1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Making Capital Investment Decisions Chapter Ten

2. 10.1 Key Concepts and Skills  Understand how to determine the relevant cash flows for various types of proposed investments  Be able to compute the CCA tax shield  Understand the various methods for computing operating cash flow  Understand how to analyze different capital budgeting decisions

3. 10.2 Relevant Cash Flows 10.1  The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted  These cash flows are called incremental cash flows  The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

4. 10.3 Asking the Right Question  You should always ask yourself “Will this cash flow occur (or not occur) ONLY if we accept the project?”  If the answer is “yes”, it should be included in the analysis because it is incremental  If the answer is “no”, it should not be included in the analysis because it will occur anyway  If the answer is “part of it”, then we should include the part that occurs (or does not occur) because of the project

5. 10.4 Common Types of Cash Flows 10.2  Sunk costs – costs that have been incurred in the past (& thus must be excluded from the current decision)  Opportunity costs – cost of foregone opportunities  Example – you purchased an asset many years ago for a nominal sum. You now want to use that asset in a current project. How much do you charge to the project, since you already own the asset?  You must charge the project with the amount you could obtain by selling the asset to another user.

6. 10.5 Common Types of Cash Flows 10.2  Side effects  Positive side effects – benefits to other projects  Example: HP printers & the cost of consumables  Negative side effects – costs to other projects  Issue of erosion or cannibalism  Be sure to only include erosion due to the new project. Erosion can also occur due to competition from other firms.  Example: Air Canada – Tango versus the mainline fleet  Changes in net working capital (NWC)  Increases in NWC are a cost of the project  Decreases in NWC are a benefit of the project  NWC often increases initially and then decreases at the end of the project’s life

7. 10.6 Common Types of Cash Flows 10.2  Financing costs  Are never included in the cash flows of the project  Financing costs are captured in the discount rate  Inflation  Nominal interest rates include an inflation component (remember the Fisher Equation). Thus the discount rate captures expected future inflation.  Project cash flows should also include the effect of inflation  Capital Cost Allowance (CCA)  CCA (depreciation for tax purposes) creates a beneficial tax shield  A tax shield is the amount of tax that would have been paid, had the project not been undertaken

8. 10.7 The Six Steps of Capital Budgeting Step #1: Calculate the PV of the initial cost plus any delivery & installation expenses minus any trade-in received Step #2: Calculate the PV of the after-tax incremental operating cash flows from undertaking the project Step #3: Calculate the PV of the tax shield from CCA Step #4: Calculate the PV of salvage Step #5: Calculate the PV of the tax shield from CCA lost due to salvage Step #6: Calculate the PV of the change in NWC

9. 10.8 The Six Steps of Capital Budgeting Step #1: PV Initial Cost = Purchase Cost + Installation – Trade-in Step #2: Step #3: Step #4: Step #5: Step #6:

10. 10.9 Defining the Terms  Where:  Rev t = Incremental revenue in period t  Exp t = Incremental expense in period t  T c = Corporate Tax Rate  UCC = Undepreciated capital cost  d = CCA tax rate  k = discount rate (the firm’s cost of capital)  Salvage = the value received at the end of the asset’s expected useful life  N = number of periods until the salvage value is realized  NWC = Net working capital (Current assets – current liabilities)

11. 10.10 Pro Forma Statements and Cash Flow 10.3  Capital budgeting relies heavily on pro forma accounting statements, particularly income statements  Computing cash flows – (refer back to Chapter 2)  Cash Flow From Assets (CFFA) = Operating Cash Flow – net capital spending (NCS) – Change (increase) in NWC  Operating Cash Flow (OCF) = EBIT + depreciation – taxes  Net Capital Spending = Net Fixed Assets End of Period – Net Fixed Assets Start of Period + Depreciation  Change in NWC = NWC End of Period – NWC Start of Period

12. 10.11 Example: Pro Forma Income Statement Sales (50,000 units at $4.00/unit)$200,000 Variable Costs ($2.50/unit)125,000 Gross profit$ 75,000 Fixed costs12,000 Depreciation ($90,000 / 3)30,000 EBIT$ 33,000 Taxes (34%)11,220 Net Income$ 21,780

