BOS 360 - Finance

CAPITAL BUDGETING
Capital budgeting provides certain techniques in evaluating current/future projects of the
firm. The most typical use of capital budgeting is to evaluate a replacement asset due to
old age (obsolescence) or break-down (maintenance). Sometimes a new asset is evaluated
as a replacement because it can reduce the costs of production with savings of energy,
raw materials, labor, and/or reduced flaws or defects. Expansion of current products or
services involve capital budgeting analysis to determine if the timing is right for such an
expansion. Expanding the business into an entirely new product or service is by far the
riskiest of ventures and all prudent Chief Financial Officers would require a capital
budgeting analysis as part of a well-thought-out business plan.
The primary job of the managers is to decide on whether or not to invest on certain
projects. An investment decision rule is a rule that allows us to differentiate between a
good and a bad investment. A good investment decision rule maintains a good balance
between flexibility and consistency, leads to firm value maximization and works on all
kinds of projects. Many firms analyze projects using a number of different investment
decision rules, but one rule has to dominate. So, if different investment decision rules
lead to different conclusions on whether the project should be accepted or not, one
decision rule has to be the tie-breaker.

1. The Rules
1.1 Net Present Value (NPV)
- It is the difference between the market value of an investment and its cost.
- It measures the increase in firm value, which is also an increase in the value of what
the shareholders own.
- It is calculated as the sum of the PV of each of the Cash Flows (CFs) (positive or
negative) that occur over the life of the project. (DCF valuation)

CF 1 CF 2 CF t
NPV =CF 0 + + + .. .+
( 1+r ) (1+r )2 (1+r )t
The rule:
NPV > 0 Accept the project
NPV < 0 Reject the project
NPV = 0 Indifferent
Assuming that various components used in the valuation (CF estimates, discount rate
etc.) are correct, a negative NPV is financially equivalent to investing today and
receiving nothing in return, hence you reject the investment.
In practice, financial managers are rarely presented with zero NPV projects.
Conceptually, a zero-NPV project earns exactly its required return. Assuming that risk
has been adequately accounted for, investing in a zero-NPV project is equivalent to
purchasing a financial asset in an efficient market. Since firm value is completely
unaffected by the investment, there is no reason for shareholders to prefer either one.

1
 BOS 360 – Finance

In reality it happens that some investment projects may have benefits that are difficult to
quantify, but exist, nonetheless (for example an investment with a low or zero NPV that
enhances a firm’s image as a good corporate citizen).
- If discount rates vary over time, then the calculation of NPV changes as follows:
CF 1 CF 2 CF t
NPV =CF 0 + + +.. .+
(1+r 1 ) (1+ r 1 )(1+r 2 ) (1+r 1 )(1+r 2 )⋅¿⋅(1+r t )

1.2 The Payback Period

- It is the length of time until the accumulated cash flows equal or exceed the original
investment. (How long it takes the investment to “break even” in accounting sense?)
- Widely used in the healthcare industry. This is due to the nature of the industry.
Technology is rapidly changing, some of the equipment tends to be extremely expensive
and the industry itself is highly competitive. What this means is that, in many cases, an
equipment purchase is complicated by the fact that, while the machine may be able to
perform its function for, say, 6 years or more, new and improved equipment is likely to
be developed that will supersede the “old” equipment long before its useful life is over.
Demand from patients and physicians for “cutting-edge technology” can drive a push for
new investment. In the face of such a situation, many hospital administrators then focus
on how long it will take to recoup the initial outlay, in addition to the NPV and IRR of
the equipment.
- Firms that operate in countries with volatile governments may also be concerned with
quick paybacks.
- The rule – investment is acceptable if its calculated payback is less than some pre-
specified number of years.
Advantages:
o Simple to use
o Favors investments that free up cash, promoting liquidity
o Adjusts for the later CFs risk in a draconian fashion, by ignoring them
altogether.
Disadvantages:
o No discounting involved
o Ignores cash flows beyond the cutoff date
o Arbitrary cutoff point
o Biased toward short-term investments
The payback period rule is flawed, but past surveys suggest that practitioners often use it
as a secondary decision measure. While the payback period is widely used in practice, it
is rarely the primary decision criterion. As William Baumol pointed out in the early
1960s, the payback rule serves as a crude “risk screening” device – the longer cash is tied
up, the greater the likelihood that it will not be returned. The payback period may be
helpful when mutually exclusive projects are compared. Given two similar projects with

2
BOS 360 – Finance

different paybacks, the project with the shorter payback is often, but not always, the
better project.

