Capital Budgeting – The Basics

ACTSC 372: Corporate Finance

Winter 2021
Pengyu Wei
Lecture Outline
§ Capital Budgeting is the decision-making process for accepting or rejecting
new projects or investments
%
𝐶"
𝑁𝑃𝑉 = 𝐶! + ' "
1+𝑟
"#$

§ NPV rule is good, but how to estimate the cash flows?

§ Initial Investment
§ Operating Cash Flows

§ What do we need to consider when estimating these cash flows?

§ Taxes
§ Inflation

§ Does NPV always work? Why and why not?

Preparation
§ PV of annuity that pays $1 at the end of next n years, @ discount rate 𝑟
1 − 1 + 𝑟 !"
𝑎 𝑛, 𝑟 =
𝑟
#
§ 1-year annuity, i.e., only 1 payment at time 1: 𝑎 1, 𝑟 =
#$%
#
§ Perpetuity, i.e., infinitely many payments: 𝑎 ∞, 𝑟 =
%

§ Increasing perpetuity that pays $1 at time 1, grows by 𝑔 every year thereafter

1
𝐼𝐴 ∞, 𝑟, 𝑔 = , 𝑔<𝑟
𝑟−𝑔
𝑔 can be negative if the payments are shrinking every year.

§ Use cases in this set of slides

§ 5-year annuity @ 𝑟 = 10%: 𝑎 5,10% = 3.791
§ 8-year annuity @ 𝑟 = 10%: 𝑎 8,10% = 5.335
Net Incremental Cash Flows
§ When assessing a project, we consider the net incremental cash flows
What is the difference between the cash flows of the entire firm
with vs. without the project?

§ Cash flows, not accounting income

§ Exclude depreciation, goodwill, unearned capital gains, etc.

§ Incremental cash flows only

§ Cash flows that change as a direct consequence of accepting a project
§ Some costs are tax-deductible: Say 𝑇& is the corporate tax rate
§ When $X cost is incurred, the tax bill is reduced by $𝑋×𝑇&
§ Net incremental cost is $𝑋 − $𝑋×𝑇& = $𝑋(1 − 𝑇& )
Net Incremental Cash Flows
§ Exclude Sunk Costs
§ A cost that has occurred in the past
§ E.g., consulting costs in the past, previous market analysis

§ Include Opportunity Costs

§ CFs that would have happen if the project is not accepted
§ e.g. using a building for project è lost rent

§ Include Side Effects

§ Synergy benefit – “side benefits” in other businesses (e.g., Michelin stars)
§ Erosion costs – “unintended cost” in other businesses (e.g., new iPhones)

§ Taxes and inflation matter (more details later)

Estimating Net Incremental Cash Flows
§ Estimating cash flows is the most difficult part of capital budgeting
§ Often starts with balance sheet, income statements, etc.
§ Then translate from earnings to cash flows
§ Simplified analysis in this class

§ Typically are the Operating Cash Flows (OCF) of the firm

§ OCF = EBIT – Taxes + Depreciation
§ EBIT = Earnings Before Interests & Taxes = Rev – Costs – Depre
§ Taxes = EBIT × Corporate Tax Rate = EBIT × 𝑇&

§ After some algebra

𝑂𝐶𝐹 = 𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡𝑠 × 1 − 𝑇& + 𝑑𝑒𝑝𝑟𝑒×𝑇&
 𝑂𝐶𝐹 = 𝐸𝐵𝐼𝑇 – 𝑇𝑎𝑥𝑒𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

§ Profits generated by the project (if accepted) is subject to taxation

§ Depreciation is an accounting “trick”. Its cash flows include
§ Initial cost when purchased (outflow), salvage value when sold (inflow)
§ With depreciation, receives tax deductions every year (details later)

§ EBIT = Earnings Before Interests and Taxes

§ So what about interests? (details later)
§ Adjustments made to the discount rate (details later)
Operating Cash Flows – Examples
§ Given estimates based on a company’s balance sheet/income statement
Corporate
Revenues Costs Depreciation
Tax Rate
$1,500 $700 $600 34%

§ Q1: How much is the EBIT?

