making capital investment decisions 6.1-6.2-6.3-6.4-6.5

Making Capital Investment Decisions

Group 3 :1. Widodo Heru Sulistyo2. Dhamar Wirawan3. Novri Arfan4. Eka Budiyanto5. Rizki Candra Sakti

Making Capital Investment Decision

1. Incremental Cash Flows: The key to capital budgeting

2. The Baldwin company: An example3. Inflation and capital budgeting4. Alternative Definitions of operating cash

flow5. Some special cases of discounted cash

flow analysis

6.1 Incremental Cash Flows: The Key to Capital Budgeting

• Corporate Finance VS Financial Acc.– Corporate finance Cash Flows, NPV– Financial Accounting Income / Earning

numbers• Capital Budgeting Calculation:

– Discount cash flow, not earning– Cash flow that incremental to the project

should be used


• Sunk Cost:– A cost that has already occured– Cannot be changed by the decision–Not incremental cash outflows

• Example: Paid a consulting firm $100,000 for test marketing analysis. This cost is irrelevant for the capital budgeting decision because its not recoverable.


• Opportunity Cost:– Lost potential revenues from other alternative– Forgoes other opprotunities – Incremental cash outflows

• Example:An empty warehouse can be used to store a machine. The price of warehouse is an opportunity cost if the firm sell the warehouse and not to market the machines.


• Side effects:– Erossion: New product reduce sales and cashflows of

existing products– Synergy: New project increases the cash flows of

existing projects

–Incremental cash outflow• Example:

– Erossion: The sell of new convertible sports car will reduce the sell of an old’s sedan.

– Synergy: Formation a racing team will generate great publicity for all products.


• Allocated Costs:– Cost across different project– Should be view as cash outflow of a project

only if it is an incremental cost of the project

• Example:– Library cost will not affect cash flow whether

the proposed project is accepted or not

6.2 The Baldwin Company (An Example)

• Baldwin company: leading producer of ball market (bowling, tennis,golf, football)

• It starts to market the new brightly colored bowling ball (estimated 10% to 15% share)

• For most project, there is a common patern: Investment (generating cash outflows), Income (provide cash inflow), plant & equipment are sold at the end of project/salvage value (more cash inflow).


Investment (Cash Outflow) for 5 years• Buying new bowling ball machine

($100,000)• Using owned building in shanghai (called

an opportunity cost of not selling the warehouse) ( $150,000)

• Net working capital (ex: inventory, account receivable,cash) ($10,000)


CASH FLOW OF BALDWIN COMPANY( $ IN THOUSAND)


Income (Cash Inflow, Taxes)• Production by year in 5 year (units): 5000, 8000, 12000, 10000,6000• The price in the first year is $20, increase

at 2% per year (to anticipate inflation rate 5%).

• First year production cost is $10 per unit, expected to grow at 10% per year.


Income (Cash Inflow, Taxes)• Depreciation of asset initial cost (machine)

is used to calculate income before taxes, it uses Modified Accelerated Cost Recovery System (MACRS).

• Net income is income after tax (34%), its calculation is used for tax books.

• For the stockholder, depreciation can be calculated by using straight line basis.


OPERATING REVENUE & COSTS


DEPRECIATION UNDER MACRS


DEPRECIATION ON STRAIGHT LINE BASIS


Salvage Value• Baldwin plans to sell bowling ball machine

at the end of project (5 year) at $30,000.• After 5 year, its book value is $5,760.• When selling an asset, one must pay

taxes (34%) on the difference between asset sales prices and its book value.

• $30,000 – { 0,34 x ($30,000-$5,760)}• Salvage value is $21,758


Total Cash Flow of project• Depreciation is not calculated• The Formula: cash flow operation (sales -

cost – taxes) + total cash flow investment

6.3 INFLATION AND CAPITAL BUDGETING

Real Interest = Nominal Interset – Inflation Rate


Interest and InflationToday (Date 0)Individual Invest$ 1.000 in bank

Because Hamburger sell for $ 1 at date 0, $ 1.000 would have purchased

1.000 hamburger

Interest rate = 10%

Date 1Individual receive$ 1.100 from bank

Because each Hamburger sells for $ 1,06 at Date 11,038 (=$1.100 / $1,06)

