CHAPTER 8

Making Capital
Investment Decisions
Ch. 8 requires thorough understanding of Ch. 2 and Ch. 7.

FIN 6301: Financial Management

Instructor: Dr. Hiro Nishi

The University of Texas at Dallas

Naveen Jindal School of Management

LEARNING OBJECTIVES

• Understand a project’s cash flows

- What costs are included / excluded?

• Be able to calculate depreciation expenses

using MACRS.

• Construct a pro forma financial statement

and make a capital investment decision.
- We will look at examples in Excel.

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 CASH FLOWS OF A
PROJECT

PROJECT CASH FLOWS

The project cash flows consist of all

“incremental changes” in the firm’s futures cash
flows that are direct consequence of taking the
project.
• We can view a project as a “mini-firm” and
evaluate it independently of other
operations at the firm.

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PROJECT CASH FLOWS

1. Annual operating cash flow (OCF)

• Revenues
• Fixed production cost
• Variable production cost
• Depreciation expense
• General & admin cost, etc.

2. Net capital spending – first & final years

3. Changes in NWC – first & final years

ADDITIONAL COSTS
Following costs are included in incremental
cash flows :

Opportunity Costs
• The firm will need to give up on
opportunities to do something else.

$0 cost since the firm

already owns the
building and land?
Project A
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ADDITIONAL COSTS

Side Effects
• Reduction in sales (= erosion) as a result
of the new project

Ford Mustang Ford Mustang (4-door)

COSTS TO BE EXCLUDED

Following costs are excluded from incremental

cash flows:

• Sunk Costs
- The cost the firm has to incur regardless of
whether the project is undertaken
- e.g., audit, investor relations
• Financing Costs
- These are NOT the cash flows generated
by the assets
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OPERATING CASH FLOW
Conventional approach:
Operating Cash Flow (OCF)
EBIT + Depreciation – Taxes

Bottom-up approach:
Operating Cash Flow (OCF)
Net Income + Depreciation + Interest paid

OPERATING CASH FLOW

Sales
Price per unit Number of units sold

Variable cost
Variable cost per unit Number of units sold

Fixed cost
• Fixed cost includes: monthly rent, salaries,
etc.
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QUESTION #1 Conventional approach

Black & Scholes Co. has the following project:

• Unit sales = 2,300
• Sales price = $53
• Variable cost = $35
• Fixed cost = $16,000
• Annual depreciation= $14,800
The tax rate is 34%. What is the operating cash flow?

EBIT = (53 – 35) ʹ 2,300 – 16,000 – 14,800 = $10,600

OCF = 10,600 + 14,800 – (10,600 ʹ 0.34) = $21,796

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QUESTION #2 Bottom-up approach

Black & Scholes Co. has the following project:

• Unit sales = 2,300
• Sales price = $53
• Variable cost = $35
• Fixed cost = $16,000
• Annual depreciation= $14,800
The tax rate is 34%. What is the operating cash flow?

EBIT = (53 – 35) ʹ 2,300 – 16,000 – 14,800 = $10,600

Net income = 10,600 ʹ (1 – 0.34) = $6,996
OCF = 6,996 + 14,800 = $21,796
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OPERATING CASH FLOW

Tax-shield approach
Operating Cash Flow (OCF)

= (Sales – Costs)(1 – Tax rate)

+ Depreciation × Tax rate

Remember that depreciation is non-cash

expense.
- Still needs to be included due to “tax effects”
- Saving tax by the amount of depreciation
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QUESTION #3 Tax-shield approach

Black & Scholes Co. has the following project:

• Unit sales = 2,300
• Sales price = $53
• Variable cost = $35
• Fixed cost = $16,000
• Annual depreciation= $14,800
The tax rate is 34%. What is the operating cash flow?

EBITDA = (53 – 35) ʹ 2,300 – 16,000 = $25,400

After-tax EBITDA = $25,400 ʹ (1 – 0.34) = $16,764
OCF = 16,764 + (14,800 ʹ 0.34) = $21,796
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 DEPRECIATION &
SALVAGE CASH FLOW

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COMPUTING DEPRECIATION

Straight-line Depreciation:

• Initial Cost ĺ Depreciate ĺ Salvage value

• Annual depreciation
Initial cost – Salvage value
=
Number of years

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COMPUTING DEPRECIATION
Modified Accelerated Cost Recovery System
(MACRS)
• Depreciate ĺ $0 (write off 100% of the cost)
• Class establishes the asset’s “life” for tax purposes
• Multiply the initial cost by a percentage
Classes & Depreciation rates:

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AFTER-TAX SALVAGE
Example:
$160,000 asset classified as a 5-year property for MACRS

Book value of the asset

= Initial cost – Accumulated depreciation

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QUESTION #4
For the project in Q1-3, the firm purchased fixed
assets that are classified as 5-year property for
MACRS. The purchase price was $70,000. What
is the book value remaining after three years?

