Chapter 10: Making Capital Investment Decisions

Question 1

Incremental cash flows

Answer 1

The difference between a firm’s future cash flows with a project and without the project.

Orrrr

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 taking the project.

Question 2

The general principle is simple enough; a relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a

Answer 2

direct consequence of the decision to take that project

Question 3

Incremental cash flows General Definition

Answer 3

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 taking the project.

Question 4

Important implication to the incremental cash flow

Answer 4

Any cash flow that exists regardless of whether or not a project is undertaken is not relevant in our project evaluation.

Question 5

Stand-alone principle

Answer 5

Evaluation of a project based on the project’s incremental cash flows

In summary: once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of mini firm with its own future revenues and costs, its own assets, and its own cash flows

Question 6

Sunk Costs

Answer 6

A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

The firm has to pay this no matter what

Example: Plane tickets already purchased, non-refundable items

Sometimes overhead cost is a sunk cost

NOT RELEVANT TO DECISION MAKING

Question 7

Opportunity Costs

Answer 7

The most valuable alternative that is given up if a particular investment is undertaken.

Example: Going to school means giving up working for 8 hours and getting paid

Question 8

Erosion

Answer 8

The portion of cash flows of a new project that come at the expense of a firm’s existing operations.

Example: Shoppers Drug Mart adding a fresh food section knowing customers of Super Store may stop shopping there and going to Shopper (even though both are owned by the same company)

Erosion is relevant only when the sales would not otherwise be lost.

For example, one of Walt Disney’s concerns when it built Euro Disney was that the new park would drain visitors from the Florida park, a popular vacation destination for Europeans.

Question 9

Beneficial Side Effects

To see Negative Side Effects visit the Erosion Slide

Answer 9

For example, you might think that Hewlett-Packard (HP) would have been concerned when the price of a printer that sold for $500 to $600 in 2003 declined to below $100 by 2014, but they weren’t.

What HP realized was that the big money is in the consumables that printer owners buy to keep their printers going, such as ink-jet cartridges, laser toner cartridges, and special paper. The profit margins for these products are substantial.

Question 10

Net Working Capital

Answer 10

For example, a project generally needs some amount of cash on hand to pay any expenses that arise.

In addition, a project needs an initial investment in inventories and accounts receivable (to cover credit sales)

The firm supplies working capital at the beginning and recovers it toward the end.

Question 11

Financing Costs

Answer 11

In analyzing a proposed investment, we DO NOT include interest paid or any other financing costs such as dividends or principal repaid

Why? Because we are interested in the cash flow generated by the assets from the project

Question 12

Inflation

Answer 12

Because capital investment projects generally have long lives, price inflation or deflation is likely to occur during the project’s life

Rates including inflation premiums are called nominal rates

Given that nominal rates include an adjustment for expected inflation, cash flow estimates must also be adjusted for inflation

Question 13

Capital Budgeting and Business Taxes in Canada

Answer 13

In Canada, various levels of government commonly offer incentives to promote certain types of capital investment that will stimulate the economy. These include grants, investment tax credits, more favourable rates for capital cost allowance (CCA), and subsidized loans

Question 14

Capital cost allowance (CCA)

Answer 14

Depreciation for tax purposes, not necessarily the same as depreciation under IFRS; depreciation method under Canadian tax law allowing for the accelerated write-off of property under various classifications.

Question 15

Other Issues

Answer 15

First, we are interested only in measuring cash flow, and more specifically, measuring it when it actually occurs, not when it arises in an accounting sense.

Second, we are always interested in after-tax cash flow since tax payments are definitely a relevant cash outflow.

Question 16

In calculating the cash flows, we make several simplifying assumptions to avoid bogging down in technical details at the outset

Answer 16

First, we use straight-line depreciation as opposed to capital cost allowance. We also assume that a full year’s depreciation can be taken in the first year.

In addition, we construct the example so the project’s market value equals its book cost when it is scrapped

Question 17

Pro forma financial statements

Projections

Answer 17

Financial statements projecting future years’ operations.

To prepare these statements, we need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We also need to know the total investment required, including any investment in net working capital.

Question 18

Example of a pro forma financial statement

Answer 18

Sales (50,000 units at $4.30/unit) 215,000

Variable costs (50,000 units at $2.50/unit) 125,000
————-
Gross profit $ 90,000

Fixed costs $ 12,000

Depreciation ($90,000/3) 30,000
————-
EBIT $ 48,000

Taxes (40%) 19,200
————–
Net income $ 28,800

*Do NOT deduct any interest, it is a financing expense and not an operating cash flow component

Question 19

Cash flow from assets has three components:

Answer 19

1) operating cash flow,
2) capital spending,
3) additions to net working capital

Question 20

Project cash flow =

equation

Answer 20

Project Operating Cash Flow - Project additions to net working capital - Project capital spending

Question 21

PROJECT OPERATING CASH FLOW

Operating cash flow =

Answer 21

Earnings before interest and taxes (EBIT) + Depreciation - Taxes

To determine the operating cash flow associated with a project, recall the definition of operating cash flow:

Question 22

If net working capital is negative, what does this mean?

Answer 22

We had freed up $XX during the year

Therefore, you would add this to your total cash flow

Question 23

In general, cash income is

equation

Answer 23

sales - increase in accounts receivable.

Question 24

Accounting depreciation is a _____________

Answer 24

non-cash deduction

Question 25

Remember that an increase in net working capital is a cash ________ and a decrease in net working capital is a cash _______

Answer 25

outflow

inflow

a negative sign shows working capital returning to the firm

Question 26

As we see, the different definitions of operating cash flow all measure the ________

Answer 26

same thing.