Hamburger can be purchased

Inflation rate has been 6% over year

Real Interest = 3,8%


Real Interest Formula

Real Interest = Nominal Interset – Inflation Rate

𝐑𝐞𝐚𝐥𝐈𝐧𝐭𝐞𝐫𝐬𝐞𝐭=𝟏+𝐍𝐨𝐦𝐢𝐧𝐚𝐥𝐈𝐧𝐭𝐞𝐫𝐬𝐞𝐭 𝐑𝐚𝐭𝐞

𝟏+𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧𝐑𝐚𝐭𝐞 −𝟏

1 + Nominal Interest = (1 + Real Interest ) x (1 + Inflation Rate)

AB


Nominal Cash Flow and Real Cash Flow• Borderless Publishing has just purchased the rights to the next

book of famed romantic novelist• The book should be available to the public in four years.• Currently, romantic novels sell for $10 in softcover

• The publisher belive that inflation will be 6% a year over the next four years.

• Publisher anticipate that prices will rise about 2% per year more than the inflation rate over the next four years.

• Border Publishing plans to sell the novel at $13,6 [=(1,08)4 x $10)

four years from now, anticipating sales of 100.000 copies


The expected cash flow in fourth years of $1,36 million (=$13,6x100.000) is Nominal Cash Flow

Using present value to estimate $1,36 million

$1,08 million expressed in term of purchasing power is

Real Cash Flow


Depreciation Page Publisher, a competitor of Borderless, recently brought a

printing press for $2.000.000 to be depreciated to zero by

straight-line methode over five years.

The depreciation each year is $400.000 (=$2.000.000/5).

$400.000 Real Quantity

Nominal Quantity

Assuming an annual inflation rate of 6%, depreciation in fourth year using present value formula:

$316.837 = [=$400.000/(1,06)4]


Discounting : Nominal or Real

Consistency in capital budgetinga. Nominal cash flow must be

discounted at the Nominal Rateb. Real cash flow must be discounted at

the Real Rate


Sun Electric Case Sun forecast the following nominal cash flow on particular project

The nominal discount rate is 14% and the inflation rate is forecast to be 5%, What is the value of the product?

Answer :Nominal Quantities, the NPV can be calculated as :

Cash Flow0 1 2

-$1.000 $ 600 $ 650


Sun Electric CaseReal Quantities, the real cash flow are these :

Real discount rate is 8,57% NPV can be calculated as :

Cash Flow

0 1 2

-$1.000 $571=

$589=


Angler Inc. The company generated the following forecast for a capital budgeting

product

The CEO, David Ang, estimated Inflation to be 10% per year over the next two years. In addition, he belives that the cash flows of the project should be discounted at nominal rate of 15,5%. His firm’s tax rate is 40%.

Year 0 Year 1 Year 2Capital Expenditure $1.210

Revenue (in real term) $1.900 $2.000

Cash expense (in real term) 950 1000

Depreciation (in real term) 605 605


Mr Ang forecast all cash flow in nominal terms, leading NPV to the following :

NPV calculated as follow :

Year 0 Year 1 Year 2Capital Expenditure -$1.210

Revenue - Expenses - Depreciation

$2.090 (=1.900 x 1,10)-1,045 (=950 x 1,10)-605 (=1.210/2)

$2.420(=2.000 x (1,10)2)-1,210 (=1.000 x (1,10)2)-605

Tax Income - Taxes (40%)

440-176

605-242

Income after sex + Depreciation

264605

363605

Cash Flow 869 968

= $268


The firm’s CFO, Stuart Wee, prefer working in real term with real rate is 5% (=1,155/1,10-1)

NPV calculated as follow :

Year 0 Year 1 Year 2Capital Expenditure -$1.210

Revenue - Expenses - Depreciation

$1.900-950-550 (=605/1,10)

$2.000-1,000-500 (=605/(1,10)2)

Tax Income - Taxes (40%)

400-160

500-200

Income after sex + Depreciation

240550

300500

Cash Flow 790 800

= $268

6.4 ALTERNATIVE DEFINITIONS OF OPERATING CASH FLOW

• In the discussion that follows, keep in mind that when we speak of cash flow, we literally mean dollars in less dollars out.

