FIN 3403 — Unit 9: Making Capital Investment Decisions

Relevant Cash Flows: What are relevant cash flows?

Cash flows that occur ONLY if a project is accepted.

Trigger: Project changes future cash flow → Relevant.

Incremental Cash Flows: What are incremental cash flows?

Changes in a firm's future cash flows directly caused by accepting a project.

Stand-Alone Principle: What does the stand-alone principle mean?

Evaluate each project independently by focusing only on its incremental cash flows.

Opportunity Costs: What are opportunity costs?

Cash flows given up by choosing a project instead of the best alternative.

Example: Using a warehouse you could rent out.

Trigger: Forgone alternative income → Include.

Sunk Costs: What are sunk costs?

Costs already incurred that cannot be recovered.

Example: Money previously spent on research.

Trigger: Already spent → Exclude.

Financial Costs: Should interest and dividends be included in project cash flows?

No. Financing costs are reflected in the discount rate (WACC), not project operating cash flows.

Side Effects: What are positive and negative side effects?

Positive: A project increases sales of another product.

Negative: A project reduces sales of an existing product (cannibalization).

Both should be included when incremental.

Net Working Capital: What is NWC?

NWC = Current Assets − Current Liabilities.

Represents funds tied up in short-term operations.

Change in NWC: How do you calculate ΔNWC?

ΔNWC = New NWC − Old NWC.

An increase in NWC generally represents a cash outflow.

ΔNWC = New NWC − Old NWC.

An increase in NWC generally represents a cash outflow.

The invested NWC is generally recovered as a cash inflow.

Trigger: Beginning → Outflow; Ending → Recovery.

OCF: What is operating cash flow?

Cash generated by a project's normal business operations.

Common Approach: What is the common OCF formula?

OCF = EBIT + Depreciation − Taxes.

Bottom-Up Approach: What is the bottom-up OCF formula?

OCF = Net Income + Depreciation.

Note: Works when there are no interest expenses.

Top-Down Approach: What is the top-down OCF formula?

OCF = Sales − Cash Costs − Taxes.

Do not subtract depreciation as a cash cost.

Tax-Shield Approach: What is the tax-shield OCF formula?

OCF = (Sales − Cash Costs)(1 − T) + Depreciation × T.

T = Tax rate.

OCF Calculation: EBIT = $400, depreciation = $3,600, taxes = $60. Find OCF.

OCF = $400 + $3,600 − $60

= $3,940

OCF Methods: Should all four OCF approaches produce the same answer?

Yes, when applied correctly using consistent assumptions.

Pro Forma Statements: What are pro forma financial statements?

Financial statements that forecast a company's future financial performance.

Trigger: Projected future income → Pro forma.

Depreciation: What is depreciation?

Allocation of an asset's cost over its useful life.

It is a non-cash expense.

Depreciation Tax Shield: Why is depreciation relevant to cash flow?

Because depreciation reduces taxable income, lowering taxes paid.

Depreciation Tax Shield: What is the formula?

Depreciation Tax Shield = D × T.

D = Depreciation expense.

T = Tax rate.

Straight-Line Depreciation: What is the formula?

D = (Initial Cost − Ending Book Value) / Number of Years.

Straight-Line Example: An asset costs $110,000 and has a $17,000 ending book value after 6 years. Find annual depreciation.

($110,000 − $17,000) / 6

= $15,500 per year

MACRS: What does MACRS stand for?

Modified Accelerated Cost Recovery System.

Used to calculate depreciation for tax purposes.

MACRS Calculation: How do you calculate annual depreciation?

Depreciation = Depreciable Basis × MACRS Rate.

MACRS Mid-Year Convention: Why does a 3-year MACRS asset depreciate over 4 years?

Because the half-year convention spreads depreciation across an additional tax year.

MACRS 3-Year Rates: What are the approximate rates from your example?

Year 1: 33%

Year 2: 45%

Year 3: 15%

Year 4: 7%

MACRS vs. Straight-Line: What is the difference?

Straight-line: Equal depreciation each year.

MACRS: Accelerated depreciation, generally larger deductions in earlier years.

Book Value: What is the formula?

Book Value = Initial Cost − Accumulated Depreciation.

Salvage Value: What is salvage value?

The estimated amount received from selling an asset at the end of its useful life.

After-Tax Salvage: What is the formula?

After-Tax Salvage = MV − T(MV − BV).

MV = Market Value.

BV = Book Value.

T = Tax Rate.

Salvage Tax: What happens if MV is greater than BV?

The company pays taxes on the gain.

Trigger: MV > BV → Tax payment.

Salvage Tax: What happens if MV is less than BV?

The company may receive a tax benefit from the loss.

Trigger: MV < BV → Tax savings.

Salvage Tax: What happens if MV equals BV?

No gain or loss, so no tax adjustment.

After-Tax Salvage = MV.

Salvage Example: MV = $17,000, BV = $0, tax rate = 40%. Find after-tax salvage.

$17,000 − 0.40($17,000 − $0)

= $10,200

Initial Investment: What costs are included at Year 0?

Equipment cost + Shipping/Installation + Initial NWC investment.

These are generally cash outflows.

Initial CF Example: Equipment = $200,000, installation = $40,000, increase in NWC = $20,000. Find CF₀.

CF₀ = −$200,000 − $40,000 − $20,000

= −$260,000

Terminal Cash Flow: What is terminal cash flow?

Additional cash received at the end of a project.

Terminal CF = After-Tax Salvage + NWC Recovery.

Terminal CF Example: After-tax salvage = $15,000 and NWC recovery = $20,000. Find terminal CF.

$15,000 + $20,000

= $35,000

Final-Year Cash Flow: What must be included in the final year?

Final-Year CF = Final OCF + Terminal CF. Example: $54,720 + $35,000 = $89,720

NPV: What is net present value?

Present value of future project cash flows minus the initial investment.

NPV Decision Rule: When should you accept or reject a project?

NPV > 0 → Accept.

NPV < 0 → Reject.

NPV = 0 → Financially indifferent.

IRR: What is the internal rate of return?

The discount rate that makes a project's NPV equal zero.

The discount rate that makes a project's NPV equal zero.

IRR > Required Return → Accept.

IRR < Required Return → Reject.

NPV & IRR Example: NPV = −$4,029.72, IRR = 9.28%, required return = 10%. Accept or reject?

Reject the project.

NPV is negative, and IRR is below the required return.