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Making Capital Investment Decisions

Making Capital Investment Decisions. Chapter Ten. Key Concepts and Skills. Understand how to determine the relevant cash flows for various types of proposed investments Be able to compute depreciation expense for tax purposes Understand the various methods for computing operating cash flow.

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Making Capital Investment Decisions

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  1. Making Capital Investment Decisions Chapter Ten

  2. Key Concepts and Skills • Understand how to determine the relevant cash flows for various types of proposed investments • Be able to compute depreciation expense for tax purposes • Understand the various methods for computing operating cash flow

  3. Chapter Outline • Project Cash Flows: A First Look • Incremental Cash Flows • Pro Forma Financial Statements and Project Cash Flows • More on Project Cash Flow • Alternative Definitions of Operating Cash Flow • Some Special Cases of Cash Flow Analysis

  4. Relevant Cash Flows • The cash flows that should be included in a capital budgeting analysis are those that will only occur 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

  5. Asking the Right Question • You should always 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

  6. Common Types of Cash Flows • Sunk costs – costs that have accrued in the past • Opportunity costs – costs of lost options • Side effects (externalities) • Positive side effects – benefits to other projects • Negative side effects – costs to other projects • Changes in net working capital • Financing costs • Taxes

  7. Pro Forma Statements and 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 + depreciation when there is no interest expense • Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

  8. Table 10.1 Pro Forma Income Statement

  9. Table 10.2 Projected Capital Requirements

  10. Table 10.5 Projected Total Cash Flows

  11. Making The Decision • Now that we have the cash flows, we can apply the techniques that we learned in chapter 9 • Enter the cash flows into the calculator and compute NPV and IRR • CF0 = -110,000; C01 = 51,780; C02 = 51,780; CO3 = 71,780 • NPV; I = 20; CPT NPV = 10,647.68 • CPT IRR = 25.8% • Should we accept or reject the project?

  12. More on NWC • 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, regardless of whether we have actually paid our suppliers yet • Finally, we have to buy inventory to support sales although we haven’t collected cash yet

  13. 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 = DT • D = depreciation expense • T = marginal tax rate

  14. Computing Depreciation • Straight-line depreciation • D = (Initial cost – salvage) / number of years • Very few assets are depreciated straight-line for tax purposes • MACRS • 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

  15. Depreciation Calculations • Financial Statements purpose • Straight Line • Accelerated, e.g., Double Declining Balance (DDB) • MACRS (Modified Accelerated Cost Recovery System) since 1986 tax reform act - depreciation calculation only for tax purposes • half year convention, a.k.a, “mid-year” convention • depreciable basis • sale of a depreciable asset • depreciation illustration

  16. Depreciation calculations • MACRS classes & Asset lives (based on DDB) • 3 year manufacturing tools • 5 year autos, trucks, computer • 7 year industrial equipment, office furniture • 10 year longer-lived equipment • Recovery allowance % for 3-, 5-, 7-, 10-year property • Ownership Class of Investment • Year 3 yr 5 yr 7 yr 10 yr • 1 33% 20% 14% 10% • 2 45 32 25 18 • 3 15 19 17 14 • 4 7 12 13 12 • 5 11 9 9 • 6 6 9 7 • 7 9 7 • 8 4 7

  17. 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)

  18. Example: Depreciation and 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 situations?

  19. Example: 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

  20. Example: 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 We will round the MACRS calculations to two decimals (.33, .45, .15, .07)

  21. Example: 7-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

  22. Original Machine Initial cost = 100,000 Annual depreciation = 9000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000 Salvage in 5 years = 10,000 New Machine Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation Required return = 10% Tax rate = 40% Example: Replacement Problem

  23. Replacement Problem – Computing Cash Flows • Remember that we are interested in incremental cash flows • If we buy the new machine, then we will sell the old machine • What are the cash flow consequences of selling the old machine today instead of in 5 years?

  24. Replacement Problem – Pro Forma Income Statements

  25. Replacement Problem – Incremental NetCapital Spending • Year 0 • Cost of new machine = 150,000 (outflow) • After-tax salvage on old machine = 65,000 - .4(65,000 – 55,000) = 61,000 (inflow) • Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow) • Year 5 • After-tax salvage on old machine = 10,000 - .4(10,000 – 10,000) = 10,000 (outflow because we no longer receive this)

  26. Replacement Problem – Cash Flow From Assets

  27. Replacement Problem – Analyzing the Cash Flows • Now that we have the cash flows, we can compute the NPV and IRR • Enter the cash flows • Compute NPV = 54,812.10 • Compute IRR = 36.28% • Should the company replace the equipment?

