Lecture 8.

Making Capital Investment

Decision I

This is based on Ch.10 of the textbook of this course: “Fundamentals of Corporate Finance,”
12th ed., written by Stephen A. Ross/Randolph W. Westerfield/Bradford D. Jordan. Don't cir-
culate it.
2 Contents

1. Project Cash Flows

2. Pro Forma Financial Statements and Project Cash Flows
3. Depreciation

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Remember

3 A Firm’s Overall Cash flow from assets

 Operating Cash Flow – Change in NWC – Capital Spending
 Operating Cash Flow(OCF)
 EBIT(A) + Depreciation – Taxes(A)
 EBIT(A) = EBIT – Net income from disposal of fixed assets
 Taxes(A): Taxes based on the rest of texable income excluding net income from dis-
posal of fixed assets
 Capital Spending
 When there is only a fixed assets purchase
 The cost of purchasing the fixed assets
 When there is only a disposal of fixed assets
 [Market value – Taxes(B)] , where Taxes(B) denotes taxes based on net in-
come from disposal of fixed assets
,
4 Project Cash Flows
 Relevant cash flows for a project
 A relevant cash flow for a project is a change in the firm’s overall
cash flow that comes about as a direct consequence of the decision to
take that project
 Because the relevant cash flows are defined in terms of changes in, or
increment to, the firm’s existing cash flow, they are called the incre-
mental cash flows associated with the project
 The difference between a firm’s cash flows with a project and those
without the project
 Any cash flow that exists regardless of whether or not a project is un-
dertaken is not relevant

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5 The Stand-Alone Principle
 In practice, it would be cumbersome to actually calculate the
total cash flows to the firm with and without a project, espe-
cially for a large firm
 Fortunately, it is not really necessary to do so
 Once we identify the effect of undertaking the proposed
project on the firm’s cash flows, we need focus only on the
project’s resulting incremental cash flows. This is called the
stand-alone principle.

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6 Incremental Cash Flows?

 Sunk costs ……………… N

 Opportunity costs .……………... Y
 Side effects …..…………… Y
 Tax deduction due to interest expenses ….. N

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7 Sunk Costs

 A sunk cost is a cost we have already paid or have already

incurred the liability to pay
 Such a cost is clearly irrelevant to the decision at hand
 Example) Suppose General Milk Company hires a financial
consultant to help evaluate whether a line of chocolate milk
should be launched. When the consultant turns in the report,
the consulting fee is a sunk cost: It must be paid whether or
not the chocolate milk line is actually launched

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8 Opportunity Costs

 The amount of money we give up by undertaking a project

 Opportunity costs arise commonly when a firm already owns
some of the assets a proposed project will be using
 Opportunity costs are incremental cash flows and are rele-
vant to the decision at hand
 Ex) Suppose we are considering doing a project in a ware-
house we bought for $100,000 years ago. In this case, the
post-tax cash flows that can be received if the warehouse is
leased are included in the cost of this project as an opportu-
nity cost.

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9 Side Effects
 Effects of undertaking a project on the cash flows of existing projects
 Side effects are incremental cash flows and are relevant to the deci-
sion at hand
 Negative effect: Erosion
 The cash flows of a new project that come at the expense of a firm’s ex-
isting projects
 In this case, the cash flows from the new line should be adjusted
downward to reflect lost profits on other lines
 Ex) The coffee business can reduce the cash flow of the herbal tea
business
 Positive effect: Synergy
 Ex) The coffee business can improve the cash flow of the sugar busi-
ness
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10 Tax Deduction due to Interest Expenses

 Interest expenses are excluded from cash outflows in project cash

flows, as in the firm’s overall cash flow form assets
 Even tax deduction due to interest expenses is not included in ana-
lyzing a proposed investment, unlike as in the firm’s overall cash
flow from assets
 Interest expenses of the project depend on what mixture of debt and
equity a firm actually chooses to use in financing the project, and such
mixture affects the firm’s capital structure.
 We are interested in the cash flow generated by the assets of the
project regardless of the capital structure
 Determining capital structure is another financial decision making
area to be analyzed separately
 Without loss of generality, we may assume there are no interest expenses
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11 Fixed and Variable Costs of a Project

 For cash flows of a project, it is convenient to divide costs into

variable and fixed costs instead of dividing them into cost of goods
sold and selling and administrative costs
 Variable costs
 Costs that vary with sales volume
 Ex) Raw material costs, performance-base bonuses, transportation costs,
Sales fees, etc.
 Fixed costs
 Costs regardless of sales volume
 Ex) Production facility rent, fixed labor costs, repair/maintenance costs, etc.