Year value
Depreciation rate Remaining book value
1 20.00% 56,000
2 32.00% 33,600
3 19.20% 20,160
4 11.52% 12,096
5 11.52% 4,032
6 5.76% -
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AFTER-TAX SALVAGE

Net Salvage Cash Flow

= SP – (SP – BV) ʹ Tax rate
Where:
SP = Sale price (also called “market” value)
BV = Book value remaining (see Q.3)

What is the second term about?

If the sale price is different from the book value
of the asset, then there is a tax effect.

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QUESTION #5
Consider Question #4. Suppose the firm can sell
the assets for $40,000 after three years. If the tax
rate is 34%, what is the net salvage cash flow
from the sale?

Note: the sale price is different from the book value

of the assets.
(40,000 – 20,160) ʹ 0.34 = 6,746

Net salvage cash flow is:

40,000 – 6,746 = $33,254
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IN-CLASS EXERCISE #1
The 3-year project below requires $3 million of initial
investment. All the fixed assets necessary for this project are
classified as 3-year properties for MACRS. What is the book
value of the initial investment after Year 3?
Year 0 Year 1 Year 2 Year 3
Net capital spending 3,000,000
Revenue 2,500,000 2,500,000 2,500,000
Operating costs 1,000,000 1,000,000 1,000,000
Depreciation
EBT 500,100 166,500 1,055,700
Tax 105,021 34,965 221,697
Net Income 395,079 131,535 834,003

Operating cash flow 1,394,979 1,465,035

Net capital Spending (3,000,000)
ǻ in NWC (400,000) 400,000
Incremental cash flow (3,400,000) 1,394,979 1,465,035

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IN-CLASS EXERCISE #2
Consider the In-class Exercise #1. What is the project’s
operating cash flow (OCF) in Year 3
Year 0 Year 1 Year 2 Year 3
Net capital spending 3,000,000
Revenue 2,500,000 2,500,000 2,500,000
Operating costs 1,000,000 1,000,000 1,000,000
Depreciation
EBT 500,100 166,500 1,055,700
Tax 105,021 34,965 221,697
Net Income 395,079 131,535 834,003

Operating cash flow 1,394,979 1,465,035

Net capital Spending (3,000,000)
ǻ in NWC (400,000) 400,000
Incremental cash flow (3,400,000) 1,394,979 1,465,035

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IN-CLASS EXERCISE #3
Consider the In-class Exercise #1. Assume that the resale
value of all the assets combined was $300,000. If the corporate
tax rate is 21%, what is the net salvage cash flow from the sale
of the fixed assets after Year 3?
Year 0 Year 1 Year 2 Year 3
Net capital spending 3,000,000
Revenue 2,500,000 2,500,000 2,500,000
Operating costs 1,000,000 1,000,000 1,000,000
Depreciation
EBT 500,100 166,500 1,055,700
Tax 105,021 34,965 221,697
Net Income 395,079 131,535 834,003

Operating cash flow 1,394,979 1,465,035

Net capital Spending (3,000,000)
ǻ in NWC (400,000) 400,000
Incremental cash flow (3,400,000) 1,394,979 1,465,035

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 PRO FORMA FINANCIAL
STATEMENT

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PRO FORMA STATEMENT

Pro Forma Financial Statement summarizes

future cash flows of a project.
• Once we know all the necessary
information, you can analyze the project
using the criteria discussed in Chapter 7.
• The NPV method is usually used.

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PRO FORMA STATEMENT

Suppose that the project in Questions 1 - 5

requires an increase in NWC by $17,000 today.

Year 0 Year 1 Year 2 Year 3

OCF $21,796 $21,796 $21,796
Change in NWC ($17,000) 17,000
Cap. spending ($70,000) 33,254
Total cash flow ($87,000) $21,796 $21,796 $72,050

Calculate the project NPV using total cash flows.

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PRO FORMA STATEMENT

Let’s go over more detailed examples.

• We will be using the Excel file posted in

eLearning!

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