Module Two

Valuation, capital budgeting and risk

Chapter 8 – Making capital

investment decisions

.
Learning Objectives
By the end of this module, you should be able to:
A. Understand how to determine the relevant cash flows for
a proposed project.
B. Understand how to determine if a project is acceptable.
C. Understand how to set a bid price for a project.
D. Understand how to evaluate the Annual Equivalent Cost
(AEC) & Annual Equivalent Benefits (AEB) of a project.
A Relevant Project cash flows
Recall: The effect of taking a project is to change the firm’s
overall cash flows today and in the future.
To evaluate a proposed investment, we must consider
these changes in the firm’s cash flows and then decide
whether they bring additional value to the firm.
Then, what kind of cash flow is relevant for an investment
project?
-> is a change in the firm’s over future CF that happens
as a direct consequence of the decision to accept the
project
-> it is also called as incremental cash flow associated
with the project (the diff b/w the firm’s future CF with and
without the project)
A Stand-alone Principle
• In practice, it would be complicated to calculate the future
impact in terms of Cash Flows to the firm, with and without a
project, especially for a large firm.
• Therefore, once the incremental cash flows from undertaking
a project have been determined, we can view that project as a
kind of “mini-company” with its own future revenues and costs,
its own assets, and its own cash flows.
• We will then be primarily interested in comparing the cash
flows from this mini-company to the cost of acquiring it.
=> This is called the stand-alone principle.
A Types of cash flows

The definition of relevant project Cash Flow is important to

evaluation of an investment opportunity, because:
any CF that exists regardless of decision “Go” or “No Go” to
develop a project, is not relevant.

Let’s check out some common examples …

(in some situations, it is not easy to decide whether a cash flow

is incremental …)
A Type of cash flows

1. A firm has already spent $2 million on Market

Research for a new product.
Should it charge this expense to the project (i.e. new
product) while evaluating it? Why?
-> Any expense that has been incurred already and
cannot be changed by the decision today (accept/reject a
project), is a sunk cost (usually R&D, test market
expenses, feasibility study etc.).
-> Sunk costs are not recoverable, therefore they should not
be charged to the project.
 Type of cash flows
A (cont.)
2. A real estate developer is thinking of converting a spare land,
which was bought many years ago for $100,000, into premium
residential condominium project.
If they carry out this project, there will be no direct cash
outflow associated with buying the spare land because they
already owned it. For purposes of evaluating the condominium
project, should they treat the spare land as “free”? Why?
-> No.
-> Because at a minimum, they could sell the spare land for some
value.
-> Using spare land to build up a condo also means that: the
developer will give up opportunity to do something else with the
spare land, thus has an opportunity cost.
A Type of cash flows (cont.)

2. (cont.) We already agree that the use of the spare land has
an opportunity cost. The next question is “How much should
we charge to the condo project for this use” or “How
much is the opportunity cost of this spare land”?
-> $100,000?
No. $100,000 is the acquisition cost which was paid many
years ago and it is not relevant anymore.
-> The opportunity cost should be charged to the project is the
market value that the land would sell for today (net of any selling
costs).
-> Or in general, this resource must be priced on its next “best
alternative use”.
A Type of cash flows (cont.)
3. Beer Co. is considering New Product, with an annual sale
volume of 750,000 bottles. The company will use its existing
distribution network to service route-to-market strategy.
The Product Manager argues that: there is no cost
associated with using this network, since it (i.e. sales
network) has been paid already and cannot be sold or leased
to a competitor (-> not competing current use).
Do you agree? Why?
-> There could be possible negative impact on the cash flows of
an existing product, which is caused by the New Product
introduction, this is also called as “erosion” or “cannibalization”.
In this case, the cash flows from the New Product should be
adjusted downward, to reflect the profits which were lost on other
existing products.
A Type of cash flows (cont.)
4. Disney considers investing in making new cartoon movie,
which may cost approximately $50 million.
Besides the revenue from selling the box-office tickets, what
could be other revenues that Disney can monetize on this
movie?
-> the sale of merchandise (toys, plastic figures, clothes, etc.)
-> increased visitor to the theme parks (i.e. Disney Land) or
subscriptions of digital platform such as Disney+
-> Intellectual Property rights (to other makers, e.g. stage
shows like “Beauty and the Beast” or “The Lion King”)
In general, if a project provides benefits for other projects within
the firm, these benefits should be valued and counted to in the
initial project analysis. These benefits are aka “synergies”

aka: also known as

A Types of cash flows
In summary:

• Sunk costs Þ a cost that has been incurred and cannot

be removed ¹ incremental cash flow.