• For a particular project and year under consideration, suppose we have the following estimates :

Sales : $1,500 ; Cash Cost : $700; Depreciation : $600 With these estimates, earning before tax (EBT) is EBT = Sales – Cash cost – Depreciation = $1,500 - $700 -$600 (6.3) = $200• As is customary in capital budgeting, we assume that no interest is paid, so

the tax bill is : Taxes = (Sales – Cash cost –Depreciation) x tc = EBT x tc = ( $1,500 - $700 -$600 ) x 0.34 = $200 x 0.34 = $68 (6.4) where tc , the corporate tax rate is 34 percentHow do we determined operating cash flow (OCF) ?

THE TOP DOWN APPROACH• Let’s follow the cash. The owner receives sales of $1,500; pays cash cost of

$700 and pays taxes $68. Thus operating cash flows must equal : OCF = Sales – Cash Cost –Taxes = $1,500 -$700 - $68 (6.5) = $732• We call this the top-bottom approaches because we start at the top of

income statement and work our way down to the cash flow by subtracting cost, taxes and other expenses.

• Along the way we left our depreciation. Why? Because depreciation is not cash flow (is an accounting concept)

• Nevertheless, does depreciation play a part in the cash flow calculations? Yes but only indirectly.

• Under the current tax rules, depreciation is deduction, lowering the taxable income. A lower income number leads to lower taxes, which turn leads to higher cash flows

THE BOTTOM UP APPROACH• This is the approach you would have had in an accounting class. First

income is calculated as : Project net income = EBT – Taxes = $200 - $68 = $132 • Next, depreciation is added back, giving us : OCF = Net income + Depreciation = $132 + $600 = $732 (6.6)• Expressing net income in term of its component, we could write OCF more

completely as : OCF = (Sales – Cash cost –Depreciation) x (1 – tc ) + Depreciation = ($1,500 - $700 -$600) x (1 – 0.34) + $600 = $732 (6.6’)• It is crucial to remember that this definition of operating cash flow as net

income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income

• Can we explain intuitively why one should add back depreciation as was done here? . As mentioned above, while depreciation reduces income, depreciation is not cash flow . Thus, one must add depreciation back when going from income to cash flow

THE TAX SHIELD APPROACH• The tax shield approach is just variant of the top down approach . If we plug

the formula of taxes provided in 6.4 into equation 6.5 we get : OCF = Sales – Cash cost –(Sales – Cash cost – Depreciation) x tc Which simplifies to : OCF = ( Sales – Cast cost ) x ( 1 – tc ) + Depreciation x tc (6.7) Where tc is again the corporate tax rate. Assuming that tc = 34%,

OCF works out to be : OCF = ($1,500 - $700 ) x 0.66 + $600 x 0.34 = $528 + $204 =$732• This approach views OCF as having two component. The first part is what

the project’s cash flows would be if there were no depreciation expense. In our example = $528

• The second part of OCF in this approach is the depreciation deduction multiplied by tax rate. This is called the depreciation tax shield.

• The only cash flow effect of deduction depreciation is to reduce our tax. In the example, the $600 depreciation deduction save $600 x 0.34 = $204 tax

THE TAX SHIELD APPROACH (Con’t)

• Student often think that the tax shield approach contradicts the bottom-up approach because depreciation is added back to equation 6.6, but only the tax shield on depreciation is added in equation 6.7

• However, the two formulae are perfectly consistent with each other , an idea most easily seen by comparing equation 6.6’ to equation 6.7.

• Depreciation is subtracted out in the first term on the right hand side of 6.6’ • No comparable subtraction occurs on the right hand side of 6.7. We add the

full amount of depreciation at the end of equation 6.6’ (and at the end of its equivalent , equation 6.6) because we subtracted out depreciation earlier in the equation.

6.5 Some Special Cases of Discounted Cash Flow Analysis • Evaluating cost – cutting proposal• Setting the bid price• Investment of unequal lives: The

equivalent annual cost method

Evaluating Cost – Cutting Proposal

• Considering automating part of an existing production process:– Equipment cost $ 80.000– Automation Saving $ 22.000 (before tax)– Equipment 5 year life (Depreciation straight-

line), Market value in year 5 $ 20.000– Tax rate 34%– Discount rate 10%


• Identifying relevant cash flow:– Initial cost $ 80.000– Salvage value (after tax)

