Chapter 9

Making Capital Investment

Decisions
Relevant Costs
• Opportunity Costs
• Side Effects/Erosion
• Net Working Capital
• Tax Effects

• Sunk Costs
• Finance Costs
Relevant Cash Flows: Incremental Cash
Flow for a Project

Corporate cash flow with the project

Minus

Corporate cash flow without the project

Pro Forma Statements and Cash Flow
• Pro Forma Financial Statements
▫ Projects future operations
• Operating Cash Flow:
▫ OCF = EBIT + Depr – Taxes
▫ OCF = NI + Depr if no interest expense
• Cash Flow From Assets:
– CFFA = OCF – NCS –ΔNWC
– NCS = Net capital spending
Shark Attractant Project
• Estimated sales: 50,000 cans
• Sales Price per can: $4.00
• Cost per can: $2.50
• Estimated life: 3 years
• Fixed costs: $12,000/year
• Initial equipment cost: $90,000
▫ 100% depreciated over 3 year life
• Investment in NWC: $20,000
• Tax rate: 34%
• Cost of capital: 20%
Shark Attractant Project
• Pro Forma Income Statement

Year 0 1 2 3
Sales   200,000 200,000 200,000
Variable Costs   125,000 125,000 125,000
Gross Profit   75,000 75,000 75,000
Fixed Costs   12,000 12,000 12,000
Depreciation   30,000 30,000 30,000
EBIT   33,000 33,000 33,000
Taxes   11,220 11,220 11,220
Net Income   21,780 21,780 21,780
Shark Attractant Project
Operating Cash Flow   51,780 51,780 51,780
Changes in NWC -20,000     20,000
Net Capital Spending -90,000      
Cash Flow From Assets -110,000 51,780 51,780 71,780

Net Present Value $10,647.69

IRR 25.76%

• Should we accept or reject the project?

The Tax Shield Approach to OCF
• Particularly useful when the major incremental cash
flows are the purchase of equipment and the associated
depreciation tax shield
▫ i.e., choosing between two different machines

OCF  Sales – costs1 – T   Depreciation  T

C
OCF  200,000 -137,000  66%  30,000  .34
OCF  51,780
Changes in NWC
• GAAP requirements:

▫ Sales recorded when made, not when cash is received

 Cash in = Sales - ΔAR

▫ Cost of goods sold recorded when the corresponding

sales are made, whether suppliers paid yet or not
 Cash out = COGS - ΔAP
Depreciation & Capital Budgeting
• Use the schedule required by the IRS for tax purposes

• Depreciation = non-cash expense

▫ Only relevant due to tax affects

• Depreciation tax shield = DT

▫ D = depreciation expense
▫ T = marginal tax rate
Computing Depreciation
• Straight-line depreciation
▫ D = (Initial cost – salvage) / number of years

• MACRS
▫ Depreciate = 0
▫ Recovery Period = Class Life
▫ 1/2 Year Convention
▫ Multiply percentage in table by the initial cost
After-Tax Salvage
• If the salvage value is different from the book value of
the asset, then there is a tax effect

• Book value = initial cost – accumulated depreciation

• After-tax salvage = salvage –T(salvage – book value)

Tax Effect on Salvage
• Net Salvage Cash Flow = SP - (SP-BV) (T)
• Where:
▫ SP = Selling Price
▫ BV = Book Value
▫ T = Corporate tax rate
 Example: Depreciation and After-Tax
Salvage
• Car purchased for $12,000
• 5-year property
• Marginal tax rate = 34%.
Depreciation 5-year Asset: 5-year Asset: 5-year Asset: 5-year Asset:
Year Beg BV Depreciation % Depreciation End BV
1 $ 12,000.00 20.00% $ 2,400.00 $ 9,600.00
2 $ 9,600.00 32.00% $ 3,840.00 $ 5,760.00
3 $ 5,760.00 19.20% $ 2,304.00 $ 3,456.00
4 $ 3,456.00 11.52% $ 1,382.40 $ 2,073.60
5 $ 2,073.60 11.52% $ 1,382.40 $ 691.20
6 $ 691.20 5.76% $ 691.20 $-
100.00% $ 12,000.00
Salvage Value & Tax Effects
• Net Salvage Cash Flow = SP - (SP-BV)(T)