1.3 The Discounted Payback Period

- The Discounted Payback Period is the length of time until the accumulated
discounted CFs equal or exceed the original investment. Use of this technique entails
all the work of NPV, but its decision rule is arbitrary.
- Since it takes into account the TVM, then it tells us how long it takes for the
investment to “break-even” in the economic sense. So, we also account for the
interest that we could have earned somewhere else for the period that we are
recuperating our money from the initial investment.
- The rule – An investment is acceptable if its discounted payback is less than some
pre-specified number of years.
Advantages:
o Easy to understand
o Biased toward liquidity
o Takes into account TVM
o If a project pays back on a discounted basis, and has all positive cash flows
after the initial investment, then it must have a positive NPV
Disadvantages:
o Requires an arbitrary cut-off period which may eliminate projects that would
increase firm value
o If there are negative cash flows after the cut-off period, the rule may indicate
acceptance of a project that has a negative NPV
o Biased against L-T projects like R&D.

1.4 The Internal Rate of Return

Internal rate of return (IRR) – the discount rate that makes the present value of the future
cash flows equal to the initial cost or investment. In other words, the discount rate that
gives a project a $0 NPV.

CF 1 CF 2 CF t
0=CF 0 + + + .. .+
( 1+ IRR ) ( 1+ IRR )2 ( 1+ IRR)t

Solve for IRR in this case. It is best that you use the financial calculator.
The rule:
If IRR is computed on Cash Flows to the Firm
IRR > cost of capital Accept the project
IRR < cost of capital Reject the project

3
BOS 360 – Finance

If IRR is computed on Cash Flows to Equity

IRR > cost of equity Accept the project
IRR < cost of equity Reject the project

1.5 The Profitability Index

CF1 CF 2 CF n
+ +. . .+
PV ofallCashInflows ( 1+r ) (1+r ) 2
(1+ r )n
PI = =
PV ofallCashOutflows CF 0

If a project has a positive NPV, then the PI will be greater than 1.

The rule:
PI > 1 NPV > 0 Accept the project
PI < 1 NPV < 0 Reject the project
PI = 0 NPV = 0 Indifferent

2. Net Present Value profile (graph)

NPV profile is a graph of an investment’s NPV at various discount rates. (Figure 1). NPV
profile provides several insights into the project’s viability.
- IRR is the point where the NPV profile intersects with the x-axis (For example in Fig.
1, IRR = 16%).
- The slope of the NPV profile measures the sensitivity of NPV to a change in discount
rates. Projects with steeper NPV profiles indicate a higher sensitivity to changes in
discount rates.
- When mutually exclusive projects are analyzed, graphing both NPV profiles together
provides a measure of the breakeven discount rate, the rate at which the manager will
be indifferent between the two projects.

NPV and IRR comparison: If a project’s cash flows are conventional (costs are paid
early and benefits are received over the life), and if the project is independent, then NPV
and IRR will give the same accept or reject decision.
IRR > discount rate NPV > 0 Accept the project
IRR = discount rate NPV = 0 Indifferent
IRR < discount rate NPV < 0 Reject the project

Figure 1. NPV Profile of a Project with Standard CFs

70,000
60,000
50,000
40,000
30,000
NPV

20,000
10,000
0 4
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
BOS 360 – Finance

