Chapter 6

Making Capital Investment Decisions

Questions
 How can we determine the relevant cash
flows for various types of capital
investments?
 How do we compute operating cash flow in

various methods?
 How can we incorporate the inflation into the

capital budgeting decision?

 What is so called the Equivalent Annual Cost

approach( 約當年度化成本 )?
6.1 Incremental Cash Flows

 Cash flows matter—not accounting earnings.

 Sunk costs ( 沉默成本 ) do not matter.
 Incremental cash flows matter.
 Opportunity costs ( 機會成本 ) matter.
 Side effects like cannibalism and erosion matter.
 Taxes matter: we want incremental after-tax
cash flows.
 Inflation matters.
Cash Flows—Not Accounting Income

 Consider depreciation expense.

 You never write a check made out to
“depreciation.”
 Much of the work in evaluating a project
lies in taking accounting numbers and
generating cash flows.
Incremental Cash Flows

 Sunk costs are not relevant

 Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.
 Opportunity costs do matter. Just because a
project has a positive NPV, that does not
mean that it should also have automatic
acceptance. Specifically, if another project
with a higher NPV would have to be passed
up, then we should not proceed.
 Incremental Cash Flows
 Side effects matter.
 Erosion is a “bad” thing. If our new product
causes existing customers to demand less
of our current products, we need to
recognize that.
 If, however, synergies result that create

increased demand of existing products, we

also need to recognize that.
Estimating Cash Flows

 Cash Flow from Operations

 Recall that:
OCF = EBIT – Taxes + Depreciation
 Net Capital Spending
 Do not forget salvage value( 殘值 ) (after tax, of
course).
 Changes in Net Working Capital ( 淨營運資金 )
 Recall that when the project winds down, we
enjoy a return of net working capital.
Interest Expense

 Later chapters will deal with the impact

that the amount of debt that a firm has
in its capital structure has on firm value.
 For now, it is enough to assume that the
firm’s level of debt (and, hence, interest
expense) is independent of the project
at hand.
 6.2 The Baldwin Company
 Costs of test marketing (already spent): $250,000
 Current market value of proposed factory site
(which we own): $150,000
 Cost of bowling ball machine: $100,000
(depreciated according to MACRS 5-year)
 Increase in net working capital: $10,000
 Production (in units) by year during 5-year life of
the machine: 5,000, 8,000, 12,000, 10,000, 6,000
The Baldwin Company
 Price during first year is $20; price increases
2% per year thereafter.
 Production costs during first year are $10 per

unit and increase 10% per year thereafter.

 Annual inflation rate: 5%

 Working Capital: initial $10,000 changes with

sales
 The Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:
(1) Bowling ball machine –100.00
21.77*
(2) Accumulated 20.00 52.00 71.20 82.70 94.20
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.30 5.80
machine after
It is assumed that the ending
depreciation (end of market
year)value of the capital investment at year 5 is $30,000. Capital gain is the
difference between ending market value and adjusted basis of the machine. The adjusted basis is the
(4) Opportunity
original purchase price cost
of the –150.00
machine less depreciation. 150.00
• (warehouse) Year0 Year 1 Year 2 Year 3 Year 4 Year 5
(1)(5)
Bowling ball machine
Net working capital –100.00 10.00 10.00 16.32 24.97 21.22 0
(2) Accumulated depreciation 20.00 52.00 71.20 82.70 94.20
(end of year)
(3) Adjusted basis of machine
(6)
afterChange in net
depreciation (end of year) –10.00
80.00 48.00 –6.32 28.80 –8.6517.30 3.755.80 21.22
working capital
The(7)capital
Totalgain is $24,240
cash flow of (=–260.00
$30,000 – $5,800). We will assume
–6.32 the incremental
–8.65 3.75 corporate
193.00 tax for
Baldwin on this
investment project is 34 percent. Capital gains tax due is $8,230 [0.34* ($30,000 – $5,800)]. The
after-tax salvage
[(1) + (4)value
+ (6)]is $30,000 – [0.34 * ($30,000 – $5,800)] = 21,770.
 The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.77
(2) Accumulated 20.00 52.00 71.20 82.70 94.20
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.30 5.80
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 193.00 investment
[(1) + (4) + (6)]

At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
 The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year

5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24
129.89

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50

Year ACRS %
Depreciation is calculated using the Modified 1 20.0%
Accelerated Cost Recovery System (shown at 2 32.0%
right). 3 19.2%
Our cost basis is $100,000. 4 11.5%
Depreciation charge in year 4 5 11.5%
= $100,000×(.115) = $11,500. 6 5.8%
Total 100.00%
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50
(11) Income before taxes 30.00 43.20 85.30 67.64 30.55
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 23.00 10.39
(13) Net Income 19.80 28.51 56.30 44.64 20.16
 Incremental After Tax Cash
Flows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
(1) Sales $100.00 $163.20 $249.70 $129.89
$212.24
Revenues

