FINA1003 / FINA1310 CORPORATE FINANCE

Faculty of Business and Economics

University of Hong Kong

Tingjun Liu

Set 9: Making Capital Investment Decisions

Key Concepts and Skills
Understand how to determine the relevant cash flows for various types
of proposed investments

Understand the various methods for computing operating cash flow

Understand how to compute project value

Understand the equivalent annual cost of a project

Reading: Chapters 10,2

Relevant Cash Flows

The relevant cash flows for a capital budgeting analysis of a project are
the incremental cash flows

The incremental effect of a project on the firm’s available cash

is the project’s incremental cash flow, or free cash flow

Cash flow that will only occur (or not occur) if the project is accepted

The stand-alone principle allows us to analyze each project in isolation

from the firm simply by focusing on incremental cash flows.
Incremental Cash Flows

Will this cash flow occur ONLY

if we accept this project?

“Yes” “No” “Part of it”

Include the part that

Include the Do not include
occurs because of
cash flow the cash flow
the project
Complexities
Forget sunk costs – costs that have accrued in the past
Include opportunity costs – costs of lost options
Side effects (externalities)
• Positive – benefits to other projects

• Negative – costs to other projects

Changes in net working capital

Do not include financing costs
Consider taxes
Forget Sunk Cost
Sunk cost: any unrecoverable cost for which the firm is already
liable. Sunk cost have been or will be paid regardless of the
decision whether or not to proceed with the project.

Example:
• In 1971 Lockheed sought a federal guarantee for a bank loan
to continue the development of the Tristar airplane. Lockheed
argued that it would be foolish to abandon a project on which
nearly $1 billion had already been spent.
Opportunity Cost
Opportunity cost of using a resource is the value it could have provided in
its best alternative use.

We need to include opportunity costs of using existing

equipment, facilities, etc., even if they are currently idle.

Example: ___________
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid $800,000
to purchase the building last year. The building is worth $900,000
today.
• The store requires no other investments. It can generate
$100,000 cash in perpetuity. Discount rate is 10%. Should the firm
open the store?
Net Working Capital

Current
Liabilities
Current
Assets Net Long-Term
Working
Debt
Capital

Adjust for
Fixed Assets
changes in net
1 Tangible working capital Shareholders’
2 Intangible Equity
Net Working Capital 凈營運資本

• Net Working capital = current assets – current liabilities

Current assets Current liabilities

• Cash • Accounts payables
• Account receivable
• Notes payable
• Inventory
• Interest payable
• Prepaid assets
• Taxes payable
Why Include Changes in NWC
• GAAP requires that sales be recorded on the income statement
when they are made, not when cash is received
• GAAP also requires that we record cost of goods sold when
sales were made, whether or not we have actually paid
suppliers yet
• Finally, a project generally needs some amount of cash on
hand to pay for any expenses that arise. A project may also
need an initial investment in inventories
• Property: as a project winds down, inventories are sold,
receivables are collected, bills are paid, and cash balances can
be drawn down. These activities free up the net working capital
originally invested. So the firm supplies working capital at the
beginning and recovers it toward the end.
Example on Net Working Capital
A firm is considering whether to open a store:
• The firm already owns the building for the store. It paid
$800,000 to purchase the building last year. The building is
worth $900,000 today.
• The store can generate $100,000 cash in perpetuity.
• Discount rate is 10%.

• To start the store, the firm also needs to purchase $200,000

worth of inventory today. Firm has infinite life.
• Should the firm open the store?
Side Effects
Project externalities are indirect effects of the project that may increase or
decrease the profits of other business activities of the firm.

Includes all resulting changes on a firm’s future cash flows caused by

the project

Cannibalization
e.g.
• Releasing iPhone 6s reduces the sales of iPhone 6
• Selling DVD of a movie can erode box office revenues

Cross-selling
e.g.
• Printer sales can increase cartridge sales
• Opening a Disney theme park can increase revenue of selling Disney toys
Financing Costs
Do NOT include cash flows from financing activities
• Such as interest payments, dividends, or principal
repayments
• To avoid double counting
• We will adjust for financing later
Pro Forma Statements and Cash Flow
Capital budgeting relies heavily on pro forma accounting
statements, particularly income statements

Computing cash flows – refresher

• Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF)–
net capital spending (NCS) – changes in NWC
Cash Flows

Operating Cash Flow = Sales – Costs – Taxes

• The “Top-Down” Approach. Three other “definitions” exist.

