Chapter 9: Making Capital Investment Decisions

Learning Objectives

• Determine the relevant cash flows for a proposed project.
• Evaluate whether a project is acceptable.
• Explain how to set a bid price for a project.
• Evaluate the equivalent annual cost of a project.

Chapter Outline

• Project Cash Flows: A First Look.
• Incremental Cash Flows.
• Pro Forma Financial Statements and Project Cash Flows.
• More about Project Cash Flow.
• Alternative Definitions of Operating Cash Flow.
• Some Special Cases of Discounted Cash Flow Analysis.

Relevant Cash Flows and the Stand-Alone Principle

• Relevant Cash Flow: A change in the firm’s future cash flows directly attributable to a project.
• Incremental Cash Flows: Difference in future cash flows with and without the project.
• Non-relevant cash flows include those that exist irrespective of the project's initiation.
• Stand-Alone Principle: Evaluating a project based on its incremental cash flows, treating it as a "minifirm."

Incremental Cash Flows

• Sunk Cost: A cost already incurred and should not be considered for future investment decisions.
• Opportunity Cost: The value of the next best alternative foregone when choosing an investment.
• Side effects of a project can affect existing projects positively or negatively, termed erosion.
• Projects often require net working capital investments in addition to long-term assets.

Financing Costs

• Exclude financing costs (interest, dividends) when analyzing a proposed investment as the focus is on cash flows generated by project assets.
• Focus on actual cash flow timings, with emphasis on after-tax cash flows since taxes represent a cash outflow.

Pro Forma Financial Statements and Project Cash Flows

• Example of Shark Attractant project outlining expected income and financials:
  • Annual sales: 50,000 cans at $4 each ($200,000).
  • Variable costs at $2.50 per can ($125,000).
  • Total fixed costs: $17,430, and Capital investment: $90,000, with a $20,000 initial net working capital.

Projected Income Statement

• Sales: $200,000
• Variable Costs: $125,000
• Fixed Costs: $17,430
• EBIT: $27,570
• Taxes (21%): $5,790
• Net Income: $21,780

Calculating Project Cash Flows

• Cash flow from assets includes:

  1. Operating Cash Flow
  2. Capital Spending
  3. Changes in Net Working Capital

• Total Project Cash Flow:
  \text{Operating Cash Flow} - \text{Changes in NWC} - \text{Capital Spending}

• Operating Cash Flow Calculation:
  \text{EBIT} + \text{Depreciation} - \text{Taxes}

Evaluating Project Viability

• The NPV from the shark attractant project is positive; thus, it's worthwhile:
  • NPV > 0 indicates a good investment.
  • IRR = 25.8% and Payback = 2.1 years demonstrates profitability.

Depreciation and Its Cash Flow Impact

• Modified Accelerated Cost Recovery System (MACRS): Allows accelerated depreciation write-off.
• Example: Equipment costing $12,000 depreciated using MACRS classifications; yields a depreciation expense affecting tax liability.
• Bonus Depreciation: Changes in legislation allowed for 100% bonus depreciation, impacting investment decisions significantly.

Special Cases of Discounted Cash Flow Analysis

• Consider efficiency improvements, competitive bids, or differing economic lives of equipment.
• NPV helps evaluate cost-saving investments such as equipment purchase and operational efficiencies.

Setting the Bid Price Example

• Bid prices in competitive contexts should ensure a zero NPV, guiding pricing decisions based on calculated costs and anticipated operating cash flows.

Selected Concept Questions

• Clarify the role of incremental cash flows in project evaluation.
• Define erosion and its relevance to investment decisions.
• Discuss how net working capital changes affect cash flows and project assessments.
• Compare different approaches (top-down vs. bottom-up) for defining operating cash flow.