7-1

Chapter Seven

Net Present Value

andFinance
Corporate
Ross Westerfield Jaffe
Capital Budgeting

Seventh Edition

Seventh Edition

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7-2

Chapter Outline
7.1 Incremental Cash Flows
7.2 The Baldwin Company: An Example
7.3 The Boeing 777: A Real-World Example
7.4 Inflation and Capital Budgeting
7.5 Investments of Unequal Lives: The Equivalent
Annual Cost Method
7.6 Summary and Conclusions

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7-3

7.1 Incremental Cash Flows

Cash flows matternot accounting earnings.

Sunk costs dont matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash
flows.
Inflation matters.

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7-4

Cash FlowsNot Accounting Earnings.

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.

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7-5

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 we should not proceed.

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7-6

Incremental Cash Flows

Side effects matter.
Erosion and cannibalism are both bad things. If
our new product causes existing customers to
demand less of current products, we need to
recognize that.

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7-7

Estimating Cash Flows

Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT Taxes +
Depreciation
Net Capital Spending
Dont forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we
enjoy a return of net working capital.
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7-8

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, its enough to assume that the firms level
of debt (hence interest expense) is independent of
the project at hand.

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7-9

7.2 The Baldwin Company: An Example

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 ACRS 5-year life).
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.
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: initially $10,000 changes with sales.
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7-10

The Worksheet for Cash Flows of the

Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Investments:
(1) Bowling ball machine
(2) Accumulated
depreciation
(3) Adjusted basis of
machine after
depreciation (end of year)
(4) Opportunity cost
(warehouse)
(5) Net working capital
(end of year)
(6) Change in net
working capital
(7) Total cash flow of 260.00
[(1) + (4) + (6)]

Year 1

Year 2

Year 3

Year 4 Year 5

100.00

80.00

20.00

52.00

71.20

82.72

48.00

28.80

17.28

5.76

150.00
10.00

21.76*
94.24

150.00
10.00

10.00
6.32

16.32

24.97

21.22

6.32

8.65

3.75

8.65

3.75

0
21.22

192.98 investment

* We assume that the ending market 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 original purchase price of the machine less
depreciation. The capital gain is $24,240 (= $30,000 $5,760). We will assume the incremental corporate tax for Baldwin on
this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 [0.34
($30,000 $5,760)]. The after-tax salvage value is $30,000 [0.34 ($30,000 $5,760)] = 21,760.
Copyright 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
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7-11

The Worksheet for Cash Flows of the

Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Investments:
(1) Bowling ball machine
(2) Accumulated
depreciation
(3) Adjusted basis of
machine after
depreciation (end of year)
(4) Opportunity cost
(warehouse)
(5) Net working capital
(end of year)
(6) Change in net
working capital
(7) Total cash flow of260.00
[(1) + (4) + (6)]

Year 1

Year 2

Year 3

Year 4 Year 5

100.00

80.00

20.00

52.00

71.20

82.72

48.00

28.80

17.28

5.76

150.00
10.00

21.76*
94.24

150.00
10.00

10.00
6.32

16.32

24.97

21.22

6.32

8.65

3.75

8.65

3.75

0
21.22

192.98 investment

At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
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7-12

The Worksheet for Cash Flows of the

Baldwin Company (continued)
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Income:
(8) Sales Revenues

Year 1

Year 2

Year 3

Year 4 Year 5

100.00

163.00

249.72

212.20 129.90

Recall that 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).
Price during first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12,000[$20(1.02)2] = 12,000$20.81 = $249,720.
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7-13

The Worksheet for Cash Flows of the

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

Income:
(8) Sales Revenues
(9) Operating costs

Year 0

Year 1

Year 2

Year 3

Year 4 Year 5

50.00

100.00
88.00

163.00
145.20

249.72
212.20 129.90
133.10 87.84

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 first year (per unit) are $10 and (increase 10% per
year thereafter).
Production costs in year 2 = 8,000[$10(1.10)1] = $88,000

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7-14

The Worksheet for Cash Flows of the

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

Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation

Year 0

Year 1

Year 2

Year 3

50.00
20.00

100.00
88.00
32.00

163.00
145.20
19.20

249.72
212.20 129.90
133.10 87.84
11.52 11.52

Depreciation is calculated using the Accelerated

Cost Recovery System (shown at right)
Our cost basis is $100,000
Depreciation charge in year 4
= $100,000(.1152) = $11,520.

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Year
1
2
3
4
5
6
Total

Year 4 Year 5

ACRS %
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%

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7-15

The Worksheet for Cash Flows of the

Baldwin Company (continued)
($ thousands) (All cash flows occur at the end of the year.)
Year 0
Income:
(8) Sales Revenues
(9) Operating costs
(10) Depreciation
(11) Income before taxes
[(8) (9) - (10)]
(12) Tax at 34 percent
(13) Net Income

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Year 1

Year 2

Year 3

Year 4 Year 5

100.00
50.00
20.00
30.00

163.00
88.00
32.00
43.20

249.72
145.20
19.20
85.32

212.20 129.90
133.10 87.84
11.52 11.52
67.58 30.54

10.20
19.80

14.69
28.51

29.01
56.31

22.98
44.60

10.38
20.16

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7-16

Incremental After Tax Cash Flows

of the Baldwin Company

Year 0

(1) Sales
Revenues
(2) Operating
costs
(3) Taxes
(4) OCF
(1) (2) (3)
(5) Total CF of
Investment
(6) IATCF
[(4) + (5)]

Year 1

Year 2

Year 3

Year 4

Year 5

$100.00

$163.00

$249.72

$212.20

$129.90

-50.00

-88.00

-145.20

133.10

-87.84

-10.20

-14.69

-29.01

-22.98

-10.38

39.80

60.51

75.51

56.12

31.68

6.32

8.65

3.75

192.98

54.19

66.86

59.87

224.66

260.
260.

39.80

$39.80 $54.19 $66.86 $59.87 $224.66

NPV $260

2
3
4
(1.10) (1.10) (1.10) (1.10)
(1.10) 5
NPV $51,588.05
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7-17

NPV Baldwin Company

CF0

260

CF1

39.80

F1
CF2
F2
CF3
F3
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CF4
F4
CF5

59.87
1
224.66

54.19
F5

10

1
66.86
1

NPV

51,588.05

Copyright 2004 by The McGraw-Hill Companies, Inc. All rights reserved.