Chapter 10

Making Capital
Investment Decisions

Making Capital Investment Decisions

Capital budgeting concepts

Relevant cash flows
Incremental cash flows after tax effects
have been considered.
The stand-alone principle
Each project can be evaluated in isolation.
Sunk costs
Have already been incurred, so they are
irrelevant.
Making Capital Investment Decisions

Capital budgeting concepts

(contd.)
Opportunity costs
Something that we give up by undertaking a
project - can be difficult to identify.
Side effects
The impact a project has on other activities
of the firm, e.g. Coke & Diet Coke.

Making Capital Investment Decisions

Capital budgeting concepts

(contd.)
Net working capital
Additional funds required at the
beginning of a project to purchase
inventory and finance accounts
receivable usually recovered at
the end of the project.

Making Capital Investment Decisions

Capital budgeting concepts

(contd.)
Financing costs
We will ignore these for now
project acceptance or rejection
should be driven by the assets, not
financing effects.

Making Capital Investment Decisions

Straight-line depreciation
Depreciation expense =
(initial cost salvage
value)/estimated life

Making Capital Investment Decisions

Example of straight-line
depreciation
Example: compute the annual
depreciation expense for a machine
that has an estimated useful life of 4
years, a zero salvage value, and an
initial cost of $10,000,000.
depreciation expense = ($10M - 0)/4
=$2.5M
Making Capital Investment Decisions

Working with MACRS

schedules
Ignore salvage value
yr convention

Making Capital Investment Decisions

Example of working with

MACRS schedules
Example: the 3-Year MACRS schedule
Year

Depreciation %

33.33

44.44

14.82

7.41

Making Capital Investment Decisions

Book value and market value

Are usually different

Making Capital Investment Decisions

Example of book value and

market value
Example: compute the first-year
depreciation expense and the book value
at the end of Year 1 for a machine in the
3-Year MACRS class that has an initial
cost of $10,000,000.
Depr. Exp. = .3333*$10M = $3.333M
Book Value = $10M - $3.333M = $5.557M
Making Capital Investment Decisions

The concept of estimating

salvage values
What you think you could sell the
equipment for when the project is
over.

Making Capital Investment Decisions

Calculating taxes
Tax = tax rate x (salvage value
book value)

Making Capital Investment Decisions

Example of calculating taxes

Example: what is the relevant tax
payment if a machine is sold for
$100,000 when the book value is
$80,000 and the tax rate is 40%?
Tax = .40 * ($100,000 - $80,000)
= $8,000
Making Capital Investment Decisions

Tax shields
Occur when equipment is sold for
less than book value.

Making Capital Investment Decisions

After-tax salvage value

After-tax salvage value =
Estimated salvage value - tax

Making Capital Investment Decisions

Example of after-tax salvage

value
Example: what is the after-tax salvage
value of a machine that is sold for
$100,000 when the book value is
$120,000 and the tax rate is 40%?
After-tax salvage value
= $100,000-[.40*($100,000-$120,000)]
= $ 108,000
Making Capital Investment Decisions

Estimating project cash

flows
Project cash flow
= operating cash flow change in
NWC capital spending
Operating cash flow
= EBIT + depreciation taxes
Scenario and sensitivity analysis
Making Capital Investment Decisions

Example of estimating
project cash flows
Example: the Philadelphia Pretzel Company
is considering an investment in a new
pretzel twister. The machine will cost
$20,000, and will be depreciated on a
straight-line basis to zero over two years.
It will generate additional sales of $50,000
per year and expenses of $35,000 per
year. The project will require an additional
investment in working capital of $5,000,
which will be freed up at the end of the
project. The tax rate is 40%.
Making Capital Investment Decisions

Example of estimating
project cash flows (contd.)
(1) Estimate the projects cash flows
and compute the NPV at a
discount rate of 12%.

Making Capital Investment Decisions

Example of estimating
project cash flows (contd.)
0

Investment
NWC
Sales
Expenses
Gross Profit
Depreciation
EBIT
Taxes
Net Income
+ Depreciation
Oper Cash flow
Project CF
NPV @ 12%
Making Capital Investment Decisions

Example of estimating
project cash flows (contd.)
Investment
NWC
Sales
Expenses
Gross Profit
Depreciation
EBIT
Taxes
Net Income

0
-20,000
-5,000

50,000
35,000
15,000
10,000
5,000
2,000
3,000

5,000
50,000
35,000
15,000
10,000
5,000
2,000
3,000

+ Depreciation

10,000

10,000

Oper Cash flow

13,000

13,000

13,000

18,000

Project CF
NPV @ 12%
IRR

(25,000)
957
15%

Making Capital Investment Decisions

Example of estimating
project cash flows (contd.)
(2) Recompute the NPV if the machine is
sold
for $3,000 after two years.
After-tax salvage value
= 3000-[.40(3000-0)] = 1800
Effect on NPV = +1800/1.122 = 1435
New NPV = 957 + 1435 = 2392
Making Capital Investment Decisions

Additional considerations in
capital budgeting
Managerial options
extra flexibility can only help a
project
Capital rationing
results from a shortage of funds

Making Capital Investment Decisions

Managerial options
The option to expand (if things go
well)
The option to abandon (if things go
poorly)
The option to wait (conditions may
improve)
Strategic options
Making Capital Investment Decisions

Capital rationing
Soft rationing
due to budget allocation within the
firm, but external financing is
available
Hard rationing
no external or internal capital is
available
Making Capital Investment Decisions