10. Making Capital Investment Decisions

1. 10. Making Capital Investment Decisions

2. 1. Project cash flows • Incremental cash flows associated with the project: cash flows consist of any or all changes in the firm’s future cash flows that are a direct consequence of taking the project. Stand-alone principle. • Sunk costs: a cost that has been already incurred and can not be removed regardless of whether or not a project would be launched. Thus it should not be considered in an investment decision. • Opportunity costs: not considered in an investment decision. • Side effects (erosion): cash flows of a new project that come at the expense of a firm’s existing projects. The cash flow from the new line should be adjusted downwards to reflect the any sales lost.

3. New working capital: It is usually financed by a loan (A/R). At the end of the life of the project, net working capital would be recovered by selling inventories, collecting A/R, etc • Financing costs: not considered in evaluating the proposed investment. • After-tax cash flow.

4. 2. Pro forma financial statement and project cash flow 1) Project cash flow (free cash flow) = Project operating cash flow – project change in net working capital – project capital spending. (1) Project operating cash flow = EBIT + Depreciation –Taxes (2) Project change in net working capital = ending net working capital - beginning net working capital (3) Project capital spending = ending net fixed asset – beginning net fixed asset + depreciation

5. Ex) Shark Attractant Can Maker • Sell 50,000 cans of shark attractant at $4 per can. • Cost of production is $2.50 per can. • Return = 20%. • Fixed costs is $12,000 per year. • Need $90,000 investment in manufacturing equipments. It would be straight-line depreciated in three years. The ending value is zero. • Need additional $20,000 investment in net working capital. There is no change in NWC each year. • Tax rate is 34%.

8. 2) Modified ACRS Depreciation (MACRS) Here, ACRS means accelerated cost recovery system. It is a depreciation method under U.S tax law allowing for the accelerated write-off of property. Book value = initial price – depreciated amount. If the asset is sold at higher price than book value, the difference will be taxed.

9. e.g) MACRS depreciation for $12,000

10. 10th edition: an comprehensive example of Majestics Mulch and Compost Company (MMCC) • Page 318 to 322. • Table 10.11 to10.14. • Recommend to replicate this example.

11. 3. Alternative Operating Cash Flows (OCF) Measurement • 1) Bottom-Up approach (under no assumption of interest payment): • OCF = Net income + depreciation • Ex) with the previous Shark Attractant Can example, • OCF = 21,780+30,000 = 51,780 • 2) Top-Down approach • OCF = Sales – Costs - Taxes • Ex) =200,000 – (125,000+12,000) -11,220 = 51,780

12. 3) Tax Shield approach • OCF = (sales – costs) × (1-T) + depreciation × T • Ex) [200,000 – (125,000+12,000)] × (1-0.34) + 30,000 × 0.34 = 51,780

13. 4. Special cases of discount cash flow analysis • 1) Cost-cutting proposals which is about upgrading facilities to improve cost effectiveness. • Ex) considering automating some part of an existing production process. • 1) necessary equipment costs $80,000. • 2) automation saves $22,000 per year • 3) the equipment is supposed to have 5 year-life and is depreciated to zero on a straight-line basis. • 4) the equipment would be worth $20,000 in five years. • 5) no change in net working capital • 6) Tax rate is 34%

14. What would be project cash flow to evaluate this case? Equation: Project cash flow (free cash flow) = Operating cash flow – project change in net working capital – project capital spending. Operating cash flow = EBIT + Depreciation-Tax = (22,000-16,000) + 16,000 – 0.34*(22,000-16,000) = 19,960. Below, 13,200 = 20,000*(1-0.34) NPV with 10% = $3,860. What is IRR?

15. 2) To buy or not to buy $200,000 computer-based inventory management system. • Assumptions: • 1) Straight-line depreciation for 4 years. It would be worth $30,000 at the end of that time. • 2) New system saves $60,000 before tax in inventory-related costs. • 3) New system frees up $45,000 in net working capitals. • 4) Tax rate: 39% • 5) Capital spending: $200,000.

16. Operating cash flow = EBIT + Depreciation – Tax = (60,000 – 200,000/4) + 200,000/4 – (60,000 - 200,000/4)*0.39 = 56,100. • NPV with 16% is $ -$12,786. What is IRR?

17. 3) Setting the bid price for a truck in the business of buying stripped-down truck platform and then modifying to the customer’s specification. What is a price for a truck to earn 20% return? Here, each year, 5 trucks are supposed to be ordered. • Capital investment: $60,000 • It would be depreciated straight-line to a zero value over 4 years. • It would be worth about $5,000 at the end. • New investment in raw material: $40,000. • Annual operating cost is $94,000. • Tax rate: $39%.

18. If you want to estimate OCF generating 20% return, you can transform the cash flow pattern. • OCF making NPV with 20% equal to zero is $30,609

19. To estimate the price, we use the bottom-up approach, OCF = net income + depreciation. • OCF = net income + Depreciation • 30,609 = net income + 60,000/4 • Net income = 15,609 = (sale – costs – depreciation)*(1-t) • Also assume that operating cost is $94,000. • Thus, 15,609 = (sale – 94,000- 60,000/4)*(1-0.39), Sale = $134,589. A price = 134,589/5 =26,918

20. 4) Equipment options with different lives. In this case, using annual cost estimate, we decide the equipment. • Machine A costs $100 to buy and $10 per year to operate. It would be replaced every two years. • Machine B costs $140 to buy and $8 per year to operate. It would be replaced every three years.

21. Total PV of costs with 10%, • Machine A = -100 – 10/1.1 – 10/(1.1^2) • = - 117.36 • Machine B = -140 – 8/1.1 – 8/(1.1^2) – 8/ (1.1^3) = -159.89 • Equivalent Annual Costs(EAC) using an annuity factor. • Machine A: • -117.36 = EAC*(1-1/(1+0.1)^2)/0.1. • EAC=-67.62

22. Machine B • -159.89=EAC*(1-1/(1+0.1)^3)/0.1 • EAC= -64.29 • B is cheaper than A.