$ 20.000 x (1 - .34) = $ 13.200


• Operating cash flow:– Automation saving = operating income

increases by $ 22.000– Depreciation

$ 80.000 / 5 = $ 16.000 per year– EBIT = Income – Depreciation

$ 22.000 - $ 16.000 = $ 6.000– Tax (from Ebit)

$ 6.000 x .34 = $ 2.040


• Operating cash flow:EBIT $ 6.000- Taxes (2.040)+ Depreciation 16.000Operating Cash Flow $ 19.960


• Relevant cash flow:

• NPV is $ 3.860, go ahead and automate

Year0 1 2 3 4 5

Capital Spending -$80.000 13.200

Operating cash flow $19.960 $19.960 $19.960 $19.960 $19.960

Total cash flow -$80.000 $19.960 $19.960 $19.960 $19.960 $33.160

Disc cash flow -10% -$80.000 $18.145 $16.496 $14.996 $13.633 $20.590

$ 3.860

Setting The Bid Price

• Decide what price to bid 5 modified trucks:– Truck $ 10.000 per truck– Lease facilities $ 24.000 per year– Modification cost $ 4.000 per truck

• Total cost per year:= $ 24.000 + (5 x (10.000+4.000))= $ 94.000


• Decide what price to bid 5 modified trucks:– New equipment $ 60.000 (dep 4 year),

salvage value $ 5.000– Invest raw material & Working capital $ 40.000– Tax rate 39%

• What the bid price per truck, if we want 20% return on investment– Aftertax salvage value

$ 5.000 x (1 - .39) = $ 3.050


• Decide what price to bid 5 modified trucks:

NPV to equal zero= $100.000 – 43.050 / 1,204

= $100.000 – 20.761 = $ 79.239

Year0 1 2 3 4

Capital Spending -$60.000 3.050

Operating cash flow +OCF +OCF +OCF +OCF

Change in NWC -$40.000 $40.000

Total cash flow -$100.000 +OCF +OCF +OCF +OCF + $43.050

Disc cash flow -20% -$79.239 +OCF +OCF +OCF +OCF


• Decide what price to bid 5 modified trucks:NPV to equal zero (PVIA (.02,4) is 2,58873)

NPV = 0 = -$79.239 + OCF x 2.58873OCF = $79.239 / 2,58873 = $ 30.609

Operating cash flow = Net Income + Depreciation$30.609 = Net income + $15.000Net Income = $ 15.609


• Decide what price to bid 5 modified trucks:Sales

Net income = (Sales – Cost – Depc) x (1 –Tax)$15.609 = (Sales - $94.000 - $51.000) x (1 - .39)Sales = $15.609 / .61 + 94.000 + 15.000

= $ 134.589Bid Price

= $ 134.589 / 5= $ 26.918

Investment of unequal lives: The equivalent annual cost method

• Decide betwen 2 machine with diferent operating cost and time period:– Initial cost and maintenance expense each

period:Date

Machine 0 1 2 3 4A $ 500 $ 120 $ 120 $ 120

B $ 600 $ 100 $ 100 $ 100 $ 100


• Decide betwen 2 machine:– Present value, discount rate 10%

Machine A

= $500 + + + = $ 798,42Machine B

= $600 + + + + = $ 916,99

Machine B has higher present value


• Decide betwen 2 machine:– Equivalent annual cost Machine A (disc 10%)• Payment ($500, $120, $120, $120) equivalent

to single payment of $798,42 at date 0• 3 year annuity: $798,42 = C x PVIA (.10,3)• C = $798,42 / 2,4869 = $ 321,05 (annuity pay)

DateMachine A 0 1 2 3 4

Cash outflow $ 500 $ 120 $ 120 $ 120

Equivalent annual cost 321,05 321,05 321,05


• Decide betwen 2 machine:– Equivalent annual cost Machine B (disc 10%)• Payment ($600, $100, $100, $100) equivalent

to single payment of $ 916,99 at date 0• 4 year annuity: $ 916,99 = C x PVIA (.10,4)• C = $ 916,99 / 3,1699 = $ 289,28 (annuity pay)

DateMachine B 0 1 2 3 4

Cash outflow $ 600 $ 100 $ 100 $ 100 $ 100

Equivalent annual cost 289,28 289,28 289,28 289,28

making capital investment decisions 6.1-6.2-6.3-6.4-6.5

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