Cash Flow =

Sales – Costs – Taxes – Capital Spending – 𝚫NWC

Alternative Definitions: Preface
• EBIT (Earnings before Interest and Taxes)

= Sales – Costs - Depreciation

• Taxable Income=EBIT-Interest

• Tax=Taxable Income * Tax Rate (T)

Four “Definitions” of Operating Cash Flows
You may see the following approaches of calculating Operating Cash Flows. They
are the same!
1) Operating Cash Flows = Sales – Costs – Taxes
• The “Top-Down” Approach
earnings before interest and taxes
2) Operating Cash Flows = EBIT – Taxes + Depreciation
• Recall EBIT = Sales – Costs – Depreciation =>
• Costs= Sales – Depreciation-EBIT
• Plug into “Top Down” formula.
Cash Flow
= EBIT – Taxes + Depreciation – Capital Spending – 𝚫NWC

1) Operating Cash Flows = Net Income Before Interest + Depreciation

• The “Bottom-Up” Approach
• Net Income Before Interest = EBIT – Taxes

4) Operating Cash Flows = (Sales – Costs) × (1-T) + Depreciation × T

• The “Tax Shield” Approach
• Assume no interest expenses
Key Points
• Interests are tax deductible
• Depreciation is tax deductible, but does not affect cash
flows
• Don’t be deceived by “Operating Cash Flows = EBIT – Taxes +
Depreciation”
• Capital spending is not tax deductible, but its depreciation is
in subsequent years
• When computing present value, use cash flows, not
accounting earnings
More on Depreciation
The depreciation expense used for capital budgeting should be
the depreciation schedule required by the IRS for tax purposes

Depreciation itself is a non-cash expense; consequently, it is

only relevant because it affects taxes

Depreciation tax shield = Depreciation x Tax Rate

Computing Depreciation
Straight-line depreciation
• D = (Initial cost – salvage) / number of years

• Very few assets are depreciated straight-line for tax purposes

MACRS (Modified Accelerated Cost Recovery System)

Chapter 10.7
• Need to know which asset class is appropriate for tax purposes

• Multiply percentage given in table by the initial cost

• Depreciate to zero
Example for Pro Forma Income Statement

Suppose we can sell 50,000 cans of shark attractant per year at

a price of $4 per can. It costs $2.50 to produce one can. The
product has a 3-year life. We require 20% return on new products.

The fixed cost for the project is $12,000 per year. We need to
invest a total of $90,000 in manufacturing equipment, which will
be 100% depreciated over the 3-year life of the project. After 3
years, the equipment has zero market value. Assume the project
needs an initial $20,000 investment in net working capital, and
the tax rate is 34%.
Pro Forma Financial Statements and Cash Flows
New Project: Selling Shark Attractant

• Sales volume = 50,000 cans/year

• Unit price = $4/can
• Unit cost = $2.50/can
• Project life = 3 years
• Fixed cost = $12,000/year
• One-time capital spending = $90,000
• Depreciation: straight-line over 3 years to
zero
• Salvage value = $0
• Initial investment in NWC = $20,000
• Tax rate = 34%
• Required rate of return = 20%
Table 10.1 Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
Table 10.5 Projected Total Cash Flows
Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in -$20,000 20,000
NWC
NCS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

OCF = NI + depreciation = 21,780 + 30,000 = 51,780 ; or

OCF = EBIT + depreciation – taxes
= 33,000 + 30,000 – 11,220 = 51,780 Back
Table 10.2 Projected Capital Requirements
Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000
∆NWC -$20,000 0 0 +$20,000
NFA 90,000 60,000 30,000 0
Depreciatio
30,000 30,000 30,000
n
∆NCS -90,000 0 0 0

∆NWC of year1= NWC of year 1 - NWC of year 0 = $20,000 - $20,000 = 0

∆NCS of year1= NFA of year 1 + depreciation of year 1 - NFA of year 0
= 30,000 + 60,000 - 90,000
Making The Decision
Now that we have the cash flows, we can apply the
techniques that we learned in Chapter 9
Enter the cash flows into the calculator and compute NPV
and IRR
• CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1

• NPV; I = 20; CPT NPV = 10,648

• CPT IRR = 25.8%

Should we accept or reject the project?