Question 27

Acronyms explained

Answer 27

OCF = Project Operating Cash Flow
S = Sales
C = Operating Costs
D = Depreciation for tax purposes (I.E CCA)
Tc = Corporate Tax Rate

Question 28

Given OCF, S, C, D, and Tc, how do you find EBIT?

Answer 28

EBIT = S - C - D

Question 29

Project operating cash flow (OCF) =

Equation

Answer 29

EBIT + D - Taxes

Question 30

Project Net Income =

Equation

Answer 30

EBIT - Taxes

Question 31

Bottom-Up Approach

Bottom Up

Answer 31

OCF = (S - C - D) + D - (S - C- D) x Tc
= (EBIT) x (1-Tc) + d
= Project net income + Depreciation

Question 32

The Top-Down Approach

Top Down

Answer 32

OCF = (S - C) - (S - C - D) x Tc

= Sales - Costs - Taxes

Question 33

The Tax Shield Approach

Answer 33

OCF = (S - C - D) + D - (S - C - D) x Tc

= (S - C) x (1 - Tc) + D x Tc

Question 34

The Tax Shield Approach views OCF as having two components

Answer 34

The first part, (S - C ) x (1 - Tc) is what the project’s cash flow would be if there were no depreciation expense

The second part of OCF in this expression, D x Tc , is called the depreciation (CCA) tax shield

Question 35

Depreciation (CCA) tax shield

Answer 35

Tax saving that results from the CCA deduction, calculated as depreciation multiplied by the corporate tax rate.

Question 36

Present Value of the Tax Shield on CCA

Answer 36

Further time savings are possible by using a formula that replaces the detailed calculation of yearly CCA.

The formula is based on the idea that tax shields from CCA continue in perpetuity as long as there are assets remaining in the CCA class

The formula applies when the CCA asset class (or pool) will remain open when the project is completed

If, however, in a special case, we find that the pool will be closed out at the end of the project’s life, we should not use this formula

Question 37

If there is a terminal _____ (i.e., the salvage value is less than this UCC), then there is a further tax shield when the asset is sold.

Answer 37

loss

Question 38

If there is a ____ (i.e., the salvage value is greater than this UCC), then there will be a recapture of a portion of the tax savings

Answer 38

Gain

Question 39

To use the Present Value of the Tax Shield on CCA you need the following

Answer 39

I = Total Capital investment in the asset that is added to the pool

d = CCA Rate for the asset class 
Tc = Company's marginal tax rate
r = Discount Rate
Sn = Salvage or disposal value of the asset in year n
Mn = Asset life in years

Question 40

Salvage Value versus UCC

Answer 40

When an asset is sold, the difference between its salvage value and ending UCC is not realized as gain or loss on the statement of comprehensive income immediately

Hence, the formula solution is more accurate as it takes into account the future CCA on this difference.

Question 41

Evaluating Cost-Cutting Proposals

Answer 41

One decision we frequently face is whether to upgrade existing facilities to make them more cost-effective. The issue is whether the cost savings are large enough to justify the necessary capital expenditure.

As always, the initial step in making this decision is to identify the relevant incremental cash flows.

First, determining the relevant capital spending is easy enough

Second, there are no working capital consequences here, so we don’t need to worry about additions to net working capital.

Operating cash flows are the third component

Question 42

Replacing an Asset

Answer 42

Instead of cutting costs by automating a manual production process, companies often need to decide whether it is worthwhile to enhance productivity by replacing existing equipment with newer models or more advanced technology

Question 43

Evaluating Equipment with Different Lives

Answer 43

The next problem we consider involves choosing among different possible systems, equipment, or procedures with different lives

As always, our goal is to maximize net present value

Equivalent annual cost (EAC) is often used as a decision-making tool in capital budgeting when comparing projects of unequal life spans.

This approach is necessary only when two special circumstances exist.

1) First, the possibilities under evaluation have different economic lives.
2) Second, and just as important, we need whatever we buy more or less indefinitely. As a result, when it wears out, we buy another one.

Question 44

Equivalent annual cost (EAC).

Answer 44

The present value of a project’s costs calculated on an annual basis.

Question 45

Setting the Bid Price

Answer 45

A somewhat different and very common scenario arises when we must submit a competitive bid to win a job. Under such circumstances, the winner is whoever submits the lowest bid.

Question 46

Winner’s curse

Answer 46

In other words, if you win, there is a good chance that you underbid.

Question 47

Do we include side effects?

Answer 47

Hell yeah

Question 48

Do we include changes in net working capital?

Answer 48

Hell yeah

Question 49

Do we include changes in financing costs?

Answer 49

Are not included, no sir!

How we choose to finance the project is a separate questions

Question 50

Do we include changes in inflation?

Answer 50

Not directly taken into account - we do not include it directly

But is taken into account in the required return

Question 51

Do we include depreciation?

Answer 51

We don’t include it as it is non-cash

Question 52

Do we include Capital Cost Allowance (CCA)

AKA the Tac shield

Answer 52

This is depreciation for tax purposes, so yes

This is an incremental cash flow we take into account for NPV

Question 53

Pro Forma Statement Run Down

Answer 53

Cash Flow From Assets (CFFA) = Operating Cash Flow - Net Capital Spending - Changes in NWC

Question 54

Operating cash flow (OCF) =

Answer 54

EBIT + Depreciation - Taxes

Question 55

Changes in NWC =

Answer 55

Ending NWC - Beginning NWC

Question 56

Net Capital Spending (NCS)

Answer 56

Ending fixed assets - beginning net fixed assets + depreciation

Question 57

Declining Balance

Answer 57

Multiplying percentage given in CCA table by the undepreciated capital cost (UCC), consider half-year rule

Question 58

Straight-line depreciation

Answer 58

(Initial cost - salvage) / number of years

No half year rule