3. Problems with the IRR

3.1 Non-conventional cash flows
So far, we have only used standard cash flows where CF 0 is negative and the future CFs
are positive. However, what if the pattern of CFs changes? When the sign of the cash
flows changes more than once or the cash inflow comes first and outflows come later,
then we are dealing with non-conventional CFs and calculating IRR will prove
problematic. Here are a couple of examples:
- If the cash flows are of loan type, meaning money is received at the beginning and
paid out over the life of the project, then the IRR is really a borrowing rate and lower
is better. A loan may be thought as a “financing” project, where there is a positive
cash flow followed by a series of negative cash flows. This is the opposite of an
“investing” project. In this case, our decision rule reverses, and we accept a project if
the IRR is less than the cost of capital, since we are borrowing at a lower rate.
- If cash flows change sign more than once, then you will have multiple internal rates
of return that will make NPV = 0. This is problematic for the IRR rule; however, the
NPV rule still works fine. Nonconventional cash flows and multiple IRRs occur when
there is a net cost to shutting down a project. The most common examples deal with
collecting natural resources. After the resource has been harvested, there is generally
a cost associated with restoring the environment. Mathematically the number of
discount rates will be determined by how many times the sign in CFs changes, as
shown in the figure.
Example 1: Suppose an investment will cost $90,000 initially and will generate the
following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
Solution:
NPV = – 90,000 + 132,000 / 1.15 + 100,000 / (1.15)2 – 150,000 / (1.15)3 = $1,769.54

Financial Calculator: CF0 = -90,000;

C01 = 132,000; F01 = 1;
C02 = 100,000; F02 = 1;
C03 = -150,000; F03 = 1;
NPV
I = 15;

5
BOS 360 – Finance

CPT NPV = 1,769.54

If you compute the IRR on the calculator, you get 10.11% because it is the first root of
the equation. So, if you just blindly use the calculator without recognizing the uneven
cash flows, NPV would indicate to accept while IRR would indicate to reject the project.
Figure 2 depicts the NPV profile for the project in Exercise 1. As cash flows that change
signs for different discount rates. The NPV profile is depicted in Figure 2. Since the sign
changes two times, mathematically it is possible to find two different IRR-s for this
project. In this case using IRR as a decision rule won’t help.

Figure 2. NPV Profile of a Project with non-conventional CFs

IRR = 10.11%
and 42.66%

Fig 2. indicates that we should accept the project if the required return is between 10.11%
and 42.66%

3.2 The Modified Internal Rate of Return (MIRR)

NPV rule assumes that intermediate CFs are reinvested at the discount rate (say weighted
average cost of capital). IRR rule assumes that intermediate CFs are reinvested at the
IRR. As a result, these two rules may yield different results.
One method for eliminating multiple IRRs and removing the assumption of reinvestment
of cash flow at the IRR is to use the Modified Internal Rate of Return (MIRR).
There are different methods of calculating MIRR, as shown in Example 2. Each method
gives you a different MIRR and there is no superior method that gives the best answer.
From a practical standpoint MIRR on a project is the weighted average of the IRR on that
project and the discount rate that the company uses. The weights depend on the
magnitude and timing of cash flows.
Example 2: Suppose an investment will cost $90,000 initially and will generate the
following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

6
BOS 360 – Finance

The required return is 15%.

Calculate the MIRR of the project.

Solution (There are a few ways to deal with this problem as you can see below):

1. Discount all negative CFs to the present using the required rate of return and then
calculate MIRR.
Year 0: -90,000 + (-150,000)/(1.15)3 = -90,000 + (-98,627.43) = -188,627.43
Year 1: 132,000
Year 2: 100,000
Year 3: 0
132 ,000 100 , 000
0=−188 , 627 . 43+ +
(1+MIRR ) (1+MIRR )2
Fin Calc: MIRR = 15.77%

2. Compound all positive CFs to the future using the required rate of return and then
calculate MIRR.

Year 0: -90,000
Year 1: 0
Year 2: 0
Year 3: -150,000 + 132,000(1.15)2+100,000(1.15)=139,570
139 , 570
0=−90 , 000+
(1+MIRR )3
Fin Calc: MIRR = 15.75%

3. Discount all cash outflows to the present, and compound all cash inflows to the last
period of the project. Then, find the rate that equates the values. The discounting and
compounding can be done at borrowing and investment rates, respectively. In this
exercise we assume these rates to be 15%, but they may be different from each other.

