Copyright 2004 McGraw-Hill AustraliaPty Ltd8-1Chapter EightMaking Capital InvestmentDecisions
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-2Chapter Organisation8.1 Project Cash Flows: A First Look8.2 Incremental Cash Flows8.3 Project Cash Flows8.4 More on Project Cash Flows8.5 Some Special Cases of Discounted Cash FlowAnalysis8.6 Summary and Conclusions
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-3Chapter Objectives• Identify incremental cash flows relevant toinvestment evaluation.• Calculate depreciation expense for tax purposes.• Apply incremental analysis to project evaluation.• Determine how to set the bid price and how tovalue options.• Compare mutually-exclusive projects using annualequivalent costs.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-4Incremental Cash Flows• Any and all changes in the firm’s future cash flowsthat are a direct consequence of undertaking theproject.• The only relevant cash flows in capital projectevaluation.• Stand-alone principle: we can evaluate the projecton its own.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-5Types of Cash Flows• Sunk costs ⇒ a cost that has already beenincurred and cannot be removed ≠ incrementalcash flow• Opportunity costs ⇒ the most valuable alternativethat is given up by the investment = incrementalcash flow• Side effects ⇒ erosion = incremental cash flow
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-6Types of Cash Flows (continued)• Financing costs ⇒ incorporated in discount rate ≠incremental cash flow• Always use after-tax incremental cash flow
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-7Investment Evaluation• Step 1 Calculate the taxable income.• Step 2 Calculate the cash flows.• Step 3 Discount the cash flows.• Step 4 Decision.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-8Example—Investment Evaluation• Purchase price $42 000• Salvage value $1000 at end of Year 3• Net cash flows Year 1 $31 000Year 2 $25 000Year 3 $20 000• Tax rate is 30%• Depreciation 20% reducing balance• Required rate of return 12%
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-13Interest• As the project’s NPV is positive, the cash flowsfrom the investment will cover interest costs (aslong as the interest cost is less than the requiredrate of return).• Interest costs should not therefore be included asan explicit cash flow.• Interest costs are included in the required rate ofreturn (discount rate) used to evaluate the project.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-14Depreciation• The depreciation expense used for capitalbudgeting should be the depreciation schedulerequired for tax purposes.• Depreciation itself is a non-cash expense;consequently, it is only relevant because it affectstaxes.• Prime cost vs diminishing value methods• Depreciation tax shield = DT-D = depreciation expense-T = marginal tax rate
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-15Disposal of Assets• If the salvage value > book value, a profit/gain ismade on disposal. This profit/gain is subject to tax(excess depreciation in previous periods).• If the salvage value < book value, the ensuing losson disposal is a tax deduction (insufficientdepreciation in previous periods).
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-16Capital Gains• Capital gains made on the sale of assets such asrental property are subject to taxation.• Capital losses are not a tax deduction but can beoffset against future capital gains.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-17Example—Incremental Cash FlowsA firm is currently considering replacing a machine purchased twoyears ago with an original estimated useful life of five years. Thereplacement machine has an economic life of three years. Otherrelevant data is summarised below:
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-18Solution—Taxable Income
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-21Setting the Bid Price• How to set the lowest price that can be profitablycharged.• Cash outflows are given.• Determine cash inflows that result in zero NPV atthe required rate of return.• From cash inflows, calculate sales revenue andprice per unit.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-22Setting the Option Value• Option value =Asset value × Probability of the Value–Present value of the exercise price ×Probability the exercise price will be paid.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-23Annual Equivalent Cost (AEC)• When comparing two mutually-exclusive projectswith different lives, it is necessary to makecomparisons over the same time period.• AEC is the present value of each project’s costs toinfinity calculated on an annual basis.• Select the project with the lowest AEC.
Copyright 2004 McGraw-Hill AustraliaPty Ltd8-24Example—AEC• Project A costs $3000 and then $1000 per annumfor the next four years.• Project B costs $6000 and then $1200 for the nexteight years.• Required rate of return for both projects is 10 percent.• Which is the better project?