Module 10: Making Capital Investment Decisions

Goals

1. Compute the relevant cash flow for a specific project.
2. Understand the standalone concept.
3. Understand various cost concepts: sunk cost, opportunity cost, side effect, market and book value.
4. Compute depreciation and the book value of a project.

Sections

1. Cash Flow, Incremental Cash Flow, and Proforma Statement
2. More information on project cash flow.

Key Concepts

Incremental Cash Flow

• Definition: Cash flow that will occur only if the project is accepted.
• Standalone Principle: Analyzes project in isolation from other company projects, focusing on incremental cash flow.
• Question to Ask: Will this cash flow occur only if we accept the project?
  • Yes: Include the cash flow.
  • No: Do not include, as it happens anyway.
  • Partly: Include part of it.

Types of Costs

• Sunk Cost: Costs that occurred in the past and should not impact the decision.
• Opportunity Cost: Cost of forgoing the next best alternative; should be included in the project.
• Side Effects:
  • Positive: Additional benefits to other company projects.
  • Negative (Erosion/Cannibalism): Adverse impacts reducing other sales.

Networking Capital

• Definition: Current assets minus current liabilities.
• New projects often require increased networking capital.
• Assumption: Recover networking capital at project's end.

Financing Costs and Taxes

• Financing Cost: Not included in capital budgeting analysis.
• Taxes: Must be included in the analysis.

Proforma Statement

• Use: Projected accounting statement used in capital budgeting.
• Components: Sales, costs, depreciation leading to net income.
• Cash Flow Calculation: Net Income + Depreciation.
• Example Problem: Analyzing an investment based on changes to units sold and costs.

Example Project Analysis

• Initial Investment: $110,000 for equipment and networking capital.
• Annual Cash Flow: $51,780 for three years.
• Net Present Value (NPV): Calculation using a discount rate of 20%.
• Decision Criteria:
  • Positive NPV: Accept the project.
  • Compare Internal Rate of Return (IRR) with Required Rate of Return.

Depreciation

• MACRS (Modified Accelerated Cost Recovery System):
  • Know asset class for tax purposes.
  • Multiply percentage from table by cost.
  • Depreciate to zero using mid-year convention.
• Example: Depreciating a computer over five years using IRS guidelines.
• Depreciation Tax Shield: Product of depreciation allowances and marginal tax rate.

Book Value and Market Value

• Book Value: Cost minus depreciation.
• Market Value: What the market is willing to pay.
• Capital Gains: When market value > book value, pay tax on the gain.

Practice Section

• Application of concepts through practical problems and illustrations.