Year 0: -90,000 + (-150,000)/(1.15)3 = -90,000 + (-98,627.43) = -188,627.43

Year 1: 0
Year 2: 0
Year 3: 132,000(1.15)2+100,000(1.15) =289,570
289 , 570
0=−188 , 627 . 43+
(1+MIRR )3
Fin Calc: MIRR = 15.36%

3.3 Mutually exclusive investment decisions

Since resources (especially time) are limited, sometimes the firm will be taking one
project and leave another one. In this case the firm is faced with mutually exclusive

7
BOS 360 – Finance

investment decisions. For example, getting to choose between two colleges that you
applied for and got accepted into.
In this situation IRR decision rule cannot be applied because it results into conflicting
decision compared to NPV decision rule.
- This conflict can be illustrated by plotting the NPV profiles for two mutually
exclusive projects.
- Crossover Rate – IRR for which the investors are indifferent between the two
mutually exclusive projects (NPVA= NPVB)
Example 3: Amazon has identified the following two mutually exclusive projects:

Perio Project A Project B

d
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74

The required return for both projects is 10%. Which project should you accept and why?

Solution:
In this exercise, first you need to solve for the crossover rate by setting NPVA = NPVB.
We solve the following equation for r:

325 325 325 200

−500+ + =−400+ +
1+r ( 1+r )2
1+ r ( 1+r )2

325−325 325−200
−(500+400)+ + =0
1+ r ( 1+r )2

0 125
−900+ + =0
1+r (1+ r )2

Use the financial calculator and CF function to calculate IRR.

CF0 = -900;
C01 = 0; F01 = 1;
C02 = 125; F02 = 1;
IRR
CPT IRR = 11.8%

8
BOS 360 – Finance

It turns out that the crossover rate (r), for which you are indifferent between these two
projects is 11.8%.

The Rule:
If the required return is less than the crossover point, in this case 11.8%, then NPVA >
NPVB, meaning that you should choose A
If the required return is greater than the crossover point, in this case 11.8%, then NPVA <
NPVB, meaning that you should choose B
Figure 3 illustrates the solution using the NPV profiles for both projects A and B. The
crossover rate is the intersection of the NPV profiles for both projects, the rate where one
would be indifferent between choosing one or the other.

Figure 3. Crossover Rate

NPV Profiles
$160.00 IRR for A = 19.43%
$140.00
IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8%
$80.00
A
NPV

$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate

3.4 The Practice of Capital Budgeting 9-38

It is common among large firms to employ a discounted cash flow technique such as IRR
or NPV along with payback period or average accounting return. It is suggested that this
is one way to resolve the considerable uncertainty over future events that surrounds the
estimation of NPV.
While uncertainty about inputs and interpretation of the outputs helps explain why
multiple criteria are used to judge capital investment projects in practice, another reason
is managerial performance assessment. When managers are judged and rewarded
primarily on the basis of periodic accounting figures, there is an incentive to evaluate
projects with methods such as payback or average accounting return. On the other hand,
when compensation is tied to firm value, it makes more sense to use NPV as the primary
decision tool.

4. Making Capital Investment Decisions

When we are faced with the financial analysis of a particular project, we should consider
the following issues regarding the CFs.

