Ch 8 Capital Budgeting

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Ch 8 Capital Budgeting

• 1. Incremental Cash Flows
• 2. An Example
• 3. The Boeing 777 A Real-World Example
• 4. Inflation and Capital Budgeting
• 5. A Capital Budgeting Simplification
• 6. Investments of Unequal Lives The Equivalent
  Annual Cost Method
• 7. Summary and Conclusions

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1. Incremental Cash Flows

• Focus on the difference in the firms cash flows
  with and without the project ---incremental cash
  flows.
• 1.1 Only cash flow is relevant
• Cash flow Cash flow from operation
• ? addition to net working capital ? capital
  spending
• transform accounting data into cash flows.
• depreciation are not cash flows.
• tax savings due to depreciation are cash flows.
• a change in net working capital affects cash
  flows.
• Always estimate cash flows on an after-tax basis,
  since this is what shareholders are interested in.

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• Do not include interest paid or any other
  financing costs such as dividends. Financing
  costs are implicitly considered in discount rate.
  
• 1.2 Estimate cash flows on an incremental basis
• Forget sunk costs. Expenditures which have
  already been made are irreversible and irrelevant
  (e.g., cost of a project feasibility study).
• Include opportunity costs. The use of land.
• Include all side effects, i.e., erosion or
  synergy effects.
• Allocated costs are relevant only if they affect
  incremental cash flows.

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2 An Example

• Costs of test marketing (already spent)
  250,000.
• The proposed factory site has no resale value.
• Cost of the machine 800,000 (asset class 8,
  20 CCA rate).
• Production (in units) by year 6,000, 9,000,
  12,000, 13,000, 12,000, 10,000, 8,000, and 6,000.
• Price initially 100, and up 2 p.a.
  thereafter.
• Production costs initially 64 and up 5 p.a.
• Fixed production costs are 50,000 each year.
• Working capital initially 40,000, then 15 of
  sales each year, and 0 by the projects end.

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1. Operating cash flows
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Example CCA (capital cost allowance)
(All cash flows occur at the end of the year.)
CCA calculations are based on a class 8, 20
rate. The machine cost 800,000. CCA charge in
year 5 368,640(0.20) 73,728.
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Operating cash flows
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Investment cash flows
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NPV of cash flows
NPV_at_4 500,135 NPV_at_10 188,042 NPV_at_15
2,280 NPV_at_20 (137,896) IRR 15.07
If the projects discount rate is above 15.07,
it should not be accepted (since NPV gt 0).
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3. The Boeing 777 A Real-World Example

• In late 1990, the Boeing Company announced its
  intention to build the Boeing 777, a commercial
  airplane that could carry up to 390 passengers
  and fly 7,600 miles.
• Analysts expected the up-front investment and RD
  costs would be as much as 8 billion.
• Delivery of the planes was expected to begin in
  1995 and continue for at least 35 years.

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NPV of the Boeing 777 Project

• Boeing should accept this project at discount
  rates less than 21 percent and reject the project
  at higher discount rates.

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4. Inflation and Capital Budgeting

• While the nominal rate has fluctuated with
  inflation, most of the time the real interest
  rate has exhibited far less variance than the
  nominal rate.
• The Fisher relation
• (1 Nominal Rate) (1 Real Rate) (1
  Inflation Rate)
• For low rates of inflation, this is often
  approximated as
• Real Rate ? Nominal Rate Inflation Rate
• Discount nominal cash flows at a nominal discount
  rate, or discount real cash flows at a real
  discount rate.
• Provided you do this, it doesn't matter whether
  you work in real or nominal terms.

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Example NPV in nominal and real term

• Whether we work in real or nominal doesn't
  matter.
• Be careful with depreciation. It is specified in
  the tax code in nominal terms. Work out
  depreciation in nominal terms and then convert to
  real terms.

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5. A capital budgeting simplification

• Operating cash flow (OCF)
• Revenues Expenses Taxes
• Taxes Tc(Revenues Expenses CCA)
• Revenues(1- Tc) Expenses(1- Tc) TcCCA
• TcCCA tax shield on CCA.

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• Present Value of the Tax Shield on CCA
• The PV of CCA tax shield is a perpetuity. The PV
  of CCA tax shield is given by

S Minresale value of assets, original price of
assets C original price of the assets d
depreciation rate that applies to the asset
class k discount rate n the time when assets
are sold
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Advantages of the tax shield approach

• Simplify calculations.
• One can use simplifying formulas (e.g. annuities
  and growing annuities.)
• No need to calculate the net income.
• One can use different discount rates associated
  with different levels of risk.

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6. Investments of unequal lives the EAC

• There are two machines that do the same thing
  (copy machines). You need to decide on which
  machine to use.
• Example 1 A case of matching life-cycle
• Machine A and B have the same benefits. A lasts
  2 years, while B lasts 1 year. The cost are

Is machine B a better choice?
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• Not necessarily. Machine B has a shorter life.
• One way to dealing with unequal lives is to
  assume that the machines are replaced by
  identical ones until we reach a point where the
  machines wear out together.

Machine B is a better choice.
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• Example 1 Equivalent Annuity Cost

• We can calculate an equivalent annuity cost
  (EAC). An EAC is like an average, but it takes
  into account the time value of money.
• Suppose we make annual payment of C over the two
  years. We want to find out C such that the PV of
  this annuity is equal to the PV of cash flow.

.

• For A  C 1.736 28.8 ? C 16.6.

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• For machine B, we want to find out C payment at
  the end of year 1 such that PV of this payment is
  equal to the PV of all cash flows given in the
  table, which is 14.6
• For B C/(110) 14.6 ? C 16.
• In this case 16 lt 16.6, so again B is preferable.
  
• Do you think this would be a good methodology for
  personal computers?

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Example of Replacement Projects

• Consider a Belgian Dentists office he needs an
  autoclave to sterilize his instruments. He has an
  old one that is in use, but the maintenance costs
  are rising and so he is considering replacing
  this indispensable piece of equipment.
• New Autoclave
• Cost 3,000 today,
• Maintenance cost 20 per year
• Resale value after 6 years 1,200
• NPV of new autoclave (at r 10)

EAC of new autoclave -553.29
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Example of Replacement Projects

• Existing Autoclave
• Year 0 1 2 3 4 5
• Maintenance 0 200 275 325 450 500
• Resale 900 850 775 700 600 500
• Total Annual Cost 340 435 478
  620 660

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Example of Replacement Projects

• New Autoclave
• EAC of new autoclave -553.29
• Existing Autoclave
• Year 0 1 2 3 4 5
• Maintenance 0 200 275 325 450 500
• Resale 900 850 775 700 600 500
• Total Annual Cost

435
478
620
660
340

• We should keep the old autoclave until its
  cheaper to buy a new one.
• Replace the autoclave after year 3 at that
  point the new one will cost 553.29 for the next
  years autoclaving and the old one will cost 620
  for one more year.

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8.7 Summary and Conclusions

• Capital budgeting must be placed on an
  incremental basis.
• Sunk costs are ignored
• Opportunity costs and side effects matter
• Inflation must be handled consistently
• Discount real flows at real rates
• Discount nominal flows at nominal rates
• When a firm must choose between two machines of
  unequal lives
• the firm can apply either the matching cycle
  approach
• or the equivalent annual cost approach