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:
- 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. - 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. - 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