§ EBIT = Revenues – Costs – Depreciation = 1500 – 700 – 600 = $200
§ Q2: How much is the amount of taxes paid?
§ Taxes = EBIT ×𝑇' = 200 × 34% = $68
§ Q3: How much is the OCF?
§ OCF = EBIT + Depreciation – Taxes = 200 + 600 – 68 = $732
Operating Cash Flows – Examples
§ Given estimates based on a company’s balance sheet/income statement
Corporate
Revenues Costs Depreciation
Tax Rate
$1,500 $700 $600 34%

§ EBIT = $200, Taxes = $68, OCF = $732

§ Bottom-up approach: 𝑂𝐶𝐹 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
§ Net Income = EBIT – Taxes = 200 – 68 = $132
§ OCF = 132 + 600 = $732
§ Top-down approach: 𝑂𝐶𝐹 = 𝑅𝑒𝑣 – 𝐶𝑜𝑠𝑡𝑠 – 𝑇𝑎𝑥𝑒𝑠
§ OCF = 1500 – 700 – 68 = $732
§ Tax shield approach: 𝑂𝐶𝐹 = 𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡𝑠 × 1 − 𝑇& + 𝐷𝑒𝑝𝑟𝑒×𝑇&
§ OCF = (1500 - 700)(1 – 34%) + 600 × 34% = $732
Let’s take a pause, where are we now?
§ The OCF is on an annual basis, i.e., annual net incremental cash flows

§ What is the project’s NPV (at time 0)?

%
𝐶"
𝑁𝑃𝑉 = 𝐶! + ' " = 𝐶! + 𝑃𝑉 𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡𝑠 × 1 − 𝑇& + 𝐷𝑒𝑝𝑟𝑒×𝑇&
1+𝑟
"#$
§ Breaking down the formula
§ 𝐶! = initial costs, not in the OCF calculation
§ 𝑃𝑉 𝐴𝑇𝑂𝐶𝐹 = PV 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 × 1 − 𝑇&
§ ATOCF = after tax OCF
§ 𝑃𝑉 𝐷𝑒𝑝𝑟𝑒×𝑇&
§ Present Value of Capital Cost Allowance Tax Shield (PVCCATS)
§ 𝑃𝑉 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛×𝑇& = 𝑃𝑉 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ×𝑇&
 𝑁𝑃𝑉 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 + 𝑃𝑉(𝐴𝑇𝑂𝐶𝐹) + 𝑃𝑉𝐶𝐶𝐴𝑇𝑆

§ Capital Costs: initial investment in plant & equipment to fund the project

§ In this course: all capital costs occur the day the project is accepted
§ In real life, these costs may be spread over time, and
§ May include a salvage value if the asset/project has finite life

§ In Canada, depreciation is referred to as Capital Cost Allowance (CCA)

§ CCA saves some of the tax costs, hence providing a “tax shield”
§ CCA is viewed as a “cost”, so it decreases the EBIT, hence reducing
taxes
§ In 8 slides, we will see
𝐶 ⋅ 𝑑 ⋅ 𝑇& 1 + 0.5𝑟 𝑆 ⋅ 𝑑 ⋅ 𝑇& 1
𝑃𝑉𝐶𝐶𝐴𝑇𝑆 = × − × (
𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟
“Simple” Depreciation Schedule
§ A machine costs $1 million & it is in a CCA class with a rate of 20%.
§ “Simple” depreciation schedule depreciates 20% every year
§ Let 𝐶=equipment cost, 𝑑=CCA rate, UCC = Undepreciated Capital Cost

Year UCC Start CCA UCC End Year UCC Start CCA UCC End
1 $ 1,000,000 $ 200,000 $ 800,000 1 𝐶 𝐶𝑑 𝐶(1 − 𝑑)
2 $ 800,000 $ 160,000 $ 640,000 2 𝐶 1−𝑑 𝐶 1−𝑑 𝑑 𝐶 1−𝑑 &
3 $ 640,000 $ 128,000 $ 512,000 3 𝐶 1−𝑑 & 𝐶 1 − 𝑑 &𝑑 𝐶 1 − 𝑑 '
4 $ 512,000 $ 102,400 $ 409,600 ⋮ ⋮ ⋮ ⋮

