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Making Capital Investment Decisions. What finance functions add the most to firm value?. General Rules of Discounting. Only cash flows matter Only examine incremental cash flow Be consistent in treatment of inflation Deduct taxes before discounting. Cash Flow are what matter.

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## Making Capital Investment Decisions

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**General Rules of Discounting**• Only cash flows matter • Only examine incremental cash flow • Be consistent in treatment of inflation • Deduct taxes before discounting**Cash Flow are what matter**• Cash flow = Dollars receive – Dollars paid • Earnings are NOT cash flow • Earnings are an ACCOUNTING NUMBER • Accountants start with cash flow, but then adjusts for timing, accruals, non-cash items etc. • Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows • You never write a check for “depreciation”**Incremental Cash Flows**• These are cash flows that the firm only incurs if it takes the project • Need to consider all incremental cash flows that can be attributed to the project • Examples: Project Interactions, Opportunity Costs, Overhead, Depreciation, Taxes (including cap gains tax), and Salvage Values**Interactions (Side Effects)**• Affects that the investment has on the cash flows of the firm’s other projects • Erosion or Cannibalism (Bad) • The new product causes existing customers to demand less of the company’s current products**Erosion in Action**• Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?**Erosion in Action**• Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?**Erosion in Action**• Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?**Erosion in Action**• Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?**Working Capital**• Money the firm has on hand that is necessary for running the business • Think of the cash in a register, how effective is the register without the cash in the drawer • If a project requires changes in working capital, we need to account for this in our calculations • Why???**Opportunity Costs**• Cash flows that can be realized from putting the assets to use in different projects. • What could we be making? • Example: When Price Club considers stocking a new product, what is the opportunity costs that it should be considering?**Overhead**• The ongoing administrative expenses a business incurs, which cannot be attributed to any specific business activity, but are necessary to run the firm. • Examples: rent, utilities, and insurance. • Accountants allocate overhead across projects • Are we concerned about the amount of overhead the account’s will assign to our project?**Overhead**• The ongoing administrative expenses a business incurs, which cannot be attributed to any specific business activity, but are necessary to run the firm. • Examples: rent, utilities, and insurance. • Accountants allocate overhead across projects • Are we concerned about the amount of overhead the account’s will assign to our project? • NO, we don’t care about accounting numbers • We do care about changes in overhead that result from our project**Example**• A firm has only one division A, with assets of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • What is the relevant cash flow as far as the decision to add division B?**Example**• A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m • What is the relevant cash flow as far as the decision to add division B?**Example**• A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m, B=(27)*(50/150)=$9m • What is the relevant cash flow as far as the decision to add division B?**Example**• A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m, B=(27)*(50/150)=$9m • What is the relevant cash flow as far as the decision to add division B? • Relevant overhead is $7m**Depreciation**• Allocates the cost of an asset over its expected life, for accounting and tax purposes • Accounts for the decline in asset value because of wear and tear or obsolescence • Depreciation is based on the asset’s expected life, not on the life of the project • LAND DOES NOT DEPRECIATE**Why do we care about Depreciation**• Depreciation is a non-cash expense, an accounting number, so why do we care about it? • Depreciation is tax deductible, and taxes are a LARGE cash expense**The Two Depreciations**• Book (Accounting) Depreciation is what appears on financial statements • Ex. Straight line depreciation • Tax Depreciation is used to determine the firms tax bill • This determines the Tax Shield**The Two EBT’s**EBDT -Book Dep -Tax Dep EBT (Book) EBT (Tax) -Taxes Paid Tax Rate Taxes Paid Net Income = Book EBT – Taxes Paid**Book Depreciation**• This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: • Salvage Value:**Book Depreciation**• This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: what did we pay for it • Salvage Value:**Book Depreciation**• This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: what did we pay for it • Salvage Value: asset value at end of it’s life • What can we sell it for?**Tax Depreciation**• Tax Depreciation is calculated using the Modified Accelerated Cost Recovery System • Tax depreciation ignores salvage value • MACRS allows for more depreciation early • How will this affect the PV of the tax shield? • Tax Shield = (Tax Depreciation * tax rate) • What is the Tax Shield?**Tax Depreciation**• Tax Depreciation is calculated using the Modified Accelerated Cost Recovery System • Tax depreciation ignores salvage value • MACRS allows for more depreciation early • How will this affect the PV of the tax shield? • Tax Shield = (Tax Depreciation * tax rate) • What is the Tax Shield? The money that now goes to investors instead of the government**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrap, $100k. • What is the yearly accounting (straight line) and tax depreciation?**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Acct & Tax Dep. Example**• Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =**Proceeds from Sale and Capital Gains Tax**• When a company sells an asset, if the price is above the tax book value, it is subject to capital gains • Capital Gains Tax Obligation = (Price- Tax Book Value) * Capital Gains Tax Rate**Capital Gains Tax Example**• You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale?**Capital Gains Tax Example**• You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • First what is the book value of the machine? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV:**Capital Gains Tax Example**• You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit:**Capital Gains Tax Example**• You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit: 600,000 - 432,000=168,000 • Capital Gains Tax owed:**Capital Gains Tax Example**• You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit: 600,000 - 432,000=168,000 • Capital Gains Tax owed 0.20 * 168,000= $33,600**Inflation and Capital Budgeting**• Inflation: general increase in the price of goods • Alternative: the general decline in the purchasing power of money • Hershey Nickel Bar: • In 1930 bar was 2 oz • In 1968 bar was ¾ oz • Inflation is an important fact of economic life and must be considered in capital budgeting.**Dealing with Inflation**• KEY: Keep everything in either real or nominal terms • Real Cash Flows → Real Discount Rate • Nominal Cash Flows → Nominal Discount Rate • As long as we are consistent in our treatment of inflation we will get the same NPV**Real vs. Nominal**• Nominal dollars: • Real dollars: • Nominal rate: • Real rate:**Real vs. Nominal**• Nominal dollars are the dollars we have in our wallets • Real dollars • Nominal rate • Real rate**Real vs. Nominal**• Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate • Real rate**Real vs. Nominal**• Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate is the “total” rate of interest • Accounts for what you should earn & inflation • Real rate**Real vs. Nominal**• Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate is the “total” rate of interest • Accounts for what you should earn & inflation • Real rate is want an investment should earn • Ignores inflation**Inflation and Discount rate**• The relationship between interest rates and inflation is known as the Fisher Equation (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

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