1. T10.1 Chapter Outline Chapter 10 Making Capital Investment Decisions Chapter Organization 10.1Project Cash Flows: A First Look 10.2Incremental Cash Flows 10.3Pro Forma Financial Statements and Project Cash Flows 10.4More on Project Cash Flows 10.5Alternative Definitions of Operating Cash Flow 10.6Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

2. T10.1 Chapter Outline (concluded) 10.7Some Special Cases of Discounted Cash Flow Analysis 10.8Summary and Conclusions Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

3. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.2 Fundamental Principles of Project Evaluation 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. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.3 Incremental Cash Flows Incremental Cash Flows Key issues:  When is a cash flow incremental?  Terminology A.Sunk costs B.Opportunity costs C.Side effects D.Net working capital E.Financing costs F.Other issues

5. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.4 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 units/year @ $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%.

6. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.4 Example: Preparing Pro Forma Statements (continued) Pro Forma Financial Statements Projected Income Statements Sales$______ Var. costs______ $20,000 Fixed costs5,000 Depreciation7,000 “EBIT”$______ Taxes (34%)2,720 Net income$______

7. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.4 Example: Preparing Pro Forma Statements (concluded) Projected Balance Sheets 0123 NWC$______$10,000$10,000$10,000 NFA21,000____________0 Total$31,000$24,000$17,000$10,000

8. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.5 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$8,000 Depreciation+7,000 Taxes-2,720 OCF$____

9. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.5 Example: Using Pro Formas for Project Evaluation (continued) Project Cash Flows 0123 OCF$12,280$12,280$12,280 NWC Sp.____________ Cap. Sp.-21,000 Total______$12,280$12,280$______

10. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.5 Example: Using Pro Formas for Project Evaluation (concluded) Capital Budgeting Evaluation: NPV = -$31,000 + $12,280/1.20 1 + $12,280/1.20 2 + $22,280/1.20 3 = $655 IRR = 21% PB = 2.3 years AAR = $5280/{(31,000 + 24,000 + 17,000 + 10,000)/4} = 25.76% Should the firm invest in this project? Why or why not?

11. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.6 Example: Estimating Changes in Net Working Capital In estimating cash flows we must account for the fact that some of the incremental sales associated with a project will be on credit, and that some costs won’t be paid at the time of investment. How? Answer: Estimate changes in NWC. Assume: 1.Fixed asset spending is zero. 2.Net working capital spending is $200: 01ChangeS/U A/R$100$200+100___ INV100150+50___ -A/P10050-50___ NWC$100$300 Chg. NWC = $_____

12. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.6 Example: Estimating Changes in Net Working Capital (continued) Now, estimate operating and total cash flow: Sales$300 Costs200 Depreciation0 EBIT$100 Tax0 Net Income$100 OCF = EBIT + Dep. - Taxes = $100 Total Cash flow = OCF - Change in NWC - Capital Spending = -$______

13. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.6 Example: Estimating Changes in Net Working Capital (concluded) Where did the -$100 in total cash flow come from? What really happened: Cash sales = $300 -______ = $200 (collections) Cash costs = $200 +______+______= $300 (disbursements) Cash flow = $200 - 300= -$100 (= cash in - cash out)

14. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.7 Example: Fairways Equipment and Operating Costs Equipment requirements: Ball dispensing machine$ 2,000 Ball pick-up vehicle7,000 Tractor and accessories9,000 $18,000 all depreciable equipment is Class 10, 30% all equipment is expected to have a salvage value of 10% of cost after 6 years Balls and buckets$ 3,000 expenditures for balls and baskets are expected to grow to 5% per year

15. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.7 Example: Fairways Equipment and Operating Costs (concluded) Operating Costs (annual) Land lease$ 12,000 Water1,500 Electricity3,000 Labor30,000 Seed & fertilizer2,000 Gasoline1,500 Maintenance1,000 Insurance1,000 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

16. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.8 Example: Fairways Revenues, Depreciation, and Other Costs Projected Revenues Year Buckets Revenues 120,000$60,000 220,75062,250 321,50064,500 422,25066,750 523,00069,000 623,75071,250

17. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.8 Example: Fairways Revenues, Depreciation, and Other Costs (continued) Cost of balls and buckets Year Cost 1$3,000 23,150 33,308 4 3,473 5 3,647 6 3,829

18. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.8 Example: Fairways Revenues, Depreciation, and Other Costs (concluded) CCA for the six year life of the project YearBeg. UCCCCAEnding UCC 1900027006300 215300459010710 31071032137497 4749722495248 5524815743674 6367411022572

19. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.9 Example: Fairways Pro Forma Income Statement Year 1 2 3 4 5 6 Revenues$60,00062,25064,50066,75069,00071,250 Variable costs3,0003,1503,3083,4733,6473,829 Fixed costs53,00053,00053,00053,00053,00053,000 Depreciation2,7004,5903,2132,2491,5743,674 EBIT1,3001,5104,9798,02810,77910,747 Taxes1952277471,2041,6171,612 Net income$ 11051,2834,2326,8249,1629,135

20. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.10 Example: Fairways Projected Increases in NWC Projected increases in net working capital Year Net working capital Increase in NWC 03,0003,000 1 3,150150 23,308158 33,473165 43,647174 53,829182 64,020-3,829

21. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.11 Example: Fairways Cash Flows Operating cash flows: Operating YearEBIT+ Depreciation- Taxes= cash flow 0$ 0$ 0$ 0$ 0 11,3002,7001953,805 21,5104,5902275,873 34,9793,2137477,445 48,0282,2491,2049,073 510,7791,5741,61710,736 610,7473,6741,61212,809

22. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.11 Example: Fairways Cash Flows (concluded) Total cash flow from assets: Operating - IncreasesCapitalTotal Yearcash flow in NWC- spending= cash flow 0$ 0$ 3,000$18,000-$21,000 13,80515003,655 25,87315805,715 37,44516507,280 49,07317408,899 510,736182010,554 612,809-3,829-1,53018,168

23. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.12 Alternative Definitions of OCF Let: OCF = operating cash flow S= sales C= operating costs D= depreciation T c = corporate tax rate

24. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.12 Alternative Definitions of OCF (concluded) The Tax-Shield Approach OCF = (S - C - D) + D - (S - C - D) x T c = (S - C) x ( 1 - T c ) + (D x T c ) =(S - C) x (1 - T c ) + depreciation tax shield The Bottom-Up Approach OCF =(S - C - D) + D - (S - C - D) x T c = (S - C - D) x (1 - T c ) + D = Net income + depreciation The Top-Down Approach OCF = (S - C - D) + D - (S - C - D) x T c = (S - C) - (S - C - D) x T c = Sales - costs - taxes

25. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.13 Chapter 10 Quick Quiz -- Part 1 of 2 Now let’s put our new-found knowledge to work. Assume we have the following background information for a project being considered by Gillis, Inc. See if you can calculate the project’s NPV and payback period. 1. Required NWC investment = $40; cost = $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 = (100 - 50 - 20) + 20 - (100 - 50 - 20)(.34) = $_____

26. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.13 Chapter 10 Quick Quiz -- Part 1 of 2 (concluded) Project cash flows are thus: 0123 OCF$39.8$39.8$39.8 Add. NWC__________ Cap. Sp.-60_____ _____$39.8$39.8$86.4 NPV = $ ______ Payback period = 2.24 years

27. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.14 Example: A Cost-Cutting Proposal Using the tax-shield approach to find OCF OCF = (S - C) x (1 - T c ) + (D x T c ) = (0 - (-3,000))(.66) + (2,000 x.34) = $1,980 + $680 = $2,660 The after-tax salvage value is market value - (market value - book value) x (T c ) $1,000 - ($1,000 - 0)(.34) = $660 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%.

28. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.14 Example: A Cost-Cutting Proposal (concluded) The cash flows are Year OCF Capital spendingTotal 00-10,000-10,000 1 2,66002,660 22,66002,660 32,66002,660 42,66002,660 52,660+6603,320

29. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.15 Chapter 10 Quick Quiz -- Part 2 of 2 Evaluating Cost Cutting Proposals Cost= $900,000 Depreciation= $180,000 Life=5 years Salvage= $330,000 Savings= $500,000/year, pretax Tax rate= 34 percent Add. to NWC= -$220,000 (note the minus sign) 1.After-tax cost saving: $500K x (______) = $______ /year. 2.Depreciation tax shield: $180K x ______ = $______ /year. 3.After-tax salvage value: $330K - ($330K - 0)(.34) = $______ 4.The cash flows are thus:

30. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.15 Chapter 10 Quick Quiz -- Part 2 of 2 (concluded) 012345 AT saving$330.0K$330.0K$330.0K$330.0K$330.0K Tax shield61.2K61.2K61.2K61.2K61.2K “OCF”__________$391.2K$391.2K$391.2K NWC Sp.__________ Cap. Sp.-900K217.8K - ____$391.2K$391.2K$391.2K$391.2K_____ The IRR is about 50%, so it looks good!

31. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price Operating IncreasesCapitalTotal Yearcash flow in NWC spending= cash flow 0$ 0-$10,000-$50,000-$60,000 1OCF00OCF 2OCF00OCF 3OCF10,000+ 6,600OCF + 16,600 The Army is seeking bids on Multiple Use Digitizing Devices (MUDDs). The contract calls for 4 units per year for 3 years. Labor 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% ax rate and a required return of 15%. Use straight-line depreciation.

32. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price (continued) Taking the present value of $16,600 in year 3 (= $10,915 at 15%) and netting against the initial outlay of -$60,000 gives Total Yearcash flow 0-$49,085 1OCF 2OCF 3OCF The result is a three-year annuity with an unknown cash flow of OCF.

33. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price (continued) The annuity factor for 3 years at 15% is 2.283. At NPV = $0, NPV = $0 = -$49,085 + (OCF x 2.283), thus OCF = $49,085/2.283 = $21,500 Using the bottom-up approach to calculate OCF, OCF = Net income + depreciation $21,500 = Net income + $50,000/3 = Net income + $16,667 Net income = $4,833 Next, noting annual costs are $40,000 + $12,000 Net income = (S - C - D) x (1 - T c ) $4,833 = (S x.66) - (52,000 x.66) - (16,667 x.66) S = $50,153/.66 = $75,989.73 Hence, sales need to be $76,000 per year or $19,000 per MUDD

34. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price (continued) Background (in $000): 1.Bid calls for 20 units/year; 3 years 2.Costs are $25/unit hardware; $10/unit other; $35 total 3.Cap. spending of $250; depreciation = $250/5 = $50/year 4.Salvage in 3 years is half of cost, $125. 5.NWC investment of $60 6.r = 16%; tax rate = 39% 7.The after-tax salvage value is $125 - ($____ - ____) x.39 = $115.25

35. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price (continued) The cash flows are: 01 23 OCF$OCF$OCF $OCF Add. to NWC-$60 +60 Cap. Sp.-250_______ ______________ -$310$OCF $OCF$OCF + _______ Find the OCF such that the NPV is zero at 16%: +$310,000 - 175,250/1.16 3 =OCF x (1 - 1/1.16 3 )/.16 $197,724.74=OCF x 2.2459 OCF=$88,038.50/year

36. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.16 Example: Setting the Bid Price (concluded) Sales? Costs700,000.00 Depreciation50,000.00 EBIT$_________ Tax24,319.70 Net income$ 38,038.50 Sales = $62,358.20 + 50,000 + 700,000 = $812,358.20/year The bid price should be $812,358.20/___ = ________/unit If the required OCF is $88,038.50, what price must we bid?

37. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.17 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.

38. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.17 Example: Equivalent Annual Cost Analysis (continued) Using the tax shield approach, cash flows for Burnout are: OCF = (Sales - costs)(1 - T c ) + Depreciation(T c ) = (0 - 100)(.66) + 12(.34) = -$66 + 4 = -$62 OperatingCapitalTotal Yearcash flow- spending= cash flow 0$ 0-$ 36-36 1-620- 62 2-620- 62 3-62+ 3.3- 58.7

39. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.17 Example: Equivalent Annual Cost Analysis (continued) Using the tax shield approach, OCFs for Longlasting are: OCF = (Sales - costs)(1 - T c ) + Depreciation(T c ) = (0 - 88)(.66) + 12(.34) = -$58 + 4 = -$54 Operating CapitalTotal YearOCF - spending = cash flow 0$ 0-$ 60 - 60 1- 54 0 - 54 2- 54 0 - 54 3- 54 0 - 54 4- 54 0 - 54 5- 54+ 3.3 - 50.7

40. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.17 Example: Equivalent Annual Cost Analysis (continued) Using a 15% required return, calculate a cost per year for the two batteries. Calculate PV of cash flows The present value of total cash flows for Burnout is -$175.40 The present value of total cash flows for Longlasting is -$239.40

41. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.17 Example: Equivalent Annual Cost Analysis (concluded) What 3 year annuity has the same PV as Burnout? The annuity factor for 3 years at 15% is 2.283 -$175.40 = EAC 2.283 EAC = -$175.40/2.283 = -$76.83 What 5 year annuity has the same PV as Longlasting? The annuity for 5 years at 15% is 3.352 -$239.40 = EAC 3.352 EAC = -$239.40/3.352 = -$71.42

42. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.18 Solution to Problem 10.5 A proposed new project has projected sales of $65,000, costs of $40,000, and depreciation of $2,250. Calculate OCF using the four approaches described in the chapter. Sales$65,000.00 Costs$40,000.00 Depreciation2,250.00 EBT$22,750.00 Taxes (@ 34%)7,735.00 Net Income$15,015.00

43. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.18 Solution to Problem 10.5 (concluded) OCF = EBIT + D - T = $22,750 + 2,250 - 7,735 = $17,265 OCF = S - C - T = $65,000 - 40,000 - 7,735 = $17,265 OCF = (S - C)(1 - T c ) + T c D = ($65,000 - 40,000)(1 -.34) +.34(2,250) = $17,265 OCF = NI + D = $15,015 + 2,250 = $17,265

44. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.19 Example Bendog’s Franks is looking at a new sausage system with an installed cost of $290,000. The project will be depreciated straight-line to zero over its 5-year life, at the end of which it will be scrapped for $50,000. The sausage system will save the firm $90,000 per year in pretax operating costs, and requires an initial investment in net working capital of $27,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?

45. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.19 Example (concluded) Annual depreciation expense = $290,000/5 = $58,000 After-tax salvage value = ($______ )(1 -.34) = $______ OCF = $90,000 (1 -.34) + (.34)(36,000) = $______ So, NPV = -$290,000 - $27,000 + $_______ (PVIFA 10%,5 ) + ($_____ + $_____)/1.1 5 = $______

46. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.20 Example A proposed cost-saving device has an installed cost of $450,000. It will be used in a 5-year project.. The required initial net working capital investment is $30,000, the marginal tax rate is 35%, and the discount rate is 12%. The device has an estimated year 5 salvage value of $75,000. What level of pretax cost savings do we require for this project to be profitable? First, calculate the annual depreciation expenses are given as: D 1 = $150,000 D 2 =$199,980 D 3 =$66,690 D 4 =$33,345

47. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.20 Example (continued) Next, calculate cash flows in years 1 through 5: After-tax salvage value = $75,000(1 -.35) = $48,750 OCF 1 =(S - C)(1 -.35) +.35($150,000) OCF 2 =(S - C)(1 -.35) +.35($199,980) OCF 3 =(S - C)(1 -.35) +.35($66,690) OCF 4 =(S - C)(1 -.35) +.35($33,345) OCF 5 =(S - C)(1 -.35)

48. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T10.20 Example (concluded) Finally, set NPV equal to 0 and solve for the unknown term, C: 0 = -$450,000 - $30,000 + (S - C)(1 -.35)(PVIFA 12%,5 ) +.35[($150,000)/1.12 + $199,980/1.12 2 + $66,690/1.12 3 + $33,345/1.12 4 ] + ($48,750 + $30,000)/1.12 5 Then (S - C)(1 -.35)(PVIFA 12%,5 ) = $________, and C = $131,712.