• If sold at EOY 5 for $3,000:

• NSCF = 3,000 - (3000 - 691.20)(.34) = $2,215.01 =
$3,000 – 784.99 = $2,215.01

• If sold at EOY 2 for $4,000:

• NSCF = 4,000 - (4000 - 5,760)(.34) = $4,598.40 =
$4,000 – (-598.40) = $4,598.40
Majestic Mulch & Compost Company (MMCC)
YEAR   0 1 2 3 4 5 6 7 8
Background
                   
Data:
Unit Sales
    3,000 5,000 6,000 6,500 6,000 5,000 4,000 3,000
Estimates
Variable
$60.00                  
Cost /unit
Fixed Costs
$25,000.00                  
per year
Sale Price per
$120.00   $120.00 $120.00 $120.00 $110.00 $110.00 $110.00 $110.00 $110.00
unit
Tax Rate 34.00%                  
Required
Return on 15.00%                  
Project
Yr 0 NWC $20,000.00                  
NWC % of
15%                  
sales
Equipment
$800,000                  
cost - installed
20%of
Salvage Value
equipment              
in year 8
cost
 Majestic Mulch & Compost Company
(MMCC)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Required
Net Working
20,000 54,000 90,000 108,000 107,250 99,000 82,500 66,000 49,500
Capital
Investment
 MMCC Pro Forma Income Statement
YEAR 0 1 2 3 4 5 6 7 8
Initial Investment
Equipment Cost (800,000)
Sales 360,000 600,000 720,000 715,000 660,000 550,000 440,000 330,000
Variable Costs 180,000 300,000 360,000 390,000 360,000 300,000 240,000 180,000
Fixed Costs 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
Depreciation (Eqpt) 114,320 195,920 139,920 99,920 71,360 71,440 71,440 35,680
EBT 40,680 79,080 195,080 200,080 203,640 153,560 103,560 89,320
Taxes 13,831 26,887 66,327 68,027 69,238 52,210 35,210 30,369
Net Operating
26,849 52,193 128,753 132,053 134,402 101,350 68,350 58,951
Income
 MMCC Projected Cash Flows

YEAR 0 1 2 3 4 5 6 7 8
Add back Depreciation 114,320 195,920 139,920 99,920 71,360 71,440 71,440 35,680
Cash Flow from
141,169 248,113 268,673 231,973 205,762 172,790 139,790 94,631
Operations
NWC investment &
(20,000) (34,000) (36,000) (18,000) 750 8,250 16,500 16,500 66,000
Recovery
Salvage Value 105,600
Total Projected Cash
(820,000) 107,169 212,113 250,673 232,723 214,012 189,290 156,290 266,231
Flow
Discounted Cash Flows (820,000) 93,190 160,388 164,821 133,060 106,402 81,835 58,755 87,031
Cumulative Cash flows (820,000) (712,831) (500,718) (250,046) (17,323) 196,690 385,979 542,269 808,500
NPV $65,483  
IRR 17.24%  
Payback 4.08
Evaluating NPV Estimates
• NPV estimates are only estimates

• Forecasting risk:
▫ Sensitivity of NPV to changes in cash flow estimates
 The more sensitive, the greater the forecasting risk

• Sources of value
▫ Be able to articulate why this project creates value
Scenario Analysis
• Examines several possible situations:
▫ Worst case
▫ Base case or most likely case
▫ Best case

