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Chapter 10
MAKING CAPITAL INVESTMENT DECISIONS
CHAPTER ORGANIZATION
10.1 Project Cash Flows: A First Look
10.2 Incremental Cash Flows
Sunk Costs
10.3 Pro Forma Financial Statements and Project Cash Flows
10.4 More about Project Cash Flow
10.5 Alternative Definitions of Operating Cash Flow
The Bottom-Up Approach
10.6 Some Special Cases of Discounted Cash Flow Analysis
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ANNOTATED CHAPTER OUTLINE
10.1. Project Cash Flows: A First Look
A. Relevant Cash Flows
Relevant cash flows – cash flows that occur (or don’t occur)
because a project is undertaken. Cash flows that will occur whether
or not we accept a project aren’t relevant.
Incremental cash flows – any and all changes in the firm’s future
cash flows that are a direct consequence of taking the project
Lecture Tip: It should be strongly emphasized that a project’s cash
1) The development of a plant on land currently owned by the
2) Consider the tax shelter provided by depreciation: What is the
B. The Stand-Alone Principle
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Lecture Tip: You might find it useful to clearly delineate the link
between the stand-alone principle and the concept of value
10.2. Incremental Cash Flows
A. Sunk Costs
Sunk cost – a cash flow already paid or accrued. These costs
Example: A firm has a policy of paying the tuition bills for any of
its newly hired managers who attend an accredited MBA program
on their own time. Two managers already taking MBA classes are
assigned to develop a new product. Should their tuition costs be
included in the project’s cash flows?
Lecture Tip: Personal examples of sunk costs often help students
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B. Opportunity Costs
C. Side Effects
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.
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 oat cereal, it will
probably reduce existing product sales.
Ethics Note: An episode of the old “L.A. Law” television series
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And this is just the beginning. Firestone settled state lawsuits in the
amount of $41.5 million in November of 2001 and class-action
D. 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.
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E. Financing Costs
F. Other Issues
Use cash flows, not accounting numbers.
Use after-tax cash flows, not pretax (the tax bill is a cash outlay,
even though it is based on accounting numbers).
Lecture Tip: Students sometimes become disheartened at what
they perceive as complexities in the various capital budgeting
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
10.3. Pro Forma Financial Statements and Project Cash Flows
A. Getting Started: Pro Forma Financial Statements
Treat the project as a mini-firm:
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1. Start with pro forma income statements (don’t include interest)
2. Determine the sales projections, variable costs, fixed costs, and
capital requirements.
Lecture Tip: Some students may still question why we are ignoring
interest, since it is clearly a cash outflow. It should be strongly
B. Project Cash Flows
From the pro forma statements compute:
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C. Projected Total Cash Flow and Value
measure desired.
10.4. More on Project Cash Flow
A. A Closer Look at Net Working Capital
Accounts receivable and inventory increase to support higher sales
levels. Accounts payable also tends to increase to support the
Lecture Tip: The NWC discussion is very important and should not
be overlooked by students. It may be helpful to reemphasize the
point of NWC and operating cash flow through accounting entries.
Example:
The same is true when inventory is purchased. If the inventory is
purchased for cash, there is an immediate cash outflow, but it
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B. Depreciation
Depreciation is a non-cash deduction. However, depreciation
Lecture Tip: Ask the students why a company might prefer
accelerated depreciation for tax purposes to the simpler straight-
line depreciation. As an example, consider the purchase of a five-
year, $50,000 machine by a company with a 34% marginal tax
rate. Assume a zero salvage value at the end of year 5 and an
appropriate discount rate of 10%.
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Book value versus market value – net fixed assets is different from
the market value of the assets since the arbitrary methods used to
compute depreciation rarely match changes in economic value.
C. An Example: The Majestic Mulch and Compost Company
(MMCC)
Lecture Tip: Although the impact of alternative depreciation
Year NI OCF CFFA
10.5. Alternative Definitions of Operating Cash Flow
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B. The Top-Down Approach
10.6. Some Special Cases of Discounted Cash Flow Analysis
A. Evaluating Cost-Cutting Proposals
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Using the Tax Shield Approach
OCF = (sales – costs)(1 – T) + DT
Sales
Costs
(Sales – Costs)(1-T)
Book Value
Depreciation
Depreciation Tax Shield
Operating Cash Flow
Net Capital Spending
Cash Flow From Assets
The “costs” figure is negative because it is a cost savings, not an expense.
Net present value
Internal Rate of Return
B. Setting the Bid Price
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Year
0
1
2
3
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C. Evaluating Equipment with Different Lives
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Lecture Tip: A complete discussion of capital budgeting under
inflation is beyond the scope of this book; nonetheless, we provide
10.7. Summary and Conclusions