§ The table goes on forever

§ PVCCA can be calculated by summing up the CCA column
§ Use varying perpetuity formula
§ The tax shield is simply PVCCA multiply by 𝑇&
“Simple” Depreciation Schedule
§ Continue with the previous example

Year UCC Start CCA UCC End Year UCC Start CCA UCC End
1 $ 1,000,000 $ 200,000 $ 800,000 1 𝐶 𝐶𝑑 𝐶(1 − 𝑑)
2 $ 800,000 $ 160,000 $ 640,000 2 𝐶 1−𝑑 𝐶 1−𝑑 𝑑 𝐶 1−𝑑 &
3 $ 640,000 $ 128,000 $ 512,000 3 𝐶 1−𝑑 & 𝐶 1 − 𝑑 &𝑑 𝐶 1−𝑑 '
4 $ 512,000 $ 102,400 $ 409,600 ⋮ ⋮ ⋮ ⋮
§ Suppose the machine is never sold, CCA is an growing perpetuity with
§ Initial payment 𝐶𝑑 & “growth rate” −𝑑
')
§ If the discount rate is 𝑟, the present value of CCA is
*+)

§ CCA is not taxed, so the “tax shield” it provides is

𝐶𝑑
×𝑇&
𝑟+𝑑
The “Half-Year” Rule
§ Canadian regulations assume that the purchase occurs in the middle of the year
§ Mathematically, split the initial cost into two parts:
§ 50% in the first year & 50% in the second year

§ Example revisited: $1 million equipment in a CCA class with a rate of 20%.

Year UCC Start CCA UCC End

1 $ 500,000 $ 100,000 $ 400,000
2 $ 900,000 $ 180,000 $ 720,000
3 $ 720,000 $ 144,000 $ 576,000
4 $ 576,000 $ 115,200 $ 460,800

§ 50%×$1𝑚𝑖𝑙 = $500 𝐾 in Year 1

§ UCC End in Year 1 + 50%×$1𝑚𝑖𝑙 = $400𝐾 + $500𝐾 = $900𝐾 in Year 2
§ How to calculate the PVCCATS in this case?
Calculations explained by tables
Year UCC Start CCA UCC End
1 0.5𝐶 0.5𝐶𝑑 0.5𝐶(1 − 𝑑)
2 0.5𝐶 1 − 𝑑 + 0.5𝐶 0.5𝐶 1 − 𝑑 𝑑 + 0.5𝐶𝑑 0.5𝐶 1 − 𝑑 & + 0.5𝐶 1 − 𝑑
3 0.5𝐶 1 − 𝑑 & + 0.5𝐶 1 − 𝑑 0.5𝐶 1 − 𝑑 &𝑑 + 0.5𝐶 1 − 𝑑 𝑑 0.5𝐶 1 − 𝑑 ' + 0.5𝐶 1 − 𝑑 &
⋮ ⋮ ⋮ ⋮

Year UCC Start CCA UCC End Year UCC Start CCA UCC End
1 0.5𝐶 0.5𝐶𝑑 0.5𝐶(1 − 𝑑) 1 0 0 0
2 0.5𝐶 1 − 𝑑 0.5𝐶 1 − 𝑑 𝑑 0.5𝐶 1 − 𝑑 & 2 0.5𝐶 0.5𝐶𝑑 0.5𝐶 1 − 𝑑
3 0.5𝐶 1 − 𝑑 & 0.5𝐶 1 − 𝑑 &𝑑 0.5𝐶 1 − 𝑑 ' 3 0.5𝐶 1 − 𝑑 0.5𝐶 1 − 𝑑 𝑑 0.5𝐶 1 − 𝑑 &
⋮ ⋮ ⋮ ⋮ ⋮ ⋮ ⋮ ⋮