• Opportunity costs Þ the most valuable alternative that

is given up if a particular investment is undertaken =
incremental cash flow.

• Side effects: erosion or synergies = incremental cash

flow.
 Types of cash flows (cont.)
A
• An investment in the project’s net working capital represents
an additional cost (beside long-term assets) of undertaking the
investment.
• At the end of the project’s life, the entire WC investment must
be evaluated, creating a cash inflow at the end of the project life.
• Financing costs Þ in analyzing a proposed investment, we
will not include interest or any other financing costs (e.g.
dividends) because we are only interested in the CF generated
by the assets of the project (or cash flows to the “mini-firm”).
Interest paid is a component of CF to creditors, not CF to the
firm or project (or cash flow from assets), so ¹ incremental CF
• However, interest expense will impact on the tax amount.
• Remember: always use after-tax incremental cash flow, since
taxes are definitely the cash outflows.
B Investment evaluation
Considering a potential investment of $42,000 for a new machine.
• Salvage value $1,000 at end of Year 3.
• Net cash flows: Year 1 $31,000
Year 2 $25,000
Year 3 $20,000.
• Tax rate is 30%.
• Depreciation 20%, reducing balance (*)
• Required rate of return 12%.
• How much is the NPV of this potential investment? Would
you accept this investment opportunity.
(*) Under the reducing balance method, the amount of depreciation is
calculated by applying a fixed percentage on the book value of the
asset at beginning of each year.
B

Source
https://www.deskera.com/blog/salvage-value/
 Solution:
B Depreciation schedule

Initial cost $42,000

Dep’n – Yr 1 (20% ´ 42 000) -$8,400
Depreciated value $33,600
Dep’n – Yr 2 (20% ´ 33 600) -$6,720
Depreciated value $26,880
Dep’n – Yr 3 (20% ´ 26 880) -$5,376
Depreciated value $21,504
Salvage value $1,000
Loss on disposal -$20,504
 Solution: Step 1 -
B Taxable income & tax payment
Year 0 Year 1 Year 2 Year 3
Net cash flows 31,000 25,000 20,000
Depreciation (8,400) (6,720) (5,376)
Loss on sale (20 504)
Taxable income $22,600 $18,280 $(5,880)
Tax rate 30% 30% 30%
Tax payment $(6,780) $(5,484) $1,764

This means that less tax will be paid.

As this is an incremental form of
analysis, it is assumed that the
business (or firm) is have earning
from other business activities
 Solution: Step 2 -
B Cash flows to the firm

Year 0 Year 1 Year 2 Year 3

Tax paid (6,780) (5,484) 1,764
Net cash flow 31,000 25,000 20,000
Salvage value 1,000
Investment (42,000)
Cash flow $(42,000) $24,220 $19,516 $22,764
B Solution: Step 3 -
NPV and decision
Year 0 Year 1 Year 2 Year 3
Cash flow (42,000) 24,220 19 516 22,764
Discount factor 1 0.8929 0.7972 0.7118
PV cash flow ($42,000) $21,626 $15,558 $16,203
NPV $11,387

Decision: NPV > 0, therefore, ACCEPT.

 => In short,
B Three-step approach for
Investment evaluation:

Step 1 Þ Calculate the tax effect of the decision.

Step 2 Þ Calculate the cash flows relevant to the decision.

Step 3 Þ Calculate discounted the cash flows, to make the

decision.
B Depreciation
• Depreciation is a non-cash expense and does not impact to
the operating cash flows; consequently, it is only relevant to
calculation of profit before taxes, and taxes.
• There are two methods of depreciation:
– prime cost (or straight-line method)
– diminishing value (or reducing balance method)
10,000

8,000

6,000

4,000 Prime cost

Ending balance
diminishing value
2,000

0
0 1 2 3 4 5 Year
B Depreciation tax shield
Depreciation cost helps reducing taxable income thus reducing
the taxes that a company must pay. This is also called as:
“Depreciation tax shield” or “Tax Saving” = D * T
where D = depreciation expense
T = % tax rate.

