module 10 making capital investment decision so in this module we have three goals we are going to learn to compute the relevant cash flow for specific project we need to understand what the standalone concept means we also need to understand what sum cost opportunity cost side effect market and book value those are all concepts that we will review and then we need to make sure we can compute the depreciation and the book value of a project so there is basically four sections the first section will be the cash flow incremental cash flow proformat statement and then just a little bit more information about the project cash flow so to put this in context so you imagine that the company is ready to invest five million dollars to build a new plan well the question is is it a good idea to spend 5 million to build a new plant will it depend if by building the new plant i will be able to increase the value of the company to generate cash flows in excess of the cost of the project well yes if not no so the first thing to do and if you need to review the various technique uh module nine uh introduce net present value and so on so you can start by doing that here i'm going to just focus on the cash flow so when we talk about cash flow in capital budgeting we need to think about the cash flow that will occur or not occur if the project is accepted so each time we will ask ourselves the question okay will this cash flow occur if i accept the project or not and those cash flow we call them incremental cash flow and what we call the standalone principle allow us to analyze its project in isolation from the company order project since we will focus on just the incremental cash flow the cash flow that are related to that specific project now how will we make the right decision to know if a cash flow needs to be included or not but we will always ask ourselves the question will this cash flow occur only if we accept the project if we say yes well then you need to include the cash flow if you say no then it should not be included since it's going to happen anyway regardless if you accept to reject the project if you say part of it well then you need to include part of it so remember incremental cash flow and the standalone principle and how to identify those incremental cash flow by asking ourselves the right question let's continue with this discussion incremental cash flow let's see if we can illustrate this a little bit more so there is different types of cash flow the first one here is a sun cost that's a cost that has occurred in the past imagine that two years ago i hired a consultant to evaluate a piece of land i have regardless of what the consultant told me and regardless of how much the consultant cost me this will not impact my decision no i have to pay the consultant regardless of what i'm doing okay so this cost will occur regardless of what i do so some costs are not included opportunity cost yes should be included in the project for instance another example you bought some land six years ago and you spent 3.6 million at that time you wanted to build a warehouse and a distribution site now if you decide to sell the land now well then you will receive 4.1 million this amount needs to be included when we calculate the cash flow because if you build the warehouse you cannot sell the land right so you lose the opportunity to sell the land another is side effect sometimes there is positive side effect and sometimes negative side effect well you need to include this in the analysis for instance a positive side effect is something that will benefit so the project imagine you decide to purchase a new truck well that new truck could also be used to deliver maybe some of the other products you have so that's a positive side effect a negative side effect also called erosion or cannibalism means that your project will have a negative impact on the other project okay so in that case well you're going to have to reduce sales for instance your restaurant and you introduce a new type of fish or chicken or something well clearly your customers will now have more choices and it's possible that they will consume less of what your previous menu was you also need to include the changes in networking capital i remind you that networking capital is current assets minus current liabilities very often when we have a new project uh the networking capital will increase okay we need to just support new inventories and stuff like that so we need to include that in the analysis now we make an assumption we assume that at the end of the life of the project well we will recover the networking capital again we make an assumption that this will happen so for instance if in the beginning of my project i need to borrow 100 million to purchase new inventories and on and on well at the end of the life of my project i will sell i will assume that i'm selling those inventories and i can recuperate what i have spent against an assumption the financing cost you know interest expenses for instance will not be included uh in the analysis because we include those in the when we calculate the required rate of return the cost of capital taxes needs to be included so let's illustrate all this by building a pro format statement so what's a performance statement well it's the statement that we project okay so capital budgeting rely very heavily on accounting statement especially pro format income statement so remember your income statement is your sales minus cost minus the appreciation and on and on until the net income remember also that what we want is to work with cash flow and remember that cash flow is many different ways that we have discussed but cash flows are equal to net income plus depreciation so it makes sense but we want to use the income statement to calculate the net income so here's an example so you believe that if you invest in a new project you will be able to have increased sales by 50 000 unit and you will be able to sell each unit at four dollars per unit of course you will have some cost variable cost of 2.50 per unit so if you multiply 50 by 4 you have 200 000 if you multiply 50 by 2.5 you have 125 000. so see i'm building my income statement yeah so what will be the profit gross profit 75. now imagine that we have fixed cost of 17 for 30. imagine that depreciation will be equal to 30 well then we can calculate