§ If the machine is never sold, the CCA tax shield is

0.5𝐶𝑑 0.5𝐶𝑑 1 𝐶𝑑𝑇( 1 + 0.5𝑟
×𝑇( + ×𝑇( × = ×
𝑟+𝑑 𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟

discounted back to time 0

CCA when an asset is sold
§ In reality, if the asset is sold, there is no more CCA tax shield
§ No more “half-year rule” for the sale of an asset
§ So need to find out how much CCA tax shield is lost due to the sale

§ Perpetuity formulas are more convenient than annuity formulas, so..

§ Pretend the original infinitely long tables were still there
§ Create an infinitely long lost of CCA table as a result of the sale
§ Do subtraction of a few infinitely long tables
§ E.g., subtraction of some perpetuities
Calculations explained by tables
Year UCC Start CCA UCC End Year UCC Start CCA UCC End
1 0.5𝐶 0.5𝐶𝑑 0.5𝐶(1 − 𝑑) 1 0 0 0
2 0.5𝐶 1 − 𝑑 0.5𝐶 1 − 𝑑 𝑑 0.5𝐶 1 − 𝑑 & 2 0.5𝐶 0.5𝐶𝑑 0.5𝐶 1 − 𝑑
3 0.5𝐶 1 − 𝑑 & 0.5𝐶 1 − 𝑑 &𝑑 0.5𝐶 1 − 𝑑 ' 3 0.5𝐶 1 − 𝑑 0.5𝐶 1 − 𝑑 𝑑 0.5𝐶 1 − 𝑑 &
⋮ ⋮ ⋮ ⋮ ⋮ ⋮ ⋮ ⋮
§ If the machine is never sold, the CCA tax shield is
0.5𝐶𝑑 0.5𝐶𝑑 1 𝐶𝑑𝑇& 1 + 0.5𝑟
×𝑇& + ×𝑇& × = ×
𝑟+𝑑 𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟
§ Sale at the end of year 𝑛 for $𝑆, CCA that we don’t have any more is

Year UCC Start CCA UCC End • Simple depreciation from time 𝑛
n+1 𝑆 𝑆𝑑 𝑆 1−𝑑
• The “loss” of tax shield is then
n+2 𝑆 1−𝑑 𝑆 1−𝑑 𝑑 𝑆 1−𝑑 &
n+3 𝑆 1−𝑑 & 𝑆 1 − 𝑑 &𝑑 𝑆 1−𝑑 '
𝑆𝑑𝑇&
⋮ ⋮ ⋮ ⋮ 𝑟+𝑑
1
×
1+𝑟 (
Present Value of CCA Tax Shield (PVCCATS)
§ The PV of the tax shield (i.e. the value of the tax deductions) is given by
the PVCCATS formula

𝐶 ⋅ 𝑑 ⋅ 𝑇& 1 + 0.5𝑟 𝑆 ⋅ 𝑑 ⋅ 𝑇& 1

𝑃𝑉𝐶𝐶𝐴𝑇𝑆 = × − × (
𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟
where
§ C = original price of the assets
§ d = CCA rate that applies to the asset class
§ 𝑇𝑐 = corporate tax rate
§ r = discount rate S = Salvage Value
§ n = the period when assets are sold
PVCCATS Example
§ Consider the purchase of a delivery truck as specified as follow
§ Initial cost $30,000, lasts for 5 years, then sold for $1,500
§ CCA class with 20% rate, 10% discount rate, 40% corporate tax

§ What is the PVCCATS?

