8-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Eight

Making Capital Investment Decisions

8-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Organisation

8.1 Project Cash Flows: A First Look

8.2 Incremental Cash Flows

8.3 Project Cash Flows

8.4 More on Project Cash Flows

8.5 Special Cases of Discounted Cash Flow Analysis

Summary and Conclusions

8-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Objectives• Identify incremental cash flows relevant to investment

evaluation.• Calculate depreciation expense for tax purposes.• Apply incremental analysis to project evaluation.• Determine how to set the bid price and how to value

options.• Compare mutually-exclusive projects using annual

equivalent costs.

8-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Project Cash Flows• The incremental cash flows for project evaluation

consist of any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project.

• The stand-alone principle is the evaluation of a project based on the project’s incremental cash flows.

8-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Types of Cash Flows• Sunk costs a cost that has already been incurred

and cannot be removed incremental cash flow.

• Opportunity costs the most valuable alternative that is given up if a particular investment is undertaken = incremental cash flow.

• Side effects erosion the cash flows of a new project that come at the expense of a firm’s existing projects = incremental cash flow.

8-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Types of Cash Flows (continued)• Financing costs the interest rate used to discount

the cash flows reflects in part the financing costs of the project incremental cash flow.

• An investment of the firm in the project’s net working capital represents an additional cost of undertaking the investment.

• Always use after-tax incremental cash flow, since taxes are definitely a cash flow.

8-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Investment Evaluation

• Step 1 Calculate the tax effect of the decision.

• Step 2 Calculate the cash flows relevant to the

decision.

• Step 3 Discount the cash flows to make the

decision.

8-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Investment Evaluation• Purchase price $42 000• Salvage value $1000 at end of Year 3• Net cash flows Year 1 $31 000

Year 2 $25 000

Year 3 $20 000• Tax rate is 30%• Depreciation 20% reducing balance• Required rate of return 12%

8-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Depreciation Schedule

8-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Taxable Income

8-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Cash Flows

Year 0 Year 1 Year 2 Year 3

Tax paid (6 780) (5 484) 1 764

Net cash flow 31 000 25 000 20 000

Salvage value 1 000

Outlay (42 000)

Cash flow $(42 000) $24 220 $19 516 $22 764

8-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—NPV and Decision

Decision: NPV > 0, therefore ACCEPT.

8-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Interest• As the project’s NPV is positive, the cash flows

from the investment will cover interest costs (as long as the interest cost is less than the required rate of return).

• Interest costs should not therefore be included as an explicit cash flow.

• Interest costs are included in the required rate of return (discount rate) used to evaluate the project.

8-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Depreciation• The depreciation expense used for capital budgeting

should be the depreciation schedule required for tax purposes.

• Depreciation is a non-cash expense; consequently, it is only relevant because it affects taxes.

• There are two methods of depreciation:– Prime cost (straight-line method in accounting)– Diminishing value (reducing balance method in accounting)

• Depreciation tax shield = DT

where D = depreciation expense

T = marginal tax rate.

8-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Disposal of Assets• If the salvage value > book value, a gain is made on

disposal. This gain is subject to tax (excess depreciation in previous periods).

• If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods).

8-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Capital Gains Tax• Capital gains made on the sale of assets such as

rental property are subject to taxation.

• For taxation purposes, the calculation of a capital gain is complicated and depends upon whether the seller is an individual or an entity such as a company or trust.

• Capital losses are not a tax deduction but can be offset against future capital gains.

8-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Inflation• When a project is being evaluated, anticipated

inflation would be reflected in the estimates of the future cash flows and the interest rate used as the discount rate in the analysis.

• As a result there will be no distortion to the analysis by not identifying inflation specifically.

8-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Incremental Form of Analysis• The description ‘incremental’ is often replaced by

‘marginal’.

• The advantage of using a marginal form of analysis is that there will only be one calculation and not two.

• By using a marginal form we are implicitly analysing one option: that is, to do nothing.

• The sign of the NPV tells us whether it is sensible to change or not.

8-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Incremental Cash Flows A firm is currently considering replacing a machine purchased two years ago with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below:

8-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Taxable Income

8-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Cash Flows

8-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—NPV and Decision

Decision: NPV < 0, therefore REJECT.

8-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

A Note on Cash Flows• Cash flows do not always conveniently occur at the

end of the period.• Taking revenue at the period end is a conservative

approach to evaluation.• If the facts made it necessary to take cash flows as

occurring at the beginning of the period this only requires a minor adjustment to the analysis.

• The period examined could be yearly, monthly or even weekly. If so, the discount rate must match the period (e.g. a weekly analysis needs a weekly rate).

8-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Setting the Bid Price• How to set the lowest price that can be profitably

charged.

• Cash outflows are given.

• Determine cash inflows that result in zero NPV at the required rate of return.

• From cash inflows, calculate sales revenue and price per unit.

8-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Setting the Option Value

• A buy option is an arrangement that gives the holder the right to buy an asset at a fixed price sometime in the future.

• Option value =

Asset value × Probability of the Value

–

Present value of the exercise price × Probability the exercise price will be paid.

8-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Annual Equivalent Cost (AEC)• When comparing two mutually-exclusive projects with

different lives, it is necessary to make comparisons over the same time period.

• AEC is the present value of each project’s costs calculated on an annual basis.

• NPVs are calculated and then converted to AECs using the relevant PVIFA (present value interest factor for annuities).

• Select the project with the lowest AEC.

8-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—AEC• Project A costs $3000 and then $1000 per annum for

the next four years.

• Project B costs $6000 and then $1200 for the next eight years.

• Required rate of return for both projects is 10 per cent.

• Which is the better project?

8-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Project A

946 $13.1699

170 $6

0.10 4,PVIFA

costs of PVAEC

$6170

$3000$3170

$30003.1699$1000

0.10 4,PVIFANPV 0

C C

8-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Project B

$23255.3349

402 $12

0.10 8,PVIFA

costs of PVAEC

402 $12

$6000$6402

$60005.3349200 $1

0.10 8,PVIFANPV 0

C C

8-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Solution—Interpretation

‘Project A is better because it costs $1946 per year

compared to Project B’s $2325 per year’.

8-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Annual Equivalent Benefit (AEB)• The AEB is used when comparing projects with cash

inflows and outflows but with unequal lives.

• The steps required to calculate the AEB are the same as those used for AEC.

• Select the project with the highest AEB.

8-32Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Summary and Conclusions• Discounted cash flow (DCF) analysis is a standard

tool in the business world.• The information provided for a specific decision may

be complex; however the analysis reduces to three distinct steps:

- Step 1 Calculate the taxable income

- Step 2 Calculate the cash flows relevant to the decision

- Step 3 Discount the cash flows to make the decision.

• Cash flows should be identified in a way that makes economic sense.