Source: https://finance-able.com/depreciation-tax-shield/
B Example - Depreciation
• The new computer system of Calculus Ltd cost $125,000.
• Calculus targets to dispose it after 3 years, sand it will probably only get
20% of the purchase price.
• The computer will be depreciated at 25%, reducing balance.
Calculate the depreciation and book values for the 3 years.
• Assume a 30% tax rate.
? What will be the after-tax proceeds from the disposal?
Year 1 Year 2 Year 3
Beginning Book Value $125,000 $93,750 $70,313
Depreciation charge ($31,250) ($23,438) ($17,578)
Ending Book value $93,750 $70,313 $52,734

• At the end of year 3, asset is sold for $25,000, incurring a loss of

$25,000 - $52,734 = -$27,734

• After-tax proceeds are $25,000 + $8,320 = $33,320

• Therefore, a tax saving of 30% × $ 27,734 = $8,320 is received.
B Disposal of assets

• If the salvage value > book value, a gain is made on

disposal. This gain is subject to tax (which also means
that: the company estimated excess depreciations in
previous periods).
• If the salvage value < book value, subsequently, the loss
on disposal is a tax deduction/saving (which also means
that: the company estimated insufficient depreciation in
previous periods).
B Inflation

▪ When a project is being evaluated, anticipated inflation

would be reflected in:
▪ the estimates of the future cash flows and
▪ the interest rate used as the discount rate in the
analysis (which will be discussed further in Chapter 10).

▪ As a result, there will be no distortion to the analysis if

not identifying inflation specifically.
B Incremental cash flows
• A firm is currently considering replacing a machine purchased 2 years
ago, with an original estimated useful life of 5 years.
• The replacement machine has an economic life of 3 years.
• Other relevant data is summarized below. Would you accept this
replacement plan?
•

Existing machine New machine

Initial cost $240 000 $360 000
Annual revenues $100 000 $150 000
Annual costs $60 000 $70 000
Annual depreciation $48 000 $120 000
Salvage value $80 000 $100 000
(Now) (End year 3)
Tax rate 30%
Required rate of return 10%
 Solution: Step 1 -
B Taxable income
Year 0 Year 1 Year 2 Year 3
Increased revenues 50 000 50 000 50 000
Increased costs (10 000) (10 000) (10 000)
Dep’n existing 48 000 48 000 48 000
Dep’n new (120 000) (120 000) (120 000)
Loss on sale (existing) (64 000)
Gain on sale (new) 100 000
Taxable income $(64 000) $(32 000) $(32 000) $68 000
Tax rate 30% 30% 30% 30%
 Solution: Step 2 –
B Cash flows
Year 0 Year 1 Year 2 Year 3
Tax
19 200 9 600 9 600 (20 400)
credit/(expense)
Increased revenues 50 000 50 000 50 000
Increased costs (10 000) (10 000) (10 000)
Salvage values 80 000 100 000
Outlay (360 000)
Cash flow $(260 800) $49 600 $49 600 $160 400
 Solution: Step 3 -
B NPV and decision

Year 0 Year 1 Year 2 Year 3

A Cash flow (260 800) 49 600 49 600 160 400
B Discount factor 1 0.9091 0.8264 0.7513
C=A*B PV of cash flow $(260 800) $45 091 $40 989 $120 508
NPV ($54 212)

Decision: NPV < 0, therefore, REJECT.

