciation (3) Adjusted basis of machine after depreciation (EOY) (4) Opportunity cost – (warehouse) (5) Net working capital (6) Change in NWC –10.00 –6.32 – (7) Total cash flow of – –6.32 – investment [(1) + (4) + (6)]
* 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, so the capital gains tax due is $8,240 [0.34 * ($30,000 – $5,760)]. The after-tax salvage value is $30,000 – [0.34 * ($30,000 – $5,760)] = 21,760.

20. The Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
After-Tax salvage Value with Mkt Value $30,000 and Cap gain of ( =24.24)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine – *
(2) Accumulated depreciation
(3) Adjusted basis of machine after depreciation (end of year)
(4) Opportunity cost – (warehouse)
(5) Net working capital
(end of year)
(6) Change in NWC – –6.32 –
(7) Total cash flow of – –6.32 – investment [(1) + (4) + (6)]
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

21. The Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues
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 3 = 12,000×[$20×(1.02)2]=12,000×$20.81=$249,720.

22. The Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues
(9) Operating costs
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

23. The Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation
Depreciation is calculated using the 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 % % % % % %
6 5.76%
Total %

24. The Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation
(11) Income before taxes [(8) – (9) - (10)
(12) Tax at 34 percent
(13) Net Income
Add back depreciation
(13) OCF

25. Incremental After Tax Cash Flows
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
(1) Sales Revenues
$100.00
$163.20
$249.72
$212.20
$129.90
(2) Operating costs
-50.00
-88.00
133.10
-87.84
(3) Taxes
-10.20
-14.69
-29.01
-22.98
-10.38
(4) OCF
(1) – (2) – (3)
39.80
60.51
75.51
56.12
31.68
(5) Total CF of Investment
–260.
–6.32
–8.65
3.75
192.98
(6) IATCF
[(4) + (5)]
–260.
39.80
54.19
66.86
59.87
224.66

26. Investments of Unequal Lives
There are times when blunt 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?

27. NPV Calculation NPVCad = -4000 + -100*A0.1,10
NPVCheap = *A0.1,5
A0.1, 5=
NPVCheap =
At first glance, the Cheapskate cleaner has a higher NPV.

28. Investments of Unequal Lives
Cadillac Air Cleaner
Cheapskate Air Cleaner
CF1 F1
CF0 I
NPV
– 4,000
CF1 F1
CF0 I
NPV
–1,000
–100
–500 10 5 10 10
–4,614.46
–2,895.39
At first glance, the Cheapskate cleaner has a higher NPV.

29. Investments of Unequal Lives
But the Cadillac lasts twice as long!
Replacement Chain
Repeat projects until they begin and end at the same time.
Compute NPV for the “repeated projects.”
The Equivalent Annual Cost Method (EAC)
Applicable to a much more robust set of circumstances than the replacement chain
The EAC is the value of the level payment annuity that has the same PV as our original set of cash flows.
I HIGHLY RECOMMEND YOU USE THE EAC METHOD!

30. EAC Calculation EACCad = 4614.46/A0.1, 10 EACCheap = 2895.39/A0.1, 5
We should purchase the Cadillac because it has lower annual costs.

31. Equivalent Annual Cost (EAC)
EAC is the annual annuity payment implied by a project’s NPV
In other words:
if the present value of an annuity is set equal to the project NPV
and an annual payment is computed
using the same term and rate as the NPV; then,
the payment is the EAC
The EAC for the Cadillac filter is $750.98
The EAC for the Cheapskate filter is $763.98
In general, select the EAC with the lower cost. This suggests a decision to reject the Cheapskate filter which had the more attractive raw NPV

32. Cadillac EAC with a Calculator
Net Present Value
Equivalent Annual Cost
CF1 F1
CF0 I
NPV
–4,000
PMT
I/Y FV PV N 10
–100 10
–4,614.46 10 10
750.98
–4,614.46

33. Cheapskate EAC with a Calculator
Net Present Value
Equivalent Annual Cost
CF1 F1
CF0 I
NPV
–1,000
PMT
I/Y FV PV N 5
–500 10
-2,895.39 5 10
763.80
–2,895.39

34. The Human Face of Capital Budgeting
Managers must be aware of optimistic bias in assumptions made by supporters of the project
Companies should have control measures in place to remove bias
Analysis of an investment done by a group independent of individual or group proposing the project
Analysts of the project must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential
Storytelling
Best analysts not only provide numbers to highlight a good investment, but also can explain why the investment makes sense

35. NPV and Microeconomics
One line of defense is to think about NPV in terms of underlying economics.
NPV is the present value of the project’s future ‘economic profits.’
Economic profits are those in excess of the ‘normal’ return on invested capital.
In ‘long-run competitive equilibrium’ all projects and firms earn zero economic profits.
In what ways does the proposed project differ from the theoretical ‘long run competitive equilibrium’?
If no plausible answers emerge, the positive NPV is likely illusory.