Chapter 6
MAKING CAPITAL INVESTMENT DECISIONS
SLIDES
CHAPTER ORGANIZATION
6.1 Incremental Cash Flows: The Key to Capital Budgeting
Cash Flows—Not Accounting Income
Sunk Costs
Opportunity Costs
Side Effects
Allocated Costs
6.1 Key Concepts and Skills
6.2 Chapter Outline
6.3 Incremental Cash Flows
6.4 Cash Flows—Not Accounting Income
6.5 Incremental Cash Flows
6.6 Incremental Cash Flows
6.7 Estimating Cash Flows
6.8 Interest Expense
6.9 The Baldwin Company
6.10 The Baldwin Company
6.11 The Baldwin Company
6.12 The Baldwin Company
6.13 The Baldwin Company
6.14 The Baldwin Company
6.15 The Baldwin Company
6.16 The Baldwin Company
6.17 Incremental After Tax Cash Flows
6.18 NPV of Baldwin Company
6.19 Alternative Definitions of OCF
6.20 Some Special Cases of Discounted Cash Flow Analysis
6.21 Cost-Cutting Proposals
6.22 Setting the Bid Price
6.23 Investments of Unequal Lives
6.24 Investments of Unequal Lives
6.25 Investments of Unequal Lives
6.26 Equivalent Annual Cost (EAC)
6.27 Cadillac EAC with a Calculator
6.28 Cheapskate EAC with a Calculator
6.29 Inflation and Capital Budgeting
6.30 Inflation and Capital Budgeting
6.31 Quick Quiz
6.2 The Baldwin Company: An Example
An Analysis of the Project
Which Set of Books?
A Note about Net Working Capital
A Note about Depreciation
Interest Expense
6.3 Alternative Definitions of Operating Cash Flow
The Top-Down Approach
The Bottom-Up Approach
The Tax Shield Approach
Conclusion
6.4 Some Special Cases of Discounted Cash Flow Analysis
Evaluating Cost-Cutting Proposals
Setting the Bid Price
Investments of Unequal Lives: The Equivalent Annual Cost Method
6.5 Inflation and Capital Budgeting
Interest Rates and Inflation
Cash Flow and Inflation
Discounting: Nominal or Real?
ANNOTATED CHAPTER OUTLINE
Slide 6.0 Chapter 6 Title Slide
Slide 6.1 Key Concepts and Skills
Slide 6.2 Chapter Outline
1. Incremental Cash Flows: The Key to Capital Budgeting
Slide 6.3 Incremental Cash Flows
A. Cash Flows—Not Accounting Income
Slide 6.4 Cash Flows—Not Accounting Income
Relevant cash flows – cash flows that occur (or do not occur) because a
project is undertaken. Cash flows that will occur whether or not we accept
a project are not relevant.
Incremental cash flows – any and all changes in the firm’s future cash
flows that are a direct consequence of taking the project
Accounting income is only relevant in that it is used as a starting point for
generating cash flows.
Use after-tax cash flows, not pretax (the tax bill is a cash outlay, even
though it is based on accounting numbers).
Lecture Tip: It should be strongly emphasized that a project’s cash flows
imply changes in future firm cash flows and, therefore, in the firm’s future
financial statements. Below are a few examples of possible projects that
would cause the student to consider the nature of an incremental item.
1) The development of a plant on land currently owned by the
company versus the same development on land that must be
purchased. This example leads to a discussion of opportunity cost.
2) Consider the tax shelter provided by depreciation: What is the
relevant depreciation effect if we replace an old machine with a
three-year remaining life and $5,000 per year depreciation? Suppose
the new machine will cost $45,000 and will be depreciated over a 5-
year life with straight-line depreciation. The depreciation expense on
the new machine would be $9,000 per year. Assume a tax rate of
40%. Therefore, the incremental depreciation expense for the first
three years is $4,000, leading to a depreciation tax shield of
$4,000(.4) = $1,600. The incremental depreciation tax shield for
years 4 and 5 is $9,000(.4) = $3,600.
Viewing projects as “mini-firms” with their own assets, revenues, and
costs allows us to evaluate the investments separately from the other
activities of the firm.
Lecture Tip: You might find it useful to clearly delineate the link between
the stand-alone principle and the concept of value additivity. By viewing
projects as “mini-firms,” we imply that the firm as a whole constitutes a
portfolio of mini-firms. As a result, the value of the firm equals the
combined value of its components. This is the essence of value additivity,
and it is assumed to hold generally whether we are discussing the cash
flows in a simple time-value problem, the value of a project, or the value
of the firm.
B. Sunk Costs
Slide 6.5 Incremental Cash Flows
Sunk cost – a cash flow already paid or accrued. These costs should not be
included in the incremental cash flows of a project. From an emotional
standpoint, it does not matter what investment has already been made. We
need to make our decision based on future cash flows, even if it means
abandoning a project that has already had a substantial investment.
Lecture Tip: Personal examples of sunk costs often help students
understand the issue or sunk costs. Ask the students to consider a
hypothetical situation in which a college student purchased a computer
for $1,500 while in high school. A better computer is now available that
also costs $1,500. The relevant factors to the decision are what benefits
would be provided by the better computer to justify the purchase price.
The cost of the original computer is irrelevant.
C. Opportunity Costs
Opportunity costs – any cash flows lost or forgone by taking one course of
action rather than another. Applies to any asset or resource that has value if
sold, or leased, rather than used.