B Incremental form of
analysis – Exercise 1
• A new VIP room for a restaurant costs $16,000.
• This VIP room cost will be depreciated to zero over 5 years.
• The new VIP room would save the restaurant $6,000 per year
of operating costs (before taxes).
• If a 10% return is required, what is the NPV of investment?
• Assume a tax rate of 30% and tax is paid in the year of
income.
B Incremental form of
analysis – Exercise 1
r = 10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings $6,000 $6,000 $6,000 $6,000 $6,000
Depreciation charge -$3,200 -$3,200 -$3,200 -$3,200 -$3,200
Taxable income $2,800 $2,800 $2,800 $2,800 $2,800

Tax payment (at rate of 30%) -$840 -$840 -$840 -$840 -$840
Savings $6,000 $6,000 $6,000 $6,000 $6,000
Outlay -$16,000
Cash flow -$16,000 $5,160 $5,160 $5,160 $5,160 $5,160
Discount factor 1.00 0.91 0.83 0.75 0.68 0.62
PV -$16,000 $4,691 $4,264 $3,877 $3,524 $3,204
NPV = $3,560
B Incremental form of
analysis – Exercise 2
• Firefighting Ltd believes it can sell 10,000 home smoke
detectors per year at $40 each.
• They cost $30 each to manufacture (variable cost).
• Fixed production costs will run to $40,000 per year.
• The necessary equipment costs of $175,000 and will be
depreciated prime cost to a zero value over the 5-year life of the
project. The actual salvage value will be $15,000 in 5 years.
• The discount rate is 12%, and the tax rate is 30%. What do
you think of the proposal?
 B Incremental form of
analysis – Exercise 2
= $40 x 10,000
= -$30 x 10,000

= $175,000/5
(on disposal)

Cash flow

• The project has a positive NPV -> it should be ACCEPTED.

B A note on cash flows
i. Cash flows do not always conveniently occur at
the end of the period.
ii. Assuming that revenue will come at the period
end is a conservative approach to evaluation.
iii. If cash flows actually occur at the beginning of
the period, this analysis only requires a minor
adjustment on the PV discount factor.
iv. The period examined could be yearly, monthly or
even weekly. If so, the discount rate must match
the period (e.g. a weekly analysis needs a weekly
rate).
 03 SPECIAL CASES OF
C DISCOUNTED CASH FLOW (DCF) ANALYSIS

We will look at 03 common cases involving DCF analysis

1) Setting Competitive bids
2) Valuing options and right to undertake an action
3) Choosing between equipment with different economic
lives
 1) Setting the bid price
C Example:
• Imagine you are in business of buying truck platforms and then modifying
them to customer specifications for resales.
• A local distributor has requested bid (i.e. price offer) for 5 modified trucks each
year for the next 4 years.
• You can buy a truck platform for $12,000 and need to rent a factory space for
$30,000 per year.
• Labour and material costs are $ 6,000/truck per year.
• Requires $72,000 in fixed assets (initial outlay) with expected salvage of $5,000
at the end of the project (depreciate straight-line).
• Tax rate = 30%. Required return = 20%
• What is the lowest price per truck that you can charge in this bidding?

continued
 Year 0 1 2 3 4
Sales units 5 5 5 5
C Unit Selling price ($) X X X X
Truck platform unit cost ($) 12,000 12,000 12,000 12,000
Labour and material unit cost ($) 6,000 6,000 6,000 6,000
P&L
Revenue ($) 5X 5X 5X 5X
Less:
Cost of truck platforms ($) -60,000 -60,000 -60,000 -60,000
Cost of labour and materials ($) -30,000 -30,000 -30,000 -30,000
Cost of leasing factory ($) -30,000 -30,000 -30,000 -30,000
Depreciation ($) -18,000 -18,000 -18,000 -18,000
Other income (diposing assets) ($) 5,000
Taxable income ($) ? ? ? ?
Cash flow
Revenue ($) 5X 5X 5X 5X
Cost of truck platforms ($) -60,000 -60,000 -60,000 -60,000
Cost of labour and materials ($) -30,000 -30,000 -30,000 -30,000
Cost of leasing factory ($) -30,000 -30,000 -30,000 -30,000
Tax payment ($) ? ? ? ?
Other income (diposing assets) ($) 5,000
Initial outlay ($) -72,000
 1) Setting the bid price
C Example:
Key logic of this exercise:

ÞThe lowest possible price that we can charge in this bidding, must
result in a NPV = 0 or IRR = required rate of return = 20% (*)
ÞBecause, at that price, you earn exactly 20% on our investment (as per
required rate of return).

