CHAPTER EIGHT Making capital investment decisions Copyright 2017

Learning objectives LO 8. 1 Understand how to determine the relevant cash flows for

Chapter organisation • • • Project cash flows: a first look Incremental cash flows

Project cash flows • The incremental cash flows for project evaluation consist of any

Types of cash flows • Sunk costs a cost that has already been incurred

Types of cash flows • Financing costs the interest rate used to discount the

Investment evaluation Step 1 Calculate the tax effect of the decision. Step 2 Calculate

Example—Investment evaluation • Purchase price $42 000. • Salvage value $1 000 at end

Solution—Depreciation schedule Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany

Solution—Taxable income Year 0 Net cash flows Depreciation Loss on sale Taxable income Year

Solution—Cash flows Year 0 Year 1 Year 2 Year 3 Tax paid (6 780)

Solution—NPV and decision Cash flow Discount PV cash flow NPV Year 0 Year 1

Interest • As the project’s NPV is positive, the cash flows from the investment

Depreciation • The depreciation expense used for capital budgeting should be the depreciation schedule

Depreciation • There are two methods of depreciation: – prime cost (straight-line method in

Disposal of assets • If the salvage value > book value, a gain is

Capital gains tax • Capital gains made on the sale of assets such as

Inflation • When a project is being evaluated, anticipated inflation would be reflected in

Incremental form of analysis • The description ‘incremental’ is often replaced by ‘marginal’. •

Example—Incremental cash flows A firm is currently considering replacing a machine purchased two years

Solution—Taxable income Year 0 Increased revenues Increased costs Dep’n existing Dep’n new Loss on

Solution—Cash flows Tax Increased revenues Increased costs Salvage values Outlay Cash flow Year 0

Solution—NPV and decision Year 0 Cash flow (260 800) Discount 1 PV of cash

A note on cash flows • Cash flows do not always conveniently occur at

Setting the bid price • How to set the lowest price that can be

Example—Setting the bid price • Consider the following information: – A local distributor has

Example—Setting the bid price Solution: • Step 1: Find the net initial outlay Fixed

Example—Setting the bid price • Assuming that the CF is the same for each

Example—Setting the bid price • Step 3: Find the sale price that gives a

Setting the option value • A buy option is an arrangement that gives the

Annual equivalent cost (AEC) • When comparing two mutually-exclusive projects with different lives, it

Example—AEC • Project A costs $3 000, and then $1 000 per annum for

Solution—Project A Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany

Solution—Project B Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany

Solution—Interpretation ‘Project A is better, because it costs $1 946 per year compared to

Annual equivalent benefit (AEB) • The AEB is used when comparing projects with cash

Quick quiz • How do we determine if cash flows are relevant to the

Summary and conclusions • Discounted cash flow (DCF) analysis is a standard tool in

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Learning objectives LO 8. 1 Understand how to determine the relevant cash flows for a proposed project. LO 8. 2 Understand how to determine if a project is acceptable. LO 8. 3 Understand how to set a bid price for a project. LO 8. 4 Understand how to evaluate the equivalent annual cost of a project. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -2

Chapter organisation • • • Project cash flows: a first look Incremental cash flows Project cash flows More on project cash flows Some special cases of discounted cash flow analysis • Summary and conclusions Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -3

Project cash flows • The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project. • The stand-alone principle is the evaluation of a project based on the project’s incremental cash flows. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -4

Types of cash flows • Sunk costs a cost that has already been incurred and cannot be removed incremental cash flow. • Opportunity costs the most valuable alternative that is given up if a particular investment is undertaken = incremental cash flow. • Side effects erosion the cash flows of a new project that come at the expense of a firm’s existing projects = incremental cash continued flow. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -5

Types of cash flows • Financing costs the interest rate used to discount the cash flows reflects, in part, the financing costs of the project incremental cash flow. • An investment of the firm in the project’s net working capital represents an additional cost of undertaking the investment. • Always use after-tax incremental cash flow, since taxes are definitely a cash flow. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -6

Investment evaluation Step 1 Calculate the tax effect of the decision. Step 2 Calculate the cash flows relevant to the decision. Step 3 Discount the cash flows to make the decision. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -7

