1. Sunk costs: costs that have accrued in the past, orwill be paid regardless of the decision
2. Opportunity costs: costs of lost options
3. Side effects: Positive side effects, benefits to other projects, Negative side effects, costs to other projects
4. Changes in net working capital
5. Financing costs
6. Taxes
Incremental Cash Flows that matter and don't matter
1. Cash flows matter—not accounting earnings.
2. Sunk costs don’t matter.
3. Incremental cash flows matter.
4. Opportunity costs matter.
5. Side effects like cannibalism matter
6. Taxes matter: we want incremental after-taxcash flows.
7. Inflation matters.
8. Allocation of existing costs does not matter
Cash Flow from Operations
OCF = EBIT – Taxes + Depreciation
OCF = NI + Depreciation
(where there is no interest expense)
Cash Flow from Assets = OCF - net capital spending - changes in NWC
Tax shield approach
OCF = (Sales - Costs) (1-T) + DT
After-tax Salvage
Book Value = Initial cost - accumulated depreciation
After-tax Salvage value = salvage - T(salvage - book value)
You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for$17,000 when you are done with it in 6 years.The company’s marginal tax rate is 40%. What is the depreciation expense each year and the after-tax salvage in year 6 for three-year MACRS?
BV = $110,000
Accum D = BV*0.33+BV*0.44+BV*0.1483+BV*0.0741
Accum D = 110,000
BV in 6 years = BV - Accum D = 0
After-tax Salvage = 17,000 - 0.4(17,000-0)
After-tax Salvage = 10,200
Replacement Problem
Pro Forma Income Statement
Cost Savings
Depreciation New
Depreciation Old
Incremental (New- Old)
EBIT (Savings - Incremental)
Taxes on EBIT
Net Income
OCF = NI + D
Year 0 include After tax salvage of old machine and capital spending of new
Year end after tax salvage of 2nd machine
Replacement Chain Analysis
1. Repeat projects until they begin and end at the same time.
2. Compute NPV for the “repeated projects.”
3. In replacement year the cash flow cost includes old tool plus replacement cost
The cost of the new machine is $127,000.
Installation will cost $20,000.
$4,000 in net working capital will be needed at the time of installation.
The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.
Simplified straight line depreciation is used.
Class life is 5 years, and the firm is planning to keep the project for 5 years.
Salvage value at the end of year 5 will be $50,000.
14% cost of capital; 34% marginal tax rate.
Find Net Initial Outlay.
Initial Outlay:
(Cost)
+(S&A)
= (Depreciable Asset)
+(Investment in working capital)
+ After-tax proceeds from sale of old asset
= Net Initial Outlay = ($151,000)
The cost of the new machine is $127,000.Installation will cost $20,000.$4,000 in net working capital will be needed at the time of installation.The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.Simplified straight line depreciation is used.Class life is 5 years, and the firm is planning to keep the project for 5 years.Salvage value at the end of year 5 will be $50,000.14% cost of capital; 34% marginal tax rate.
Find Annual Cash Flows
Incremental revenue
- Incremental costs
- Depreciation on project Incremental earnings before taxes
- Tax on incremental EBT Incremental earnings after taxes
+ Depreciation reversal
= Annual Cash Flow
ACF = 46,461
The cost of the new machine is $127,000.Installation will cost $20,000.$4,000 in net working capital will be needed at the time of installation.The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.Simplified straight line depreciation is used.Class life is 5 years, and the firm is planning to keep the project for 5 years.Salvage value at the end of year 5 will be $50,000.14% cost of capital; 34% marginal tax rate.
Find Terminal Cash Flow
Salvage value
- Tax on capital gain
+ Recapture of NWC
= Terminal Cash Flow
TCF = 37,000
Cost of equipment = $400,000
Shipping & installation will be $20,000
$25,000 in net working capital required at setup
3-year project life
5-year class life
Simplified straight line depreciation
Revenues will increase by $220,000 per year
Defects costs will fall by $10,000 per year
Operating costs will rise by $30,000 per year
Salvage value after year 3 is $200,000
Cost of capital = 12%marginal tax rate = 34%
CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160,560 + 214,120 = 374,680
Discount rate = 12%
IRR = 22.1%
NPV = $93,044.
Accept the project!
Cost of equipment = $550,000
Shipping & installation will be $25,000
$15,000 in net working capital required at setup
8-year project life, 5-year class life
Simplified straight line depreciation
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Salvage value after year 8 is $40,000
Cost of capital = 14%, marginal tax rate = 34%
Initial Outlay (590,000)
197,500 = Annual Cash Flow yrs 1-5
158,400 = Annual Cash Flow yrs 6-8
41,400 Terminal Cash Flow
Replacement Project:
Old Asset (5 years old):
Cost of equipment = $1,125,000
10-year project life, 10-year class life
Simplified straight line depreciation
Current salvage value is $400,000
Cost of capital = 14%, marginal tax rate =35%
(1,417,125) Net Initial Outlay
337,295 = Differential Cash Flow
393,000 Terminal Cash Flow
NPV = (55,052.07)
IRR = 12.55%
Which of these capital investment analysis techniques facilitates comparison of projects with unequal useful lives?
C. Replacement Chain
At the conclusion of your project, your company sells a fixed asset for $200,000. The asset’s book value is $148,000, and the firm’s tax rate is 34 percent. Calculate the after-tax cash flow from this sale
After-tax cash flow $182,320
A firm purchases a machine for $2,000,000 which has a class life of 3 years MACRS. The firm’s cost of capital is 12 percent. When calculating operating cash flows, what are
1.The yearly depreciation tax shields
2.The total present value of the tax benefits
3-Yr MACR
33.33%
44.45%
14.81%
PV $515,003
You are evaluating the proposed acquisition of a machine that costs $220,000. The machine will result in increased sales of $120,000 per year for 3 years, but costs will increase by $25,000 per year. The machine will be depreciated 3 years MACRS and will be sold for an estimated $50,000 after 3 years. NWC will increase by $75,000 and remain constant for the life of the project. The firm’s tax rate is 40 percent and discount rate is 9 percent. Calculate the project’s cash flows and NPV.
Initial outlay (295,000)
Operating Cash Flow 70,033
Terminal Cash Flow 111,521
Which should treat as incremental cash flowa. Reduction in sales of a company's other products caused by the investmentb. an expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted.c. cost of R&D in connection with the product during the past three years.d. annual depreciation expenses from the investmente. dividend payments by the firmf. resale value of plant and equipment at end of the project's lifeg. salary and medical costs for production personnel who will be employed only if the project is accepted.
a. yes, b. yes, c. no, d. yes, e. no, f. yes, g, yes
Which costs not relevanta. land you already own that will be used for the project but otherwise will be sold for $700K.b. a $300K drop in sales of other product that result from introduction of new one.c. $200K research last year
a. Relevant - opportunity cost
b. relevant - erosion side effect
c. not relevant - sunk cost
Given the choice would firm prefer MACRS or straight line.
For tax purposes prefer MACRS because provide larger depreciation earlier and hence larger tax shield.