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McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-0ChapterOutline7.1IncrementalCashFlows7.2TheBaldwinCompany:AnExample7.3InflationandCapitalBudgeting7.4InvestmentsofUnequalLives:TheEquivalentAnnualCostMethod7.5SummaryandConclusionsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-17.1IncrementalCashFlowsCashflowsmatternotaccountingearnings.Sunkcostsdontmatter.Incrementalcashflowsmatter.Opportunitycostsmatter.Sideeffectslikecannibalismanderosionmatter.Taxesmatter:wewantincrementalafter-taxcashflows.Inflationmatters.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-2CashFlowsNotAccountingEarnings.Considerdepreciationexpense.Youneverwriteacheckmadeoutto“depreciation”.Muchoftheworkinevaluatingaprojectliesintakingaccountingnumbersandgeneratingcashflows.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-3IncrementalCashFlowsSunkcostsarenotrelevantJustbecause“wehavecomethisfar”doesnotmeanthatweshouldcontinuetothrowgoodmoneyafterbad.Opportunitycostsdomatter.JustbecauseaprojecthasapositiveNPVthatdoesnotmeanthatitshouldalsohaveautomaticacceptance.SpecificallyifanotherprojectwithahigherNPVwouldhavetobepassedupweshouldnotproceed.Sideeffectsmatter.Erosionandcannibalismarebothbadthings.Ifournewproductcausesexistingcustomerstodemandlessofcurrentproducts,weneedtorecognizethat.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-4EstimatingCashFlowsCashFlowsfromOperationsRecallthat:OperatingCashFlow=EBITTaxes+DepreciationNetCapitalSpendingDontforgetsalvagevalue(aftertax,ofcourse).ChangesinNetWorkingCapitalRecallthatwhentheprojectwindsdown,weenjoyareturnofnetworkingcapital.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-5InterestExpenseLaterchapterswilldealwiththeimpactthattheamountofdebtthatafirmhasinitscapitalstructurehasonfirmvalue.Fornow,itsenoughtoassumethatthefirmslevelofdebt(henceinterestexpense)isindependentoftheprojectathand.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-67.2TheBaldwinCompany:AnExampleCostsoftestmarketing(alreadyspent):$250,000.Currentmarketvalueofproposedfactorysite(whichweown):$150,000.Costofbowlingballmachine:$100,000(depreciatedaccordingtoACRS5-yearlife).Increaseinnetworkingcapital:$10,000.Production(inunits)byyearduring5-yearlifeofthemachine:5,000,8,000,12,000,10,000,6,000.Priceduringfirstyearis$20;priceincreases2%peryearthereafter.Productioncostsduringfirstyearare$10perunitandincrease10%peryearthereafter.Annualinflationrate:5%WorkingCapital:initially$10,000changeswithsales.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-7TheWorksheetforCashFlowsoftheBaldwinCompanyYear 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1)Bowlingballmachine100.0021.76*(2)Accumulated20.0052.0071.2082.7294.24depreciation(3)Adjustedbasisof80.0048.0028.8017.285.76machineafterdepreciation(endofyear)(4)Opportunitycost150.00150.00(warehouse)(5)Networkingcapital10.0010.0016.3224.9721.220(endofyear)(6)Changeinnet10.006.328.653.7521.22workingcapital(7)Totalcashflowof260.006.328.653.75192.98investment(1)+(4)+(6)*Weassumethattheendingmarketvalueofthecapitalinvestmentatyear5is$30,000.Capitalgainisthedifferencebetweenendingmarketvalueandadjustedbasisofthemachine.Theadjustedbasisistheoriginalpurchasepriceofthemachinelessdepreciation.Thecapitalgainis$24,240(=$30,000$5,760).WewillassumetheincrementalcorporatetaxforBaldwinonthisprojectis34percent.Capitalgainsarenowtaxedattheordinaryincomerate,sothecapitalgainstaxdueis$8,2400.34($30,000$5,760).Theafter-taxsalvagevalueis$30,0000.34($30,000$5,760)=21,760.