FINA2010 Financial Management

Lecture 5: Capital Budgeting II

Instructor: Prof. Si Cheng

CUHK Business School

1
 Last Lecture
• Net Present Value (NPV)
• Payback and Discounted Payback Period
• Internal Rate of Return (IRR)
• Profitability Index (PI)

2
 Lecture Outline
• Incremental Cash Flows
• Pro Forma Financial Statements and Project
Cash Flows
• Depreciation and Salvage Value
• Alternative Definitions of Operating Cash Flow
• Some Special Cases of Discounted Cash Flow
Analysis

3
 Learning Objectives
• Be able to determine the relevant cash flows
for various types of proposed investments.
• Understand the various methods for
computing operating cash flow.
• Be able to assess a cost-cutting project.
• Be able to set a bid price for a project.
• Be able to evaluate the equivalent annual
annuity (or cost) of a project.
4
 NPV Analysis: Best Decision Method
• NPV is the best capital budgeting decision
method to apply.
– Estimate the expected future cash flows: amount
and timing (use a timeline)
– Estimate the required return for projects of this
risk level.
𝑛 𝐶𝐹𝑡
– 𝑁𝑃𝑉 = σ𝑡=1 − 𝐶𝐹0
1+𝑟 𝑡

5
Cash Flows in a Typical Project

6
 Identify Relevant Cash Flows
• Rule #1: based on cash flows rather than accounting
earnings.
• Accounting treatment of capital expenditures
– Depreciation expenses ≠ actual cash outflows
• Rule #2: only incremental cash flows are relevant.
– CFs with the project minus CFs without the project
• The cash flows that should be included in a capital
budgeting analysis are only those that will occur if
the project is accepted.
– Will this CF occur ONLY if we accept the project?
7
 Which Trip To Go?
• Assume you have purchased tickets for two ski
trips. One was a trip for $1,000, and a second,
even more enjoyable trip for $500. You realized
that the two trips actually overlapped, and
neither ticket could be refunded or resold. Which
one would you go?

8
 Types of Cash Flow Effects
• Sunk costs: costs that have already been incurred
and cannot be removed ─ not relevant
– E.g., exploration (mining), R&D costs incurred
• Opportunity costs: costs of options which must
be forgone by taking the project ─ relevant
– E.g., the use of land or plant that is already owned

9
 Example
• XYZ Company spent $0.2 million for a marketing study
that estimated a increasing demand for home treadmills.
• Three years ago, they purchased some land for $3
million. Today, the land is valued at $4 million.
• Six years ago, they purchased some equipment for $1.5
million. This equipment has a current book value of $1
million and a market value of $0.8 million.
• This land and equipment can be used for this project.
• What is the initial cash flow for capital budgeting analysis
whether to start manufacturing this product?
• The relevant cash flow is:

10
 Types of Cash Flow Effects
• Side effects (or Externalities) ─ relevant
– Positive side effects: benefits to other projects,
e.g., a new distribution system (sales↑ added to
the new project)
– Negative side effects: costs to other projects
(erosion or cannibalism), e.g., introduction of a
new product will reduce the sales of existing
similar products (sales↓ deducted from the new
project)

11
 Types of Cash Flow Effects
• Changes in net working capital (NWC) ─ relevant
– Current assets↑: require cash, e.g., inventory↑ to
support new operations, and accounts receivable↑ as
a result of new operations
– Current liabilities↑: reduce cash needed, accounts
payable↑ as a result of new operations
– Adjust for the difference in cash flow that results from
accounting conventions
– For most projects, increase in NWC initially and
recover NWC at the end.

12
 Types of Cash Flow Effects
• Financing costs ─ not relevant
– Companies generally do not finance individual
projects due to economies of scale.
– Financing cost is included in the required return
(adjust in denominator).
– Ignore financing costs in estimating cash flows, thus
exclude interest expense and the tax effect of interest
expense.
• Taxes ─ relevant
– All cash flows must be measured on an after-tax basis.

