Chapter 8

MAKING CAPITAL INVESTMENT DECISIONS

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-1

KEY CONCEPTS AND SKILLS

Determine the relevant cash flows for various
types of capital investments
Compute depreciation expense for tax purposes
Incorporate inflation into capital budgeting
Employ the various methods for computing
operating cash flow
Apply the Equivalent Annual Cost approach

8-2

CHAPTER OUTLINE
8.1 Incremental Cash Flows
8.2 The Baldwin Company: An Example
8.3 Inflation and Capital Budgeting
8.4 Alternative Definitions of Cash Flow
8.5 Investments of Unequal Lives: The Equivalent
Annual Cost Method

8-3

8.1 INCREMENTAL CASH FLOWS

Cash flows matternot accounting
earnings.
Sunk costs dont matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like synergy, cannibalism and
erosion matter.
Taxes matter: we want incremental aftertax cash flows.
Inflation matters.
8-4

CASH FLOW: THE BASIS OF CAPITAL

BUDGETING DECISIONS
When performing capital budgeting analysis:
Always base calculations on cash flow, not income

Earnings Cash
Need cash for capital spending
Need cash for rewarding shareholders
Therefore, capital expenditure analysis must be based on
cash

8-5

CASH FLOWS ACCOUNTING

INCOME
Much of the work in evaluating a project lies in
converting accounting income to cash flow
Examples of reconciling items:
Depreciation (most common example)
You never write a check made out to depreciation.

Amortization
Deferrals and Accruals

8-6

INCREMENTAL CASH FLOWS

Remember: Incremental cash flows arise as a
consequence of selecting a project
Seems like a simple task
Not so, there are many pitfalls in identifying incremental
cash flow

8-7

INCREMENTAL CASH FLOWS

Sunk costs are not relevant
Just because we have come this far does not mean
that we should continue to throw good money after bad.

Opportunity costs do matter. Just because a

project has a positive NPV, that does not mean
that it should also have automatic acceptance.
Specifically, if another project with a higher NPV
would have to be passed up, then we should not
proceed.

8-8

INCREMENTAL CASH FLOWS

Side effects matter.

Erosion and cannibalism are both bad

things. If our new product causes
existing customers to demand less of
current products, we need to
recognize that.
If, however, synergies result that
create increased demand of existing
products, we also need to recognize
that.
8-9

INCREMENTAL CASH FLOWS

Allocations
Overhead may be allocated to the new project
Allocations are only relevant if the project increases or
decreases the cash outlay of the entire firm

Salvage Value
Dont forget to treat salvage value (after tax, of course) as a
cash inflow at the end of the project

Changes in Net Working Capital

Many projects require an increase in NWC (inventory,
receivables, and other current assets) when initiated; this is
a cash outlay at the beginning of the project
Dont forget: To reduce NWC at the end of a project requiring
increased NWC; this is a cash inflow at the end of the project

8-10

ESTIMATING CASH FLOWS

Cash Flow from Operations
Recall that:
OCF = EBIT Taxes + Depreciation

8-11

INTEREST EXPENSE
Later chapters will deal with the
impact that the amount of debt that
a firm has in its capital structure
has on firm value.
For now, its enough to assume that
the firms level of debt (and, hence,
interest expense) is independent of
the project at hand.
8-12

8.2 THE BALDWIN COMPANY

Costs of test marketing (already spent):
$250,000
Current market value of proposed factory site
(which we own): $150,000
Cost of bowling ball machine: $100,000
(depreciated according to MACRS 5-year)
Increase in net working capital: $10,000
Production (in units) by year during 5-year life of
the machine: 5,000, 8,000, 12,000, 10,000,
6,000

8-13

THE BALDWIN COMPANY

Price during first year is $20; price increases 2%
per year thereafter.
Production costs during first year are $10 per unit
and increase 10% per year thereafter.
Annual inflation rate: 5%
Working Capital: initial $10,000 changes with
sales

8-14

THE BALDWIN COMPANY

($ thousands) (All cash flows occur at the end of the year.)

8-15

THE BALDWIN COMPANY

At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

8-16

THE BALDWIN COMPANY

Year 0

Income:
(8) Sales Revenues

Year 1

Year 2

Year 3

Year 4

100.00 163.20 249.72 212.20

Year 5

129.90

Recall that production (in units) by year during the 5-year life of the machine is
given by: (5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12,000[$20(1.02)2] = 12,000$20.81 = $249,720.

8-17

THE BALDWIN COMPANY

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Income:
(8) Sales Revenues
(9) Operating costs

100.00
-50.00

163.20
-88.00

249.72
-145.20

-133.10

212.20
-87.84

129.90

Again, production (in units) by year during 5-year life of the machine is given
by: (5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000[$10(1.10)1] = $88,000

8-18

THE BALDWIN COMPANY

Year 0

Year 1

Year 2

Year 3

Year 4

100.00
-50.00
-20.00

163.20 249.72 212.20

-88.00 -145.20 -133.10
-32.00 -19.20
11.52

Year 5

Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation

Depreciation is calculated using the Modified

Accelerated Cost Recovery System (shown at
right).
Our cost basis is $100,000.
Depreciation charge in year 4 = $100,000(.1152)
= $11,520.