𝐶 = 30𝐾, 𝑑 = 20%, 𝑇" = 40%, 𝑟 = 10%
𝑆 = 1.5𝐾, 𝑛=5
𝐶 ⋅ 𝑑 ⋅ 𝑇" 1 + 0.5𝑟 𝑆 ⋅ 𝑑 ⋅ 𝑇" 1
𝑃𝑉𝐶𝐶𝐴𝑇𝑆 = × − × = $7,388
𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟 #

§ $2,000 maintenance cost, tax-deductible, is paid at the end of each year. What is
the net present value (NPV) of the initial and maintenance costs and the salvage?
$1,500
𝑁𝑃𝑉$,"&'( = −$30,000 − $2,000 ∗ 1 − 40% ⋅ 𝑎 5,10% + = −$33,618
1 + 10% )
Equivalent Annual Costs (EAC)
§ There are cases where a direct NPV analysis is too simple
§ E.g., Comparing projects with unequal lives
§ E.g., Cheap but short-lived machine vs. expensive but high-quality machine

§ Consider the purchase of a delivery truck, with 2 choices:

§ Truck A costs $30,000 at purchase and has $2,000/yr maintenance cost. It
can be sold for $1,500 after 5 years.
§ Truck B costs $35,000 at purchase and has $2,500/yr maintenance cost. It can
be sold for $2,000 after 8 years.
§ CCA class with 20% rate, 40% corporate tax, and 10% discount rate.

§ Which truck is preferred and why?

§ Prefer the one that is less costly, every year.
Direct NPV Analysis
§ Truck A has net incremental CFs 𝑁𝑃𝑉$ = $7,388 − $33,618 = −$26,230
§ NPV of Truck B is calculated as
𝐶* ⋅ 𝑑 ⋅ 𝑇" 1 + 0.5𝑟 𝑆* ⋅ 𝑑 ⋅ 𝑇" 1
𝑃𝑉𝐶𝐶𝐴𝑇𝑆* = × − × = $8,660
𝑟+𝑑 1+𝑟 𝑟+𝑑 1+𝑟 #
$2,000
𝑁𝑃𝑉*,"&'( = −$35,000 − 2500 ⋅ 1 − 40% ⋅ 𝑎 8,10% + = −$42,069
1 + 10% +
𝑁𝑃𝑉* = −$42,069 + $8,660 = −$33,409

§ The negative NPVs indicate the costs for purchasing Truck A & Truck B
§ Truck A seems less costly than Truck B, but
§ Truck B lasts longer (8 years) than Truck A (5 years).
Direct NPV Analysis
§ The NPV of the cash flows of each truck are:
§ 𝑁𝑃𝑉, = −$26,230
§ 𝑁𝑃𝑉- = −$33,409
§ It seems the NPV rule suggests that Truck A is better (i.e., higher NPV)
§ But Truck B lasts longer

§ For a fair comparison, what does each truck cost per year?

§ Instead of NPV, we look at the equivalent annual costs (EACs)

§ Spread the NPV to each year in a “financially equivalent” way
Equivalent Annual Costs (EAC)
§ Definition/Calculation
𝑁𝑃𝑉
𝑁𝑃𝑉 = 𝐸𝐴𝐶×𝑎 𝑛, 𝑟 ⇒ 𝐸𝐴𝐶 =
𝑎 𝑛, 𝑟

§ Additional remarks:
§ NPV is the PV of uneven cashflows
§ EAC is the financially equivalent equal annual amount
§ 𝑎 𝑛, 𝑟 is the annuity-immediate factor: payment is made at the end of each year
§ PV of annuity due (payments at the beginning of each year) is 𝑎 𝑛, 𝑟 × 1 + 𝑟

§ Examples:
§ Car loan
§ Equipment Financing
Equivalent Annual Costs (EAC)
§ The EACs for Truck A and Truck B are
𝑁𝑃𝑉, 𝑁𝑃𝑉-
𝐸𝐴𝐶, = = −6,919 𝑎𝑛𝑑 𝐸𝐴𝐶- = = −6,262
𝑎 5,10% 𝑎 8,10%
§ So, Truck B is actually better on an annual basis

§ The “-” sign indicates that, mathematically, EACs are cash outflows
§ In practice, EACs are sometimes quoted as positive numbers

