Making Investment Decisions With The Net Present Value Rule
Making Investment Decisions With The Net Present Value Rule
Making Investment Decisions With The Net Present Value Rule
Difference between accounting income and cash flow is due to the following
accounting adjustments:
Capital Expenses: Deducting current expenses (through depreciation) instead
of capital expenses
Depreciation is a non-cash expense
Matching Principle
Capital Expenses
If a firm pays a huge lump sum on a certain investment, we do not conclude
that the firm is performing poorly (even though a lot of cash is paid)
Instead of deducting capital expenditure as it occurs, the accountant
depreciates the outlay over several years
This makes sense when judging firm performance but will be problematic when
calculating NPV
Given a discount rate of 10%, calculating NPV using accounting income yields $41.23 > 0 This
wrongly suggests that we should accept this project
Using CFs, NPV would be negative given any positive discount rate Project should be rejected
To determine cash flow from income, add back depreciation and subtract capital expenditure
Matching Principle
Matching principle – GAAP says to show revenue when it accrues and
match the expenses required to generate the revenue
Revenue is usually recognized at the time of sale, which is not necessarily the
same as the time of collection.
Matching principle: Determine revenues and match those revenues with the
costs associated with producing them
Example: We manufacture a product for $1,000 (t = -1) and then sell it on credit
for $1,200 (Sale occurs at t = 0 but cash is received at t = 1)
It would be misleading to say that the firm was losing at t = -1 (CF was negative) or
that it was extremely profitable at t = 1 (CF was positive) => the accountant
recognizes revenues and costs at the time of sale.
However, the figures shown on the income statement may not be at all representative
of the actual cash inflows and outflows that occurred during a particular period.
2-4
Incremental Cash Flows
Rule 2: Estimate Cash Flows on an Incremental Basis:
Irrelevant
Sunk costs
6 8-6
Incremental Cash Flows
A sunk cost is a cost that has already occurred
8-8
Incremental Cash Flows
By taking project A, the firm forgoes other opportunities for
using its assets (such as investing in project B)
8-9
Problem
A firm is looking at setting up a new manufacturing plant in South
Park to produce garden tools. The company bought some land six
years ago for $6 million in anticipation of using it as a warehouse
and distribution site, but the company has since decided to rent
these facilities from a competitor instead. If the land were sold
today, the company would net $6.4 million. The company wants to
build its new manufacturing plant on this land; the plant will cost
$14.2 million to build, and the site requires $890,000 worth of
grading before it is suitable for construction. What is the proper
cash flow amount to use as the initial investment in fixed assets
when evaluating this project?
Answer: $21,490,000
8-10
Incremental Cash Flows
The side effects of the proposed project on
other parts of the firm matter in determining
the incremental CFs
Answer: $403,600,000
8-13
Depreciation
The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
IRS for tax purposes
10-14
Computing Depreciation
Straight-line depreciation
Dep = (Initial cost – salvage) / number of years
10-15
Computing Depreciation
A piece of newly purchased industrial equipment costs
$1,080,000 and is classified as seven-year property
under MACRS. Calculate the annual depreciation
allowances and end-of-the-year book values for this
equipment.
Year Beginning Book Value MACRS Depreciation Ending Book value
1 $1,080,000.00 0.1429 $154,332.00 $925,668.00
2 925,668.00 0.2449 264,492.00 661,176.00
3 661,176.00 0.1749 188,892.00 472,284.00
4 472,284.00 0.1249 134,892.00 337,392.00
5 337,392.00 0.0893 96,444.00 240,948.00
6 240,948.00 0.0892 96,336.00 144,612.00
7 144,612.00 0.0893 96,444.00 48,168.00
8 48,168.00 0.0446 48,168.00 0 10-16
MACRS Tax Depreciation Schedules
Tax depreciation
allowed under the
modified
accelerated cost
recovery system
(MACRS)
(Figures in percent of
depreciable investment)
After-tax Salvage Value
If the salvage value is different from the book value of the
asset, then there is a tax effect
Under current tax laws, the company is required to pay
taxes at the ordinary income tax rate on the difference
between the sale price (Market Value) and the book value.
Taxes must be paid because the difference between the
MV and the BV is “excess” depreciation and it must be
recaptured when the asset is sold.
Book value = initial cost – accumulated depreciation
After-tax salvage = MV – T(MV – BV)
10-18
Problem
An asset used in a four-year project falls in the five-
year MACRS class for tax purposes. The asset has an
acquisition cost of $7,900,000 and will be sold for
$1,400,000 at the end of the project. If the tax rate is
35%, what is the after-tax salvage value of the asset?
Year MACRS %
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
10-19
Problem
Consider an asset that costs $548,000 and is
depreciated straight-line to zero over its eight-year
tax life. The asset is to be used in a five-year project;
at the end of the project, the asset can be sold for
$105,000. If the relevant tax rate is 35%, what is the
after-tax cash flow from the sale of this assets?
8-20
Inflation and Capital Budgeting
Rule 3 - Treat Inflation Consistently
In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows discounted at
nominal rates.
Nominal rate of interest – quoted rate of interest, change in purchasing power and
inflation (Unadjusted for inflation)
The nominal rate on an investment is the percentage change in the number of dollars you
have.
Example: Suppose inflation rate is 5%. An investment is available that will be worth
$115.50 in one year. It costs $100 today.
FV = PV (1+r) => r = 15.5% nominal return
With 5% inflation, each of the $115.50 nominal dollars is worth 5% less in real terms =>
The real dollar value of the investment in one year is:
115.5/1.05 = $110 => r = 10% Real return (Fisher Effect gives same answer)
5-22
The Fisher Effect
The Fisher Effect defines the relationship between real rates, nominal
rates, and inflation.