Year
1
2
3
4
5
6
Total

129.90
-87.84
-11.52

ACRS %
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%
8-19

THE BALDWIN COMPANY

8-20

$
3
9
.
8
0
$
5
4
.
1
9
$
6
.
8
$
5
9
.
8
7
$
2
4
.
6
N
P
V
5$12.608(1)(0)2(10)3(10)4(10)5
INCREMENTAL AFTER TAX CASH
FLOWS
Year 0

(1) Sales
Revenues
(2) Operating
costs
(3) Taxes

(4) OCF
(1) (2) (3)
(5) Total CF of
Investment
(6) IATCF
[(4) + (5)]

Year 1

Year 2

Year 3

Year 4

Year 5

$100.00

$163.20

$249.72

$212.20

$129.90

-50.00

-88.00

-145.20

133.10

-87.84

-10.20

-14.69

-29.01

-22.98

-10.38

39.80

60.51

75.51

56.12

31.68

6.32

8.65

3.75

192.98

54.19

66.86

59.87

224.66

260.
260.

39.80

8-21

NPV OF BALDWIN COMPANY

(USING TEXAS INSTRUMENTS BA-II PLUS CALCULATOR)

CF0

260

F3

CF1

39.80

CF4

F1
CF2
F2

1
54.19

F4
CF5

59.87
1

I
NPV

10
51.588

224.66

1
F5

CF3

66.86
8-22

8.3 INFLATION AND CAPITAL

BUDGETING
Inflation is an important fact of economic life and
might be considered in capital budgeting.
Consider the relationship between interest rates
and inflation, often referred to as the Fisher
equation:
(1 + Nominal Rate) = (1 + Real Rate) (1 +
Inflation Rate)

8-23

INFLATION AND CAPITAL BUDGETING

For low rates of inflation, this is often approximated:

Real Rate Nominal Rate Inflation Rate

While the nominal rate in the U.S. has fluctuated with
inflation, the real rate has generally exhibited far less
variance than the nominal rate.
In capital budgeting, one must compare real cash
flows discounted at real rates or nominal cash flows
discounted at nominal rates.

8-24

8.4 ALTERNATIVE 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
Dont subtract non-cash deductions

Tax Shield Approach

OCF = (Sales Costs)(1 T) + Depreciation*T
8-25

8.5 INVESTMENTS OF UNEQUAL LIVES

There are times when application of the NPV
rule can lead to the wrong decision. Consider a
factory that must have an air cleaner that is
mandated by law. There are two choices:
The Cadillac cleaner costs $4,000 today, has
annual operating costs of $100, and lasts 10 years.
The Cheapskate cleaner costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.

Assuming a 10% discount rate, which one

should we choose?

8-26

INVESTMENTS OF UNEQUAL LIVES

Cadillac Air Cleaner

Cheapskate Air Cleaner

CF0

CF0

4,000

1,000

CF1

100

CF1

500

F1

10

F1

10

10

NPV

4,614.46

NPV

2,895.39

At first glance, the Cheapskate cleaner has a higher NPV.

8-27

INVESTMENTS OF UNEQUAL LIVES

This overlooks the fact that the Cadillac cleaner
lasts twice as long.
When we incorporate that, the Cadillac cleaner is
actually cheaper (i.e., has a higher NPV).
Two methods exist to analyze this situation
further:
Replacement Chain
Repeat projects until they begin and end at the same time.
Compute NPV for the repeated projects.

The Equivalent Annual Cost Method

8-28

REPLACEMENT CHAIN APPROACH

The Cadillac cleaner time line of cash flows:
-$4,000 100 -100
-100 -100 -100

1
9

-100 -100 -100

-100 -100

10

The Cheapskate cleaner time line of cash flows over ten years:

-$1,000 500 -500

-500 -500

1
9

-500 -500 -1,500

-500 -500

-500

10
8-29

REPLACEMENT CHAIN APPROACH

Cadillac Air Cleaner
CF0
CF1

4,000
100

Cheapskate Air Cleaner

CF0

1,000

CF1

500

F1
F1

10

CF2

10

F2

NPV

4,614

CF3
F3

4
1,500
1
500
5

I
NPV

10
4,693
8-30

EQUIVALENT ANNUAL COST (EAC)

EAC is the annual annuity payment implied by a
projects NPV
In other words:

if the present value of an annuity is set equal to the project NPV

and an annual payment is computed
using the same term and rate as the NPV; then,
the payment is the EAC

The EAC for the Cadillac filter is $750.98

The EAC for the Cheapskate filter is $763.80
In general, select the EAC with the lower cost. This
suggests a decision to reject the Cheapskate filter
which had the more attractive raw NPV

8-31

CADILLAC EAC WITH A CALCULATOR

Net Present Value

CF0

4,000

CF1

Equivalent Annual Cost

10

100

I/Y

10

F1

10

PV

4,614.46

10

PMT

750.98

NPV

4,614.46

FV

8-32

CHEAPSKATE EAC WITH A

CALCULATOR
Net Present Value

CF0

1,000

CF1

Equivalent Annual Cost

500

I/Y

10

F1

PV

-2,895.39

10

PMT

763.80

NPV

2,895.39

FV

8-33

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?
How should cash flows and discount rates be
matched when inflation is present?
What is equivalent annual cost, and when should
it be used?

8-34