§ Isn’t NPV “the golden rule”? Why doesn’t it work this time?
§ The NPVs cover different time periods, so cannot be directly compared
§ We can make it work by covering the same time period, say forever
Indirect NPV Analysis
§ Assume/Pretend that operation is required forever
§ Every expired truck will be replaced by the same truck

§ 𝑁𝑃𝑉! = −$26,230, which is incurred every 5 years (perpetuity due)

§ 5-year discount rate 𝑟) = 1 + 10% ) − 1 = 61.05%
§ PV of a perpetuity due that pays $1 every 5 years 𝑎 ∞, 𝑟) ⋅ 1 + 𝑟)
§ The NPV for infinitely many Truck A is then
−$26,230
𝑁𝑃𝑉*,, = 𝑁𝑃𝑉* ⋅ 𝑎 ∞, 𝑟) ⋅ 1 + 𝑟) = 1 + 61.05% = −$69,193
61.05%

§ Similar calculations shows that

−$33,409
𝑁𝑃𝑉",$ = 1 + 114.36% = −$62,623
114.36%
§ So Truck B is indeed less costly to cover the same time period as Truck A
EAC and NPV Revisited
§ What is the EAC for Truck A and Truck B to cover an infinite time period?
§ 𝑁𝑃𝑉!,$ = −$69,193, 𝑁𝑃𝑉",$ = −$62,623
%
§ 10% perpetuity factor is 𝑎 ∞, 10% = = 10
%&%
§ Then:
𝑁𝑃𝑉!,$ −$69,193
𝐸𝐴𝐶!,$ = = = −$6,919
𝑎(∞, 10%) 10
𝑁𝑃𝑉",$ −$62,623
𝐸𝐴𝐶",$ = = = −$6,262
𝑎 ∞, 10% 10
§ These EACs are the same as those for a single truck

§ The indirect NPV analysis and EAC analysis produce the same conclusion
§ The direct NPV analysis overlooks the different truck lifetimes
Inflation and Capital Budgeting
§ Purchasing power of $1 changes through inflation
§ Nominal terms: CFs expressed in dollar
§ Real terms: CFs expressed in purchasing power

§ Effects of inflation must be included in capital budgeting

§ Especially in long term projects

§ Definition
1 + 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑅𝑎𝑡𝑒 = 1 + 𝑅𝑒𝑎𝑙 𝑅𝑎𝑡𝑒 × 1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
which can be approximated by
Real Rate ≅ Nominal Rate – Inflation Rate
when the rates are small
Example
§ Inflation rate is 6%; nominal interest rate is 10%
§ CFs are $100 now in real terms at the end of next 2 years

§ Calculate PV in nominal terms

𝐶$ = 100 1.06 , 𝐶. = 100 1.06 .

𝐶$ 𝐶.
𝑃𝑉 = + . = 189.22
1.10 1.10

§ Calculate PV in real terms

1.10
𝐶$ = 𝐶. = 100, 𝑖*/01 = − 1 = 3.78%
1.06
𝐶$ 𝐶.
𝑃𝑉 = + = 189.22
1.0378 1.0378 .
Dealing with Inflation
§ Consistency is the key
§ Discount real cash flows at real rates
§ Discount nominal cash flows at nominal rates

§ Conversion is okay
§ Convert cash flows to match discount rates
§ Convert discount rates to match cash flows
§ Pick either real or nominal by convention, but not both
§ DO NOT mix and match-money illusion

§ In practice, CCA tax shields are often calculated in nominal terms.

§ It is recorded every year without adjustment to inflation
Inflation
§ Consider the purchase of a delivery truck, with 2 choices:
§ Truck A costs $30,000 at purchase and has $2,000/yr maintenance cost. It
can be sold for $1,500 after 5 years. Cash flows are quoted in nominal terms.
§ Truck B costs $35,000 at purchase and has $2,500/yr maintenance cost. It can
be sold for $2,000 after 8 years. Cash flows are quoted in real terms.
§ 40% corporate tax, 10% nominal discount rate, and 1% inflation rate. Ignore CCA.
§ Which truck is preferred and why?

