1. Chapter 10 Making Capital Investment Decisions
Homework: 23, 24, 31, 32 & 34

2. Lecture Organization
Identify relevant cash flows
Construct forecasted financial statements
Alternative definitions of OCF
CCA versus straight-line deprecation
Capital budgeting examples

3. Fundamental Principles of Project Evaluation
Project evaluation - the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision.
Relevant cash flows - the incremental cash flows associated with the decision to invest in a project.
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.
Stand-alone principle - evaluation of a project based on the project’s incremental cash flows.

4. Relevant Cash Flows
Honda Corp. is considering a new car model to replace the Accord
which earns 340,000 million yen a year in Accord sales
Estimates it will sell 2 million units of the new model and earn 210,000 yen on each unit (420,000 million yen in revenues)
Incremental cash flows = Cash Flow(With new car model)
- Cash Flows(Without new car model)
420, ,000 = 80,000 million yen

5. Stand-Alone Principle
Evaluate project on the basis of its incremental cash flows
Project = "Mini-firm"
Allows us to evaluate the investment project separately
from other activities of the firm
Cash Flows from the Project = Cash Flows from Assets

6. Aspects of Incremental Cash Flows
Sunk Costs
Opportunity Costs
Side Effects (Erosion)
Net Working Capital
Financing Costs
All Cash Flows should be after-tax cash flows

7. Sunk Costs
The Limited hires The Boston Consulting Group (BCG) to evaluate whether a new product line should be launched. The consulting fees are paid no matter what.

8. Opportunity Costs
Firm paid $300,000 land to be used for a warehouse. The
current market value of the land is $450,000.
Opportunity Cost =
Sunk Cost =

9. Side Effects and Erosion
A drop in Big Mac revenues when McDonald's
introduced the Arch Deluxe.

10. Net Working Capital Investment in inventories and receivables.
This investment is recovered at the end of project.

11. Financing Costs
Interest, principal on debt and dividends.

12. Pro Forma Financial Statements
and DCF Valuation
Pro forma financial statements
Best current estimate of future cash flows
Exclude interest expenses and other financing costs
Use statements to obtain Project cash flow
If stand-alone principle holds:
Project Cash Flow = Cash Flow from Assets =
Operating Cash Flow - Net Capital Spending - Additions to Net Working Capital

13. Depreciation Economic and future market value are ignored.
Depreciation expense uses the cost of asset.
Care about depreciation because it affects tax bill
Use tax accounting rules for depreciation.
CCA
Straight-line

14. Additions to Net Working Capital
Will start with a NWC number (date 0)
NWC will change during project life (e.g. grow at a rate of 3% per period)
NWC(year 2) = NWC(year1)*1.03
Or, NWC will equal Y% of sales each period (e.g. 15%)
NWC(year 2) = 0.15*Sales(year 2)
All NWC is recovered at the end of the project.
Inventories are run down
Unpaid bills are paid.
Bring NWC account to zero.

15. Ways to Capital Budgeting Problem
Date 0:
Buy the fixed asset -- Cash Outflow
Date T:
Sell the fixed asset -- Cash Inflow
If no more assets of the same class:
Record after-tax gain or loss

16. Example: Preparing Pro Forma Statements
Suppose we want to prepare a set of pro forma financial statements for a project for Norma Desmond Enterprises. In order to do so, we must have some background information. In this case, assume:
1. Sales of 10,000 $5/unit.
2. Variable cost/unit is $3. Fixed costs are $5,000/year. Project has no salvage value. Project life is 3 years.
3. Project cost is $21,000. Depreciation is $7,000/year.
4. Net working capital is $10,000.
5. The firm’s required return is 20%. The tax rate is 34%.

