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Lecture 9 - Making Capital Investment Decisions - Chapter 10

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90 views51 pages

Lecture 9 - Making Capital Investment Decisions - Chapter 10

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remover.units1y
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FINA1003 / FINA1310 CORPORATE FINANCE

Faculty of Business and Economics


University of Hong Kong

Dr. Shiyang Huang

Lecture 9: Making Capital Investment Decisions


Course Overview
• Introduction

• Part I: Valuation
• Time Value of Money, Discounted Cash Flow Valuation,
Bond and Stock Valuation.

• Part II: Risk and Return


• Historical Risk and Return Relationships, CAPM.

• Part III: Capital Budgeting


• Real Investment Decisions, Cost of Capital.

• Part IV: Financing Decisions


• Raising Capital, Tradeoff between Equity and Debt.
Key Takeaways
• Net Present Value (NPV) Rule
• Alternatives to the NPV Rule
• Cash Flow Calculation
• Discounted Cash Flow Analysis
• Scenario and Sensitivity Analysis
• Capital Rationing

Reading: Chapter 10

2
Key Concepts and Skills
• Understand how to determine the relevant cash flows for
various types of proposed investments
• Understand the various methods for computing
operating cash flow
• Understand how to evaluate the equivalent annual cost
of a project
Relevant Cash Flows

• The cash flows that should be included in a capital


budgeting analysis are those that will only occur (or not
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
Relevant Cash Flows
Use incremental cash flows

Will this cash flow occur ONLY


if we accept this project?

“Yes” “No” “Part of it”

Include the part that


Include the Do not include
occurs because of
cash flow the cash flow
the project
Common Types of Cash Flows
• Forget sunk costs – costs that have accrued in the past
• 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
• Do not include financing costs
Sunk Cost
Forget cash flows that have occurred in the past

Example:
• In 1971 Lockheed sought a federal guarantee for a bank
loan to continue the development of the Tristar airplane.
• Lockheed argued that it would be foolish to abandon a
project on which nearly $1 billion had already been spent.
Opportunity Cost
Include opportunity costs of using existing equipment,
facilities, etc.

Example:
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid
$800,000 to purchase the building last year. The building is
worth $900,000 today.
• The store can generate $100,000 cash in perpetuity.
• Discount rate is 10%. Should the firm open the store?
Net Working Capital
Adjust for changes in net working capital

Example:
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid $800,000
to purchase the building last year. The building is worth $900,000
today.
• The store can generate $100,000 cash in perpetuity.
• Discount rate is 10%.

• To start the store, the firm also needs to purchase $200,000


worth of inventory today.
• Should the firm open the store?
Side Effects
Incremental cash flow includes all resulting changes on a firm’s
future cash flows caused by the project

• Cannibalization
• e.g.
• Releasing iPhone 6s reduces the sales of iPhone 6
• Selling DVD of a movie can erode box office revenues

• Cross-selling
• e.g.
• Printer sales can increase cartridge sales
• Opening a Disney theme park can increase revenue of selling
Disney toys
Financing Costs
Do NOT include cash flows from financing activities
• Such as interest payments, dividends, or principal
repayments
• To avoid double counting
• We will adjust for financing later
Pro Forma Statements and Cash Flow
• Capital budgeting relies heavily on pro forma
accounting statements, particularly income statements
• Computing cash flows
Cash Flow From Assets (CFFA)
= OCF – net capital spending (NCS) – changes in NWC
• Operating Cash Flow (OCF) = EBIT + depreciation – taxes
• OCF = Net income + depreciation (when there is no interest
expense)
Key point: interest expense is not considered here,
because it is a financing cost, not an operating cost!
Cash Flows
Operating Cash Flow = EBIT – Taxes + Depreciation

• EBIT stands for “Earnings before Interest and Taxes”

• We compute Taxes on EBIT

Therefore,

Cash Flow

= EBIT – Taxes + Depreciation – Capital Spending – 𝚫𝚫NWC


“Four” Definitions of Operating Cash Flows
You may see the following approaches of calculating Operating Cash
Flows. They are the same!

1) Operating Cash Flows = EBIT – Taxes + Depreciation

2) Operating Cash Flows = Net Income Before Interest +


Depreciation
• The “Bottom-Up” Approach
• Net Income Before Interest = EBIT - Taxes

3) Operating Cash Flows = Sales – Costs – Taxes


• The “Top-Down” Approach
• Sales – Costs = EBIT + Depreciation

4) Operating Cash Flows = (Sales – Costs) × (1-T) + Depreciation × T


• The “Tax Shield” Approach: Tax=EBIT ×T
Example for Pro Forma Income Statement

Suppose we can sell 50,000 cans of shark attractant per year at a


price of $4 per can. It costs $2.50 to produce one can. The product
has a 3-year life. We require 20% return on new products.