13. 10.12 Example: Projected Capital Requirements Year 0123 NWC↑$20,000↓$20,000 Net Fixed Assets $90,000

14. 10.13 Example: Projected Total Cash Flows Year 0123 Op Cash Flow$51,780 Change in NWC ↑$20,000↓$20,000 Capital Spending ↑$90,000 CFFA-$110,000$51,780 $71,780

15. 10.14 Making The Decision  Given the cash flows, we can apply the techniques from Chapter 9  Assume the required return is 20%  Enter the cash flows into the calculator and compute NPV and IRR 110,000 +/-CF 0 51,780CF 1 51780CF 2 71,780CF 3 20I 2 nd NPV $10,648 2 nd IRR 25.8%  Should we accept or reject the project?

16. 10.15 The Six Steps of Capital Budgeting Step #1: PV Initial Cost = - 90,000 Step #2: Step #3: Step #4: Step #5: Step #6: Note: This is not a good example for use with the Six Steps, since CCA (depreciation) is calculated straight-line over three years. This is then captured in the cash flows in Step Two.

17. 10.16 Summary of Project Cash Flows  Step #1:- 90,000  Step #2:+109,074  Step #3:0  Step #4:0  Step #5:0  Step #6:- 8,426  NPV = + 10,648

18. 10.17 More on NWC 10.4  Why do we have to consider changes in NWC separately?  An investment in current assets is exactly the same as an investment in a fixed asset (but it is harder to visualize)  An increase in NWC requires either:  An increase in Current Assets (a use of cash)  A reduction in Current Liabilities (a use of cash)  GAAP requires that sales be recorded on the income statement when made, not when cash is received (recorded as an Account Receivable on the B/S)  GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet (costs recorded as an Account Payable on the B/S)  Finally, we have to buy inventory to support sales although we haven’t collected cash yet (Both inventory and accounts payable rise)

19. 10.18 Capital Cost Allowance (CCA)  CCA is depreciation for tax purposes  The depreciation expense used for capital budgeting should be calculated according to the CCA schedule dictated by the tax code  Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes  Depreciation tax shield = DT C  D = depreciation expense  T C = corporation’s marginal tax rate

20. 10.19 Computing Depreciation  Need to know which asset class for tax purposes  Declining Balance  Multiply the undepreciated capital cost (UCC) by the CCA rate (from the Tax Act)  Half-year rule (can only deduct 50% of the usual amount in the year of acquisition of the asset)  Can use PV of CCA Tax Shield Formula (see next page)  Straight-line depreciation  Very few assets are depreciated straight-line for tax purposes  Depreciation = (Initial cost – salvage) / number of years

21. 10.20 PV of CCA Tax Shield Formula  Where:  UCC = Initial cost of asset, including installation costs less any trade-in value received for an existing asset  d = CCA rate  Tc = Corporate Tax Rate  k = discount rate (corporation’s cost of capital)

22. 10.21 PV of the Tax Shield from CCA Lost due to Salvage  Where  S = Salvage value  n = number of periods until the salvage value is realized

23. 10.22 Example: Depreciation and Salvage  You purchase equipment for $100,000 plus it costs $10,000 to have it delivered and installed. Based on past information, you believe that the equipment will have a salvage value of $17,000 in 6 years. The company’s marginal tax rate is 40%. If the applicable CCA rate is 20% and the required return on this project is 10%, what is the present value of the tax shield from CCA less the present value of the tax shield lost from salvage?

24. 10.23 Example: Depreciation and Salvage continued  The delivery and installation costs must be added to the initial cost of the asset and then depreciated

25. 10.24 Example #1: Cost Cutting  Your company is considering a new production system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated at a CCA rate of 20%. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%.

26. 10.25 Example #1: Cost Cutting Step #1: PV Initial Cost = - 1,000,000 Step #2: Step #3:

27. 10.26 Example #1: Cost Cutting Step #4: Step #5: Step #6:

28. 10.27 Summary of Cash Flows: Cost Cutting Step #1 -1,000,000 Step #2 718,688 Step #3 275,132 Step #4 34,029 Step #5 - 9,723 Step #6 0 NPV $18,126 Since the NPV is positive, the firm should proceed with the cost cutting initiative. If the NPV were negative, the firm should not proceed.

