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1、McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Making Capital Investment Decisions Chapter 8McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Key Concepts and SkillsUnderstand how to determine the relevant cash flows for va
2、rious types of capital investmentsBe able to compute depreciation expense for tax purposesIncorporate inflation into capital budgetingUnderstand the various methods for computing operating cash flowApply the Equivalent Annual Cost approachMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies,
3、 Inc. All rights reserved.Chapter Outline8.1 Incremental Cash Flows8.2 The Baldwin Company: An Example8.3 Inflation and Capital Budgeting8.4 Alternative Definitions of Cash Flow8.5 Investments of Unequal Lives: The Equivalent Annual Cost MethodMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Compa
4、nies, Inc. All rights reserved.8.1 Incremental Cash FlowsCash flows matternot accounting earnings.Sunk costs dont matter.Incremental cash flows matter.Opportunity costs matter.Side effects like cannibalism and erosion matter.Taxes matter: we want incremental after-tax cash flows. Inflation matters.M
5、cGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Cash FlowsNot AccountingConsider depreciation expense. You never write a check made out to “depreciation.”Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.McGraw-
6、Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Incremental Cash FlowsSunk costs are not relevantJust because “we have come this far” does not mean that we should continue to throw good money after bad.Opportunity costs do matter. Just because a project has a positive
7、 NPV, that does not mean that it should also have automatic acceptance. Specifically, if another project with a higher NPV would have to be passed up, then we should not proceed.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Incremental Cash FlowsSide effects
8、matter.Erosion and cannibalism are both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that.If, however, synergies result that create increased demand of existing products, we also need to recognize that.McGraw-Hill/IrwinCopyright 20
9、07 by The McGraw-Hill Companies, Inc. All rights reserved.Estimating Cash FlowsCash Flow from OperationsRecall that:OCF = EBIT Taxes + DepreciationNet Capital SpendingDont forget salvage value (after tax, of course).Changes in Net Working CapitalRecall that when the project winds down, we enjoy a re
10、turn of net working capital.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Interest ExpenseLater chapters will deal with the impact that the amount of debt that a firm has in its capital structure has on firm value.For now, its enough to assume that the firms
11、level of debt (and, hence, interest expense) is independent of the project at hand.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.8.2 The Baldwin CompanyCosts of test marketing (already spent): $250,000Current market value of proposed factory site (which we ow
12、n): $150,000Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year)Increase in net working capital: $10,000Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All
13、 rights reserved.The Baldwin CompanyPrice during first year is $20; price increases 2% per year thereafter.Production costs during first year are $10 per unit and increase 10% per year thereafter.Annual inflation rate: 5%Working Capital: initial $10,000 changes with salesMcGraw-Hill/IrwinCopyright 2
14、007 by The McGraw-Hill Companies, Inc. All rights reserved.The Baldwin CompanyYear 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1) Bowling ball machine100.00 21.76*(2) Accumulated 20.0052.0071.2082.72 94.24 depreciation(3) Adjusted basis of 80.0048.0028.8017.28 5.76 machine after depreciation (end
15、of year)(4) Opportunity cost150.00 150.00(warehouse)(5) Net working capital 10.00 10.0016.3224.9721.22 0 (end of year)(6) Change in net 10.006.32 8.653.75 21.22 working capital(7) Total cash flow of260.00 6.32 8.653.75 192.98 investment(1) + (4) + (6)($ thousands) (All cash flows occur at the end of
16、 the year.)McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.The Baldwin CompanyAt the end of the project, the warehouse is unencumbered, so we can sell it if we want to.Year 0Year 1Year 2Year 3Year 4 Year 5 Investments:(1) Bowling ball machine100.00 21.76*(2) Ac
17、cumulated 20.0052.0071.2082.72 94.24 depreciation(3) Adjusted basis of 80.0048.0028.8017.28 5.76 machine after depreciation (end of year)(4) Opportunity cost150.00 150.00(warehouse)(5) Net working capital 10.00 10.0016.3224.9721.22 0 (end of year)(6) Change in net 10.006.32 8.653.75 21.22 working ca
18、pital(7)Total cash flow of260.00 6.32 8.653.75 192.98 investment(1) + (4) + (6)McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.The Baldwin CompanyYear 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.20249.72212.20 129.90 Recall that producti
19、on (in units) by year during the 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000).Price during the first year is $20 and increases 2% per year thereafter.Sales revenue in year 3 = 12,000$20(1.02)2 = 12,000$20.81 = $249,720.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hi
20、ll Companies, Inc. All rights reserved.The Baldwin CompanyYear 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.20249.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.84Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000
21、, 12,000, 10,000, 6,000).Production costs during the first year (per unit) are $10, and they increase 10% per year thereafter.Production costs in year 2 = 8,000$10(1.10)1 = $88,000McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.The Baldwin CompanyYear 0Year 1Ye