The fixed cost for the project is $12,000 per year. We need to
invest a total of $90,000 in manufacturing equipment, which will
be 100% depreciated over the 3-year life of the project. After 3
years, the equipment has zero market value. Assume the project
needs an initial $20,000 investment in net working capital, and the
tax rate is 34%.
Pro Forma Financial Statements and Cash Flows
New Project: Selling Shark Attractant

• Sales volume = 50,000 cans/year


• Unit price = $4/can
• Unit cost = $2.50/can
• Project life = 3 years
• Fixed cost = $12,000/year
• One-time capital spending = $90,000
• Depreciation: straight-line over 3 years, 100%
depreciation
• Initial investment in NWC = $20,000
• Tax rate = 34%
• Required rate of return = 20%
Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000


Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
Table 10.5 Projected Total Cash Flows
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in -$20,000 20,000
NWC
NCS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

 OCF = NI + depreciation = 21,780 + 30,000 = 51,780 ; or


 OCF = EBIT + depreciation – taxes
= 33,000 + 30,000 – 11,220 = 51,780
Making The Decision
• NPV
51,780 51,780 71,780
• 𝑁𝑁𝑁𝑁𝑁𝑁 = −110,000 + + +
1+20% 1+20% 2 1+20% 3
=10,647.69

• IRR
51,780 51,780 71,780
• −110,000 + + 1+𝐼𝐼𝐼𝐼𝐼𝐼
1+𝐼𝐼𝐼𝐼𝐼𝐼 2 + 1+𝐼𝐼𝐼𝐼𝐼𝐼 3
IRR = 25.8%
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, whether we have
actually paid our suppliers yet
• Finally, we must buy inventory to support sales, although we
haven’t collected cash yet
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 = Depreciation x Tax Rate


Computing Depreciation
• Straight-line depreciation

• D = Initial cost / number of project’s life

=Initial Cost/number of years


• Very few assets are depreciated straight-line

• 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
Computing Depreciation-MACRS
After-tax Market Value
• If the market value is different from the book value of the
asset, then there is a tax effect
• Book value = initial cost – accumulated depreciation

• After-tax market value

= market value – Tax rate * (market value – book value)


• After tax market value

= Market Value* (1 – Tax rate) only if the book value =0


Example of Project Cash Flows
A machine purchased for $1,000,000 with a life of 10 years
generates annual revenues of $300,000 and incurs operating
expenses of $100,000. Assume that the machine will be
depreciated over 10 years using straight-line depreciation. The
corporate tax rate is 40%.

What are the accounting earnings? What are the cash flows?
Example of Project Cash Flows

Recall
• Use cash flows. Accounting earnings do not accurately reflect the
actual timing of cash flows
Example: Depreciation and After-tax market value

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 market value in year 6 for each of the
following situations?
Example: Straight-line

• Suppose the appropriate depreciation schedule


is straight-line
• BV in year 6 = 0

• After-tax market value

= 17,000 - .4(17,000 – 0)
= 10,200
Example: Three-year MACRS

Year MACRS D BV in year 6


percent
= 110,000 – 36,663 –
1 .3333 .3333(110,000) = 48,895 – 16,291 –
36,663 8,151
2 .4445 .4445(110,000) =
=0
48,895
3 .1481 .1481(110,000) = After-tax market value
16,291
= 17,000 - .4(17,000 – 0)
4 .0741 .0741(110,000) = = $10,200
8,151
Example: Seven-Year MACRS
Year MACRS D BV in year 6
Percent
= 110,000 – 15,719 –
1 .1429 .1429(110,000) =
15,719 26,939 – 19,239 –
2 .2449 .2449(110,000) =
13,739 – 9,823 – 9,812
26,939 = 14,729
3 .1749 .1749(110,000) =
19,239 After-tax market value
4 .1249 .1249(110,000) = = 17,000 – .4(17,000
13,739 – 14,729)
5 .0893 .0893(110,000) =
9,823 = 16,091.60
6 .0892 .0892(110,000) =
9,812
Example: Replacement Problem
Original Machine New Machine
• Initial cost = 100,000 • Initial cost = 150,000
• Annual depreciation = • 5-year life
9,000 • Market Value in 5 years =
• Purchased 5 years ago 0
• Cost savings = 50,000 per
• Book Value = 55,000
year
• Market Value today = • Straight-line depreciation
65,000
 Required return = 10%
• Market Value in 5 years =
 Tax rate = 40%
10,000
• Straight-line depreciation
Replacement Problem

• 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?
Replacement Problem

Incremental Capital Spending


Buy new machine = 150,000 (outflow)

Sell old machine = 65,000 - 0.4(65,000 – 55,000)


= 61,000 (inflow)

Net capital spending


=150,000–61,000 SV BV
=89,000(outflow)
Replacement Problem
Incremental Operating Cash Flow

relevant
Replacement Problem

Incremental After-Tax Market Value


Net Market Value on new machine
= 0 - 0.4(0 -0)
=0
SV BV
Net Market Value on old machine
= 10,000 - 0.4(10,000 – 10,000)
= 10,000
This is an opportunity cost because we no
longer receive this at Year 5

Terminal CF = -10,000
Replacement Problem
Year 0 1 2 3 4 5

Capital -89,000
Spending

OCF 38,400 38,400 38,400 38,400 38,400

SV (New) 0
SV (Old) -10,000

∆NWC 0 0

NCF -89,000 38,400 38,400 38,400 38,400 28,400


Replacement Problem
• Now we can compute the NPV
• NPV = 50,357

• Should the company replace the equipment?


