Ch. 10 Making Capital Investment Decisions

•What are the different methods for computing operating cash flow and when are they important?

Bottom up, top down, tax shield

Cash Flow from assets (CFFA)

OCF - net capital spending (NCS) - changes in NWC

You should always ask yourself

"Will this cash flow occur ONLY if we accept the project?"

Equivalent Annual Cost (EAC)

the present value of a project's costs calculated on an annual basis -Use the annuity formula -Final problem is choosing among different possible systems, equipment setups, or procedures to find the most cost-effective alternative -What amount, paid each year over the life of the machine, has the same PV of costs?---use when investments are mutually exclusive, have differing lives, and will be replaced at the end of their lives

"Will this cash flow occur ONLY if we accept the project?" (part of it)

then we should include the part that occurs because of the project (include the part that will change)

•What is the basic process for finding the bid price?

Its an iterative process

"Will this cash flow occur ONLY if we accept the project?" (YES)

" it should be included in the analysis because it is incremental (include in the project)

"Will this cash flow occur ONLY if we accept the project?" (NO)

" it should not be included in the analysis because it will occur anyway (don't include int he project)

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 salvage in year 6 for each of the following situations?

-D = (110,000 - 17,000) / 6 = 15,500 every year for 6 years -BV in year 6 = 110,000 - 6(15,500) = 17,000 -After-tax salvage = 17,000 - .4(17,000 - 17,000) = 17,000

Straight line depreciation

-D = (Initial cost - salvage) / number of years -Very few assets are depreciated straight-line for tax purposes

•What is equivalent annual cost and when should it be used?

-EAC is an annuity where the PV equals the NPV of the cost -When the assets last different lengths of times

•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 have to buy inventory to support sales, although we haven't collected cash yet

MACRS vs. straight line

-MACRS is unusual and different than straight line because MACRS includes depreciation to 0 and the midyear convention -Straight line goes down to salvage value, not to zero -MACRS is beneficial in terms of paying lower taxes (take more depreciation earlier)

MACRS

-Need to know which asset class is appropriate for tax purposes -Multiply percentage given in table by the initial cost -Depreciate to zero -Mid-year convention

Tax Shield Approach to compute OCF

-OCF = (Sales - Costs)(1 - T) + Depreciation*T -views OCF as having two components. The first is what the project's cash flow would be if there were no depreciation expense. The second part is the depreciation deduction multiplied by the tax rate. This is the depreciation tax shield.

Top-Down Approach to compute OCF

-OCF = Sales - Costs - Taxes -Don't subtract non-cash deductions -start with sales and work our way down to net cash flow by subtracting costs, taxes, and other expenses. Leave out any noncash items like depreciation

Incremental cash flows

-When we take on a capital project, we ask ourselves what is going to change and what is not going to change -the difference between a firm's future cash flows with a project and those without the project (Any cash flow that exists regardless of whether or not a project is undertaken is not relevant)

•Bottom-Up Approach to compute OCF

-Works only when there is no interest expense -OCF = NI + depreciation -start with net income and add back any noncash deductions such as depreciation. Only correct if there is no interest expense subtracted in the calculation of net income -investment banker's approach

opportunity costs

-costs of lost options -the most valuable alternative that is given up if a particular investment is undertaken. Ex. if we use the mill as a condo complex, the opportunity cost is the opportunity to do something else with the mill like selling it (typically the market value of the investment today, its an opportunity cost that we include because we could sell it)

sunk costs

-costs that have accrued in the past -when project fails it is the cost that we cannot recover -It should not be considered an investment decision so it is irrelevant -It cannot be changed by the decision today to accept or reject a project.

•A $1,000,000 investment is depreciated using a seven-year MACRS class life. It requires $150,000 in additional inventory and will increase accounts payable by $50,000. It will generate $400,000 in revenue and $150,000 in cash expenses annually, and the tax rate is 40%. What is the incremental cash flow in years 0, 1, 7, and 8?

Annual depreciation expense: Year 1: .1429 x $1million = $142,900 Year 7: .0893 x $1million = $89,300 Year 8: .0446 x $1million = $44,600 Time 0 cash flow = -$1million investment - ($150,000 - $50,000) = -$1,100,000 Time 1 and 7 cash flow = ($400,000 - $150,000) x (1 - .4) + (.4 x $89,300) = $185,720 Time 8 cash flow = ($400,000 - $150,000) x (1 - .4) + (.4 x $44,600) + $100,000 NWC = $267,840 (assumes zero salvage value)

Net Working Capital

Cash income is sales minus the increase in AR Cash costs = costs less the increase in A/P Cash flow = cash inflow - cash outflow = operating cash flow - change in NW Including Net working capital changes in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments We have a net working capital when we invest the first year, but will recover the amount the final year as a cash inflow NWC = AR - AP

cost cutting

Issue is whether the cost savings are large enough to justify the necessary capital expenditure Steps: 1.Identify the relevant incremental cash flows 2. Find the working capital 3. Consider the operating cash flows 4. We have an additional depreciation deduction

•How do we determine if cash flows are relevant to the capital budgeting decision?

Looking at cash flows that come from assets Incremental cash flow--cash flows that change for this capital item`

After tax salvage

Sale price + (Book value − Sale price)(T)•-----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) -Have to pay taxes on the difference between the sale price and book value. -This is "excess" depreciation and must be "recaptured" when the asset is sold -This is not a tax on a capital gain -If book value exceeds the market value, then the difference is treated as a loss for tax purposes--tax savings -The after tax salvage value is salvage value you get minus the taxes you pay on that transaction

positive side effects

benefits to other projects

Changes in Net Working Capital

can affect the cash flows of a project every year of the project's life. -Like NPV - if you build up inventory thats an investment, AP is a decrease to NWC -project needs some cash on hand to pay any expenses that arise and an initial investment in inventories and AR. Some of the financing for this will be AP but the firm will have to supply the balance The balance represents the investment in NWC

negative side effects

costs to other projects

financing costs

do not include interest paid or another other financing costs like dividends or principal repaid because we are interested in the cash flow generated by the assets of the project

setting up the bid price

the present value of a project's cost calculated on an annual basis Steps: 1. Look at the capital spending and net working capital investment 2. Determine operating cash flow for NPV to equal zero (calculate the PV of nonoperating cash flow from the last year and subtract from initial investment) 3. Find net income

Taxes

we are always interested in after tax cash flows

Pro Forma statements

•Capital budgeting relies heavily on pro forma accounting statements, particularly income statements--should not include interest expense

Operating Cash Flow (OCF)

1) EBIT + Depreciation - Taxes 2) Net income + depreciation (when there is no interest expense)

Depreciation tax shield

= depreciation expense x marginal tax rate (marginal tax rate is 21% right now)

project cash flow

= project operating cash flow - project change in net working capital - project capital spending

Stand alone principle

the assumption that evaluation of a project may be based on the project's incremental cash flows.

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

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