9
BOS 360 – Finance

- Only relevant cash flows should be considered in the analysis. These are cash flows
that occur (or don’t occur) because a project is undertaken. Cash flows that will occur
whether or not we accept a project aren’t relevant.
- Projects may be viewed as “mini firms” with their own assets, revenues and costs.
This allows us to evaluate the projects separately from the other activities of the firm
(stand-alone principle).
- We take into consideration only incremental cash flows. So, we estimate the change
in the future cash flows that are a direct consequence of taking the project

4.1 Incremental Cash Flows

- Sunk Costs - cash flows already paid or accrued. These costs should not be included
in the incremental cash flows of a project. From a financial standpoint, it does not
matter what investment has already been made. We need to make our decision based
on future cash flows, even if it means abandoning a project that has already had a
substantial investment.
- Opportunity costs – any cash flows lost or forgone by taking one course of action
rather than another. Applies to any asset or resource that the company already owns
and that has value if sold, or leased, rather than used. So in the estimation of CFs, the
opportunity cost would be valued at the market price of the asset if it was to be sold
today.
- Side Effects - With multi-line firms, projects often affect one another – sometimes
helping, sometimes hurting. The point is to be aware of such effects in calculating
incremental cash flows.
One of these side effects is Erosion (or cannibalism), which mean new project
revenues are gained at the expense of existing products/services. For example,
whenever Kellogg’s brings out a new oat cereal, it will probably reduce existing
product sales.
- Net Working Capital – New projects often require incremental investments in cash,
inventories, and receivables that need to be included in cash flows if they are not
offset by changes in payables. Later, as projects end, this investment is often
recovered.
- Financing Costs - We generally don’t include the cash flows associated with interest
payments or principal on debt, dividends, or other financing costs in computing cash
flows. Financing costs instead are reflected in the discount rate used to discount the
project cash flows.
- Use after-tax cash flows, not pretax (the tax bill is a cash outlay, even though it is
based on accounting numbers).

4.2 General Steps in evaluating a project

10
BOS 360 – Finance

Treat the project as a mini-firm:

Start with pro-forma1 income statements (don’t include interest) and balance sheets. Note
that the balance sheets are often forgone, and only the income statements are used. This is
because the NWC requirements are often considered as a percent of sales and the major
fixed asset requirements are the initial cost and salvage value.
1. Determine the sales projections, variable costs, fixed costs, and capital requirements.
2. From the pro-forma statements compute CFs.
3. Tabulate total cash flows and determine NPV, IRR, and any other measure desired.

Projecting Cash Flow of Assets (CFA):

CFA = OCF – net capital spending – changes in NWC

Operating Cash Flows (OCF):

Depending on the information that you have you can calculate OCF (solve Exercise 11):
OCF = EBIT + depreciation – taxes (bottom-up approach)
OCF = NI + depreciation (if Int. Expense = 0)
OCF = Sales – Costs – taxes (top-down approach)
OCF = (Sales – Costs)*(1- tax rate) + Depreciation*tax rate (tax-shield approach)

The best choice of operating cash flow calculation method is determined by the
information that is supplied for the problem at hand.
Projected NI for the purposes of estimating OCF is calculated as follows:
Revenue = Price/unit * Quantity
- Variable Costs = Variable Cost per unit * Quantity
- Fixed Costs
- Other Costs
- Depreciation
= EBIT
- Tax Expense (EBIT*Tax rate)
= NI
Note: Interest Expense is never included in the calculations of NI. Any financing costs
for the project are included in the calculation of the discount rate.

Net Working Capital:

NWC may either be projected based on a specific percentage of Sales or based on
projections of specific current assets or current liabilities accounts.

1
A pro-forma financial statement is one based on certain assumptions and projections.

11
BOS 360 – Finance

Based on the form of the equation, you subtract increases in NWC (cash outflows) and
add decreases in NWC (cash inflows) for the years for which the information is given.
NWC = Current Assets – Current Liabilities
Current Assets: Cash, Accounts Receivable, Inventory
Current Liabilities: Accounts Payable
AR and Inventory increase to support higher levels of sales. AP also increases to support
higher levels of Inventory.
CFs associated with these increases do not appear on the income statement until the
goods produced are sold. If they aren’t on the income statement, they won’t be part of
operating cash flow. So, we have to consider changes in NWC separately.