13
Overall Incremental Project Cash Flows
• Net initial investment outlay: initial cost, NWC ↑
• Future operating cash flows (on an after-tax basis
+ depreciation)
• Cash outflows later required to support the initial
investment outlay
– E.g., cash flows associated with a major overhaul,
∆NWC over the life of the project
• Terminal year cash flows: net (after-tax) salvage
value, NWC ↓
14
 Pro Forma Statements and Cash Flow
• Capital budgeting relies heavily on pro forma (i.e.,
projected) accounting statements, particularly
income statements.
• Recall how to compute cash flows (Lecture 2):
• Operating Cash Flow (OCF) = EBIT + Depreciation
– Taxes
• Cash flow from assets (CFFA) = OCF − Net capital
spending (NCS) − Changes in net working capital
(∆NWC)

15
 Example A: Beverage Business
• We expect to sell 50,000 bottles of orange juice per year at
a price of $4 per bottle. It costs us $2.5 per bottle to make
the juice. Fixed costs such as rent on the production facility
will be $17,430 per year.
• We need to invest a total of $90,000 in manufacturing
equipment, and the cost will be straight-line fully
depreciated over the 3-year life. The tax rate is 21%.
• A net working capital of $20,000 is required throughout the
duration of the project. The net working capital amount is
expected to be fully recovered at the end of the project.

16
 Example A: Pro Forma Income Statement
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Fixed costs 17,430
Depreciation ($90,000/3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

• OCF = EBIT + Depreciation – Taxes = 27,570 + 30,000 − 5,790 =

$51,780

17
Example A: Projected Capital Requirements

• CFFA = OCF − NCS − ∆NWC

• Net capital spending (NCS) per year:
– Year 0 NCS = $90,000
• Change in net working capital (∆NWC) per year:
– Year 0 ∆NWC = $20,000
– Year 3 ∆NWC = –$20,000

18
Example A: Projected Total Cash Flows
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
(−) NCS −$90,000
(−) ∆NWC −$20,000 $20,000
CFFA −$110,000 $51,780 $51,780 $71,780

• Cash flow from assets (CFFA) = OCF − Net capital

spending (NCS) − Changes in net working capital
(∆NWC)
19
Example A: The Capital Budgeting Decision

• Now that we have the net cash flows, we can

apply the evaluation techniques in Lecture 4.
• Assume the discount rate is 20%.
• We can calculate the NPV and IRR of the project.
• NPV = 51,780/1.2 + 51,780/1.22 + 71,780/1.23 −
110,000 = $10,648
• IRR = 25.8%
• Should we accept or reject the project? Accept!

20
 Depreciation Expenses
• The depreciation expense used for capital
budgeting should be the depreciation schedule
required for tax purposes.
– Straight-line depreciation
– Accelerated depreciation: e.g., depreciation schedule
for different assets are provided under Modified
Accelerated Cost Recovery System (MACRS) used in
the U.S.
• Depreciation itself is a non-cash expense, it is only
relevant because it affects taxes.
• Depreciation tax shield = Depreciation × Tax rate

21
 Computing Depreciation (I)
• Straight-line depreciation
– Depreciation (D) = (Initial cost – Salvage)/Number
of years
– Accumulated depreciation = D × Number of years
in use
– Book Value (B) = Initial cost – Accumulated
depreciation

22
 Computing Depreciation (II)
• Modified Accelerated Cost Recovery System (MACRS)
– Need to know which asset class is appropriate for tax
purposes
– Multiply percentage given in table by the initial cost
– Depreciate to zero
– Half-year convention

23
 Net Salvage Value
• If the salvage value (S) is different from the
book value (B) of the asset, then there is a tax
effect.
• After-tax salvage value: S – T(S – B)
– where T = applicable tax rate
– If S > B: gain on sale, tax payment
– If B > S: loss on sale, tax saving/refund

24
 Example: Depreciation
• You purchase an equipment for $100,000 and
it costs $20,000 to have it delivered and
installed. Based on past information, you
believe that you can sell the equipment for
$12,000 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?