Example—Investment evaluation • Purchase price $42 000. • Salvage value $1 000 at end of Year 3. • Net cash flows: Year 1 $31 000 Year 2 $25 000 Year 3 $20 000. • Tax rate is 30%. • Depreciation 20%, reducing balance. • Required rate of return 12%. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -8

Solution—Taxable income Year 0 Net cash flows Depreciation Loss on sale Taxable income Year 1 31 000 (8 400) Year 3 20 000 (5 376) (20 504) $22 600 $18 280 $(5 880) Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. Year 2 25 000 (6 720) 2 -10

Solution—Cash flows Year 0 Year 1 Year 2 Year 3 Tax paid (6 780) (5 484) 1 764 Net cash flow 31 000 25 000 20 000 Salvage value Outlay Cash flow 1 000 (42 000) $24 220 Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. $19 516 $22 764 2 -11

Solution—NPV and decision Cash flow Discount PV cash flow NPV Year 0 Year 1 Year 2 Year 3 (42 000) 1 ($42 000) 24 220 0. 8929 $21 626 19 516 0. 7972 $15 558 22 764 0. 7118 $16 203 $11 387 Decision: NPV > 0, therefore, ACCEPT. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -12

Interest • As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return). • Interest costs should not, therefore, be included as an explicit cash flow. • Interest costs are included in the required rate of return (discount rate) used to evaluate the project. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -13

Depreciation • The depreciation expense used for capital budgeting should be the depreciation schedule required for tax purposes. • Depreciation is a non-cash expense; consequently, it is only relevant because it affects taxes. continued Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -14

Depreciation • There are two methods of depreciation: – prime cost (straight-line method in accounting) – diminishing value (reducing balance method in accounting) • Depreciation tax shield = DT where D = depreciation expense T = marginal tax rate. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -15

Disposal of assets • If the salvage value > book value, a gain is made on disposal. This gain is subject to tax (excess depreciation in previous periods). • If the salvage value < book value, the ensuing loss on disposal is a tax deduction (insufficient depreciation in previous periods). Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -16

Capital gains tax • Capital gains made on the sale of assets such as rental property are subject to taxation. • For taxation purposes, the calculation of a capital gain is complicated and depends upon whether the seller is an individual or an entity, such as a company or trust. • Capital losses are not a tax deduction but can be offset against future capital gains. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -17

Inflation • When a project is being evaluated, anticipated inflation would be reflected in the estimates of the future cash flows and the interest rate used as the discount rate in the analysis. • As a result, there will be no distortion to the analysis by not identifying inflation specifically. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -18

Incremental form of analysis • The description ‘incremental’ is often replaced by ‘marginal’. • The advantage of using a marginal form of analysis is that there will only be one calculation and not two. • By using a marginal form we are implicitly analysing one option: that is, to do nothing. • The sign of the NPV tells us whether or not it is sensible to change. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -19

Example—Incremental cash flows A firm is currently considering replacing a machine purchased two years ago, with an original estimated useful life of five years. The replacement machine has an economic life of three years. Other relevant data is summarised below: Initial cost Annual revenues Annual costs Annual depreciation Salvage value Tax rate Required rate of return Existing machine $240 000 $100 000 $60 000 $48 000 $80 000 (Now) 30% 10% Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. New machine $360 000 $150 000 $70 000 $120 000 $100 000 (End year 3) 2 -20

Solution—Taxable income Year 0 Increased revenues Increased costs Dep’n existing Dep’n new Loss on sale (existing) Gain on sale (new) Taxable income Year 1 Year 2 Year 3 50 000 (10 000) 48 000 (120 000) $(32 000) 100 000 $68 000 (64 000) $(32 000) Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -21

Solution—Cash flows Tax Increased revenues Increased costs Salvage values Outlay Cash flow Year 0 19 200 80 000 (360 000) $(260 800) Year 1 9 600 50 000 Year 2 9 600 50 000 Year 3 (20 400) 50 000 (10 000) 100 000 $49 600 $160 400 Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -22