($thousands)(Allcashflowsoccurattheendoftheyear.)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-8TheWorksheetforCashFlowsoftheBaldwinCompanyAttheendoftheproject,thewarehouseisunencumbered,sowecansellitifwewantto.($thousands)(Allcashflowsoccurattheendoftheyear.)Year 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1)Bowlingballmachine100.0021.76*(2)Accumulated20.0052.0071.2082.7294.24depreciation(3)Adjustedbasisof80.0048.0028.8017.285.76machineafterdepreciation(endofyear)(4)Opportunitycost150.00150.00(warehouse)(5)Networkingcapital10.0010.0016.3224.9721.220(endofyear)(6)Changeinnet10.006.328.653.7521.22workingcapital(7)Totalcashflowof260.006.328.653.75192.98investment(1)+(4)+(6)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-9TheWorksheetforCashFlowsoftheBaldwinCompany(continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)SalesRevenues100.00163.00249.72212.20129.90($thousands)(Allcashflowsoccurattheendoftheyear.)Recallthatproduction(inunits)byyearduring5-yearlifeofthemachineisgivenby:(5,000,8,000,12,000,10,000,6,000).Priceduringfirstyearis$20andincreases2%peryearthereafter.Salesrevenueinyear3=12,000$20(1.02)2=12,000$20.81=$249,720.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-10TheWorksheetforCashFlowsoftheBaldwinCompany(continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)SalesRevenues100.00163.00249.72212.20129.90(9)Operatingcosts50.0088.00145.20133.1087.84($thousands)(Allcashflowsoccurattheendoftheyear.)Again,production(inunits)byyearduring5-yearlifeofthemachineisgivenby:(5,000,8,000,12,000,10,000,6,000).Productioncostsduringfirstyear(perunit)are$10and(increase10%peryearthereafter).Productioncostsinyear2=8,000$10(1.10)1=$88,000McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-11TheWorksheetforCashFlowsoftheBaldwinCompany(continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)SalesRevenues100.00163.00249.72212.20129.90(9)Operatingcosts50.0088.00145.20133.1087.84(10)Depreciation20.0032.0019.2011.5211.52($thousands)(Allcashflowsoccurattheendoftheyear.)DepreciationiscalculatedusingtheAcceleratedCostRecoverySystem(shownatright)Ourcostbasisis$100,000Depreciationchargeinyear4=$100,000(.1152)=$11,520.YearACRS%120.00%232.00%319.20%411.52%511.52%65.76%Total 100.00%McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-12TheWorksheetforCashFlowsoftheBaldwinCompany(continued)Year 0Year 1Year 2Year 3Year 4 Year 5Income:(8)SalesRevenues100.00163.00249.72212.20129.90(9)Operatingcosts50.0088.00145.20133.1087.84(10)Depreciation20.0032.0019.2011.5211.52(11)Incomebeforetaxes30.0043.2085.3267.5830.54(8)(9)-(10)(12)Taxat34percent10.2014.6929.0122.9810.38(13)NetIncome19.8028.5156.3144.6020.16($thousands)(Allcashflowsoccurattheendoftheyear.)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-13IncrementalAfterTaxCashFlowsoftheBaldwinCompanyYear 0Year 1Year 2Year 3Year 4Year 5(1)SalesRevenues$100.00$163.00$249.72$212.20$129.90(2)Operatingcosts-50.00-88.00-145.20133.10-87.84(3)Taxes-10.20-14.69-29.01-22.98-10.38(4)OCF(1)(2)-(3)39.8060.5175.5156.1231.68(5)TotalCFofInvestment260.6.328.653.75192.98(6)IATCF(4)+(5)260.39.8054.1966.8659.87224.66McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-147.3InflationandCapitalBudgetingInflationisanimportantfactofeconomiclifeandmustbeconsideredincapitalbudgeting.Considertherelationshipbetweeninterestratesandinflation,oftenreferredtoastheFisherrelationship:(1+NominalRate)=(1+RealRate)(1+InflationRate)Forlowratesofinflation,thisisoftenapproximatedasRealRateNominalRateInflationRateWhilethenominalrateintheU.S.hasfluctuatedwithinflation,mostofthetimetherealratehasexhibitedfarlessvariancethanthenominalrate.Whenaccountingforinflationincapitalbudgeting,onemustcomparerealcashflowsdiscountedatrealratesornominalcashflowsdiscountedatnominalrates.