(2) Operating -50.00 -88.00 -145.20 133.10 -87.85

costs
(3) Taxes -10.20 -14.69 -29.00 -23.00 -10.39

(4) OCF 39.80 60.51 75.50 56.14 31.66

(1) – (2) – (3)
(5) Total CF of –260. –6.32 –8.65 3.75 193.00
Investment
(6) IATCF –260. 39.80 54.19 66.85 59.89 224.66
[(4) + (5)]

$39.80 $54.19 $66.85 $59.89 $224.66

NPV  $260   2
 3
 4

(1.10) (1.10) (1.10) (1.10) (1.10) 5
NPV $51.59
7.3 Inflation and Capital Budgeting

 Inflation
is an important fact of economic life
and must be considered in capital budgeting.
 Consider the relationship between interest
rates and inflation, often referred to as the
Fisher equation( 費雪方程式 ):
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
名目利率 實質利率 通貨膨脹率
Inflation and Capital Budgeting

 For low rates of inflation, this is often approximated:

Real Rate  Nominal Rate – Inflation Rate
 While the nominal rate in the U.S. has fluctuated
with inflation, the real rate has generally exhibited
far less variance than the nominal rate.
 In capital budgeting, one must compare real cash
flows discounted at real rates or nominal cash flows
discounted at nominal rates.
6.4 Other Methods for Computing OCF

 Bottom-Up Approach
 Works only when there is no interest expense
 OCF = NI + depreciation
 Top-Down Approach
 OCF = Sales – Costs – Taxes
 Do not subtract non-cash deductions
 Tax Shield ( 稅盾 )Approach
 OCF = (Sales – Costs)(1 – T) + Depreciation*T
6.5 Investments of Unequal Lives

 There are times when application of the NPV

rule can lead to the wrong decision. Consider
a factory that must have an air cleaner that is
mandated by law. There are two choices:
 The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100, and lasts 10 years.
 The “Cheapskate cleaner” costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.
 Assuming a 10% discount rate, which one
should we choose?
Investments of Unequal Lives
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 – 4,000 CF0 –1,000

CF1 –100 CF1 –500

N 10 N 5

I 10% I 10%

NPV –4,614.46 NPV –2,895.39

At first glance, the Cheapskate cleaner has a higher NPV.
Investments of Unequal Lives

 This overlooks the fact that the Cadillac

cleaner lasts twice as long.
 When we incorporate the difference in

lives, the Cadillac cleaner is actually

cheaper (i.e., has a higher NPV).
Equivalent Annual Cost (EAC)

 The EAC is the value of the level payment

annuity that has the same PV as our original
set of cash flows.
 For example, the EAC for the Cadillac air cleaner is
$750.98.
 The EAC for the Cheapskate air cleaner is $763.80,
thus we should reject it.
Cadillac EAC with a Calculator

CF0 –4,000 N 10

CF1 –100 I/Y 10%

N 10 PV –4,614.46

I 10% PMT 750.98

NPV –4,614.46 FV
Cheapskate EAC with a Calculator

CF0 –1,000 5

CF1 –500 10%

N 5 -2,895.39

I 10% 763.80

NPV –2,895.39
Exercise 1
 Your firm purchased a warehouse for $335,000 six
years ago. Four years ago, repairs were made to
the building which cost $60,000. The annual taxes
on the property are $20,000. The warehouse has a
current book value of $268,000 and a market value
of $295,000. The warehouse is totally paid for and
solely owned by your firm. If the company decides to
assign this warehouse to a new project, what value,
if any, should be included in the initial cash flow of
the project for this building?

 Opportunity cost = $295,000

Exercise 2
 Ernie's Electrical is evaluating a project which will
increase sales by $50,000 and costs by $30,000.
The project will cost $150,000 and will be
depreciated straight-line to a zero book value over
the 10 year life of the project. The applicable tax rate
is 34%. What is the operating cash flow for this
project?

 Tax = .34  [$50,000 - 30,000 - ($150,000  10)] =

$1,700; OCF = $50,000 - $30,000 - $1,700 =
$18,300
Exercise 3
 A project will produce operating cash flows of $45,000 a
year for four years. During the life of the project,
inventory will be lowered by $30,000 and accounts
receivable will increase by $15,000. Accounts payable
will decrease by $10,000. The project requires the
purchase of equipment at an initial cost of $120,000. The
equipment will be depreciated straight-line to a zero book
value over the life of the project. The equipment will be
salvaged at the end of the project creating a $25,000
 CF0 = $30,000
after-tax - $15,000
cash flow. At the -end
$10,000
of the- project,
$120,000 net working
= -$115,000
capital will return to its normal level. What is the net
present value of-$30,000
C04 = $45,000 this project given a +required
+ $15,000 $10,000return of
+ $25,000
14%?
= $65,000