25
 Example: Depreciation
• Suppose the appropriate depreciation
schedule is straight-line to be fully
depreciated.
• D = (120,000 – 0)/6 = $20,000 per year
• Year 6 B = 120,000 – 6 × 20,000 = 0
• After-tax salvage value = S – T(S – B) = 12,000
– 0.4 × (12,000 – 0) = $7,200 → net after-tax
cash proceeds

26
 Example: Depreciation
• Suppose the appropriate depreciation
schedule is straight-line and taking the
estimated salvage value into consideration.
• D = (120,000 – 12,000)/6 = $18,000 per year
• Year 6 B = 120,000 – 6 × 18,000 = $12,000
• After-tax salvage value = S – T(S – B) = 12,000
– 0.4 × (12,000 – 12,000) = $12,000

27
 Example: Depreciation
• Suppose the appropriate depreciation schedule is
three-year MACRS.
Year MACRS Percent D
1 33.33% 33.33% × 120,000 = 39,996
2 44.45% 44.45% × 120,000 = 53,340
3 14.81% 14.81% × 120,000 = 17,772
4 7.41% 7.41% × 120,000 = 8,892

• Year 6 B = 120,000 – 39,996 – 53,340 – 17,772 –

8,892 = 0
• After-tax salvage value = S – T(S – B) = 12,000 – 0.4 ×
(12,000 – 0) = $7,200
28
 Quick Review MCQ
• You are considering a project that will generate
sales of $89,000, costs of $56,000, and annual
depreciation of $26,000. What is the value of the
operating cash flow if the tax rate is 34 percent?
A. $28,380
B. $30,620
C. $33,000
D. $47,780
E. $59,000

29
 Methods for Computing OCF
• OCF = EBIT + Depreciation − Taxes ①
– We can always find OCF with the above formula.
• Bottom-Up Approach (no interest expense)
– NI = EBIT − Taxes (substitute to ①)
→ OCF = NI + Depreciation ②

30
 Methods for Computing OCF
• Top-Down Approach (no interest expense)
– NI = Sales – Costs – Depreciation – Taxes ③
→ OCF = Sales – Costs – Taxes (② + ③)
– Don’t subtract non-cash deductions or interest
expense
• Tax Shield Approach (no interest expense)
– EBIT = Sales – Costs – Depreciation
– Taxes = EBIT × T substitute to ①
– where T is the corporate tax rate
→ OCF = (Sales – Costs) × (1 – T) + Depreciation × T
depreciation tax shield
31
 Example A: Computing OCF (Bottom-Up)
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Fixed costs 17,430
Depreciation ($90,000/3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

• OCF = NI + Depreciation = 21,780 + 30,000 = $51,780

32
 Example A: Computing OCF (Top-Down)
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Fixed costs 17,430
Depreciation ($90,000/3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

• OCF = Sales – Costs – Taxes = 200,000 − 125,000 − 17,430 −

5,790 = $51,780

33
 Example A: Computing OCF (Tax Shield)
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Fixed costs 17,430
Depreciation ($90,000/3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

• OCF = (Sales – Costs) × (1 – T) + Depreciation × T = (200,000 −

125,000 − 17,430) × (1 – 0.21) + 30,000 × 0.21 = $51,780

34
 Case I: Cost-Cutting Proposals
• Suppose we are considering automating some part of
an existing production process. The necessary
equipment costs $80,000 to buy and install. The
automation will save $22,000 per year (before taxes) by
reducing labor and material costs.
• Assume that the equipment has a five-year life and is
depreciated to zero on a straight-line basis over that
period. It can be sold for $20,000 in five years.
• Discount rate = 10%, Tax rate = 21%
• Should we automate?