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-15ExampleofCapitalBudgetingunderInflationSonyInternationalhasaninvestmentopportunitytoproduceanewstereocolorTV.TherequiredinvestmentonJanuary1ofthisyearis$32million.Thefirmwilldepreciatetheinvestmenttozerousingthestraight-linemethod.Thefirmisinthe34%taxbracket.ThepriceoftheproductonJanuary1willbe$400perunit.Thepricewillstayconstantinrealterms.Laborcostswillbe$15perhouronJanuary1.Thewillincreaseat2%peryearinrealterms.Energycostswillbe$5perTV;theywillincrease3%peryearinrealterms.Theinflationrateis5%Revenuesarereceivedandcostsarepaidatyear-end.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-16ExampleofCapitalBudgetingunderInflationTherisklessnominaldiscountrateis4%.Therealdiscountrateforcostsandrevenuesis8%.CalculatetheNPV.Year1Year2Year3Year4PhysicalProduction(units)100,000200,000200,000150,000LaborInput(hours)2,000,0002,000,0002,000,0002,000,000Energyinput,physicalunits200,000200,000200,000200,000McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-17ExampleofCapitalBudgetingunderInflationThedepreciationtaxshieldisarisk-freenominalcashflow,andisthereforediscountedatthenominalrisklessrate.Costofinvestmenttoday=$32,000,000Projectlife=4yearsAnnualdepreciationexpense:Depreciationtaxshield=$8,000,000.34=$2,720,000McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-18ExampleofCapitalBudgetingunderInflationRiskyRealCashFlowsPrice:$400perunitwithzerorealpriceincreaseLabor:$15perhourwith2%realwageincreaseEnergy:$5perunitwith3%realenergycostincreaseYear1After-taxRealRiskyCashFlows:After-taxrevenues=$400100,000(1-.34)=$26,400,000After-taxlaborcosts=$152,000,0001.02(1-.34)=$20,196,000After-taxenergycosts=$52,00,0001.03(1-.34)=$679,800After-taxnetoperatingCF=$26,400,000-$20,196,000-$679,800=$5,524,200McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-19ExampleofCapitalBudgetingunderInflation$5,524,200$31,499,886$31,066,882$17,425,007-$32,000,000012 34YearOneAfter-taxrevenues=$400100,000(1-.34)=$26,400,000YearOneAfter-taxlaborcosts=$152,000,0001.02(1-.34)=$20,196,000YearOneAfter-taxenergycosts=$52,00,0001.03(1-.34)=$679,800YearOneAfter-taxnetoperatingCF=$5,524,200McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-20ExampleofCapitalBudgetingunderInflationTheprojectNPVcannowbecomputedasthesumofthePVofthecost,thePVoftheriskycashflowsdiscountedattheriskyrateandthePVoftherisk-freecashflowsdiscountedattherisk-freediscountrate.NPV=-$32,000,000+$69,590,868+$9,873,315=$47,464,183McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-21InvestmentsofUnequalLivesTheEquivalentAnnualCostMethodReplacementChainRepeattheprojectsforever,findthePVofthatperpetuity.Assumption:Bothprojectscanandwillberepeated.MatchingCycleRepeatprojectsuntiltheybeginandendatthesametimelikewejustdidwiththeaircleaners.ComputeNPVforthe“repeatedprojects”.