Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 10. Making Capital

Investment Decisions

(^368) © The McGraw−Hill
Companies, 2002
SUMMARY AND CONCLUSIONS
This chapter has described how to go about putting together a discounted cash flow
analysis. In it, we covered:

1. The identification of relevant project cash flows. We discussed project cash flows
   and described how to handle some issues that often come up, including sunk costs,
   opportunity costs, financing costs, net working capital, and erosion.


2. Preparing and using pro forma, or projected, financial statements. We showed how
   information from such financial statements is useful in coming up with projected
   cash flows, and we also looked at some alternative definitions of operating cash flow.


3. The role of net working capital and depreciation in determining project cash flows.
   We saw that including the change in net working capital was important in cash flow
   analysis because it adjusted for the discrepancy between accounting revenues and

CONCEPT QUESTIONS

10.6a Under what circumstances do we have to worry about unequal economic

lives? How do you interpret the EAC?

10.6bIn setting a bid price, we used a zero NPV as our benchmark. Explain why this is

appropriate.

CHAPTER 10 Making Capital Investment Decisions 339

10.7

Notice that the operating cash flow is actually positive in both cases because of the large

depreciation tax shields. This can occur whenever the operating cost is small relative to the

purchase price.

To decide which system to purchase, we compute the EACs for both using the appropriate

annuity factors:

Filtration system:
$973,112 EAC 3.6048

EAC 
$269,951

Precipitation system:
$1,531,650EAC 4.9676

EAC 
$308,328

The filtration system is the cheaper of the two, so we select it. In this case, the longer life

and smaller operating cost of the precipitation system are not sufficient to offset its higher ini-

tial cost.

Filtration System Precipitation System

Aftertax operating cost 
$ 39,600 
$ 6,600

Depreciation tax shield 74,800 80,750

Operating cash flow $ 35,200 $ 74,150

Economic life 5 years 8 years

Annuity factor (12%) 3.6048 4.9676

Present value of operating cash flow $ 126,888 $ 368,350

Capital spending 
1,100,000 
1,900,000

Total PV of costs 
$ 973,112 
$1,531,650