17. Example: Preparing Pro Forma Statements (continued)
Pro Forma Financial Statements
Projected Income Statements
Sales $______
Var. costs ______
$20,000
Fixed costs 5,000
Depreciation 7,000
“EBIT” $______
Taxes (34%) 2,720
Net income $______

18. Example: Preparing Pro Forma Statements (concluded)
Projected Balance Sheets
NWC $______ $10,000 $10,000 $10,000
NFA 21,000 ______ ______ 0
Total $31,000

19. Example: Using Pro Formas for Project Evaluation
Let’s use the information from the previous example to do a capital budgeting
Project operating cash flow (OCF):
EBIT
Depreciation
Taxes
OCF $____

20. Example: Using Pro Formas for Project Evaluation (continued)
Project Cash Flows
OCF
NWC Sp. ______ ______
Cap. Sp. -21,000
Total ______ ______

21. Example: Using Pro Formas for Project Evaluation (concluded)
Capital Budgeting Evaluation:
NPV =
PB =
AAR =
Should the firm invest in this project? Why or why not?

22. Alternative Definitions of OCF
Let:
OCF = operating cash flow
S = sales
C = operating costs
D = depreciation
Tc = corporate tax rate

23. Alternative Definitions of OCF (concluded)
The Tax-Shield Approach
OCF = (S - C - D) + D - (S - C - D) x Tc
= (S - C) x ( 1 - Tc) + (D x Tc)
= (S - C) x (1 - Tc) + depreciation tax shield
The Bottom-Up Approach
OCF = (S - C - D) + D - (S - C - D) x Tc
= (S - C - D) x (1 - Tc) + D
= Net income + depreciation
The Top-Down Approach
OCF = (S - C - D) + D - (S - C - D) x Tc
= (S - C) - (S - C - D) x Tc
= Sales - costs - taxes

24. Calculate the project’s NPV and payback period.
Chapter 10 Quick Quiz
Assume we have the following background information for a project being considered by Gillis, Inc.
Calculate the project’s NPV and payback period.
1. Required NWC investment = $40; initial capital spending = $60; 3 year life
2. Annual sales = $100; annual costs = 50; straight line depreciation to $0
3. Salvage value = $10; tax rate = 34%, required return = 12%
The after-tax salvage is $10 - ($___ - ___ )(.34) = $6.6
OCF = ( ) ( )(.34) = $_____

25. Chapter 10 Quick Quiz (concluded)
Project cash flows are thus:
OCF $39.8 $39.8 $39.8
Add. NWC _____ _____
Cap. Sp _____
_____ $39.8 $39.8 $86.4
NPV = $ ______
Payback period = years

26. Example: Fairways Equipment and Operating Costs
Equipment requirements:
Ball dispensing machine $ 2,000
Ball pick-up vehicle 7,000
Tractor and accessories 9,000
$18,000
all depreciable equipment is Class 10, 30%
all equipment is expected to have a salvage value of 10% of cost after 6 years. Assume there are no more class 10 assets after the project ends.
Balls and buckets $ 3,000
expenditures for balls and baskets are expected to grow to 5% per year
Corporate tax rate is 15%

27. Example: Fairways Equipment and Operating Costs (concluded)
Operating Costs (annual)
Land lease $ 12,000
Water 1,500
Electricity 3,000
Labor 30,000
Seed & fertilizer 2,000
Gasoline 1,500
Maintenance 1,000
Insurance 1,000
Misc. 1,000
$53,000
Working Capital
Initial requirement = $3,000
Working capital requirements are expected to grow at 5% per year for the life of the project

28. Example: Fairways Revenues, Depreciation, and Other Costs
Projected Revenues
Year Buckets Revenues
1 20,000 $60,000
2 20,750 62,250
3 21,500 64,500
4 22,250 66,750
5 23,000 69,000
6 23,750 71,250

29. Example: Fairways Revenues, Depreciation, and Other Costs (continued)
Cost of balls and buckets
Year Cost
1 $3,000
2 3,150
3 3,308
4 3,473
5 3,647
6 3,829

30. Example: Fairways Revenues, Depreciation, and Other Costs (concluded)
CCA for the six year life of the project
Year Beg. UCC CCA Ending UCC

