Chapter 6: Making capital

investment decisions

Corporate Finance
Ross, Westerfield, and
Jaffe
Outline

1. Relevant/incremental cash flows

2. An example
3. The equivalent annual cost method
TVM

We need to evaluate a new project using the

TVM technique.
That is, we should discount future expected
cash flows (specifically, FCFs) back to
present time and compare PV to initial costs:
whether NPV > 0?
Discount cash flows, not earnings.
Relevant cash flows

But before we do this, a few notions about

cash flows need to be addressed.
The cash flows in the capital-budgeting time
line need to be relevant cash flows; that is
they need to be incremental in nature.
Incremental cash flows: those cash flows that
will only occur if the project is accepted.
Ask 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.
Sunk costs

A sunk cost is a cost that has already

occurred regardless of whether the project is
accepted.
Example: consulting fee for evaluating a
project.
Sunk costs should not be taken into
consideration when evaluating a project.
Opportunity costs

Opportunity costs (OCs) are the costs of

giving up the second best use of resources.
Example: a vacant land.
Opportunity costs should be taken into
consideration when evaluating the project.
Side effects

Accepting a new project may have side effects.

Erosion occurs when a new project reduces the
sales and cash flows of existing projects.
Synergy occurs when a new project increases
the sales and cash flows of existing projects.
Cash flows due to erosion and synergy are
incremental cash flows.
An example, I

Baldwin Company is considering an investment

project: producing colored bowling balls.
The estimated life of the project: 5 years.
The cost of test marketing: $250,000.
Would be produced in a vacant building owned by the
firm; the property can be sold for $150,000 after taxes.
The cost of a new machine: $100,000.
The estimated market value of the machine at the end
of 5 years: $30,000.
An example, II

Production by year for the 5-year life: 5,000

units, 8,000 units, 12,000 units, 10,000 units,
and 6,000 units.
The price of bowling balls in the first year:
$20.
The price of bowling balls will increase at 2%
per year.
No debt financing; no interest expenses.
An example, III

First-year production costs: $10 per unit.

Production costs will increase at 10% per year.
Incremental/marginal corporate tax rate: 34%.
An initial investment (at year 0) in net working
capital: $10,000.
NWC at the end of each year will be equal to 10% of
sales for that year.
NWC at the end of the project is zero.
An example, IV
Depreciation

Depreciation for tax purpose in the U.S. is based

on the Modified Accelerated Cost Recovery
System (MACRS).
See Table 6.3 (p. 176) for IRS depreciation
schedule.
For a 5-year depreciation, the depreciation
schedule is: 20% (year 1), 32% (year 2), 19.2%
(year 3), 11.5% (year 4), 11.5% (year 5), and 5.8%
(year 6).
An example, V
After-tax salvage cash flow

OCF = sales costs taxes.

The estimated salvage market value of the machine
is 30% of $100,000; that is, $30,000.
The machine will have been depreciated to 5.8% of
$100,000 at that time; that is, $5,800.
The taxable amount is $24,200 ($30,000 - $5,800).
The after-tax salvage cash flow is: $30,000 (34%
$24,200) = $21,772.
An example, VI
Decision

Ifthe nominal discount rate (cost of equity) is

less than 16%, we accept the project.
In other words, if the discount rate is higher
than 16%, we have a negative NPV.
NPV

The firm uses no debt. Thus the appropriate

discount rate is the cost of equity.
Suppose that cost of equity is 15%.
NPV = 5473.43 (> 0).
An example, VII
Alternative definitions of OCF

Inour previous calculation, we used the top-

down approach to compute OCF ( = sales
costs taxes).
Another 2 alternative methods: the bottom-up
method, and the tax shield method.
See pp. 186-189.
The equivalent annual cost method

This method is useful (1) when one tries to

choose between 2 machines of unequal
lives, or (2) whether one should replace an
existing machine with a new one.
Whereas a general capital budgeting
problem is often computed in nominal terms,
the equivalent annual cost (EAC) method
works best in real terms.
Nominal vs. real
2 machines with unequal lives

Revenues per year are the same, regardless

of machine.
The nominal discount rate (NR) is 13.3%.
The expected inflation rate (E(I)) is 3%. The
real discount rate (RR) is 10%.
(1 + NR) = (1 + RR) (1 + E(I))
(1 + 13.3%) = (1 + 10%) (1 + 3%).
Real cost outflows w/ real
discount rate
Equivalent annual cost

One needs to use real (nominal) discount rate to

discount real (nominal) cash flows.
For A, the EAC is $321.05.
798.42 PV; 3 N; 10 I/Y; CPT PMT.
For B, the EAC is $289.28.
916.99 PV; 4 N; 10 I/Y; CPT PMT.
B has a lower equivalent annual cost. We
should choose B.
End-of-chapter

Concept questions: 1-12.

Questions and problems: 1-20.