1. 8-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Eight Making Capital Investment Decisions

2. 8-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Organisation 8.1 Project Cash Flows: A First Look 8.2 Incremental Cash Flows 8.3 Project Cash Flows 8.4 More on Project Cash Flows 8.5 Special Cases of Discounted Cash Flow Analysis Summary and Conclusions

3. 8-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

4. 8-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Project Cash Flows 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 undertaking the project. The stand-alone principle is the evaluation of a project based on the project’s incremental cash flows.

5. 8-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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 if a particular investment is undertaken = incremental cash flow. Side effects  erosion  the cash flows of a new project that come at the expense of a firm’s existing projects = incremental cash flow.

6. 8-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Types of Cash Flows (continued) Financing costs  the interest rate used to discount the cash flows reflects in part the financing costs of the project  incremental cash flow. An investment of the firm in the project’s net working capital represents an additional cost of undertaking the investment. Always use after-tax incremental cash flow, since taxes are definitely a cash flow.

7. 8-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Investment Evaluation Step 1  Calculate the tax effect of the decision. Step 2  Calculate the cash flows relevant to the decision. Step 3  Discount the cash flows to make the decision.

8. 8-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Investment Evaluation Purchase price $42 000 Salvage value $1000 at end of Year 3 Net cash flowsYear 1 $31 000 Year 2 $25 000 Year 3 $20 000 Tax rate is 30% Depreciation 20% reducing balance Required rate of return 12%

9. 8-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Depreciation Schedule

10. 8-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Taxable Income

11. 8-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Cash Flows Year 0Year 1Year 2Year 3 Tax paid (6 780) (5 484) 1 764 Net cash flow 31 000 25 000 20 000 Salvage value 1 000 Outlay (42 000) Cash flow$(42 000)$24 220$19 516$22 764

12. 8-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—NPV and Decision Decision: NPV > 0, therefore ACCEPT.

13. 8-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

14. 8-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Depreciation The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes. Depreciation is a non-cash expense; consequently, it is only relevant because it affects taxes. There are two methods of depreciation: –Prime cost (straight-line method in accounting) –Diminishing value (reducing balance method in accounting) Depreciation tax shield = DT where D = depreciation expense T = marginal tax rate.

15. 8-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Disposal of Assets If the salvage value > book value, a gain is made on disposal. This 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).

16. 8-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Capital Gains Tax Capital gains made on the sale of assets such as rental property are subject to taxation. For taxation purposes, the calculation of a capital gain is complicated and depends upon whether the seller is an individual or an entity such as a company or trust. Capital losses are not a tax deduction but can be offset against future capital gains.

17. 8-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Inflation When a project is being evaluated, anticipated inflation would be reflected in the estimates of the future cash flows and the interest rate used as the discount rate in the analysis. As a result there will be no distortion to the analysis by not identifying inflation specifically.

18. 8-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Incremental Form of Analysis The description ‘incremental’ is often replaced by ‘marginal’. The advantage of using a marginal form of analysis is that there will only be one calculation and not two. By using a marginal form we are implicitly analysing one option: that is, to do nothing. The sign of the NPV tells us whether it is sensible to change or not.

19. 8-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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:

20. 8-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Taxable Income

21. 8-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Cash Flows

22. 8-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—NPV and Decision Decision: NPV < 0, therefore REJECT.

23. 8-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan A Note on Cash Flows Cash flows do not always conveniently occur at the end of the period. Taking revenue at the period end is a conservative approach to evaluation. If the facts made it necessary to take cash flows as occurring at the beginning of the period this only requires a minor adjustment to the analysis. The period examined could be yearly, monthly or even weekly. If so, the discount rate must match the period (e.g. a weekly analysis needs a weekly rate).

24. 8-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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.

25. 8-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Setting the Option Value A buy option is an arrangement that gives the holder the right to buy an asset at a fixed price sometime in the future. Option value = Asset value × Probability of the Value – Present value of the exercise price × Probability the exercise price will be paid.

26. 8-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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 calculated on an annual basis. NPVs are calculated and then converted to AECs using the relevant PVIFA (present value interest factor for annuities). Select the project with the lowest AEC.

27. 8-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 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?

28. 8-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Project A

29. 8-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Project B

30. 8-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Interpretation ‘Project A is better because it costs $1946 per year compared to Project B’s $2325 per year’.

31. 8-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Annual Equivalent Benefit (AEB) The AEB is used when comparing projects with cash inflows and outflows but with unequal lives. The steps required to calculate the AEB are the same as those used for AEC. Select the project with the highest AEB.

32. 8-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Discounted cash flow (DCF) analysis is a standard tool in the business world. The information provided for a specific decision may be complex; however the analysis reduces to three distinct steps: - Step 1  Calculate the taxable income - Step 2  Calculate the cash flows relevant to the decision - Step 3  Discount the cash flows to make the decision. Cash flows should be identified in a way that makes economic sense.