After-tax Salvage
If the salvage value is different from the book value of
the asset, then there is a tax effect
Book value = initial cost – accumulated depreciation
After-tax salvage = salvage – Tax (salvage – book value)
• After tax salvage = Salvage (1 - Tax) only if the book
value =0
Example of Project Cash Flows
A machine purchased for $1,000,000 with a life of 10 years
generates annual revenues of $300,000 and incurs operating
expenses of $100,000. Assume that the machine will be
depreciated over 10 years using straight-line depreciation. The
corporate tax rate is 40%.

What are the accounting earnings? What are the cash flows?
What is the NPV?
Example of Project Cash Flows

Recall
• Use cash flows. Accounting earnings do not accurately reflect the
actual timing of cash flows
Example: Depreciation and After-tax Salvage

You purchase equipment for $100,000, and it costs

$10,000 to have it delivered and installed. Based on
past information, you believe that you can sell the
equipment for $17,000 when you are done with it in
6 years. The company’s marginal tax rate is 40%.
What is the depreciation expense each year and the
after-tax salvage in year 6 for each of the following
situations?
Example: Straight-line

Suppose the appropriate depreciation schedule is

straight-line
• D = (110,000 – 17,000) / 6 = 15,500 every year for 6
years
• BV in year 6 = 110,000 – 6(15,500) = 17,000

• After-tax salvage = 17,000 - .4(17,000 – 17,000) =

17,000
Example: Three-year MACRS

Year MACRS D BV in year 6 =

percent 110,000 – 36,663 –
1 .3333 .3333(110,000) = 48,895 – 16,291 –
36,663 8,151 = 0
2 .4445 .4445(110,000) =
48,895 After-tax salvage
= 17,000 -
3 .1481 .1481(110,000) = .4(17,000 – 0) =
16,291 $10,200
4 .0741 .0741(110,000) =
8,151
Example: Seven-Year MACRS
Year MACRS D BV in year 6 =
Percent
110,000 – 15,719 –
1 .1429 .1429(110,000) = 26,939 – 19,239 –
15,719
13,739 – 9,823 –
2 .2449 .2449(110,000) =
26,939 9,812 = 14,729
3 .1749 .1749(110,000) =
19,239 After-tax salvage
4 .1249 .1249(110,000) = = 17,000 –
13,739 .4(17,000 –
5 .0893 .0893(110,000) = 14,729) =
9,823 16,091.60
6 .0892 .0892(110,000) =
9,812
Example: Replacement Problem

Original Machine New Machine

• Initial cost = 100,000 • Initial cost = 150,000

• Annual depreciation = • 5-year life

9,000 • Salvage in 5 years = 0
• Purchased 5 years ago • Cost savings = 50,000 per
• Book Value = 55,000
year
• Straight-line depreciation
• Salvage today = 65,000
Required return = 10%
• Salvage in 5 years =
10,000 Tax rate = 40%

• Straight-line depreciation
Replacement Problem – Computing Cash Flows

Remember that we are interested in incremental

cash flows
If we buy the new machine, then we will sell the
old machine
What are the cash flow consequences of selling the
old machine today instead of in 5 years?
Replacement Problem

Incremental Capital Spending

Buy new machine = 150,000 (outflow)

Sell old machine = 65,000 - 0.4(65,000 – 55,000)

= 61,000 (inflow)

