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Chapter 10
Making Capital
Investment Decisions
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Capital budgeting concepts
Relevant cash fows
Incremental cash fows ater tax eectshave been considered.
he !stand"alone# principle
$ach pro%ect can be eval&ated in isolation.
'&nk costs(ave alread) been inc&rred* so the) areirrelevant.
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Capital budgeting concepts(contd.)
+pport&nit) costs
'omething that we give &p b) &ndertaking apro%ect " can be di,c< to identi).
'ide eects
he impact a pro%ect has on other activities
o the -rm* e.g. Coke Diet Coke.
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Capital budgeting concepts(contd.)
/et working capital
0dditional &nds re1&ired at the
beginning o a pro%ect to p&rchaseinventor) and -nance acco&ntsreceivable 2 &s&all) recovered at
the end o the pro%ect.
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Capital budgeting concepts(contd.)
3inancing costs4e will ignore these or now 2
pro%ect acceptance or re%ectionsho&ld be driven b) the assets* not-nancing eects.
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Straightline depreciation
Depreciation expense 5
6initial cost 2 salvage
val&e78estimated lie
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!"ample o# straightlinedepreciation
$xample9 comp&te the ann&aldepreciation expense or a machine
that has an estimated &se&l lie o :)ears* a ;ero salvage val&e* and aninitial cost o *>>>*>>>.
depreciation expense 5 6M " >78:5
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$orking %ith M&C'Sschedules
Ignore salvage val&e
A )r convention
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!"ample o# %orking %ithM&C'S schedules
$xample9 the B"ear M0CR' sched&le
ear Depreciation
= BB.BB
? ::.::
B =:.E?
: F.:=
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ook value and market value
0re &s&all) dierent
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!"ample o# book value andmarket value
$xample9 comp&te the -rst")eardepreciation expense and the book val&eat the end o ear = or a machine in the
B"ear M0CR' class that has an initialcost o *>>>*>>>.
Depr. $xp. 5 .BBBBGM 5
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he concept o# estimatingsalvage values
4hat )o& think )o& co&ld sell thee1&ipment or when the pro%ect is
over.
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Calculating ta"es
ax 5 tax rate x 6salvage val&e 2book val&e7
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!"ample o# calculating ta"es
$xample9 what is the relevant taxpa)ment i a machine is sold or
>*>>> when the book val&e is*>>> and the tax rate is :>J
ax 5 .:> G 6>*>>> " *>>>75 >>
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a" shields
+cc&r when e1&ipment is sold orless than book val&e.
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terta" salvage value
0ter"tax salvage val&e 5$stimated salvage val&e " tax
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!"ample o# a#terta" salvagevalue
$xample9 what is the ater"tax salvageval&e o a machine that is sold or>*>>> when the book val&e is*>>> and the tax rate is :>J
0ter"tax salvage val&e
5 >*>>>"K.:>G6>*>>>"*>>>7L5 < =>E*>>>
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!stimating pro*ect cash+o%s
ro%ect cash fow5 operating cash fow 2 change in
/4C 2 capital spending
+perating cash fow5 $HI N depreciation 2 taxes
'cenario and sensitivit) anal)sis
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!"ample o# estimatingpro*ect cash +o%s
$xample9 the hiladelphia ret;el Compan)is considering an investment in a newpret;el twister. he machine will cost
*>>>* and will be depreciated on astraight"line basis to ;ero over two )ears.It will generate additional sales o *>>>per )ear and expenses o >> per)ear. he pro%ect will re1&ire an additionalinvestment in working capital o >>*which will be reed &p at the end o thepro%ect. he tax rate is :>.
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!"ample o# estimatingpro*ect cash +o%s (contd.)
6=7 $stimate the pro%ectOs cash fowsand comp&te the / at a
disco&nt rate o =?.
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!"ample o# estimatingpro*ect cash +o%s (contd.)
0 1 2Investment (20)000
NWC (*)000 *)000
Sales *0)000 *0)000
Expenses *)000 *)000
Gross Profit 1*)000 1*)000
Depreciation 10)000 10)000
EBIT *)000 *)000
Taxes 2)000 2)000
Net Income )000 )000
+ Depreciation 10)000 10)000
per Cas! flo" 1)000 1)000
Pro#ect C$ ,2*)000- 1)000 1.)000
NP% & 12' /*
I 1*'
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!"ample o# estimatingpro*ect cash +o%s (contd.)
6?7 Recomp&te the / i the machine issold or >> ater two )ears.
0ter"tax salvage val&e5 B>>>"K.:>6B>>>">7L 5 =E>>
$ect on / 5 N=E>>8=.=?? 5 =:B@
/ew / 5 P@F N =:B@ 5 ?BP?
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&dditional considerations incapital budgeting
Managerial optionsextra fexibilit) can onl) help a
pro%ect
Capital rationing
res<s rom a shortage o &nds
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Managerial options
he option to expand 6i things gowell7
he option to abandon 6i things gopoorl)7
he option to wait 6conditions ma)
improve7 'trategic options
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Capital rationing
'ot rationingd&e to b&dget allocation within the
-rm* b&t external -nancing isavailable
(ard rationingno external or internal capital isavailable