Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 10. Making Capital
Investment Decisions(^362) © The McGraw−Hill
Companies, 2002
The second part of OCF in this approach is the depreciation deduction multiplied by
the tax rate. This is called the depreciation tax shield. We know that depreciation is a
noncash expense. The only cash flow effect of deducting depreciation is to reduce our
taxes, a benefit to us. At the current 34 percent corporate tax rate, every dollar in depre-
ciation expense saves us 34 cents in taxes. So, in our example, the $600 depreciation de-
duction saves us $600 .34 $204 in taxes.
For the shark attractant project we considered earlier in the chapter, the depreciation
tax shield would be $30,000 .34 $10,200. The aftertax value for sales less costs
would be ($200,000 137,000) (1 .34) $41,580. Adding these together yields
the value of OCF:
OCF $41,580 10,200 $51,780
This calculation verifies that the tax shield approach is completely equivalent to the ap-
proach we used before.
Conclusion
Now that we’ve seen that all of these approaches are the same, you’re probably won-
dering why everybody doesn’t just agree on one of them. One reason, as we will see in
the next section, is that different approaches are useful in different circumstances. The
best one to use is whichever happens to be the most convenient for the problem at hand.
SOME SPECIAL CASES OF DISCOUNTED
CASH FLOW ANALYSIS
To finish our chapter, we look at three common cases involving discounted cash flow
analysis. The first case involves investments that are primarily aimed at improving effi-
ciency and thereby cutting costs. The second case we consider comes up when a firm is
involved in submitting competitive bids. The third and final case arises in choosing be-
tween equipment options with different economic lives.
There are many other special cases we could consider, but these three are particularly
important because problems similar to these are so common. Also, they illustrate some
very diverse applications of cash flow analysis and DCF valuation.
Evaluating Cost-Cutting Proposals
One decision we frequently face is whether or not to upgrade existing facilities to make
them more cost-effective. The issue is whether or not the cost savings are large enough
to justify the necessary capital expenditure.
For example, suppose we are considering automating some part of an existing pro-
duction process. The necessary equipment costs $80,000 to buy and install. The au-
tomation will save $22,000 per year (before taxes) by reducing labor and material costs.
For simplicity, assume that the equipment has a five-year life and is depreciated to zero
CONCEPT QUESTIONS
10.5a What are the top-down and bottom-up definitions of operating cash flow?
10.5bWhat is meant by the term depreciation tax shield?
CHAPTER 10 Making Capital Investment Decisions 333
depreciation tax shield
The tax saving that
results from the
depreciation deduction,
calculated as
depreciation multiplied
by the corporate tax
rate.