Net capital spending

=150,000–61,000 SV BV
=89,000(outflow)
Replacement Problem
Incremental Operating Cash Flow

relevant
Replacement Problem

Incremental After-Tax Salvage

Net Salvage Value on new machine
= 0 - 0.4(0 -0)
=0
SV BV
Net Salvage Value on old machine
= 10,000 - 0.4(10,000 – 10,000)
= 10,000
This is an opportunity cost because we no
longer receive this at Year 5

Terminal CF = -10,000
 Replacement Problem
Year 0 1 2 3 4 5

Capital -89,000
Spending

OCF 38,400 38,400 38,400 38,400 38,400

SV (New) 0
SV (Old) -10,000

∆NWC 0 0

NCF -89,000 38,400 38,400 38,400 38,400 28,400

Replacement Problem
• Now we can compute the NPV
• NPV = 50,357

• Should the company replace the equipment?

 New Machine Old Machine New - Old

Year 0 -150,000 -[65,000 - 0.4(65,000 – -89000

55,000)] = -61000
Year 1 (50000-30000)(0.6) (0-9000)(0.6) 38400
+30000=42000 +9000=3600

Year 2 42000 3600 38400

Year 3 42000 3600 38400

Year 4 42000 3600 38400

Year 5 42000 3600 38400

Year 5 0 3600+10000-(10000 – -10000

10000)(0.4)=10000
NPV@10% 15546.44 -41143.95 56690.39
Example: Cost Cutting
Your company is considering a new computer system that will
initially cost $1 million. It will save $300,000 per year in
inventory and receivables management costs. The system is
expected to last for five years and will be depreciated using 3-
year MACRS. The system is expected to have a salvage value
of $50,000 at the end of year 5. There is no impact on net
working capital. The marginal tax rate is 40%. The required
return is 8%.
Comprehensive Problem Exercise
A $1,000,000 investment is depreciated using a seven-
year MACRS class life. At time 0, it requires $150,000 in
additional inventory and increases accounts payable by
$50,000. It will generate $400,000 in revenue and
$150,000 in cash expenses annually, and the tax rate is
40%. What is the incremental cash flow in years 0, 1, 7,
and 8?
Equivalent Annual Cost
Projects of Unequal Lives
The Question
• Consider a factory which must have an air cleaner. The
equipment is mandated by law, so there is no “doing without”
even though the NPV is negative.
• One choice is “Cheapskate cleaner” that costs $1,000 today,
has annual operating cost of $500 and lasts for 3 years.
Assume operating costs occur at the end of the year. The
following depicts the costs (cash outflows) for one life cycle of
it.
• Suppose the factory also has access to “Cadillac Cleaner”
which costs $2500 today, has annual operating cost of $100
and lasts for 4 years. Which one is better?
• Assume factory has infinite life and discount rate r=10%.

$1,000 500 500 500

0 1 2 3 4 5 6 7 8 9 10
How to make the decision
• Compare the initial cost?
• Compare PV in one life cycle?
• Compare average PV per year?
• Or something else?
How to make the decision (cont)
• Compare PV in one life cycle?
1000+500/1.1+500/(1.1*1.1)+500/(1.1*1.1*1.1)=2243.4
2500+100/1.1+100/(1.1*1.1)+100/(1.1*1.1*1.1)+100/(1.1*1.1*
1.1*1.1)=2817.0
Problem: ignores the cleaner’s lifetime.
• Compare average PV per year?
2243.4/3= 747.8, 2817/4=704.2
Problem: can not take simple average.
Example 1
• Assume the factory decides to use the “Cheapskate cleaner”
forever. Recall the factory has infinite life such that the costs
continue forever. The following depicts the costs (cash
outflows) for the first 10 years.
• What is the PV of all costs?

$1,000 500 500 1500 500 500 1500 500 500 1500 500

0 1 2 3 4 5 6 7 8 9 10
Note to Example 1
• It is a combination of (1) a standard PV calculation of cash
flows with finite periods, and (2) perpetual cash flows
Solution Method One
• Form 3 groups.
• Group 1: initial cost at time 0.
• PV=$1000.
• Group 2: perpetuity of $500.
• PV=$500/0.1=$5000.
• Group 3: “perpetuity” of $1000, once every 3 years, starting
3 years later.
PV of Group 3
• A standard perpetuity if treating 3 years as a single period.