31. Example: Fairways Pro Forma Income Statement
Year
Revenues $60,000 62,250 64,500 66,750 69,000 71,250
Variable costs 3,000 3,150 3,308 3,473 3,647 3,829
Fixed costs 53,000 53,000 53,000 53,000 53,000 53,000
Depreciation 2,700 4,590 3,213 2,249 1,574
EBIT 1,300 1,510 4,979 8,028 10,779
Taxes ,204 1,617
Net income $ ,283 4,232 6,824 9,162

32. Example: Fairways Projected Increases in NWC
Projected increases in net working capital
Year Net working capital Increase in NWC
0 3,000 ____
1 3,
2 3,
3 3,
4 3,
5 3,
6 4,020 ____

33. Example: Fairways Cash Flows
Operating cash flows:
Operating Year EBIT + Depreciation - Taxes = cash flow
0 $ $ $ $
1 1,300 2, ,805
2 1,510 4, ,873
3 4,979 3, ,445
4 8,028 2,249 1,204 9,073
5 10,779 1,574 1,617 10,736
6 ______ _____ ______ _______

34. Example: Fairways Cash Flows (concluded)
Total cash flow from assets:
Operating - Increases Capital Total Year cash flow in NWC - spending = cash flow
0 $ $ ______ $18,000 -$_____
1 3, ,655
2 5, ,715
3 7, ,280
4 9, ,899
5 10, ,554
6 ______ _____ ______ ______

35. Present Value of the Tax Shield on CCA
Let:
C = total capital cost added to the pool (initial UCC)
d = CCA rate for the asset class
k = discount rate
S = salvage value of asset
Tc = corporate tax rate
n = asset life in years

36. Notes for Present Value of CCA Tax Shield (CCATS)

37. Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal
Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a scrap value of $1,000 after five years. The equipment is in class 8 with a CCA rate of 20%. The marginal tax rate is 34% and the appropriate discount rate is 10%.
(Assume there are other class 8 assets in use after 5 years.)

38. Example 1: Using CCATS to Evaluate a Cost-Cutting Proposal (concluded)

39. Example 2: Straight-line Depreciation and Cost-Cutting Proposal
Redo the previous example with straight-one deprecation.
Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year over a 5-year period. Assume no changes in net working capital and a scrap value of $1,000 after five years. For simplicity, assume straight-line depreciation. The marginal tax rate is 34% and the appropriate discount rate is 10%.

40. Example 2: Straight-line Depreciation and Cost-Cutting Proposal (concluded)

41. Example: Setting the Bid Price
The Army is seeking bids on Multiple Use Digitizing Devices (MUDDs). The contract calls for 4 units per year for 3 years. Labour and material costs are estimated at $10,000 per MUDD. Production space can be leased for $12,000 per year. The project will require $50,000 in new equipment which is expected to have a salvage value of $10,000 after 3 years. Making MUDDs will require a $10,000 increase in net working capital. Assume a 34% tax rate and a required return of 15%. Use straight-line depreciation.
Operating Increases Capital Total Year cash flow in NWC spending = cash flow
0 $ ______ ______ _______
1 OCF 0 0 OCF
2 OCF 0 0 OCF
3 OCF ______ ______ OCF + ______

42. Example: Setting the Bid Price (concluded)

43. Annual Operating Costs
Evaluating equipment with different economic lives
Machine A
Machine B
Costs
Annual Operating Costs
Replace
$100
$140
$10 $8
Every 3 years
Every 2 years

44. Equivalent Annul Cost (EAC)
PV(Costs) = EAC*(Annuity Factor)
EAC = PV(Costs)/Annuity Factor

45. Example: Equivalent Annual Cost Analysis
Two types of batteries are being considered for use in electric golf carts at City Country Club. Burnout brand batteries cost $36, have a useful life of 3 years, will cost $100 per year to keep charged, and have a salvage value of $5. Longlasting brand batteries cost $60 each, have a life of 5 years, will cost $88 per year to keep charged, and have a salvage value of $5. Assume straight-line depreciation.

46. Example: Equivalent Annual Cost Analysis (concluded)