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R=r+h
8-24
Inflation
Example
You invest in a project that will produce real cash
flows of -$100 in year zero and then $35, $50, and
$30 in the three respective years. If the nominal
discount rate is 15% and the inflation rate is 10%,
what is the NPV of the project?
Regardless of the actual financing, firms typically calculate a project’s cash flows
under the assumption that the project is financed only with equity Treat all CFs
required for project as coming from stockholders and all cash inflows as going to them
Adjustments for debt financing are generally reflected in the discount rate, not CFs
Allows for the separation of the investment decision from the financing decision
Assuming all equity financing, analyze whether project has positive NPV
Then, if project is valuable, perform a separate analysis of the best financing strategy
Changes in NWC
What is working capital?
Current assets – current liabilities
Net investment in short term assets
8-30
Estimating Cash Flows
Cash Flow from Operations
OCF = EBIT – Taxes + Depreciation
OCF = Net income + depreciation (when there is no interest expense)
CF from capital investment and disposal = Fixed Assets Sold – Fixed Assets Bought
Don’t forget salvage value (after tax, of course)
8-31
IM&C’s Project
The firm is analyzing a proposal for marketing their product as a garden
fertilizer.
This machinery can be dismantled and sold for net proceeds estimated at
$1.949M in year 7 This is your forecast of the plant’s salvage value.
8-32
IM&C’s Project
The forecasts are shown in the below table. All entries are in nominal
terms. Numbers are reported in $1,000s.
0 1 2 3 4 5 6 7
1 Sales 523 12,887 32,610 48,901 35,834 19,717
2 Cost of goods sold 837 7,729 19,552 29,345 21,492 11,830
3 other costs 4,000 2,200 1,210 1,331 1,464 1,611 1,772
4 Depreciation 1,583.33 1,583.33 1,583.33 1,583.33 1,583.33 1,583.33
5 Pretax profit (1-2-3-4) -4,000 -4,097.33 2,364.67 10,143.67 16,508.67 11,147.67 4,531.67
6 Taxes -1400 -1,434.07 827.63 3,550.28 5,778.03 3,901.68 1,586.08
7 Net Income (5-6) -2,600 -2,663.26 1,537.04 6,593.39 10,730.64 7,245.99 2,945.59
8 OCF (1-2-3-6) -2,600 -1,079.93 3,120.37 8,176.72 12,313.97 8,829.32 4,528.92
9 NWC 550 1,289 3,261 4,890 3,583 2,002 0
CF from changes in
10 -550 -739 -1972 -1629 1307 1581 2002
working capital
6,110 3,444
3,520 or $3,520,000
1.20 1.20
6 7
8-34
The Baldwin Company
Current market value of proposed factory site (building and land where the bowling
balls would be manufactured which the company owns): $150,000
Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000,
10,000, 6,000
8-36
The Baldwin Company
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%
The appropriate incremental corporate tax rate in the
bowling bowl project is 34%
Working Capital: initial $10,000 and it changes with
sales
8-37
The Baldwin Company (NWC)
Like any other manufacturing firm, Baldwin finds
that it must make an investment in NWC
It will purchase raw materials before production and sale =>
Inventory increases
Its credit sales will generate AR
8-38
The Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)
8-40
The Baldwin Company (Salvage Value)
Taxes must be paid because the difference
between the MV and the BV is “excess”
depreciation and it must be recaptured when
the asset is sold.
8-42
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Year-end Book Value 80.00 48.00 28.80 17.28 5.76
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 3 = 12,000×[$20×(1.02)2] = 12,000×$20.81 = $249,720.
8-45
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
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
8-46
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.72 212.20 129.90
(9) Operating costs 50.00 88.00 145.20 133.10 87.84
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
8-48
Incremental After Tax Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
F1 1 NPV 51.588
F4 1
CF2 54.19
CF5 224.66
F2 1
F5 1
CF3 66.86
8-50
The Investment Timing Decision
Problem 1: Investment Timing Decision
Should you invest now or in the future?
Some projects are more valuable if undertaken in the
future
Examine start dates (t) for investment and calculate
net future value for each date
Discount net values back to present
Equivalent Annual Cash Flow - The cash flow per period with the same
present value as the actual cash flow as the project.
present value of cash flows
Equivalent annual cost (annuity) =
annuity factor
Equivalent Annual Cash Flows
Example
Given the following COSTS from operating two machines and a 6%
cost of capital, which machine has the lower equivalent annual cost?
(Note all numbers in the below chart are outflows)
Year
Mach. 0 1 2 3 NPV@6% E.A.C.
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
Would you rather make annual lease payments of 10.61 or 11.45? Choose
A since its EAC is lower
The Choice between Long- and Short-Lived Equipment:
Replacement Chain Approach
Consider a factory that must have an air
cleaner that is mandated by law. There are two
choices:
The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100, and lasts 10 years.
The “Cheapskate cleaner” costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.
Assuming a 10% discount rate, which one
should we choose?
8-55
The Choice between Long- and Short-Lived Equipment:
Replacement Chain Approach
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 – 4,000 CF0 –1,000
F1 10 F1 5
I 10 I 10
8-57
The Choice between Long- and Short-Lived Equipment
Two Approaches
8-58
Replacement Chain Approach
The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100
-100
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
8-59
Replacement Chain Approach
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 –4,000 CF0 –1,000
CF1 –500
CF1 –100
F1 4
F1 10 CF2 –1,500
I 10 F2 1
CF3 –500 I 10
NPV –4,614
F3 5 NPV –4,693
8-60