Fundamentals of Corporate Finance/3e,ch08

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

8-1

Chapter Eight

Making Capital Investment Decisions


8-2

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 Some Special Cases of Discounted Cash Flow

Analysis

8.6 Summary and Conclusions


8-3

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.


8-4

Incremental Cash Flows

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

• The only relevant cash flows in capital project evaluation.

• Stand-alone principle: we can evaluate the project on its own.


8-5

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 by the investment = incremental cash flow

• Side effects erosion = incremental cash flow


8-6

Types of Cash Flows (continued)

• Financing costs incorporated in discount rate incremental cash flow

• Always use after-tax incremental cash flow


8-7

Investment Evaluation

• Step 1 Calculate the taxable income.

• Step 2 Calculate the cash flows.

• Step 3 Discount the cash flows.

• Step 4 Decision.


8-8

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%


8-9

Solution—Depreciation Schedule


8-10

Solution—Taxable Income


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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


8-12

Solution—NPV and Decision

Decision: NPV > 0, therefore ACCEPT.


8-13

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.


8-14

Depreciation

• The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes.

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

• Prime cost vs diminishing value methods• Depreciation tax shield = DT

-D = depreciation expense-T = marginal tax rate


8-15

Disposal of Assets

• If the salvage value > book value, a profit/gain is made on disposal. This profit/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).


8-16

Capital Gains

• Capital gains made on the sale of assets such as rental property are subject to taxation.

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


8-17

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:


8-18

Solution—Taxable Income


8-19

Solution—Cash Flows


8-20

Solution—NPV and Decision

Decision: NPV < 0, therefore REJECT.


8-21

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.


8-22

Setting the Option Value

• Option value =

Asset value × Probability of the Value

–

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


8-23

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 to infinity calculated on an annual basis.

• Select the project with the lowest AEC.


8-24

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?


8-25

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


8-26

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


8-27

Solution—Interpretation

Project A is better because it costs $1946 per year compared to Project B’s $2325 per year.

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