Making Capital Investment Decisions

1. Making Capital Investment Decisions

2. What finance functions add the most to firm value?

3. General Rules of Discounting • Only cash flows matter • Only examine incremental cash flow • Be consistent in treatment of inflation • Deduct taxes before discounting

4. Cash Flow are what matter • Cash flow = Dollars receive – Dollars paid • Earnings are NOT cash flow • Earnings are an ACCOUNTING NUMBER • Accountants start with cash flow, but then adjusts for timing, accruals, non-cash items etc. • Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows • You never write a check for “depreciation”

5. Incremental Cash Flows • These are cash flows that the firm only incurs if it takes the project • Need to consider all incremental cash flows that can be attributed to the project • Examples: Project Interactions, Opportunity Costs, Overhead, Depreciation, Taxes (including cap gains tax), and Salvage Values

6. Interactions (Side Effects) • Affects that the investment has on the cash flows of the firm’s other projects • Erosion or Cannibalism (Bad) • The new product causes existing customers to demand less of the company’s current products

7. Erosion in Action • Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?

8. Erosion in Action • Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?

9. Erosion in Action • Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?

10. Erosion in Action • Denon is planning on introducing a Blu-Ray player, which will likely hurt the sales of their DVD players. Are all of the sales/profits of the Blu-Ray project incremental?

11. Working Capital • Money the firm has on hand that is necessary for running the business • Think of the cash in a register, how effective is the register without the cash in the drawer • If a project requires changes in working capital, we need to account for this in our calculations • Why???

12. Opportunity Costs • Cash flows that can be realized from putting the assets to use in different projects. • What could we be making? • Example: When Price Club considers stocking a new product, what is the opportunity costs that it should be considering?

13. Overhead • The ongoing administrative expenses a business incurs, which cannot be attributed to any specific business activity, but are necessary to run the firm. • Examples: rent, utilities, and insurance. • Accountants allocate overhead across projects • Are we concerned about the amount of overhead the account’s will assign to our project?

14. Overhead • The ongoing administrative expenses a business incurs, which cannot be attributed to any specific business activity, but are necessary to run the firm. • Examples: rent, utilities, and insurance. • Accountants allocate overhead across projects • Are we concerned about the amount of overhead the account’s will assign to our project? • NO, we don’t care about accounting numbers • We do care about changes in overhead that result from our project

15. Example • A firm has only one division A, with assets of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • What is the relevant cash flow as far as the decision to add division B?

16. Example • A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m • What is the relevant cash flow as far as the decision to add division B?

17. Example • A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m, B=(27)*(50/150)=$9m • What is the relevant cash flow as far as the decision to add division B?

18. Example • A firm has only one division A, with assts of $100m and overhead of $20m. It is planning to add another division B. Division B will have another $50m in assets. Due to the addition of this division, overhead is expected to increase to $27m. The firm allocates overheads for the two divisions based on their assets. • What are the allocated overhead expenses? • A=(27)*(100/150)=$18m, B=(27)*(50/150)=$9m • What is the relevant cash flow as far as the decision to add division B? • Relevant overhead is $7m

19. Depreciation • Allocates the cost of an asset over its expected life, for accounting and tax purposes • Accounts for the decline in asset value because of wear and tear or obsolescence • Depreciation is based on the asset’s expected life, not on the life of the project • LAND DOES NOT DEPRECIATE

20. Why do we care about Depreciation • Depreciation is a non-cash expense, an accounting number, so why do we care about it? • Depreciation is tax deductible, and taxes are a LARGE cash expense

21. The Two Depreciations • Book (Accounting) Depreciation is what appears on financial statements • Ex. Straight line depreciation • Tax Depreciation is used to determine the firms tax bill • This determines the Tax Shield

22. The Two EBT’s EBDT -Book Dep -Tax Dep EBT (Book) EBT (Tax) -Taxes Paid Tax Rate Taxes Paid Net Income = Book EBT – Taxes Paid

23. Book Depreciation • This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: • Salvage Value:

24. Book Depreciation • This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: what did we pay for it • Salvage Value:

25. Book Depreciation • This type of depreciation is used to calculate a company’s Net Income • Straight line Depreciation: • (Investment – Salvage Value) / Expected life • Investment: what did we pay for it • Salvage Value: asset value at end of it’s life • What can we sell it for?