D. Side Effects
Slide 6.6 Incremental Cash Flows
With multi-line firms, projects often affect one another – sometimes
helping, sometimes hurting. The point is to be aware of such effects in
calculating incremental cash flows.
Erosion (Cannibalism) – new project revenues gained at the expense of
existing products/services.
Synergies – new projects add revenues to existing projects
Lecture Tip: Additional examples of side-effects associated with decisions
can be useful. Here are some possibilities.
a) Whenever Kellogg’s brings out a new cereal, it will probably reduce
sales in existing product lines.
b) McDonald’s introduction of the Arch Deluxe had a substantial, and
to a large extent unanticipated, impact on the sale of Big Macs. The
internal analysts had assumed that a larger proportion of sales of the
Arch Deluxe would come from new customers than actually occurred.
c) Whenever a university adds a new program, it needs to consider
how many new students will come to the university because of the new
program and how many existing students will change majors.
Ethics Note: An episode of the old “L.A. Law” television series presented
an interesting example of the ethical aspects of capital budgeting.
According to the script, an automobile manufacturer knowingly built cars
that had a tendency to explode when involved in accidents of a certain
type. Rather than redesigning the cars (at substantial additional cost), the
manufacturer calculated the expected costs of future lawsuits and
determined that it would be cheaper to sell an unsafe car and defend itself
against lawsuits than to redesign the car.
Many would say that the above example is an inappropriate (to say the
least) and unrealistic application of cost-benefit analysis. Yet, history
suggests that it is not so unrealistic. Manufacturers make similar decisions
on a daily basis. The recall of 6.5 million Firestone tires on some Ford
cars in the fall of 2000 is an excellent example.
The companies involved knew that there were problems with the treads
separating from the tire long before the recall. As problems and criticisms
mounted, Ford voluntarily recalled an additional 13 million tires in May
of 2001. Firestone was forced to recall an additional 3.5 million tires in
October of 2001 after refusing to do so in July. The cost of the various
recalls is astronomical and has substantially lowered the profits for both
Ford and Bridgestone/Firestone. In fact, Ford cut its dividend in October,
2001 (a sure sign that things were not going to get better soon).
And, this is just the beginning. Firestone settled state lawsuits in the
amount of $41.5 million in November of 2001 and class-action status was
given to approximately 3.5 million “economic loss” lawsuits filed against
both Ford and Firestone. These lawsuits do not count the numerous
lawsuits filed by the families of the individuals that were either killed or
injured in accidents. As of July 2001, the death toll stood at 203, and the
number of injured was over 700. And, the cost does not stop with the
direct costs of the recalls and lawsuits; business dropped dramatically for
both companies because of a lack of trust from the public.
It is easy to say that the cost is irrelevant, given the potential loss of
human life. However, we know that estimation error exists in all parts of
the decision making process. What happens when a company
underestimates the potential danger? (This is not meant to imply that
Firestone and Ford made the correct decision initially. Too much
information is still unavailable and it will be years before it all comes
out.) The point is that sometimes the “side effects” of many decisions are
complex, but very important.
Slide 6.7 Estimating Cash Flows
With the inputs identified, calculate OCF using the formula developed
earlier in the course:
OCF = EBIT – Taxes + Depreciation
Do not forget salvage values and changes in net working capital.
New projects often require incremental investments in cash, inventories,
and receivables that need to be included in cash flows if they are not offset
by changes in payables. Later, as projects end, this investment is often
recovered.
Slide 6.8 Interest Expense
Remember the separation theorem: financing and investment decisions are
separate. Thus, interest expense, which is a result of financing choice,
should not be included as a relevant cash flow.
More generally, we do not typically include the cash flows associated with
interest payments or principal on debt, dividends, or other financing costs
in computing cash flows. Financing costs are reflected in the rate used to
discount the project cash flows.
E. Allocated Costs
Lecture Tip: Students sometimes become disheartened at what they
perceive as complexities in the various capital budgeting calculations. You
may find it useful to remind them that, in reality, setting up timelines and
performing calculations are typically the least burdensome portion of the
task. Rather, the difficulties arise
principally in two areas: (1) generating good investment projects and (2)
developing reliable cash flow estimates for these projects.
It should be pointed out that investing in fixed assets differs from
investing in financial assets in at least one important sense. It is easy to
find the investment opportunity set for financial assets and then perform
an analysis to decide among the opportunities. Preparation of a capital
budget, on the other hand, requires that people investigate and develop
new project proposals, estimate the cash flows associated with these
projects, and only then perform the analyses.
Developing reliable cash flow estimates ranges from being a relatively
minor task (say a simple replacement project) to one that is subject to a
great deal of uncertainty. This requires all the analytical tools available
and experience. That is why it is important to encourage students to find a
mentor and watch and learn on the job. They should not expect to know
everything when they walk in the door.
2. The Baldwin Company: An Example
For most projects, there is a common cash flow pattern:
1. Firms invest at the beginning of the project, which represents a
cash outflow
2. Product/service sales provide cash inflow over the life of the
project
3. Plant and equipment are sold off at the end of the project
A. An Analysis of the Project
Treat the project as a mini-firm:
1. Start with pro forma income statements (do not include interest) and
balance sheets. Note that the balance sheets are often forgone, and only the
income statements are used. This is because the NWC requirements are
often considered as a percent of sales, and the major fixed asset
requirements are the initial cost and salvage.
2. Determine the sales projections, variable costs, fixed costs, and capital
requirements.