Chapter 11

Advanced Topics in Capital Budgeting

Learning Objectives
Estimate project cash flows

Describe the difference between independent and mutually
exclusive projects

Compare projects with different lives using the equivalent
annual series technique
Estimating Project Cash Flows
Guidelines
Add back depreciation to net income.
Ignore interest expense.
All project cash flows must be incremental.
Ignore allocated costs and sunk costs.
Include opportunity costs.
Net working capital.
Add back depreciation
Depreciation is a non-cash expense
Tax deductible
Add the depreciation back to the net income
cash flow = net income + depreciation expense
Commonly referred to as free cash flow
Ignore interest expense
A projects value (desirability) is determined by the cash flows
that generates, not by how the project is financed.
In determining a projects cash flows, we ignore its financing
cost, i.e., the interest expense.
All project cash flows must be incremental
To evaluate a project, we look at the cash flows which it
contributes towards the firms existing cash flows. In other
words, we look at projects incremental cash flows.
How to determine incremental cash flows?
1. Look at the firms cash flows without the project.
2. Look at the firms cash flows with the project.
3.The difference is the incremental cash flows.
Ignore allocated costs and sunk costs
Allocated costs: rent, supervisory salaries, administrative
costs, and various overhead expenses
These costs are not incremental. They dont change even if the project is
undertaken. Thus, they should not be considered in estimating the projects
incremental cash flows.
Sunk (irrecoverable) costs: costs which cannot be recovered
regardless of whether the firm undertakes the project.
Examples: R&D expenses, consultant fees.
Include opportunity costs
Suppose the project requires the use of some asset owned by
the firm.
If the asset is not used by the project, the firm can sell the asset
for $X. This $X is the opportunity cost of the asset. Such a
cost should be included in the projects cost.
An assets opportunity cost is the money that the firm can
receive if the asset is put to the next best use. The next best
use may be to sell the asset.
Net working capital
Very often, a project will require an initial increase in net
working capital. This increase in net working capital must be
added to the projects costs.
Assume that this additional working capital is liquidated (sold
for cash) at the end of the projects life.
This liquidation is a cash inflow in the last period.
The opposite pattern is also possible. In other words, if taking
on a project reduces the net working capital, then the size of
this reduction is subtracted from the projects initial cost and
the last period cash inflow


Capital budgeting example
Problem 11.6: You are given the responsibility of conducting the
project selection analysis in your firm. You have to calculate the
NPV of a given project. The appropriate cost of capital is 12
percent and the firm is in the 30 percent tax bracket. You are
provided the following pieces of information regarding the
project:


Calculate initial cost
Initial cost is the sum of:
o Market value of land: $1 million (opportunity cost)
o Land improvement $100,000
o Plant & machinery: $20 million
o Incremental working capital: $1 million

= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
= $22,100,000
Calculate the annual incremental cash flow:
Step one
Calculate the annual depreciation expense, for this project,
fixed assets refer to $20million plant & machinery. Therefore,
Depreciation = (20,000,000 3,000,000)/10
= $1,700,000

Calculate incremental sales
Incremental sales = 0.8 x 15,000,000 = $12,000,000
Calculate the annual incremental cash flow:
Step two
Draw up the incremental income statement

Incremental sales 12,000,000
Less Incremental variable cost 9,000,000
Less Incremental managerial salaries 200,000
Less Incremental depreciation 1,700,000
Equals Incremental taxable income 1,100,000
Less Incremental tax @30% 330,000
Equals Incremental net income 770,000
Add back depreciation 1,700,000
Incremental cash flow $2,470,000
Consider other cash flows at end of project
At the end of projects life (t=10), company
Recovers $1 m additional working capital (item 9)
Receives $3 m salvage value from plant & machinery (item 8)

Additional cash flows at end of project
= 1,000,000 + 3,000,000 = $4,000,000
Bring all the cash flows together
CF0 (initial cost) = $22,100,000
Annual incremental after-tax cash flow (Year 1 through Year
10) = $2,470,000
Additional cash flow in Year 10 = $4,000,000
Finally, we compute the NPV using a discount rate of 12
percent
NPV = -$6,856,056.17
Decision: reject the project.


Mutually Exclusive Projects
Projects are mutually exclusive if accepting one implies that
the other projects will be foregone.
When projects are mutually exclusive and have equal lives, you
have to
o Rank the projects based on their NPVs
o Choose the best project, provided the projects NPV is
positive
With mutually exclusive projects that have equal lives,
choosing the project with the highest NPV is always correct.
16
Mutually Exclusive Projects Example
Consider the following two mutually exclusive projects that have
equal lives, for a firm using a discount rate of 10%, which project(s)
should we accept?
Project NPV IRR PI
A $100,000 10.2% 1.04
B $1 11% 1.11
C $70,000 23% 1.32
D $24,000 13% 1.44
Comparing projects with unequal lives:
Equivalent annual series (EAS)
When projects are mutually exclusive but have unequal lives
o We construct the equivalent annual series (EAS) of each project
o We choose the project with the highest EAS

A projects EAS is the payment on an annuity whose life is the
same as that of the project and whose present value, using the
discount rate of the project, is equal to the projects NPV.
EAS example
Consider Projects J & K, with the following cash flows. The
discount rate is 10%.
Project C0 C1 C2 C3 C4
J -12000 6000 6000 6000
K -18000 7000 7000 7000 7000
EAS for Project J
Compute Project Js NPV
Verify that NPV(J) = $2,921.11
Find the payment on the 3-year (life of project J) annuity whose
PV is equal to $2,921.11.
N=3, I/Y=10, PV=-2921.11, FV=0, Then CPT, PMT.
PMT = 1,174.62, which is Project Js EAS.

So, finding EAS is nothing more than finding the payment of an
annuity.
EAS for Project K
Verify that Project Ks NPV= $4,189.06
Find the payment on the 4-year (life of project K) annuity
whose PV is equal to $ 4,189.06.
N=4, I/Y=10, PV=- 4,189.06, FV=0, Then CPT, PMT.
PMT = 1,321.53, which is Project Ks EAS.

Recall that Project Js EAS=1174.62

So, choose Project K since it has the higher EAS.
Congratulations!



FI 3300: Corporate Finance
Accounting Review (2)
Statement of
Cash Flows (3)
Financial statement
Analysis (4)



Strategic Financial
Management (5)
Firms Financial Statements Valuation
Time Value of Money (6, 7)
Financial Securities &
Markets (8)
Valuation of
Bond & Stock (9)
Capital Budgeting
Basics (10)
Capital Budgeting
Advanced (11)