$1000
PV = = $3021.1
(1 + 0.1) − 1
3
Total PV
• PV is additive.
Total PV=$1000+$5000+$3021.1
=$9021.1
Solution Method Two
(If annual operating costs different)
• Form 4 groups.
• Group 1: cost at time 0.
• PV=$1000.
• Group 2: costs at times 1,4,7,…
• Group 3: costs at times 2,5,8,…
• Group 4:costs at times 3,6,9,…
PV of Group 2
• Recall group 2 includes times 1,4,7,…
• A standard perpetuity if treating 3 years as a single period and
standing at time -2.
• Convert the above PV to time 0.

$500
PV (standing at time -2) =
(1 + 0.1)3 − 1
$500
PV (standing at time 0) = (1 + 0.1) 2
= $1827.8
(1 + 0.1) − 1
3
PV of Group 3
• Recall group 3 includes times 2,5,8,…
• A standard perpetuity if treating 3 years as a single period and
standing at time -1.
• Convert the above PV to time 0.

$500
PV (standing at time -1) =
(1 + 0.1)3 − 1
$500
PV (standing at time 0) = (1 + 0.1) = $1661.6
(1 + 0.1) − 1
3
PV of Group 4
• Recall group 3 includes times 3,6,9,…
• A standard perpetuity if treating 3 years as a single period.
• No need to go to a different time!

$1500
PV = = $4531.8
(1 + 0.1) − 1
3
Total PV
• PV is additive.
Total PV=$1000+$1827.8+$1661.6+$4531.8
=$9021.2
Solution Method Three
(If Annual Operating Costs different and
Cycle Long)

• The entire stream of cash flows are infinite repetition of

cash flows of a cycle.
PV of a Cycle of Cash flows
$1,000 500 500 500

0 1 2 3

$500 $500 $500

PV = $1000 + + +
1 + 0.1 (1 + 0.1) 2
(1 + 0.1)3
= $1000 + $454.5 + 413.2 + $375.7 = $2243.4
or :
$500 1
PV = $1000 + [1 − ] = $2243.4
0.1 (1 + 0.1) 3
Total PV
$2243.4 $2243.4 $2243.4 $2243.4

0 1 2 3 4 5 6 7 8 9 10
• A standard perpetuity if treating 3 years as one period and
standing at time -3

$2243.4
PV (at time -3) =
(1 + 0.1) − 1
3

$2243.4
PV (at time 0) = (1 + 0.1) = $9021.0
3

(1 + 0.1) − 1
3
Recap Method Three Graphically
• Infinite repetition of cash flows in cycles of 3 years.
• Group cash flows within each cycles together.
• Replace cash flows in a cycle starting at t by a single cash
flow of $2243.4 at time t.

1000 500 500 500 1000

500
$1,000 500 500 500 1000 500 500 500

0 1 2 3 4 5 6 7 8 9 10
Example 2 (1/3)
• Now suppose that in addition to “Cheapskate Cleaner”, the
factory also has access to “Cadillac Cleaner”.
• The factory can use one cleaner forever, or they can switch
between them at any point (for simplicity we assume
switching can be done only at the end of a complete cycle).
Example 2 (1/3)
• Example 2 continues from example 1.
• Suppose that in addition to “Cheapskate Cleaner”, the
factory also has access to “Cadillac Cleaner” which costs
$2500 today, has annual operating cost of $100 and lasts
for 4 years.
• The factory can use one cleaner forever, or they can switch
between them at any point (for simplicity we assume
switching can be done only at the end of a complete cycle).
Example 2 (2/3)
• There are infinite possible plans. For example, the
following lists 4 of the possible plans.
• use Cheapskate forever.
• use Cadillac forever.
• use Cheapskate for 2 cycles then Cadillac forever.
• use Cheapskate for one cycle then Cadillac for one cycle,
keep switching after each cycle. The following lists the
cash outflows in this situation for illustrative purposes.
2500 100 100 100 100
2500
$1,000 500 500 500 1000 500 500 500