26. Tax Depreciation • Tax Depreciation is calculated using the Modified Accelerated Cost Recovery System • Tax depreciation ignores salvage value • MACRS allows for more depreciation early • How will this affect the PV of the tax shield? • Tax Shield = (Tax Depreciation * tax rate) • What is the Tax Shield?

27. Tax Depreciation • Tax Depreciation is calculated using the Modified Accelerated Cost Recovery System • Tax depreciation ignores salvage value • MACRS allows for more depreciation early • How will this affect the PV of the tax shield? • Tax Shield = (Tax Depreciation * tax rate) • What is the Tax Shield? The money that now goes to investors instead of the government

29. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrap, $100k. • What is the yearly accounting (straight line) and tax depreciation?

30. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000

31. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

32. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

33. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

34. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

35. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

36. Acct & Tax Dep. Example • Purchase an asset costing $1m, which has a 5 year expected life. After 5 years you can sell it for scrape, $100k. • What is the yearly accounting and tax depreciation? • Straight line (1,000,000 – 100,000)/5 = 180,000 • Tax 1,000,000 * schedule percent =

37. Proceeds from Sale and Capital Gains Tax • When a company sells an asset, if the price is above the tax book value, it is subject to capital gains • Capital Gains Tax Obligation = (Price- Tax Book Value) * Capital Gains Tax Rate

38. Capital Gains Tax Example • You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale?

39. Capital Gains Tax Example • You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • First what is the book value of the machine? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV:

40. Capital Gains Tax Example • You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit:

41. Capital Gains Tax Example • You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit: 600,000 - 432,000=168,000 • Capital Gains Tax owed:

42. Capital Gains Tax Example • You purchase a machine that will cost your company $1.5m, that has a life of 5 years. You plan to use the project for 3 years and then sell the machine for $600k, at the end of 5 years the machine is worth $50k. The capital gains rate is 20%. What is the tax obligation resulting from the sale? • Initial investment: 1,500,000; 5 years • Tax Dep: 20%, 32%, 19.2% • Year 3 BV: 1,500,000 * (1-0.2-0.32-0.192)=432,000 • Profit: 600,000 - 432,000=168,000 • Capital Gains Tax owed 0.20 * 168,000= $33,600

43. Inflation and Capital Budgeting • Inflation: general increase in the price of goods • Alternative: the general decline in the purchasing power of money • Hershey Nickel Bar: • In 1930 bar was 2 oz • In 1968 bar was ¾ oz • Inflation is an important fact of economic life and must be considered in capital budgeting.

44. Dealing with Inflation • KEY: Keep everything in either real or nominal terms • Real Cash Flows → Real Discount Rate • Nominal Cash Flows → Nominal Discount Rate • As long as we are consistent in our treatment of inflation we will get the same NPV

45. Real vs. Nominal • Nominal dollars: • Real dollars: • Nominal rate: • Real rate:

46. Real vs. Nominal • Nominal dollars are the dollars we have in our wallets • Real dollars • Nominal rate • Real rate

47. Real vs. Nominal • Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate • Real rate

48. Real vs. Nominal • Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate is the “total” rate of interest • Accounts for what you should earn & inflation • Real rate

49. Real vs. Nominal • Nominal dollars are the dollars we have in our wallets • Real dollars refer to a dollar’s purchasing power at a specific point in time • Nominal rate is the “total” rate of interest • Accounts for what you should earn & inflation • Real rate is want an investment should earn • Ignores inflation

50. Inflation and Discount rate • The relationship between interest rates and inflation is known as the Fisher Equation (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)