earnings before interest and taxes which will be 75 minus 17 minus 30 and imagine that the tax rate is 21 21 of 27 is 5790 and my net income is does twenty one thousand seven hundred and eighty so in this case what will be given if i had to have a solve a problem like that well this will have to be given i need to know what will the project uh generate i will this will have to be known this of course will be known fixed cost i will also have some information about how much this project will cost me so clearly i will spend ninety thousand dollars the new machine new equipment something and this new machine new equipment will allow me to increase sales okay now in this case we will assume just linear depreciation so remember linear depreciation means we depreciate the same amount every year and imagine that the life of this new machine is three years so that will have to be given to i will have to say well this is linear three years so 90 divided by 3 is 30 and then you will need to also know the tax rate so the rest i think we can calculate so let's continue this problem as i just mentioned we need to calculate the cash flow the operating cash flow or net income plus depreciation when there is no interest expenses and there is no interest expenses because as was mentioned in the beginning we assume no that there is no financing cost let's see if i can locate this here there is no financing cost okay there is no interest expenses so [Music] we just uh used the pro format income statement and have obtained net income of 21780. if this company will always have the same amount of sales fifty thousand fifty fifty fifty the same price the same cost the same tax rate well then the cash flow will always be the same it will always be net income plus the appreciation assume that the problem is telling us that this project will only um be kept this new machine for three years that it will cost us 90 000 that we need a rate of return of at least 20 of this type of project and this type of project will require an investment in net working capital of twenty thousand i need an investment of twenty thousand so what are all the cash flow of this specific project well they're presented here the first cash flow is minus 110 let's write those cash flow here to just make it a little bit clearer so the first cash flow in year zero i need to spend the 90 000 to buy the new piece of equipment and i need 20 000 in networking capital which is 110 000 okay so i need to borrow 110 000 in exchange for this 110 000 what can i expect to receive well i'm expecting to receive so this will be negative i expect to receive um several positive cash flow expect to receive 51 780 every single year for three years right so let's take a look in here so my investment is 110 and we will receive a cash flow 51 780 twice and the last cash flow will be 51 780 plus the recovery of networking capital remember i mentioned to you here that in the beginning of the project we will borrow at the end we receive the money back so my networking capital is 20 000 so at the end i will have plus 20 000 which is what this reflects and then you can calculate the net present value using a discount rate of 20 and you obtain a net present value of 10 000. now remember when the net present value is positive this is a good reason to accept the project now you could also in this case compare the cost of capital that was given the required rate of return was 20 i was given and let's assume that we calculate the internal rate of return present it on this slide and is 25.8 so clearly you are acquiring here you're making more money right than what you're spending so this is good you should accept the project so let's finish this by reviewing the last section about depreciation so you probably have covered in accounting the macrs which stands for modify accelerated cost recovery system in this case to apply this method you need number one to know which asset class is appropriate for tax purposes and of course that will always be given for instance if you purchase a computer a computer will be depreciated over five years then the second thing you will do you will multiply the percentage given in the table by the cost so we'll give you the percentage in this table here okay and then you need to remember you will depreciate to zero this means if you have some equipment that you depreciate over three years well at the end the equipment should be totally depreciated you should have zero also remember the mid-year convention as you can see when we say we depreciate over three years there is one two three four depreciation allowances even five years there is one two three four five six okay there's always one extra i just gave you three class life here is more of course in reality and this alfie is coming from the fact that companies can purchase assets whenever they want to and we assume that for the first year we will depreciate it for alpha year regardless of when the assets was purchased so let's illustrate so i have a computer and my computer be long in a five year class my computer is going to cost one hundred thousand and if my computer is a zero missing cost 100 000 which is the first thing that is given here that's given yeah how much will i depreciate well 20 the first year 32 the second year 19 twice 11.52 and one time five thousand seven hundred and sixty okay so um if you add all the depreciation allowance so 20 plus 32 plus 19 plus 11 plus 11 plus 5 you will obtain 100 000. okay so this means these assets will be totally depreciated so which depreciation should we use when we um operate in capital budgeting you should use the depreciation that is recommended by the irs for tax purposes so this will be this technique here the macrs and remember that's important for you maybe it's not always obvious immediately but we will illustrate that so depreciation is a non-cash expenses it's only relevant because it impact taxes so the depreciation tax shield is d the depreciation expenses allowances times the marginal tax rate and the last piece of information the book value is cost minus depreciation market value is what the market is ready to pay when the market value is greater than the book value we have a capital gain and we are going to have to pay tax on the capital gain so let's look at the practice section where we will illustrate all those concepts excellent