Solution—NPV and decision Year 0 Cash flow (260 800) Discount 1 PV of cash $(260 800) flow NPV ($54 212) Year 1 49 600 0. 9091 $45 091 Year 2 49 600 0. 8264 $40 989 Year 3 160 400 0. 7513 $120 508 Decision: NPV < 0, therefore, REJECT. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -23

A note on cash flows • Cash flows do not always conveniently occur at the end of the period. • Taking revenue at the period end is a conservative approach to evaluation. • If the facts make it necessary to take cash flows as occurring at the beginning of the period, this only requires a minor adjustment to the analysis. • The period examined could be yearly, monthly or even weekly. If so, the discount rate must match the period (e. g. a weekly analysis needs a weekly rate). Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -24

Setting the bid price • How to set the lowest price that can be profitably charged. • Cash outflows are given. • Determine cash inflows that result in zero NPV at the required rate of return. • From cash inflows, calculate sales revenue and price per unit. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -25

Example—Setting the bid price • Consider the following information: – A local distributor has requested bid for 5 trucks each year for the next 4 years. – You can buy a truck for $12 000. – Need to lease a factory space for $30 000 per year. – Labour and material costs are $ 6 000 per year. – Requires $72 000 in fixed assets (initial outlay) with expected salvage of $5 000 at the end of the project (depreciate straight-line). – Tax rate = 30% continued – Required return = 20% Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -26

Example—Setting the bid price Solution: • Step 1: Find the net initial outlay Fixed assets Less the PV of after tax salvage [5 000(1 -0. 3)/(1+0. 2)4 Net Initial investment 72, 000. 00 1, 687. 89 70, 312. 11 • Step 2: Find the cash inflows (CFs) over the life of the project that makes NPV zero. continued Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -27

Example—Setting the bid price • Assuming that the CF is the same for each year and that it occur at the end of each year, we can write: continued Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -28

Example—Setting the bid price • Step 3: Find the sale price that gives a cash inflow of $27 161 per year. Cash inflow = Profit + Depreciation $27 161 = Profit + ($72 000/4) Profit = $27 161 − $18 000 = $9 161 We know: Profit = (Sales − Costs − Depreciation)(1 − TC) Sales = $9 161/0. 70 + $120 000 + $18 000 = $151 087 Sales per truck = $151 087 / 5 = $30 218 Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -29

Setting the option value • A buy option is an arrangement that gives the holder the right to buy an asset at a fixed price sometime in the future. Option value = Asset value × Probability of the value – Present value of the exercise price × Probability the exercise price will be paid Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -30

Annual equivalent cost (AEC) • When comparing two mutually-exclusive projects with different lives, it is necessary to make comparisons over the same time period. • AEC is the present value of each project’s costs calculated on an annual basis. • NPVs are calculated, and then converted to AECs using the relevant PVIFA (present value interest factor for annuities). • Select the project with the lowest AEC. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -31

Example—AEC • Project A costs $3 000, and then $1 000 per annum for the next four years. • Project B costs $6 000, and then $1 200 for the next eight years. • Required rate of return for both projects is 10 per cent. • Which is the better project? Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -32

Solution—Interpretation ‘Project A is better, because it costs $1 946 per year compared to Project B’s $2 325 per year’. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -35

Annual equivalent benefit (AEB) • The AEB is used when comparing projects with cash inflows and outflows, but with unequal lives. • The steps required to calculate the AEB are the same as those used for AEC. • Select the project with the highest AEB. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -36

Quick quiz • How do we determine if cash flows are relevant to the capital budgeting decision? • What are the different methods for computing operating cash flow, and when are they important? • What is the basic process for finding the bid price? • What is equivalent annual cost, and when should it be used? Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -37

Summary and conclusions • Discounted cash flow (DCF) analysis is a standard tool in the business world. • The information provided for a specific decision may be complex; however, the analysis reduces to three distinct steps: Step 1 Calculate the taxable income Step 2 Calculate the cash flows relevant to the decision Step 3 Discount the cash flows to make the decision. • Cash flows should be identified in a way that makes economic sense. Copyright © 2017 Mc. Graw-Hill Education (Australia) Pty Ltd PPTs to accompany Fundamentals of Corporate Finance 7 e by Ross et al. 2 -38