29. 10.28 Example #2: Repair versus Replace  Original Machine  Initial cost = 100,000  Purchased 5 years ago  Salvage today = 65,000  Salvage in 5 years = 10,000  New Machine  Initial cost = 150,000  5-year life  Salvage in 5 years = 0  Cost savings = 50,000 per year Required return = 10% CCA Rate = 20% Tax rate = 40%

30. 10.29 Example #2: Repair versus Replace Step #1: PV of Initial Cost less trade-in = -$150,000 + 65,000 = -85,000 Step #2: Step #3:

31. 10.30 Example #2: Repair versus Replace Step #4: Step #5: Step #6:

32. 10.31 Summary of Cash Flows: Repair vs Replace Step #1 -85,000 Step #2 +113,724 Step #3 +21,636 Step #4 - 6,209 Step #5 +1,656 Step #6 0 NPV $45,806 Since the NPV is positive, the firm should proceed with acquiring the new machine. If the NPV were negative, the firm should keep the old machine.

33. 10.32 Example #3: Equivalent Annual Cost Analysis  Machine A  Initial Cost = $150,000  Pre-tax operating cost = $65,000  Expected life is 8 years  Machine B  Initial Cost = $100,000  Pre-tax operating cost = $57,500  Expected life is 6 years The machine chosen will be replaced indefinitely Neither machine will impact revenue No change in NWC is required The required return is 10% CCA rate is 20% Tax rate is 40%. Which machine should you buy?

34. 10.33 Example #3: Equivalent Annual Cost Analysis  To perform an equivalent annual cost calculation, first calculate the NPV of each alternative, using the 6 steps.  Then divide the NPV by the annuity factor to obtain an equivalent annual cost/benefit  Choose the alternative with the higher annual benefit or lower annual cost

35. 10.34 Example #3: Equivalent Annual Cost Analysis Machine A Step #1: $150,000 Step #2: Step #3:

36. 10.35 Example #3: Equivalent Annual Cost Analysis Step #4: Step #5: Step #6:

37. 10.36 Example #3: Equivalent Annual Cost Analysis Machine B Step #1: $100,000 Step #2: Step #3:

38. 10.37 Example #3: Equivalent Annual Cost Analysis Step #4: Step #5: Step #6:

39. 10.38 Example #3: Equivalent Annual Cost Analysis Calculate the NPV for each machine & divide by the annuity factor Machine A Machine B Step #1-150,000-100,000 Step #2-208,062-150,256 Step #3+38,182+25,455 Step #400 Step #500 Step #600 Total NPV$319,880$224,801 Equivalent Annual Cost$59,960$51,615 To calculate EAC, divide NPV by the annuity factor (see next page for the annuity factor)

40. 10.39 EAC: Calculating the Annuity Factors  The formula for the PV of an ordinary annuity looks like this:  The Annuity Factor is the component contained within the brackets  The Annuity Factors for Machine A & B are thus:

41. 10.40 Example #4: Setting the Bid Price  Consider the example in the textbook:  Need to produce 5 modified trucks per year for 4 years  We can buy the truck platforms for $10,000 each  Facilities will be leased for $24,000 per year  Labor and material costs are $4,000 per truck  Need $60,000 investment in new equipment, depreciated at 20% (CCA class 8)  Expect to sell the equipment for $5,000 at the end of 4 years  Need $40,000 in net working capital  Tax rate is 43.5%  Required return is 20%

42. 10.41 Example #4: Setting the Bid Price Step #1$60,000 Step #2 Step #3

43. 10.42 Example #4: Setting the Bid Price Step #4 Step #5 Step #6

44. 10.43 Example #4: Setting the Bid Price Step #1-$60,000 Step #2-$137,488 Step #3+$11,963 Step #4+$2,411 Step #5-$524 Step #6-$20,710 PV Costs -$204,348

45. 10.44 Example #4: Setting the Bid Price  To calculate the bid price, must now set the PV of costs equal to the PV of revenue P is equal to the required bid price per truck

46. 10.45 Summary 10.8  You should know:  How to determine the relevant incremental cash flows that should be considered in capital budgeting decisions  How to calculate the CCA tax shield for a given investment  How to perform a capital budgeting analysis for:  Replacement problems  Cost cutting problems  Bid setting problems  Projects of different lives