§ Indirect NPV and EAC are useful, but be mindful about real vs. nominal values.
EAC Analysis
§ CCA is ignored, Truck A’s costs is 𝑁𝑃𝑉$,#&,-#./ = −$33,618, in nominal terms
𝑁𝑃𝑉$
𝐸𝐴𝐶$,#&,-#./ = = −$8,868
𝑎 5, 𝑟#&,-#./
§ Truck B’s costs are in real terms, so will need the real discount rate
1 + 𝑟#&,-#./
𝑟01./ = − 1 = 8.91%
1 + 𝑟-#2/.(-&#
§ NPV of the costs, in real terms, is
$2,000
𝑁𝑃𝑉-,%./0 = −$35,000 − 2500 ⋅ 1 − 40% ⋅ 𝑎 8,8.91% + 1
= −$42,319
1 + 8.91%
−$42,319
𝐸𝐴𝐶*,01./ = = −$7,621
𝑎 8,8.91%

§ It is wrong to compare 𝐸𝐴𝐶$,#&,-#./ with 𝐸𝐴𝐶*,01./ !

§ Need a way to convert real & nominal EACs…
Indirect NPV Analysis
§ 𝑁𝑃𝑉$,#&,-#./ = −$33,618, which is incurred every 5 years, in nominal terms
𝑟),#&,-#./ = 1 + 𝑟#&,-#./ ) − 1 = 61.05%
𝑁𝑃𝑉$,3 = 𝑁𝑃𝑉$,#&,-#./ ⋅ 𝑎 ∞, 𝑟),#&,-#./ ⋅ 1 + 𝑟),#&,-#./ = −$88,682

§ 𝑁𝑃𝑉-,*/01 = −$42,319, which is incurred every 8 years, in real terms

𝑟+,01./ = 1 + 𝑟01./ + − 1 = 97.96%
𝑁𝑃𝑉*,3 = 𝑁𝑃𝑉*,01./ ⋅ 𝑎 ∞, 𝑟+,01./ ⋅ 1 + 𝑟+,01./ = −$85,522

§ Note that these 𝑁𝑃𝑉3 ’s are time-0 values, thus are both real and nominal
§ 𝑁𝑃𝑉*,3 > 𝑁𝑃𝑉$,3 , so Truck B is less costly
Conversion between Real and Nominal EACs
§ Nominal and real EACs can be calculated as
𝑁𝑃𝑉3 𝑁𝑃𝑉3
𝐸𝐴𝐶#&,-#./ = , 𝐸𝐴𝐶01./ =
𝑎 ∞, 𝑟#&,-#./ 𝑎 ∞, 𝑟01./
§ Then, for the same equipment, we have 𝑁𝑃𝑉3 = 𝑁𝑃𝑉3 , which means
𝐸𝐴𝐶#&,-#./ 𝐸𝐴𝐶01./
𝐸𝐴𝐶#&,-#./ ⋅ 𝑎 ∞, 𝑟#&,-#./ = 𝐸𝐴𝐶01./ ⋅ 𝑎 ∞, 𝑟𝑒𝑎𝑙 ⇒ =
𝑟#&,-#./ 𝑟01./
4
§ Because the perpetuity formula is 𝑎 ∞, 𝑟 =
0
§ Using the above conversion formula, we have
Truck A Truck B Preference
𝑁𝑃𝑉3 −$88,682 −$85,522 Truck B
𝐸𝐴𝐶#&,-#./ −$8,868 −$8,552 Truck B
𝐸𝐴𝐶01./ −$7,902 −$7,621 Truck B

§ EAC and indirect NPV analysis always arrive at the same conclusion!
Summary and Conclusions
§ Capital budgeting uses only net incremental cash flows.
§ Sunk costs are ignored
§ Opportunity costs and side effects matter

§ Inflation must be handled consistently

§ Discount real cash flows at real rates
§ Discount nominal cash flows at nominal rates

§ When a firm must choose between two machines of unequal lives:

§ Equivalent Annual Cost (EAC)

§ Bottom line: Capital budgeting is a difficult task!