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12 Project Cash Flows

 Project Operating Cash Flow – Projcet Change in NWC –

Project Capital Spending
 Reflect opportunity costs and side effects on each term
 It is often convenient to consider opportunity costs separately

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13 Project Operating Cash Flow

 EBIT(A) + Depreciation – Taxes(A)

 EBIT(A) = Sales – Fixed costs – Variable costs – Depreciation
 Taxes(A) = EBIT(A) Tax rate

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14 Net Working Capital

 Normally a project will require that the firm invest in net working
capital in addition to long-term assets
 For example, a project will generally need some amount of cash on
hand to pay any expenses that arise.
 In addition, a project will need an investment in inventories and ac-
counts receivable.
 Some of the financing for these will be in the form of amounts owed
to suppliers(accounts payable), but the firm will have to supply the
balance.
 This balance represents the investment in net working capital.
 As a project winds down, inventories are sold, receivables are col-
lected, bills are paid, and cash balances can be drawn down.
 These activities free up the net working capital invested
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15 Project Capital Spending
 When purchasing fixed assets
 The purchasing cost
 When disposing of fixed assets
 [Market value – Taxes(B)],
where Taxes(B) = (Market value – Book value) Tax rate

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16 Pro Forma Financial Statements

 Financial statements projecting future years’ operations

 A convenient and easily understood means of summarizing much
of the relevant information for a project
 To prepare these statements, we will need estimate of quantities
such as unit sales, the selling price per unit, the variable cost per
unit, and total fixed costs
 We will also need to know the total investment required, includ-
ing any investment in net working capital

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17 Pro Forma Financial Statements - continued

 The first thing we need when we begin evaluating a proposed

investment is a set of pro forma, or projected, financial state-
ments
 Given that, we can develop the projected cash flows from the
project
 Once we have the cash flows, we can estimate the value of the
project using the techniques we described in the previous lecture
 A projected income statement includes neither “Interest expense”
nor “Net income from disposal of fixed assets

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18 Depreciation and Cash Flows

 Accounting depreciation is a noncash deduction

 As a result, depreciation has cash flow consequences only because it
influences the tax bill
 The way that depreciation is computed for tax purposes is the rele-
vant method for capital investment decisions
 Not surprisingly, the procedures are governed by tax law

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19 Depreciation Tax Shield

 Project operating cash flow

= EBIT(A) + Depreciation – Taxes(A)
= EBIT(A) + Depreciation – EBIT(A)Tax rate
= Sales – Costs – (Sales – Costs – Depreciation)Tax rate
= (Sales – Costs )(1 – Tax rate) + Depreciation Tax rate
 Depreciation tax shield (Tax savings by depreciation)
 Depreciation Tax rate
 From now on, if there is no confusion, “EBIT(A)” will be simply ex-
pressed as “ EBIT”, and “ Taxes(A) ” will be simply expressed as “ Taxes”

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20 Modified ACRS Depreciation (MACRS)

 A depreciation system enacted by the Tax Reform Act of 1986

 This system is a modification of the accelerated cost recovery sys-
tem (ACRS) instituted in 1981
 ACRS: A depreciation method under U.S. tax law allowing for the ac-
celerated write-off of property under various classifications
 The basic idea under MACRS is that every asset is assigned to a
particular class
 An asset’s class establishes its life for tax purposes
 Once an asset’s tax life is determined, the depreciation for each
year is computed by multiplying the cost of the asset by a fixed per-
centage
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21 MACRS Property classes

Class Examples
Three-year Equipment used in research
Five-year Autos, computers
Seven-year Most industrial equipment

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22 MACRS Depreciation Allowances

Property Class
Year Three-year Five-year Seven-year
1 33.33 % 20.00 % 14.29 %
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46

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23 Example) We consider an automobile costing $12,000. Autos are
normally classified as five year property
Year MACRS Percentage Depreciation
1 20.00% 0.2000 12,000 = $2,400.00
2 32.00 0.3200 12,000 = 3,840.00
3 19.20 0.1920 12,000 = 2,304.00
4 11.52 0.1152 12,000 = 1,382.40
5 11.52 0.1152 12,000 = 1,382.40
6 5.76 0.0576 12,000 = 691.20
Sum 100.00% $12,000.00

 It may appear odd that the five-year property is depreciated over six years. The tax
accounting reason is that it is assumed we have the asset for only six months in the
first year and, consequently, six months in the last year. As a result, there are five
12-month periods, but we have some depreciation in each of six different tax
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24 Example) We consider an automobile costing $12,000. Autos are
normally classified as five year property
Year Beginning Book Value Depreciation Ending Book Value
1 $12,000 $2,400.00 $9,600.00
2 $9,600.00 3,840.00 5,760.00
3 5,760.00 2,304.00 3,456.00
4 3,456.00 1,382.40 2,073.60
5 2,073.60 1,382.40 691.20
6 691.20 691.20 .00

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25 Book Value vs. Market Value
 In calculating depreciation under current tax law, the eco-
nomic life and future market value of the asset are not an
issue
 As a result, the book value of an asset can differ substan-
tially from its actual market value

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26 Cash flow from the disposal of a fixed asset

 Post-tax Cash Flow from the Sale of a Fixed Asset

 Market value – Taxes based on net income from the sale of the
fixed asset
= Market value (Market value – Book value)Tax rate
 If the book value is less than the market value, the differ-
ence between market value and book value is “excess” de-
preciation, and it must be “recaptured” when the asset is
sold. So the taxes must be paid.
 If the book value exceeds the market value, then the differ-
ence is treated as a loss for tax purposes. In this case, a tax
savings should occur.

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27 An Example of Calculating Post-tax CF from the Sale of a Fixed
Asset
 Consider the $12,000 car in the previous example. Sup-
pose the corporate tax rate is 21%.
 If we sell the car after 5 years when the market value is
$3,000, then
 Post-tax CF = 3000 – (3000 – 691.20)0.21 = $2,515.15
 If we sell the car after 2 years when the market value is
$4,000, then
 Post-tax CF = 4000 – (4000 – 5,760.00)0.21 = $4,369.6

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28

Thank You!!!

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