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Making Capital Market Investment Decisions Chapter 10

Making Capital Market Investment Decisions Chapter 10. The cash flows that should be included in a capital budgeting analysis are those that will occur only if the project is accepted These cash flows are called incremental cash flows

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Making Capital Market Investment Decisions Chapter 10

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  1. Making Capital Market Investment DecisionsChapter 10 • The cash flows that should be included in a capital budgeting analysis are those that will occur only 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

  2. Asking the Right Question • Ask yourself “Will this cash flow 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 because of the project

  3. Common Types of Cash Flows Don’t Include: • Sunk costs – costs that have accrued in the past – usually are nota relevant cash flow • Financing costs– not a relevant cash flow, as is handled in the discounting But you should include: • Opportunity costs – costs of lost options • Side effects • Positive side effects – benefits to other projects • Negative side effects – costs to other projects • Changes in net working capital • Taxes – are relevant

  4. Pro Forma Statementsand Cash Flow • Capital budgeting relies heavily on pro forma accounting statements, particularly income statements • Computing cash flows – refresher • Operating Cash Flow (OCF) = EBIT + depreciation – taxes • OCF = Net income + depreciationwhen there is no interest expense • Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

  5. Pro Forma Income Statement Business Plan: Make Shark Attractant

  6. Projected Capital Requirements Depreciable asset is our Net Fixed Asset

  7. Projected Total Cash Flows Net Income + Depreciation

  8. Making The Decision • Should we do this? • Let the required return be 20% • Enter the cash flows into the calculator and compute NPV and IRR • CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780 • NPV; I = 20; CPT NPV = 10,648 • CPT IRR = 25.8% • Should we accept or reject the project?

  9. More on Net Working Capital • Why do we have to consider changes in NWC separately? • GAAP requires that sales be recorded on the income statement when made, not when cash is received • GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet • Finally, we have to buy inventory to support sales although we haven’t collected cash yet

  10. Depreciation • The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes • Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes • Depreciation tax shield = D·T • D = depreciation expense • T = marginal tax rate

  11. Computing Depreciation • Straight-line depreciation • D = (Initial cost – salvage) / number of years • Very few assets are depreciated straight-line for tax purposes • MACRS Modified Accelerated Cost Recovery System • Need to know which asset class is appropriate for tax purposes • Multiply percentage given in table by the initial cost • Depreciate to zero • Mid-year convention

  12. Tax Cut and Jobs Act (TCJA)

  13. After-tax Salvage • If the salvage value is different from the book value of the asset, then there is a tax effect • Book value = initial cost – accumulated depreciation • After-tax salvage = salvage – T·(salvage – book value) Tax payment on the excess over book value

  14. Depreciation & After-tax Salvage • You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years. The company’s marginal tax rate is 40%. • What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following three situations?

  15. 1. With Straight-line Depreciation • Suppose the appropriate depreciation schedule is straight-line • D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years • BV in year 6 = 110,000 – 6(15,500) = 17,000 • After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000 • Here we have no added taxes.

  16. 2. With three-year MACRS BV in year 6 = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = 0 After-tax salvage = 17,000 - .4(17,000 – 0) = $10,200

  17. 3. With Seven-Year MACRS BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718 After-tax salvage = 17,000 - .4(17,000 – 14,718) = 16,087.20

  18. Projects with Different LivesConstant Scale Replication • How to compare mutually exclusive projects with constant scale replication, with different lives. • Chevy lasts 7 years and Volvo 10 years • View each as a chain of repeat purchases. 7 14 21 28 35 42 C V 10 20 30 40

  19. Equivalent Annual CostEAC(or Equivalent Annual Value) • Step 1 • Find the NPV of the Chevy NPV(7) • Find the NPV of the Volvo NPV(10) • Step 2 • Annualize the cost for the Chevy & Volvo • EAC(Chevy) = NPV(7) / PVAF( 7years, k%) • EAC(Volvo) = NPV(10) / PVAF( 10 years, k%) Pick the lower cost option.

  20. Chevy costs $20,000 • Volvo costs $36,000 • Ignore yearly maintenance costs • Let the discount rate be 10% • Salvage value of the Chevy is $2,000 • Salvage value of the Volvo is $5,000 • NPV(Chevy) = -20,000 + 2000/(1.1)7 = -$18,973.68 • EAC(Chevy) • N = 7; I/Y = 10; PV = 18973.68; FV = 0; CPT PMT = -$3,897.29 per year for the Chevy • NPV(Volvo) = -36,000 + 5000/(1.1)10 = -$34,072.28 • EAC(Volvo) • N = 10; I/Y = 10; PV = 34072.28; FV = 0; CPT PMT = -$5,545.11 per year for the Volvo

  21. When to Replace an Existing Machine? • Alternatives • Replace now • Wait one year • Wait until the 2nd year, etc. • Step 1 • Calculate the EAV for the new machine • Step 2 • Replace when the EAV for the new machine > NCF of the old machine

  22. With time, the old machine is ready to be replaced. Replacement EAV NCF declines with time Optimal Replacement time

  23. Problem • Machine A was purchased 5 years ago for $200,000 and produces a NCF of $80,000 per year. No salvage value, but could last 5 more years. • Machine A1X, the new one, costs $120,000, with cash flows of 110,000, 121,000, 133,100. • Cost of capital is 10%. What should you do?

  24. Solution • NPV(A1X) = -120,000 + 300,000 = $180,000 • EAV(A1X) • N = 3; I/Y =10; PV = -180,000, CPT PMT = 72,380.66 Because EAV < NCF, wait, don’t replace!

  25. Quiz Questions • How do we determine if cash flows are relevant to the capital budgeting decision? • What are the different methods for computing operating cash flow and when are they important? • What is equivalent annual cost (or value) and when should it be used?

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