Capital Budgeting: Making Capital Investment Decisions Risk Analysis, Scenario Analysis and Break-Even Analysis

Capital Budgeting
Making Capital Investment Decisions

Risk Analysis, Scenario Analysis and Break-even Analysis
Chapter Outline
6.1 Incremental Cash Flows: The Key to Capital Budgeting

6.2 The Baldwin Company: An Example
6.3 Alternative Definitions of Operating Cash Flow
© 2019 McGraw-Hill Education. 6-2

6.1. Incremental Cash Flows
• Always use cash flows rather than accounting figures in NPV calculations.
• Relevant cash flows: always use incremental cash flows. What does this
mean?
- The changes in the firm’s cash flows that occur as a direct consequence of
accepting the project.
- Calculate cash flows as: cash flows with project less cash flows without project
(1) Sunk costs should be ignored in calculating incremental flows

- Costs that have already occurred.
Example: if you have already paid for a marketing study, the cost already
paid (i.e., sunk) should have no bearing on your calculations or decisions.
(2) Opportunity costs should be included in calculating incremental flows
If already own an asset that will be used for project, must subtract the
maximum PV of cash flows that asset could fetch under alternative use
Example: if you own a piece of land that you will use to build a factory, the
value of that land must be treated as a cost
(3) All negative or positive side effects should be included in incremental flows
Example: producing new economy car will generate more profitable future
sales of existing projects as customers become attached to your brand –
positive side effect (synergy)
Example: developing new jumbo jet line will erode some sales of existing
lines – negative side effect (erosion)
6.2. Example of NPV Calculation: The Baldwin Company
A leading producer of balls, such as tennis balls, baseballs, golf balls, etc.
Another promising segment identified: Colored bowling balls.
Sent questionnaire to consumers and positive responses.
Capital budgeting relies heavily on pro forma (projected) financial statements,

particularly income statements.
Computing cash flows – refresher
 Operating Cash Flow (OCF) = EBIT + depreciation – taxes
 Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) –
changes in NWC
Information for the bowling ball project
• Costs of test marketing (already spent): $250,000
• Current market value of proposed factory site (which we own): $150,000
• Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-
year)
• Increase in net working capital: $10,000
• Production (in units) by year during 5-year life of the machine: 5,000, 8,000,
12,000, 10,000, 6,000
• Price during first year is $20; price increases 2% per year thereafter.
• Production costs during first year are $10 per unit and increase 10% per year
thereafter.
• Annual inflation rate: 5%
• Working capital: initial $10,000 changes with sales (10% of sales)
Worksheet for Cash Flows from Investments
($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.77*
(2) Accumulated 20.00 52.00 71.20 82.70 94.20 depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.30 5.80
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0 (end of
year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22 working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 193.00 investment
[(1) + (4) + (6)]
Notes:
(1) The depreciation (in percentage) under MACRS 5 year are: 0.200, 0.320, 0.192, 0.115, 0.115, 0.058
(2) 21.77 = 30 (salvage value) - .34 x [30 – 5.8] (corporate taxes on proceeds)
(3) At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
(4) Working capital needs depend on activity, you get this back at the end
Cash Flows from Operations

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.

Cash Flow from Operations (continued)

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50
Depreciation is calculated using the Modified Year ACRS %

Accelerated Cost Recovery System (shown at 1 20.0%
right). 2 32.0%
Our cost basis is $100,000. 3 19.2%
Depreciation charge in year 4 4 11.5%
= $100,000×(.115) = $11,500. 5 11.5%
6 5.8%
Total 100.00%

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50
(11) Income before taxes 30.00 43.20 85.30 67.64 30.55
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 23.00 10.39
(13) Net Income 19.80 28.51 56.30 44.64 20.16
Incremental After Tax Cash Flows
(1) Sales $100.00 $163.20 $249.70 $212.24 $129.89

Revenues
(2) Operating -50.00 -88.00 -145.20 133.10 -87.85
costs
(3) Taxes -10.20 -14.69 -29.00 -23.00 -10.39
(4) OCF 39.80 60.51 75.50 56.14 31.66

(1) – (2) – (3)
(5) Total CF of –260. –6.32 –8.65 3.75 193.00
Investment
(6) IATCF –260. 39.80 54.19 66.85 59.89 224.66
[(4) + (5)]
NPV if the appropriate discount rate is 10%?
$39.80 $54.19 $66.85 $59.89 $224.66
NPV  $260       51.59
(1.10) (1.10) 2 (1.10)3 (1.10) 4 (1.10)5
Some notes on the example
– Sunk costs are ignored as they should be

– A note for NWC
• While change in NWC is on average 0, it is typically negative in
early years and positive in later years.
• Cash generated elsewhere in the first must be used to offset the
requirement for NWC
– What about interest expense?
• Later chapters will deal with the impact that the amount of debt that a
firm has in its capital structure has on firm value.
• For now, it is enough to assume that the project is financed only with
equity.
– All items are stated in nominal terms
6.3 Other Methods for Computing OCF
• Bottom-Up Approach
– Works only when there is no interest expense
– OCF = EBIT + depreciation-tax
• Top-Down Approach
– OCF = Sales – Costs – Taxes
– Do not subtract non-cash deductions
• Tax Shield Approach

– OCF = (Sales – Costs)(1 – T) + Depreciation*T
Summary
– How do we determine if cash flows are relevant to the capital
budgeting decision?
– What are the different methods for computing operating cash flow,
and when are they important?

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Capital Budgeting

Making Capital Investment Decisions

6.1 Incremental Cash Flows: The Key to Capital Budgeting

© 2019 McGraw-Hill Education. 6-2

(1) Sunk costs should be ignored in calculating incremental flows

Another promising segment identified: Colored bowling balls.

Sent questionnaire to consumers and positive responses.

Capital budgeting relies heavily on pro forma (projected) financial statements,

Computing cash flows – refresher

 Operating Cash Flow (OCF) = EBIT + depreciation – taxes

($ thousands) (All cash flows occur at the end of the year.)

($ thousands) (All cash flows occur at the end of the year.)

Sales revenue in year 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.

($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Depreciation is calculated using the Modified Year ACRS %

($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales $100.00 $163.20 $249.70 $212.24 $129.89

(4) OCF 39.80 60.51 75.50 56.14 31.66

– Sunk costs are ignored as they should be

• Tax Shield Approach

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