Example: Cost Cutting
• Your company is considering a new computer system

that will initially cost $1 million. It will save $300,000


per 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 market 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%.
Example: Cost Cutting
Example: Cost Cutting

313,320 357,800 239,240 209,640 210,000


• NPV= −1,000,000 + 1+8%
+ 1+8% 2
+ 1+8% 3
+ 1+8% 4
+ 1+8% 5
=83,797.50

• IRR
313,320 357,800 239,240 209,640 210,000
−1,000,000 + + + + +
1 + 𝐼𝐼𝐼𝐼𝐼𝐼 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 2 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 3 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 4 1 + 𝐼𝐼𝐼𝐼𝐼𝐼 5
=0
IRR = 11.45%
10-41

Example: Setting the Bid Price


• We are considering to sell for five trucks per year, for four years.
• Total costs per year is $94,000
• Initial investment is $60,000
• Straight-line depreciation over the four years
• The expected sale price is $5,000 at the end of year 4
• Investment in inventories and other working capital items is
$40,000
• Tax rate is 39%
• Required rate of return is 20%
10-42

Example: Setting the Bid Price


 OCF is unknown
Year 0 Year 1 Year 2 Year 3 Year 4

OCF +OCF +OCF +OCF +OCF

Change in -$40,000 +40,000


NWC

Capital -$60,000 3,050


Spending

Total CF -$100,000 +OCF +OCF +OCF +OCF+$43,050

 After-tax market value


= market value – Tax (market value – book value)
= 5000 – 39% * (5000 – 0)
= 3050
10-43

Example: Setting the Bid Price


Year 0 Year 1 Year 2 Year 3 Year 4
OCF +OCF +OCF +OCF +OCF
Change in -$40,000 +40,000
NWC

Capital -$60,000 3,050


Spending

Total CF -$100,000 +OCF +OCF +OCF +OCF


+$43,050

NPV=
-100,000+43,050/(1.20)4+OCF/1.2+OCF/1.22+OCF/1.23+OCF/1.24

NPV = 0 @20% => OCF = 30,609


So after we bid for the contract, we need to generate at least $30,609
per year in operating cash flow.
10-44

Example: Setting the Bid Price


OCF = Net Income + Depreciation
=> Net Income = 30,609 – 15,000 = 15,609

Sales ?

Costs $94,000

Depreciation ($60,000 / 4) 15,000

Taxes (39%) ?

Net Income $ 15,609


10-45

Example: Setting the Bid Price

• Net Income = (Sales – Costs – Depreciation) * (1-Tax)


=>Sales = 134,589

• Therefore, we will bid for 5 trucks that can be sold at


$134,589 in total.

• So, we will bid $26,918 per truck. This will guarantee


that our return will be 20% on this contract.
Example: Equivalent Annual Cost
Analysis
 Burnout Batteries  Long-lasting Batteries
• Initial Cost = $36 each • Initial Cost = $60 each
• 3-year life • 5-year life
• $100 per year to keep • $88 per year to keep charged
charged • Expected market value = $5
• Expected market value= $5 • Straight-line depreciation
• Straight-line depreciation

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 15%, and the tax rate is 34%.


Burnout Batteries
Initial Cost 36 Tax Rate 34%
Required
Operating Cost 100 Return 15%
Depreciation 12.00

Expected Market After-tax


Value 5 market value 3.30

Year 0 1 2 3
OCF -61.92 -61.92 -61.92
NCS -36.00 3.30
NWC 0.00 0.00
CFFA -36.00 -61.92 -61.92 -58.62

NPV -$175.21
EAC -$76.74
Long-Lasting Batteries
Initial Cost 60 Tax Rate 34%
Operating Required
Cost 88 Return 15%
Depreciation 12

After-tax
Expected market 3.3
Market Value 5 value

Year 0 1 2 3 4 5
OCF -54.00 -54.00 -54.00 -54.00 -54.00
NCS -60.00 3.30
NWC 0.00 0.00
CFFA -60.00 -54.00 -54.00 -54.00 -54.00 -50.70

NPV -$239.38
EAC -$71.41
Key Concepts and Skills
• Only incremental cash flows should be included in a capital
budgeting analysis;
• The stand-alone principle: analyze each project in isolation
from the firm
• Computing cash flows

• 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
Summary and conclusions of chapter 10
• Only incremental cash flows should be included. The stand-
alone principle applies.
• Cash flows
= Operating Cash Flow (OCF) -Change in NWC
- Net capital spending.
• Interest expense is not considered part of the cash flow,
because it is a financing cost, not an operating cost.
• Evaluating a project
• Replacement Problem
• Setting the bid price
• Equivalent Annual Cost Analysis

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