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-227.4InvestmentsofUnequalLives:TheEquivalentAnnualCostMethodTherearetimeswhenapplicationoftheNPVrulecanleadtothewrongdecision.Considerafactorywhichmusthaveanaircleaner.Theequipmentismandatedbylaw,sothereisno“doingwithout”.Therearetwochoices:The“Cadillaccleaner”costs$4,000today,hasannualoperatingcostsof$100andlastsfor10years.The“cheapercleaner”costs$1,000today,hasannualoperatingcostsof$500andlastsfor5years.Whichoneshouldwechoose?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-237.4InvestmentsofUnequalLives:TheEquivalentAnnualCostMethodAtfirstglance,thecheapcleanerhasthelowerNPV(r=10%):ThisoverlooksthefactthattheCadillaccleanerlaststwiceaslong.Whenweincorporatethat,theCadillaccleanerisactuallycheaper.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-247.4InvestmentsofUnequalLives:TheEquivalentAnnualCostMethodTheCadillaccleanertimelineofcashflows:-$4,000100-100-100-100-100-100-100-100-100-100012345678910-$1,000500-500-500-500-1,500-500-500-500-500-500012345678910The“cheapercleaner”timelineofcashflowsover ten years:McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-25InvestmentsofUnequalLives:EACTheEquivalentAnnualCostMethodApplicabletoamuchmorerobustsetofcircumstancesthanreplacementchainormatchingcycle.TheEquivalentAnnualCostisthevalueofthelevelpaymentannuitythathasthesamePVasouroriginalsetofcashflows.NPV=EAC ArTForexample,theEACfortheCadillacaircleaneris$750.98TheEACforthecheaperaircleaneris$763.80whichconfirmsourearlierdecisiontorejectit.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-26ExampleofReplacementProjectsConsideraBelgianDentistsoffice;heneedsanautoclavetosterilizehisinstruments.Hehasanoldonethatisinuse,butthemaintenancecostsarerisingandsoisconsideringreplacingthisindispensablepieceofequipment.NewAutoclaveCost=$3,000today,Maintenancecost=$20peryearResalevalueafter6years=$1,200NPVofnewautoclave(atr=10%):EACofnewautoclave=-$553.29McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-27ExampleofReplacementProjectsExistingAutoclaveYear012345Maintenance0200275325450500Resale900850775700600500Total Annual CostTotalCostforyear1=(9001.10850)+200=$340340435TotalCostforyear2=(8501.10775)+275=$435478 TotalCostforyear3=(7751.10700)+325=$478620TotalCostforyear4=(7001.10600)+450=$620TotalCostforyear5=(6001.10500)+500=$660660Note that the total cost of keeping an autoclave for the first year includes the$200 maintenance cost as well as the opportunity cost of the foregone future value of the$900 we didnt get from selling it in year 0 less the$850 we have if we still own it at year 1.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-28ExampleofReplacementProjects340435478620660NewAutoclaveEACofnewautoclave=-$553.29ExistingAutoclaveYear012345Maintenance0200275325450500Resale900850775700600500Total Annual CostWeshouldkeeptheoldautoclaveuntilitscheapertobuyanewone.Replacetheautoclaveafteryear3:atthatpointthenewonewillcost$553.29forthenextyearsautoclavingandtheoldonewillcost$620foronemoreyear.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.7-297.5SummaryandConclusionsCapitalbudgetingmustbeplacedonanincrementalbasis.SunkcostsareignoredOpportunitycostsandsideeffectsmatterInflationmustbehandledconsistentlyDiscountrealflowsatrealratesDiscountnominalflowsatnominalrates.Whenafirmmustchoosebetweentwomachinesofunequallives:thefirmcanapplyeitherthematchingcycleapproachortheequivalentannualcostapproach.END
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