Introduction to Corporate Finance

(avery) #1
Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

IV. Capital Budgeting 10. Making Capital
Investment Decisions

© The McGraw−Hill^363
Companies, 2002

on a straight-line basis over that period. It will actually be worth $20,000 in five years.
Should we automate? The tax rate is 34 percent, and the discount rate is 10 percent.
As always, the first step in making such a decision is to identify the relevant incre-
mental cash flows. First, determining the relevant capital spending is easy enough. The
initial cost is $80,000. The aftertax salvage value is $20,000 (1 .34) $13,200 be-
cause the book value will be zero in five years. Second, there are no working capital
consequences here, so we don’t need to worry about changes in net working capital.
Operating cash flows are the third component to consider. Buying the new equipment
affects our operating cash flows in two ways. First, we save $22,000 before taxes every
year. In other words, the firm’s operating income increases by $22,000, so this is the rel-
evant incremental project operating income.
Second, and it’s easy to overlook this, we have an additional depreciation deduction.
In this case, the depreciation is $80,000/5 $16,000 per year.
Because the project has an operating income of $22,000 (the annual pretax cost sav-
ing) and a depreciation deduction of $16,000, taking the project will increase the firm’s
EBIT by $22,000 16,000 $6,000, so this is the project’s EBIT.
Finally, because EBIT is rising for the firm, taxes will increase. This increase in taxes
will be $6,000 .34 $2,040. With this information, we can compute operating cash
flow in the usual way:

So our aftertax operating cash flow is $19,960.
It might be somewhat more enlightening to calculate operating cash flow using a dif-
ferent approach. What is actually going on here is very simple. First, the cost savings in-
crease our pretax income by $22,000. We have to pay taxes on this amount, so our tax
bill increases by .34 $22,000 $7,480. In other words, the $22,000 pretax saving
amounts to $22,000 (1 .34) $14,520 after taxes.
Second, the extra $16,000 in depreciation isn’t really a cash outflow, but it does re-
duce our taxes by $16,000 .34 $5,440. The sum of these two components is
$14,520 5,440 $19,960, just as we had before. Notice that the $5,440 is the depre-
ciation tax shield we discussed earlier, and we have effectively used the tax shield ap-
proach here.
We can now finish off our analysis. Based on our discussion, the relevant cash flows
are:

At 10 percent, it’s straightforward to verify that the NPV here is $3,860, so we should
go ahead and automate.

334 PART FOUR Capital Budgeting


EBI T$ 6,000
Depreciation 16,000
Taxes 2,040
Operating cash flow $19,960

Year
0 12345
Operating cash flow $19,960 $19,960 $19,960 $19,960 $19,960
Capital spending $80,000 13,200
Total cash flow $80,000 $19,960 $19,960 $19,960 $19,960 $33,160
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