0 1 2 3 4 5 6 7 8 9 10
Example 2 (3/3)
• Question: What is the optimal plan, among the infinite
possibilities, that minimizes the PV of costs?
• If you have trouble with a rigorous proof, try to guess the answer
and give a qualitative argument to support your answer.
Heuristic Solution
• This is an example of investments of unequal lives.
• Let’s first calculate PV from possibility 2: always use Cadillac.
• PV of a cycle: $2500+$100/0.1[1-1/1.14]=$2817.0
• Total PV: [$2817.0/(1.14-1)]*1.14 =$8886.8
• Total PV is less than always using Cheapskate.
• Qualitatively, Cadillac is cheaper than Cheapskate “on
average”. Therefore, the best plan is to always use Cadillac.

$2817.0 $2817.0 $2817.0

0 1 2 3 4 5 6 7 8 9 10
Rigorous Solution: Difficulties
• Need to show the optimal plan has a smaller PV than all
other plans.
• Two cleaners have different life cycles.
• Comparison with plan 4 as an example.
 Compare Optimal Plan with Plan 4
• Difficulties: one stream does not obviously dominate the
other.
• Causes: Cash flow size changes within each stream.
2500 100 100 100 100
$2,500 100 100 100 100 2500 100 100

0 1 2 3 4 5 6 7 8 9 10
2500 100 100 100 100
2500
$1,000 500 500 500 1000 500 500 500

0 1 2 3 4 5 6 7 8 9 10
Overcoming the Difficulties
• Solution: “equalize” the cash flows within a cycle then
compare.
• Details of cash flow distribution not important, as long as PV
is the same.
The Equivalent Annual Cost Method
• The Equivalent Annual Cost is the value of the level payment
annuity that has the same PV as our original set of cash flows.
Equivalent Annual Cost: Cheapskate
EACch 1
[1 − ] = $2243.4
0.1 (1 + 0.1) 3

EACch = $902.1
$1,000 500 500 500

0 EAC EAC EAC

Equivalent Annual Cost: Cadillac
EACca 1
[1 − ] = $2817.0
0.1 (1 + 0.1) 4

EACca = $888.7
$2500 100 100 100 100

0 EAC EAC EAC EAC

 Compare Optimal Plan with Plan 4
• The comparison is straightforward using Equivalent Annual
Costs.

0 888.7 888.7 888.7 888.7

0 888.7 888.7 888.7 888.7 0 888.7 888.7

0 1 2 3 4 5 6 7 8 9 10
0 888.7 888.7 888.7 888.7
0
0 902.1 902.1 902.1 0 902.1 902.1 902.1

0 1 2 3 4 5 6 7 8 9 10
A Rigorous Proof
• With access to both cleaners, for any possible plan, the
cash outflow at any time is either EACca or EACch.
• Since EACca < EACch, the plan to always use Cadillac,
which corresponds to a perpetual cash outflow of EACca, is
the least expensive.
The Equivalent Annual Cost Method
• We may be tempted to conclude that the cheaper
alternative is better
• Requires a much smaller initial investment
• However, Cadillac cleaner has less operating costs
and lasts longer.
• Key for making the optimal decision is to put them on
equal footing
• Compute an equivalent annual cash flow. A powerful method.
• This is the correct way to “average” PV.
Comparing with Simple Average Method

• Suppose “Cheapskate cleaner” lasts for 1 year. It

costs nothing today, has annual operating cost of
$1100.
• Suppose “Cadillac Cleaner” lasts for 2 years. It
costs nothing today. First year cost is $1100 and
second year cost is $1210.
• What does the simple average comparison say?
• What is the EAC comparison?
• Which one makes sense?
Summary and conclusions of chapter 10
Only incremental cash flows should be included. The stand-alone principle
applies.

Cash flows = Operating Cash Flow (OCF) + Change in NWC + Net capital
spending.

interest expense is not considered part of the cash flow, because it is a financing
cost, not an operating cost.

Evaluating a project

Replacement Problem

Equivalent Annual Cost Analysis