22、ar 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.20249.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.84(10) Depreciation 20.00 32.00 19.20 11.52 11.52Depreciation is calculated using the Accelerated Cost Recovery System (shown at right).Our cost basis is $100,000.Deprecia
23、tion charge in year 4 = $100,000(.1152) = $11,520.YearACRS % 120.00% 232.00%319.20%411.52%511.52%65.76%Total 100.00%McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.The Baldwin CompanyYear 0Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues100.00163.20249
24、.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.84(10) Depreciation 20.00 32.00 19.20 11.52 11.52(11) Income before taxes 30.00 43.20 85.32 67.58 30.54 (8) (9) - (10)(12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38(13) Net Income 19.80 28.51 56.31 44.60 20.16McGraw-Hill/IrwinCop
25、yright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Incremental After Tax Cash Flows Year 0Year 1Year 2Year 3Year 4Year 5(1) Sales Revenues $100.00$163.20$249.72$212.20$129.90(2) Operating costs -50.00-88.00-145.20133.10-87.84(3) Taxes -10.20-14.69-29.01-22.98-10.38(4) OCF(1) (2) (3)
26、39.8060.5175.5156.1231.68(5) Total CF of Investment260. 6.328.653.75192.98(6) IATCF(4) + (5)260. 39.8054.1966.8659.87224.66588.51$)10. 1 (66.224$)10. 1 (87.59$)10. 1 (86.66$)10. 1 (19.54$)10. 1 (80.39$260$5432NPVNPVMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserve
27、d.NPV of Baldwin Company139.8051.588260CF1F1CF0INPV10154.19CF2F2166.86CF3F3159.87CF4F41224.66CF5F5McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.8.3 Inflation and Capital BudgetingInflation is an important fact of economic life and must be considered in capita
28、l budgeting.Consider the relationship between interest rates and inflation, often referred to as the Fisher equation:(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Inflation and Capital BudgetingFor low
29、rates of inflation, this is often approximated: Real Rate Nominal Rate Inflation RateWhile the nominal rate in the U.S. has fluctuated with inflation, the real rate has generally exhibited far less variance than the nominal rate.In capital budgeting, one must compare real cash flows discounted at re
30、al rates or nominal cash flows discounted at nominal rates.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Other Methods for Computing OCFBottom-Up ApproachWorks only when there is no interest expenseOCF = NI + depreciationTop-Down ApproachOCF = Sales Costs Tax
31、esDont subtract non-cash deductionsTax Shield ApproachOCF = (Sales Costs)(1 T) + Depreciation*TMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.8.5 Investments of Unequal LivesThere are times when application of the NPV rule can lead to the wrong decision. Consi
32、der a factory that must have an air cleaner that is mandated by law. There are two choices:The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100, and lasts 10 years.The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500, and lasts 5 years.Assuming a 1
33、0% discount rate, which one should we choose?McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Investments of Unequal LivesAt first glance, the Cheapskate cleaner has a higher NPV.101004,614.46 4,000CF1F1CF0INPV1055002,895.391,000CF1F1CF0INPV10Cadillac Air Cleane
34、rCheapskate Air CleanerMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Investments of Unequal LivesThis overlooks the fact that the Cadillac cleaner lasts twice as long.When we incorporate that, the Cadillac cleaner is actually cheaper (i.e., has a higher NPV).
35、McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Investments of Unequal LivesReplacement ChainRepeat projects until they begin and end at the same time.Compute NPV for the “repeated projects.”The Equivalent Annual Cost MethodMcGraw-Hill/IrwinCopyright 2007 by Th
36、e McGraw-Hill Companies, Inc. All rights reserved.Replacement Chain ApproachThe Cadillac cleaner time line of cash flows:-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -1000 1 2 3 4 5 6 7 8 9 10-$1,000 500 -500 -500 -500 -1,500 -500 -500 -500 -500 -5000 1 2 3 4 5 6 7 8 9 10The Cheapskate cleane
37、r time line of cash flows over ten years:McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Replacement Chain Approach101004,6144,000CF1F1CF0INPV1045004,6931,000CF1F1CF0INPV10Cadillac Air CleanerCheapskate Air Cleaner11,500CF2F25500CF3F3McGraw-Hill/IrwinCopyright
38、2007 by The McGraw-Hill Companies, Inc. All rights reserved.Equivalent Annual Cost (EAC)Applicable to a much more robust set of circumstances than the replacement chainThe EAC is the value of the level payment annuity that has the same PV as our original set of cash flows.For example, the EAC for th
39、e Cadillac air cleaner is $750.98.The EAC for the Cheapskate air cleaner is $763.80, which confirms our earlier decision to reject it.McGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Cadillac EAC with a Calculator101004,614.464,000CF1F1CF0INPV10750.98104,614.461
40、0PMTI/YFVPVNPVMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Cheapskate EAC with a Calculator55002,895.391,000CF1F1CF0INPV10763.8010-2,895.39 5PMTI/YFVPVNPVMcGraw-Hill/IrwinCopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.Quick QuizHow do
41、we determine if cash flows are relevant to the capital budgeting decision?What are the different methods for computing operating cash flow, and when are they important?How should cash flows and discount rates be matched when inflation is present?What is equivalent annual cost, and when should it be used?