Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 10. Making Capital

Investment Decisions

© The McGraw−Hill^357

Companies, 2002

Total Cash Flow and Value We now have all the cash flow pieces, and we put them

together in Table 10.14. In addition to the total project cash flows, we have calculated

the cumulative cash flows and the discounted cash flows. At this point, it’s essentially

plug-and-chug to calculate the net present value, internal rate of return, and payback.

If we sum the discounted flows and the initial investment, the net present value (at

15 percent) works out to be $65,488. This is positive, so, based on these preliminary

projections, the power mulcher project is acceptable. The internal, or DCF, rate of return

is greater than 15 percent because the NPV is positive. It works out to be 17.24 percent,

again indicating that the project is acceptable.

Looking at the cumulative cash flows, we can see that the project has almost paid

back after four years because the table shows that the cumulative cash flow is almost

zero at that time. As indicated, the fractional year works out to be $17,322/214,040 

.08, so the payback is 4.08 years. We can’t say whether or not this is good because we

don’t have a benchmark for MMCC. This is the usual problem with payback periods.

Conclusion This completes our preliminary DCF analysis. Where do we go from

here? If we have a great deal of confidence in our projections, then there is no further

analysis to be done. MMCC should begin production and marketing immediately. It is

unlikely that this will be the case. It is important to remember that the result of our

analysis is an estimate of NPV, and we will usually have less than complete confidence

in our projections. This means we have more work to do. In particular, we will almost

surely want to spend some time evaluating the quality of our estimates. We will take up

this subject in the next chapter. For now, we take a look at some alternative definitions

of operating cash flow, and we illustrate some different cases that arise in capital

budgeting.

CONCEPT QUESTIONS

10.4a Why is it important to consider changes in net working capital in developing

cash flows? What is the effect of doing so?

10.4bHow is depreciation calculated for fixed assets under current tax law? What ef-

fects do expected salvage value and estimated economic life have on the cal-

culated depreciation deduction?

328 PART FOUR Capital Budgeting

TABLE 10.12

Changes in Net Working

Capital, Power Mulcher

Project

Year Revenues Net Working Capital Cash Flow

0 $ 20,000 
$20,000

1 $360,000 54,000 
34,000

2 600,000 90,000 
36,000

3 720,000 108,000 
18,000

4 715,000 107,250 750

5 660,000 99,000 8,250

6 550,000 82,500 16,500

7 440,000 66,000 16,500

8 330,000 49,500 16,500