Making Capital Investment Decisions



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Making Capital Investment Decisions

  • Chapter
  • Ten

Key Concepts and Skills

  • Understand how to determine the relevant cash flows for various types of proposed investments
  • Be able to compute the CCA tax shield
  • Understand the various methods for computing operating cash flow
  • Understand how to analyze different capital budgeting decisions

Chapter Outline

  • Project Cash Flows: A First Look
  • Incremental Cash Flows
  • Pro Forma Financial Statements and Project Cash Flows
  • More on Project Cash Flow
  • Alternative Definitions of Operating Cash Flow
  • Applying the Tax Shield Approach to the Majestic Mulch and Compost Company Project
  • Some Special Cases of Cash Flow Analysis

Relevant Cash Flows 10.1

  • 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

Asking the Right Question

  • You should always ask yourself “Will this cash flow occur (or not occur) ONLY if we accept the project?”
    • If the answer is “yes”, it should be included in the analysis because it is incremental
    • If the answer is “no”, it should not be included in the analysis because it will occur anyway
    • If the answer is “part of it”, then we should include the part that occurs (or does not occur) because of the project

Common Types of Cash Flows 10.2

  • Sunk costs – costs that have been incurred in the past
  • Opportunity costs – costs of lost options
  • Side effects
    • Positive side effects – benefits to other projects (existing operations)
    • Negative side effects – costs to other projects
  • Changes in net working capital (keep this in mind)
  • Financing costs (interest, dividends excluded)
  • Inflation (adjust cash flows for it)
  • Capital Cost Allowance (CCA) - consider cash flows on an after-tax basis

Pro Forma Statements and Cash Flow 10.3

  • Capital budgeting relies heavily on pro forma accounting statements, particularly income statements
  • Computing cash flows – refresher
    • Operating Cash Flow (OCF) = EBIT + depreciation – taxes
    • Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC

Example: 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

Example: Projected Capital Requirements

  • Year
  • 0
  • 1
  • 2
  • 3
  • NWC
  • $20,000
  • $20,000
  • $20,000
  • $20,000
  • Net Fixed Assets
  • 90,000
  • 60,000
  • 30,000
  • 0
  • $110,000
  • $80,000
  • $50,000
  • $20,000

Example: Projected Total Cash Flows

  • Year
  • 0
  • 1
  • 2
  • 3
  • OCF
  • $51,780
  • $51,780
  • $51,780
  • Change in NWC
  • -$20,000
  • 20,000
  • Capital Spending
  • -$90,000
  • CFFA
  • -$110,000
  • $51,780
  • $51,780
  • $71,780

Making The Decision

  • Now that we have the cash flows, we can apply the techniques that we learned in chapter 9
  • Assume the required return is 20%
  • Enter the cash flows into Excel and compute NPV and IRR
    • NPV = 10,648
    • IRR = 25.8%
  • Should we accept or reject the project?

More on NWC 10.4

  • 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, regardless of whether we have actually paid our suppliers yet
    • Finally, we have to buy inventory to support sales although we haven’t collected cash yet

Capital Cost Allowance (CCA)

  • CCA is depreciation for tax purposes
  • The depreciation expense used for capital budgeting should be calculated according to the CCA schedule dictated by the tax code
  • Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes
  • Depreciation tax shield = DT
    • D = depreciation expense
    • T = marginal tax rate

Computing Depreciation

  • Need to know which asset class is appropriate for tax purposes
  • Straight-line depreciation
  • Declining Balance
    • Multiply percentage given in CCA table by the undepreciated capital cost (UCC)
    • Half-year rule
    • Can use PV of CCA Tax Shield Formula:

PV of CCA Tax Shield Formula

  • Where:
    • C = Cost of asset
    • d = CCA tax rate
    • Tc = Corporate Tax Rate
    • k = discount rate
    • S = Salvage value
    • n = number of periods in the project

Example: Depreciation and Salvage

  • 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%. If the applicable CCA rate is 20% and the required return on this project is 10%, what is the present value of the CCA tax shield?

Example: Depreciation and Salvage continued

Other Methods for Computing OCF 10.5

  • Bottom-Up Approach
    • Works only when there is no interest expense
    • OCF = NI + depreciation
  • Top-Down Approach
    • OCF = Sales – Costs – Taxes
    • Don’t subtract non-cash deductions
  • Tax Shield Approach
    • OCF = (Sales – Costs)(1 – T) + Depreciation*T

Salvage Value versus UCC 10.6

  • Using the methods described in the previous slide will give incorrect answers when the salvage value differs from its UCC
  • If the asset is depreciated using a declining balance method, then the CCA tax shield formula is the most accurate approach, since it takes into account the future CCA impact

Example: Cost Cutting 10.7

  • Your company is considering a new production system that will initially cost $1 million. It will save $300,000 a year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated at a CCA rate of 20%. The system is expected to have a salvage 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%.
  • Click on the Excel icon to work through the example

Example: Replacement Problem

  • Original Machine
    • Initial cost = 100,000
    • CCA rate = 20%
    • Purchased 5 years ago
    • Salvage today = 65,000
    • Salvage in 5 years = 10,000
  • New Machine
    • Initial cost = 150,000
    • 5-year life
    • Salvage in 5 years = 0
    • Cost savings = 50,000 per year
    • CCA rate = 20%
  • Required return = 10%
  • Tax rate = 40%

Example: Replacement Problem continued

  • 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?

Example: Replacement Problem continued

  • If we sell the old equipment today, then we will receive $65,000 today. However, we will also NOT receive $10,000 in 5 years
  • The appropriate number to use in the NPV analysis is the net salvage value
  • Always consider after-tax cash flows
  • You can use your calculator for the cash flows and salvage, but there are no short cuts for finding the PV of the CCA tax shield

Example: Replacement Problem continued

  • Net present value of the project is:
  • Therefore, the old equipment should be replaced.

Example: Equivalent Annual Cost Analysis

  • Machine A
    • Initial Cost = $150,000
    • Pre-tax operating cost = $65,000
    • Expected life is 8 years
  • Machine B
    • Initial Cost = $100,000
    • Pre-tax operating cost = $57,500
    • Expected life is 6 years
  • 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 10%, the applicable CCA rate is 20% and the tax rate is 40%.
  • Which machine should you buy?

Example: Setting the Bid Price

  • Consider the example in the textbook:
    • Need to produce 5 modified trucks per year for 4 years
    • We can buy the truck platforms for $10,000 each
    • Facilities will be leased for $24,000 per year
    • Labor and material costs are $4,000 per truck
    • Need $60,000 investment in new equipment, depreciated at 20% (CCA class 8)
    • Expect to sell equipment for $5000 at the end of 4 years
    • Need $40,000 in net working capital
    • Tax rate is 43.5%
    • Required return is 20%

Quick Quiz

  • How do we determine if cash flows are relevant to the capital budgeting decision?
  • What are the different methods for computing operating cash flow and when are they important?
  • What is the basic process for finding the bid price?
  • What is equivalent annual cost and when should it be used?

Summary 10.8

  • You should know:
    • How to determine the relevant incremental cash flows that should be considered in capital budgeting decisions
    • How to calculate the CCA tax shield for a given investment
    • How to perform a capital budgeting analysis for:
      • Replacement problems
      • Cost cutting problems
      • Bid setting problems
      • Projects of different lives

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