  28. Other Methods for Computing OCF • Bottom-Up Approach • Works only when there is no interest expense • OCF = NI + depreciation • Top-Down Approach • OCF = Sales – Costs – Taxes • Don’t subtract non-cash deductions • Tax Shield Approach • OCF = (Sales – Costs)(1 – T) + Depreciation*T

  29. Example: Cost Cutting • Your company is considering new computer system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%. • Click on the Excel icon to work through the example

  30. Example: Setting the Bid Price • Consider the example in the book: • Need to produce 5 modified trucks per year for 4 years • We can buy the truck platforms for $10,000 each • Facilities will be leased for $24,000 per year • Labor and material costs are $4,000 per truck • Need $60,000 investment in new equipment, depreciated straight-line to a zero salvage • Actually expect to sell it for $5000 at the end of 4 years • Need $40,000 in net working capital • Tax rate is 39% • Required return is 20%

  31. Machine A Initial Cost = $5,000,000 Pre-tax operating cost = $500,000 Straight-line depreciation over 5 year life Expected salvage = $400,000 Machine B Initial Cost = $6,000,000 Pre-tax operating cost = $450,000 Straight-line depreciation over 8 year life Expected salvage = $700,000 Example: Equivalent Annual Cost Analysis The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required. The required return is 9% and the tax rate is 40%.

  32. Quick Quiz • 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 the basic process for finding the bid price? • What is equivalent annual cost and when should it be used?

  33. Integrated Case: Allied Food Products • New expansion requires, at t=0, equipment $200,000 plus additional $40,000 for shipping and installation. Inventories would rise by $25,000, accounts payable would go up by $5,000. Use MACRS 3-year depreciation. • Project life is 4 years. Cash inflow begin at t=1 and ends at t=4. Equipment salvage value is $25,000. • Sales will be $200,000, of which 60% will be cash operating cost (total operating costs less depreciation). Tax rate=40%, WACC=10%. • Project has similar equal risk to other assets.

  34. Proposed Project: • Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost: $240,000. • Inventories will rise by $25,000 and payables by $5,000. • Economic life = 4 years. • Scrap (or used machine Sale) value = $25,000. (we will depreciate down to 0) • MACRS 3-year class.

  35. Sales: 100,000 units/yr @ $2. • Variable cost = 60% of sales. • Tax rate = 40%. • Cost of capital = R = 10%.

  36. NCF1 NCF2 NCF3 NCF4 Integrated case - Allied Food products, question a.Set up, without numbers, a time line for the project’s cash flows: 4 0 1 2 3 Initial Costs OCF1 OCF2 OCF3 OCF4 + (CFo) Terminal CF NCF0

  37. B.1. Investment at t = 0: Equipment -$200 Installation & Shipping -40 Increase in inventories -25 Increase in A/P 5 Net CF0 -$260 DNWC = $25 - $5 = $20.

  38. B.3. What’s the annual depreciation? Due to 1/2-year convention, a 3-yr asset is depreciated over 4 years.

  39. B.4. Operating cash flows:

  40. B.5. Net Terminal CF at t = 4: Q. Always a tax on SV? Ever a positive tax number? Q. How is NOWC recovered?

  41. C.1. Should CFs include interest expense? Dividends? • No. The cost of capital is accounted for by discounting at the 10% cost of capital (R), so deducting interest and dividends would be “double counting” financing costs.

  42. C.2. Suppose $50,000 had been spent last year to improve the building. Should this cost be included in the analysis? No. This is a sunk cost. Analyze incremental investment.

  43. C.3. Suppose the plant could be leased out for $25,000 a year. Would this affect the analysis? • Yes. Accepting the project means foregoing the $25,000. This is an opportunity cost, and it should be charged to the project. • A.T. opp. cost = $25,000 (1 - T) = $25,000(0.06) = $15,000 annual cost.

  44. C4. If the new product line would decrease sales of the firm’s other lines, would this affect the analysis? • Yes. The effect on other projects’ CFs is an “externality.” • Net CF loss per year on other lines would be a cost to this project. • Externalities can be positive or negative, i.e., complements or substitutes.

  45. 4 0 1 2 3 79.6 91.2 62.4 -260 54.8 NPV = -$4.047 IRR = 9.3% NPV = -260 + 72.364 +75.372 +46.882+61.335 D. Here are all the project’s net CFs (in thousands) on a time line: R = 10% 35 89.8 Terminal CF Enter CFs in CF register, and I = 10%.

  46. 1 2 3 79.7 91.2 62.4 What’s the project’s MIRR? 4 0 -260 89.7 10% 68.6 10% 110.4 PV outflows 10% 106.1 MIRR = ? 374.8 -260 TV inflows Can we solve using a calculator?

  47. INPUTS 4 10 255.97 0 TV = FV = 374.8 N I/YR PV PMT FV OUTPUT CF0 = 0 CF1 = 79.7 CF2 = 91.2 CF3 = 62.4 CF4 = 89.7 I = 10 Yes. NPV = 255.97

  48. Use the FV = TV of inputs to find MIRR INPUTS 4 -260 0 374.8 9.6 N I/YR PV PMT FV OUTPUT MIRR = 9.6%. Since MIRR < k = 10%, reject the project.

  49. 1 2 3 79.6 91.2 62.4 What’s the Payback Period?We will not worry about this 4 0 -260 89.8 Cumulative: -260 -180.4 -89.2 -26.8 63.0 Payback = 3 + 26.8 / 89.8 = 3.3 years.

  50. E. If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold, and the incremental CFs would be the changes from the old to the new situation.

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