• Provides a range of possible outcomes

Scenario Analysis Example
  Base Lower Upper
Units 6,000 5,500 6,500
Price/unit $ 80.00 $ 75.00 $ 85.00
Variable cost/unit $ 60.00 $ 58.00 $ 62.00
Fixed cost/year $ 50,000 $ 45,000 $ 55,000
  BASE WORST BEST

Initial investment $ 200,000

Depreciated to salvage value of 0 over 5 years
Depreciation/year $ 40,000
Project Life 5years
Tax rate 34%
Required return 12%
 BASE WORST BEST
Units 6,000 5,500 6,500
Price/unit $ 80.00 $ 75.00 $ 85.00
Variable
$ 60.00 $ 62.00 $ 58.00
cost/unit
Fixed Cost $ 50,000 $ 55,000 $ 45,000
Sales $ 480,000 $ 412,500 $ 552,500
Variable Cost 360,000 341,000 377,000
Fixed Cost 50,000 55,000 45,000
Depreciation 40,000 40,000 40,000
EBIT 30,000 (23,500) 90,500
Taxes 10,200 (7,990) 30,770
Net Income 19,800 (15,510) 59,730
+ Depreciation 40,000 40,000 40,000
TOTAL CF 59,800 24,490 99,730
NPV 15,566 (111,719) 159,504
IRR 15.1% -14.4% 40.9%
Problems with Scenario Analysis
• Considers only a few possible outcomes
• Assumes perfectly correlated inputs
▫ All “bad” values occur together and all “good” values
occur together
• Focuses on stand-alone risk, although subjective
adjustments can be made
Sensitivity Analysis
• Shows how changes in an input variable affect NPV or
IRR
• Each variable is fixed except one
▫ Change one variable to see the effect on NPV or IRR
• Answers “what if” questions
Sensitivity Analysis
• Strengths
▫ Provides indication of stand-alone risk.
▫ Identifies dangerous variables.
▫ Gives some breakeven information.

• Weaknesses
▫ Does not reflect diversification.
▫ Says nothing about the likelihood of change in a
variable.
▫ Ignores relationships among variables.
Sensitivity Analysis: Unit Sales
Sensitivity Analysis: Unit Sales

Base Units Units

Units 6,000 5,500 6,500
Price/unit $ 80 80 80
Variable cost/unit $ 60 60 60
Fixed cost/year $ 50,000 50,000 50,000
Initial investment $ 200,000    
Depreciated to salvage
value of 0 over 5 years
Depreciation/year $ 40,000    
Tax rate 34%    
Required Return 12%    
Sensitivity Analysis: Unit Sales
BASE UNITS UNITS FC FC
Units 6,000 5,500 6,500 6,000 6,000
Price/unit $ 80 $ 80 $ 80 $ 80 $ 80
Variable cost/unit $ 60 $ 60 $ 60 $ 60 $ 60
Fixed cost $ 50,000 $ 50,000 $ 50,000 $ 55,000 $ 45,000
Sales $ 480,000 $ 440,000 $ 520,000 $ 480,000 $ 480,000
Variable Cost 360,000 330,000 390,000 360,000 360,000
Fixed Cost 50,000 50,000 50,000 55,000 45,000
Depreciation 40,000 40,000 40,000 40,000 40,000
EBIT 30,000 20,000 40,000 25,000 35,000
Taxes 10,200 6,800 13,600 8,500 11,900
Net Income 19,800 13,200 26,400 16,500 23,100
+ Depreciation 40,000 40,000 40,000 40,000 40,000
TOTAL CF 59,800 53,200 66,400 56,500 63,100
NPV $ 15,566 $ (8,226) $ 39,357 $ 3,670 $ 27,461
Sensitivity Analysis: Fixed Costs
Sensitivity Analysis: Fixed Costs

