The document discusses capital investment decision making and cash flow analysis. It provides an example of evaluating a proposed project to produce colored bowling balls. It details the costs, revenues, production quantities, and cash flows over 5 years. It calculates the net present value (NPV) using a discount rate of 15%, which is positive, indicating the project should be accepted. The document also discusses using the equivalent annual cost method to evaluate projects with different lifetimes in real terms.
The document discusses capital investment decision making and cash flow analysis. It provides an example of evaluating a proposed project to produce colored bowling balls. It details the costs, revenues, production quantities, and cash flows over 5 years. It calculates the net present value (NPV) using a discount rate of 15%, which is positive, indicating the project should be accepted. The document also discusses using the equivalent annual cost method to evaluate projects with different lifetimes in real terms.
The document discusses capital investment decision making and cash flow analysis. It provides an example of evaluating a proposed project to produce colored bowling balls. It details the costs, revenues, production quantities, and cash flows over 5 years. It calculates the net present value (NPV) using a discount rate of 15%, which is positive, indicating the project should be accepted. The document also discusses using the equivalent annual cost method to evaluate projects with different lifetimes in real terms.
Corporate Finance Ross, Westerfield, and Jaffe Outline
1. Relevant/incremental cash flows
2. An example 3. The equivalent annual cost method TVM
We need to evaluate a new project using the
TVM technique. That is, we should discount future expected cash flows (specifically, FCFs) back to present time and compare PV to initial costs: whether NPV > 0? Discount cash flows, not earnings. Relevant cash flows
But before we do this, a few notions about
cash flows need to be addressed. The cash flows in the capital-budgeting time line need to be relevant cash flows; that is they need to be incremental in nature. Incremental cash flows: those cash flows that will only occur if the project is accepted. Ask the right question
You should always ask yourself Will this
cash flow occur ONLY if we accept the project? If the answer is yes, it should be included in the analysis because it is incremental. If the answer is no, it should not be included in the analysis because it will occur anyway. Sunk costs
A sunk cost is a cost that has already
occurred regardless of whether the project is accepted. Example: consulting fee for evaluating a project. Sunk costs should not be taken into consideration when evaluating a project. Opportunity costs
Opportunity costs (OCs) are the costs of
giving up the second best use of resources. Example: a vacant land. Opportunity costs should be taken into consideration when evaluating the project. Side effects
Accepting a new project may have side effects.
Erosion occurs when a new project reduces the sales and cash flows of existing projects. Synergy occurs when a new project increases the sales and cash flows of existing projects. Cash flows due to erosion and synergy are incremental cash flows. An example, I
Baldwin Company is considering an investment
project: producing colored bowling balls. The estimated life of the project: 5 years. The cost of test marketing: $250,000. Would be produced in a vacant building owned by the firm; the property can be sold for $150,000 after taxes. The cost of a new machine: $100,000. The estimated market value of the machine at the end of 5 years: $30,000. An example, II
Production by year for the 5-year life: 5,000
units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year: $20. The price of bowling balls will increase at 2% per year. No debt financing; no interest expenses. An example, III
First-year production costs: $10 per unit.
Production costs will increase at 10% per year. Incremental/marginal corporate tax rate: 34%. An initial investment (at year 0) in net working capital: $10,000. NWC at the end of each year will be equal to 10% of sales for that year. NWC at the end of the project is zero. An example, IV Depreciation
Depreciation for tax purpose in the U.S. is based
on the Modified Accelerated Cost Recovery System (MACRS). See Table 6.3 (p. 176) for IRS depreciation schedule. For a 5-year depreciation, the depreciation schedule is: 20% (year 1), 32% (year 2), 19.2% (year 3), 11.5% (year 4), 11.5% (year 5), and 5.8% (year 6). An example, V After-tax salvage cash flow
OCF = sales costs taxes.
The estimated salvage market value of the machine is 30% of $100,000; that is, $30,000. The machine will have been depreciated to 5.8% of $100,000 at that time; that is, $5,800. The taxable amount is $24,200 ($30,000 - $5,800). The after-tax salvage cash flow is: $30,000 (34% $24,200) = $21,772. An example, VI Decision
Ifthe nominal discount rate (cost of equity) is
less than 16%, we accept the project. In other words, if the discount rate is higher than 16%, we have a negative NPV. NPV
The firm uses no debt. Thus the appropriate
discount rate is the cost of equity. Suppose that cost of equity is 15%. NPV = 5473.43 (> 0). An example, VII Alternative definitions of OCF
Inour previous calculation, we used the top-
down approach to compute OCF ( = sales costs taxes). Another 2 alternative methods: the bottom-up method, and the tax shield method. See pp. 186-189. The equivalent annual cost method
This method is useful (1) when one tries to
choose between 2 machines of unequal lives, or (2) whether one should replace an existing machine with a new one. Whereas a general capital budgeting problem is often computed in nominal terms, the equivalent annual cost (EAC) method works best in real terms. Nominal vs. real 2 machines with unequal lives
Revenues per year are the same, regardless
of machine. The nominal discount rate (NR) is 13.3%. The expected inflation rate (E(I)) is 3%. The real discount rate (RR) is 10%. (1 + NR) = (1 + RR) (1 + E(I)) (1 + 13.3%) = (1 + 10%) (1 + 3%). Real cost outflows w/ real discount rate Equivalent annual cost
One needs to use real (nominal) discount rate to
discount real (nominal) cash flows. For A, the EAC is $321.05. 798.42 PV; 3 N; 10 I/Y; CPT PMT. For B, the EAC is $289.28. 916.99 PV; 4 N; 10 I/Y; CPT PMT. B has a lower equivalent annual cost. We should choose B. End-of-chapter
Institute Progressive Tax Reform and More Effective Tax Collection, Indexing Taxes To Inflation. A Tax Reform Package Will Be Submitted To Congress by September 2016