35
 Example: Cost-Cutting Proposals
• Operating cash flow
– Depreciation = 80,000/5 = $16,000
– EBIT = 22,000 − 16,000 = $6,000
→ OCF = EBIT + Depreciation – Taxes = 6,000 +
16,000 − 6,000 × 0.21 = $20,740
• Net capital spending
– Year 0: Equipment costs = $80,000 (outflow)
– Year 5: After-tax salvage value = S – T(S – B) =
20,000 − 0.21 × (20,000 − 0) = $15,800 (inflow)

36
 Example: Cost-Cutting Proposals
Year 0 1 2 3 4 5

OCF $20,740 $20,740 $20,740 $20,740 $20,740

(−) NCS −$80,000 $15,800

(−) NWC 0 0

CFFA −$80,000 $20,740 $20,740 $20,740 $20,740 $36,540

• NPV = 20,740 × [1 − (1/1.15)]/0.1 + (15,800/1.15) −

80,000 = $8,431
Accept!
• IRR = 13.7%

37
 Case II: Setting The Bid Price
• Sometimes we need to submit a competitive bid
to win a job ─ the winner is whoever submits the
lowest bid.
• Winner’s curse: if you win, there is a good chance
you underbid.
• The goal of our analysis is to determine the
lowest price we can profitably charge.
• This maximizes our chances of being awarded the
contract while guarding against the winner’s
curse.
38
 Example: Bid Price
• Suppose we are in the business of buying stripped-down truck
platforms and then modifying them to customer
specifications for resale. A local distributor has requested bids
for 5 modified trucks each year for the next four years.
• Costs:
– Facilities: $24,000 per year
– Truck platforms: $10,000 per truck
– Labor and material cost: $4,000 per truck
→ Total costs: 24,000 + 5 × (10,000 + 4,000) = $94,000 per year
– New equipment: $60,000, depreciated straight-line to zero over the
four years, salvage value $5,000
• We also need to invest $40,000 today in working capital. We
will get this back at the end of year 4.
• Required return = 20%, Tax rate = 21%
• How to set a price on the truck?
39
 Example: Bid Price
• Net capital spending
– Year 0: Equipment costs = $60,000 (outflow)
– Year 4: After-tax salvage value = S – T(S – B) = 5,000 – 0.21
× (5,000 – 0) = $3,950 (inflow)

Year
0 1 2 3 4
OCF OCF OCF OCF OCF
(−) NCS −$60,000 $3,950
(−) ∆NWC −$40,000 $40,000
CFFA −$100,000 OCF OCF OCF OCF + $43,950

40
 Example: Bid Price
• The lowest possible price we can profitably charge will
result in a zero NPV at 20 percent.
Year 0 Year 1 Year 2 Year 3 Year 4
CFFA −$100,000 OCF OCF OCF OCF + $43,950

• NPV = PV of OCF + 43,950/1.24 − 100,000 = 0

• PV of OCF = $78,805
• Convert to an ordinary annuity problem!
1− 1/(1+0.2)4
• 78,805 = 𝐶 ×
0.2
• 𝐶 = $30,442
41
 Financial Calculator Solution

Inputs 4 20 −100,000 43,950

N I/Y PV PMT FV
Compute 30,442
• N: 4 periods (enter as 4)
• I/Y: 20% discount rate per period (enter as 20)
• PV: −100,000 (net outflow)
• FV: 43,950 (net inflow)
• PMT: compute (resulting answer is positive)

42
 Example: Bid Price
• Recall Tax Shield Approach
– Depreciation = 60,000/4 = $15,000
– OCF = (Sales – Costs) × (1 – Tax rate) + Depreciation ×
Tax rate
→ 30,442 = (Sales − 94,000) × (1 – 0.21) + 15,000 × 0.21
→ Sales = $128,546
• The sales price per truck: 128,546/5 = $25,709.
• If we bid for $26,000 per truck and get the contract,
our return would be just over 20 percent.

