Chap010 Instructors

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© 2003 The McGraw-Hill Companies, Inc. All rights

Making CapitalInvestmentDecisions

Chapter

Ten


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McGraw-Hill!Irwin © 2003 The McGraw-Hill Companies, Inc. All rights

10.2 Key Concepts and Skills

• Understand how to determine the relevantcash flows for various types of proposedinvestments

• Be able to compute depreciation expense fortax purposes• Understand the various methods for

computing operating cash flow


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10.3 Chapter Outline

• ro!ect "ash #lows$ % #irst &oo' • (ncremental "ash #lows• ro #orma #inancial )tatements and ro!ect

"ash #lows• *ore on ro!ect "ash #low• %lternative +efinitions of ,perating "ash

#low• )ome )pecial "ases of "ash #low %nalysis


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10.- Relevant Cash Flows

• he cash flows that should be included in acapital budgeting analysis are those that willonly occur if the pro!ect is accepted

• hese cash flows are called incremental cash flows• he stand-alone principle allows us to analy/e

each pro!ect in isolation from the firm simply by focusing on incremental cash flows


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10. Asking the Right uestion

• ou should always as' yourself ill thiscash flow occur ,4& if we accept the pro!ect56 7 (f the answer is yes68 it should be included in the

analysis because it is incremental 7 (f the answer is no68 it should not be included in

the analysis because it will occur anyway

7 (f the answer is part of it68 then we shouldinclude the part that occurs because of the pro!ect


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10.9 Common !ypes o" Cash Flows

• )un' costs 7 costs that have accrued in the past• ,pportunity costs 7 costs of lost options

• )ide effects 7 ositive side effects 7 benefits to other pro!ects 7 4egative side effects 7 costs to other pro!ects

• "hanges in net wor'ing capital• #inancing costs• axes


7/30McGraw-Hill!Irwin © 2003 The McGraw-Hill Companies, Inc. All rights

10.: #ro Forma Statements and Cash Flow

• "apital budgeting relies heavily on pro formaaccounting statements8 particularly incomestatements

• "omputing cash flows 7 refresher 7 ,perating "ash #low ;,"#< = >B( ?depreciation 7 taxes

7 ,"# = 4et income ? depreciation when there isno interest expense

7 "ash #low #rom %ssets ;"##%< = ,"# 7 netcapital spending ;4")< 7 changes in 4 "



10.@ !a$le %&'% #ro Forma Income Statement

)ales ; 08000 units at A-.00 unit< A2008000

Cariable "osts ;A2. 0 unit< 12 8000

Dross profit A : 8000

#ixed costs 128000

+epreciation ;AE08000 3< 308000

>B( A 338000axes ;3-F< 118220

4et (ncome A 218:@0



10.E !a$le %&'( #ro)ected Capital Re*uirements

ear

0 1 2 3

4 " A208000 A208000 A208000 A208000

4et #ixed%ssets E08000 908000 308000 0

otal(nvestment

A1108000 A@08000 A 08000 A20800



10.10 !a$le %&'+ #ro)ected !otal Cash Flows

ear

0 1 2 3

,"# A 18:@0 A 18:@0 A 18:@0

"hange in 4 "

GA208000 208000

"apital)pending GAE08000

"##% GA110800 A 18:@0 A 18:@0 A:18:@0


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10.12 More on ,-C

• hy do we have to consider changes in 4 "separately5 7 D%% reHuires that sales be recorded on the

income statement when made8 not when cash isreceived

7 D%% also reHuires that we record cost of goodssold when the corresponding sales are made8

regardless of whether we have actually paid oursuppliers yet 7 #inally8 we have to buy inventory to support sales

although we havenKt collected cash yet



10.13 Depreciation

• he depreciation expense used for capital budgeting should be the depreciation schedulereHuired by the (I) for tax purposes

• +epreciation itself is a nonGcash expense8conseHuently8 it is only relevant because itaffects taxes

• +epreciation tax shield = +

7 + = depreciation expense 7 = marginal tax rate



10.1- Computing Depreciation

• )traightGline depreciation 7 + = ;(nitial cost 7 salvage< number of years 7 Cery few assets are depreciated straightGline for

tax purposes

• *%"I) 7 4eed to 'now which asset class is appropriate for

tax purposes

7 *ultiply percentage given in table by the initialcost 7 +epreciate to /ero 7 *idGyear convention



10.1 A"ter.ta/ Salvage

• (f the salvage value is different from the boo'value of the asset8 then there is a tax effect• Boo' value = initial cost 7 accumulated

depreciation• %fterGtax salvage = salvage 7 ;salvage 7 boo' value<



10.19 0/ample1 Depreciation and A"ter.ta/ Salvage

• ou purchase eHuipment for A1008000 and itcosts A108000 to have it delivered andinstalled. Based on past information8 you

believe that you can sell the eHuipment forA1:8000 when you are done with it in 9 years.

he companyKs marginal tax rate is -0F. hatis the depreciation expense each year and theafterGtax salvage in year 9 for each of thefollowing situations5



10.1: 0/ample1 Straight.line Depreciation

• )uppose the appropriate depreciation scheduleis straightGline 7 + = ;1108000 7 1:8000< 9 = 1 8 00 every year for

9 years 7 BC in year 9 = 1108000 7 9;1 8 00< = 1:8000 7 %fterGtax salvage = 1:8000 G .-;1:8000 7 1:8000< =