Base Fixed Cost Fixed Cost

Units 6,000 6,000 6,000
Price/unit $ 80 80 80
Variable cost/unit $ 60 60 60
Fixed cost/year $ 50,000 55,000 45,000
Initial investment $ 200,000    
Depreciated to salvage
value of 0 over 5 years
 Depreciation/year $ 40,000    
Tax rate 34%    
Required Return 12%    
Sensitivity Analysis: Fixed Costs
  BASE FC FC
Units 6,000 6,000 6,000
Price/unit $ 80 $ 80 $ 80
Variable cost/unit $ 60 $ 60 $ 60
Fixed cost $ 50,000 $ 55,000 $ 45,000
Sales $ 480,000 $ 480,000 $ 480,000
Variable Cost 360,000 360,000 360,000
Fixed Cost 50,000 55,000 45,000
Depreciation 40,000 40,000 40,000
EBIT 30,000 25,000 35,000
Taxes 10,200 8,500 11,900
Net Income 19,800 16,500 23,100
+ Depreciation 40,000 40,000 40,000
TOTAL CF 59,800 56,500 63,100
NPV $ 15,566 $ 3,670 $ 27,461
Disadvantages of Sensitivity and Scenario
Analysis
• Neither provides a decision rule.
▫ No indication whether a project’s expected return is
sufficient to compensate for its risk.

• Ignores diversification.
▫ Measures only stand-alone risk, which may not be the
most relevant risk in capital budgeting.
Managerial Options
• Contingency planning
• Option to expand
▫ Expansion of existing product line
▫ New products
▫ New geographic markets
• Option to abandon
▫ Contraction
▫ Temporary suspension
• Option to wait
• Strategic options
Capital Rationing
• Capital rationing occurs when a firm or division has
limited resources
▫ Soft rationing – the limited resources are temporary,
often self-imposed
▫ Hard rationing – capital will never be available for
this project

• The profitability index is a useful tool when faced with

soft rationing
Double Declining Balance Method
• Accelerated form of depreciation
• Circumstances:
▫ The asset is consumed more rapid rate during the
early part of its useful life
▫ Intent of recognizing more expense now, thereby
shifting profit further into the future
Double Declining Balance Method
• Divide 100% by the number of years of the asset
• Multiply the number by 2
• Multiply to the book value at the beginning of the year

• Ceases when the book value = estimate salvage value

Example
• ABC Company purchased a machine for
$100,000. It has an estimated salvage value of
$10,000 and a useful life of 5 years.
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000
2
3
4
5
Total
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000 40,000 60,000
2 60,000
3
4
5
Total
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000 40,000 60,000
2 60,000 24,000 36,000
3 36,000
4
5
Total
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000 40,000 60,000
2 60,000 24,000 36,000
3 36,000 14,400 21,600
4 21,600
5
Total
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000 40,000 60,000
2 60,000 24,000 36,000
3 36,000 14,400 21,600
4 21,600 8,640 12,960
5 12,960
Total
Example
Year Net Book Value, Depreciation Net Book Value,
beginning = 100%/5 x 2 x NBV,beg end
1 $100,000 40,000 60,000
2 60,000 24,000 36,000
3 36,000 14,400 21,600
4 21,600 8,640 12,960
5 12,960 2,960 10,000
Total $90,000
Sum of Year’s Digit
• Accelerate the recognition of depreciation
• Most of the depreciation is recognized in the first few
years of its useful life
• More appropriate than straight-line method if an asset
depreciates more quickly or has greater production
capacity in its early years
• It artificially reduces the profit in early years and
excessive profit in later years.
Sum of Year’s Digit

SYD = n(n+1)
2

n= estimated useful life

Example
• ABC Company purchased a machine for $100,000. It has
an estimated salvage value of $10,000 and a useful life of
5 years.

SYD = 5(5+1)
2
= 15
or
1+2+3+4+5 = 15
Example
Year Remaining SYD Applicable % Annual
useful life Depreciation
1 5 5/15 33.33 $30,000
2 4 4/15 26.67 24,000
3 3 3/15 20.00 18,000
4 2 2/15 13.33 12,000
5 1 1/15 06.67 6,000
Totals 15 100.00% $90,000