43
 Case III: Mutually Exclusive Unequal
Life Projects
• Suppose our firm is planning to expand and we have to
select 1 of 2 machines. They differ in terms of economic
life. Assume a required return of 14%. How do we decide
which machine to select? The after-tax cash flows are:
Year Machine 1 Machine 2
0 −45,000 −45,000
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000
44
 Example: Unequal Life Projects
• Step 1: Calculate NPV
• NPV1 = $1,432
• NPV2 = $1,664
• So, does this mean Machine 2 is better?
• Not Necessarily – the two NPVs can’t be
compared simply as they are. Why?
– They have unequal useful lives!

45
 Example: Unequal Life Projects
• Step 2: Calculate Equivalent Annual Annuity (EAA)
• If we assume that each project will be replaced
an infinite number of times in the future, we can
convert each NPV to an annuity.
• Note that the projects’ EAAs can be compared to
determine which is the best project.
• EAA: simply find an equivalent annuity to the
lump-sum NPV.

46
 Example: Unequal Life Projects
• Machine 1: NPV1 = $1,432
1− 1/(1+0.14)3
– 1,432 = 𝐸𝐴𝐴1 ×
0.14
– EAA1 = $617
• Machine 2: NPV2 = $1,664
1− 1/(1+0.14)6
– 1,664 = 𝐸𝐴𝐴2 ×
0.14
– EAA2 = $428

47
 Example: Unequal Life Projects
• Machine 1: NPV1 = $1,432, EAA1 = $617
• Machine 2: NPV2 = $1,664, EAA2 = $428
• What does this tell us?
– NPV1 is equivalent to receiving $617 per year.
– NPV2 is equivalent to receiving $428 per year.
• Reduced a problem with different time
horizons to an issue of finding “equivalent”
annuities and comparing.
48
 Example: Unequal Life Projects
• Step 3: Apply appropriate decision rule
• Decision Rule: select the highest EAA.
– EAA1 = $617
– EAA2 = $428
– Choose Machine 1.
• If we are comparing costs, we choose the
lowest EAA, also known as Equivalent Annual
Cost (EAC).

49
 Comprehensive Problem
• 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. We will get this
working capital back at the end of year 8.
• 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?
• Note: The MACRS percentage for year 1, 7, and 8 is
14.29%, 8.93% and 4.46%, respectively.
50
 Comprehensive Problem Answer
• Depreciation expense:
– Year 1: 14.29% × 1,000,000 = $142,900
– Year 7: 8.93% × 1,000,000 = $89,300
– Year 8: 4.46% × 1,000,000 = $44,600
• Operating cash flow: OCF = (Sales – Costs) × (1 – T) +
Depreciation × T
– Year 1: (400,000 − 150,000) × 0.6 + 142,900 × 0.4 =
$207,160
– Year 7: (400,000 − 150,000) × 0.6 + 89,300 × 0.4 = $185,720
– Year 8: (400,000 − 150,000) × 0.6 + 44,600 × 0.4 = $167,840

51
 Comprehensive Problem Answer
• Change in net working capital:
– Year 0: 150,000 − 50,000 = $100,000
Year
0 1 7 8
OCF $207,160 $185,720 $167,840
(−) NCS −$1,000,000
(−) ∆NWC −$100,000 $100,000
CFFA −$1,100,000 $207,160 $185,720 $267,840

52
 Quick Review Question
• You purchased some fixed assets six years ago at a
cost of $165,700. You have been depreciating these
assets using straight-line depreciation to a zero book
value over 10 years. Today, you are selling these
assets for $62,500. What is the after-tax cash flow
from this sale if the applicable tax rate is 35%?

53
 Summary
• Identify relevant project cash flows:
opportunity costs, externalities, net working
capital, and taxes.
• Prepare Pro Forma (projected) financial
statements, especially the projected cash
flows.
• Some special cases in discounted cash flow
analysis: cost-cutting investments, set a bid
price, and unequal lives problem.

54