1:8000



10.1@ 0/ample1 !hree.year MACRS

ear *%"I) percent

+

1 .3333 .3333;1108000< =398993

2 .---- .----;1108000< =-@8@@-

3 .1-@2 .1-@2;1108000< =198302

- .0:-1 .0:-1;1108000< =@81 1

BC in year 9 =1108000 7 398993 7-@8@@- 7 198302 7@81 1 = 0

%fterGtax salvage= 1:8000 G .-;1:8000 7 0< =

A108200



10.1E 0/ample1 2.3ear MACRS

ear *%"I)

ercent

+

1 .1-2E .1-2E;1108000< = 1 8:1E

2 .2--E .2--E;1108000< = 298E3E

3 .1:-E .1:-E;1108000< = 1E823E

- .12-E .12-E;1108000< = 138:3E

.0@E3 .0@E3;1108000< = E8@23

9 .0@E3 .0@E3;1108000< = E8@23

BC in year 9 =1108000 7 1 8:1E 7298E3E 7 1E823E 7138:3E 7 E8@23 7E8@23 = 1-8:1@

%fterGtax salvage= 1:8000 G .

-;1:8000 71-8:1@< =1980@:.20



10.20 0/ample1 Replacement #ro$lem

• ,riginal *achine 7 (nitial cost = 1008000 7 %nnual depreciation =

E000

7 urchased years ago 7 Boo' Calue = 8000 7 )alvage today = 9 8000 7 )alvage in years =

108000

• 4ew *achine 7 (nitial cost = 1 08000 7 Gyear life 7 )alvage in years = 0

7 "ost savings = 08000 per year

7 3Gyear *%"I)depreciation

• IeHuired return = 10F• ax rate = -0F



10.21 Replacement #ro$lem 4 Computing Cash Flows

• Iemember that we are interested inincremental cash flows• (f we buy the new machine8 then we will sell

the old machine• hat are the cash flow conseHuences ofselling the old machine today instead of in years5



10.22 Replacement #ro$lem 4 #ro Forma Income Statements

ear 1 2 3 -"ost)avings

08000 08000 08000 08000 08000

+epr.

4ew -E8 00 9:8 00 228 00 108 00 0

,ld E8000 E8000 E8000 E8000 E8000

(ncrem. -08 00 @8 00 138 00 18 00 ;E8000<

>B( E8 00 ;@8 00< 398 00 -@8 00 E800axes 38@00 ;38-00< 1-8900 1E8-00 238900

4( 8:00 ; 8100< 218E00 2E8100 3 8-00



10.23 Replacement #ro$lem 4 Incremental ,etCapital Spending

• ear 0 7 "ost of new machine = 1 08000 ;outflow< 7 %fterGtax salvage on old machine = 9 8000 G .

-;9 8000 7 8000< = 918000 ;inflow< 7 (ncremental net capital spending = 1 08000 7

918000 = @E8000 ;outflow<

• ear 7 %fterGtax salvage on old machine = 108000 G .

-;108000 7 108000< = 108000 ;outflow because weno longer receive this<


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10.2- Replacement #ro$lem 4 Cash Flow From Assets

ear 0 1 2 3 -

,"# -98200 38-00 3 8-00 308900 298-00

4") G@E8000 G108000

∆ (n 4 "

0 0

"##% G@E8000 -98200 38-00 3 8-00 308900 198-00


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10.2 Replacement #ro$lem 4 Analy5ing the Cash Flows

• 4ow that we have the cash flows8 we cancompute the 4 C and (II 7 >nter the cash flows 7 "ompute 4 C = [email protected] 7 "ompute (II = 39.2@F

• Should the company replace the equipment?


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10.29 Other Methods "or Computing OCF

• BottomGUp %pproach 7 or's only when there is no interest expense 7 ,"# = 4( ? depreciation

• opG+own %pproach 7 ,"# = )ales 7 "osts 7 axes 7 +onKt subtract nonGcash deductions

• ax )hield %pproach 7 ,"# = ;)ales 7 "osts


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10.2: 0/ample1 Cost Cutting

• our company is considering new computer systemthat will initially cost A1 million. (t will saveA3008000 a year in inventory and receivablesmanagement costs. he system is expected to last forfive years and will be depreciated using 3Gyear*%"I). he system is expected to have a salvagevalue of A 08000 at the end of year . here is noimpact on net wor'ing capital. he marginal tax rateis -0F. he reHuired return is @F.

• "lic' on the >xcel icon to wor' through the example


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10.2@ 0/ample1 Setting the 6id #rice

• "onsider the example in the boo'$ 7 4eed to produce modified truc's per year for - years 7 e can buy the truc' platforms for A108000 each 7 #acilities will be leased for A2-8000 per year

7 &abor and material costs are A-8000 per truc' 7 4eed A908000 investment in new eHuipment8 depreciated

straightGline to a /ero salvage 7 %ctually expect to sell it for A 000 at the end of - years

7 4eed A-08000 in net wor'ing capital 7 ax rate is 3EF 7 IeHuired return is 20F


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10.2E 0/ample1 0*uivalent Annual Cost Analysis

• *achine % 7 (nitial "ost = A 80008000 7 reGtax operating cost =

A 008000

7 )traightGlinedepreciation over yearlife

7 >xpected salvage =A-008000

• *achine B 7 (nitial "ost = A980008000 7 reGtax operating cost =

A- 08000

7 )traightGline depreciationover @ year life 7 >xpected salvage =

A:008000

he machine chosen will be replaced indefinitely and neithermachine will have a differential impact on revenue. 4o changein 4 " is reHuired.

he reHuired return is EF and the tax rate is -0F.


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