(*) Otherwise, the NPV will be negative and you should not participate
in this bidding from the beginning.

continued
 1) Setting the bid price
C Example:

Solution:

• Step 1: Find the net initial outlay

Fixed assets 72,000.00
Less the PV of after-tax salvage -1,687.89

(1+20%)4
−5,000 × (1−30%)

= Net Initial investment 70,312.11

• Step 2: Find the cash inflows (CFs) over the life of the
project that makes NPV = 0, at required rate of return 20%

continued
 1) Setting the bid price
C Example:
Step 2:
Assuming the CF (from reselling trucks) is the same for each
year and it will occur at the end of each year,
we can write:
1
1−
(1 + 20%)
0 = −70,312.11 + ×
20%

70,312.11 70,312.11
= =
1 2.5887
1−
(1 + 20%)
20%

continued
=$ ,
 1) Setting the bid price
C Example:
• Step 3:
Find the sale price that gives a Net CF = $27,161/year.
Cash inflow = Profit + Depreciation
$27,161 = Profit + ($72,000 / 4)
Profit = $27,161 − $18,000
= $9,161
We know:
Profit = (Sales − Costs − Depreciation)×(1 − TC)
Sales = $9,161÷(1-30%) + $120,000 + $18,000
= $151,087
Price per truck = $151,087÷5 = $30,218
C 2) Valuing option
A buy option is an arrangement, that gives the holder the right
to buy an asset, at a fixed price, sometime in the future.

E.g: You are offered an option to purchase a land lot in Long Thanh
(Dong Nai) in 15 years at price = VND10 billion.
If the interest rate is 8% and the current value of the land lot is
VND3.5 billion. How much would you pay for this option?
Firstly, convert the price to be paid in 15-year time to present.
The PV of the exercise price = = VND3.15 billion.
Since you own a right, to buy an asset worth VND3.5b, at a
%

favourable price => this right/option has value:

Option value = current value of Asset – PV of the exercise price
= 3.5 – 3.15 = VND0.35 billion.
 3) Choosing between equipment
D with different economic lives
Assuming you are evaluating 2 different audio systems.
• Ear Surround costs $45,000, has a 3-year life, and costs $5,000
per year to operate.
• The Audio-Aura costs $65,000, has a 5-year life, and costs $4,000
per year to operate.
The discount rate is 8%.
Assuming depreciation and taxes are zero, which system do you prefer?

Cash flows Year 0 1 2 3 4 5

in relation to Ear Surround -$45,000 -$5,000 -$5,000 -$5,000 0 0
02 systems Audio-Aura -$65,000 -$4,000 -$4,000 -$4,000 -$4,000 -$4,000

Hint: in order to compare 02 options, we need to convert cash flows

above into equivalent annuity cash flows.
In other words, if you need to pay annually, equal amount of cash flows,
to own and operate an asset (instead of buy an asset at year 0 and pay
annual costs to operate) which option would be more cost efficient.
 3) Choosing between equipment
D with different economic lives
Annual Equivalent Cost (AEC)
• AEC is the amount, paid annually over the life of the asset/
project, which has same PV to that of actual costs related to that
asset/project.
• How to calculate AEC:
i. Calculate the PV of the each asset/project, and then
ii. Converted to AECs using the relevant PVIFA (present value
interest factor for annuities, or simply just “annuity factor”).
• Decision rule: select the project with the lowest absolute AEC.
D Solution: Ear Surround

( %)
%
PVEar Surround = −$45,000 − $5,000 × = -$57,885.5

PV of
AECEar Surround =
PVIFA 3; 8%

−$57,885.5
=
2.577
= −$22.461.5

PVIFA: Present Value Interest Factor of Annuity

D Solution: Audio-Aura

( . )
.
PVAudio−Aura = −$65,000 − $4,000 = -$80,970.8

PV of −
−
AEC =
PVIFA 5; 8%

−$80,970.8
=
3.9927

| >| |=> Audio Aura would be preferred.

= −$20,279.7

$22.461.5 $20,279.7
 3) Choosing between equipment
D with different economic lives
Annual Equivalent Benefit (AEB)
• The AEB is used when comparing projects with cash
inflows and outflows, but with unequal lives.
• The steps required to calculate the AEB are the same as
those used for AEC.
• Select the project with the highest AEB.