Net Capital Spending:

+ purchase price of the new asset
- selling price of the asset replaced (if applicable)
+ costs of site preparation, setup, and startup
+/- increase (decrease) in tax liability due to sale of old asset at other than book value
= net capital spending

Initial cost of machinery is current cash outflow and enters with a negative sign.
When the project is over, even if the machinery has fully depreciated, it has market value.
So, it is possible to sell this machinery for its market value, although book salvage value
may be zero. In that case you are making a profit and that is taxed.
After tax salvage value (at the end of the project) = Market Value – (MV-BV)(tax
rate)
Depreciation is counted on OCF, not in this category.

Depreciation:
Depreciation is a non-cash deduction. However, depreciation affects taxes, which are a
cash flow. The relevant depreciation expense is the depreciation that will be claimed for
tax purposes. There are two methods of computing depreciation that are acceptable from
IRS.
MACRS depreciation – most assets are required to be depreciated using MACRS
(Modified Accelerated Cost Recovery System). Each asset is assigned to a specific
property class, and depreciation is figured based on certain percentages provided by IRS.
Note that assets are depreciated to zero, and MACRS follows a mid-year convention. The
mid-year convention causes depreciation expense to be taken in one more year than
specified by the property class, i.e., 3-year MACRS has four years of depreciation
expense.

12
BOS 360 – Finance

Straight line depreciation method – This method charges the cost evenly throughout
the useful life of a fixed asset. This method is appropriate when the economic benefits
from an asset are expected to be realized evenly over its useful life. Straight line method
is also convenient to use where no reliable estimate can be made regarding the pattern of
economic benefits expected to be derived over an asset's useful life.
Straight line depreciation can be calculated using any of the following formulas:
Cost −Book Salvage Value
Annual Depreciation=
Useful Life
Where:
- Cost is the initial acquisition or construction costs related to the asset as well
as any subsequent capital expenditure.
- Book Salvage Value (residual value, scrap value), is the estimated proceeds
expected from the disposal of an asset at the end of its useful life. The portion
of an asset's cost equal to residual value is not depreciated because it is
expected to be recovered at the end of an asset's useful life
- Useful Life is the estimated time period that the asset is expected to be used
starting from the date it is available for use up to the date of its disposal or
termination of use. Useful life is normally expressed in units of years or
months.
Since arbitrary methods are used to compute depreciation, the book value of the assets
will almost always be different from their market value.

Discount Rate:
Capital budgeting requires an estimate of the discount rate in order to perform the
analysis. The estimate of the discount rate may come from information gathered on
similar projects with similar risk.
Another good representative for the discount rate of the project is the weighted average
cost of capital (WACC) of the firm. WACC is a composite cost of financing that takes
into account the capital structure of the firm and the cost of raising capital through
different forms: debt, common stock and preferred stock.
Capital Structure – is the firm’s combination of debt and equity. Given that the firm
uses both debt and equity (common stock and preferred stock), a firm’s cost of capital
reflects the average riskiness of all of the securities it has issued, some of which may be
less risky (bonds) or riskier (stocks).
Weighted Average Cost of Capital (WACC)
Cost of capital, required return, and appropriate discount rate are different phrases that all
refer to the opportunity cost of using capital in one way as opposed to alternative
financial market investments of the same systematic risk.
- required return is from an investor’s point of view
- cost of capital is the same return from the firm’s point of view
- appropriate discount rate is the same return as used in a NPV calculation

13
BOS 360 – Finance

It is important to note that the cost of capital associated with an investment depends on
the risk of that investment. In other words, the cost of capital depends primarily on the
use of the funds, not the source of funds. As such, WACC can also be thought of as an
opportunity cost of capital or what an investor would expect to earn in an alternative
investment with a similar risk profile.
The basic formula is:
WACC =w cs k cs + w ps k ps + wd k d (1−tax)
where,
kcs = the cost of common stock
kd = the cost of debt
kps = the cost of the preferred stock
tax = marginal or effective tax rate
MCap
w cs= = the weight of cost of equity
V
D
w d = = the weight of cost of debt
V
MVofPS
w ps= = the weight of cost of the preferred stock
V
MCap = the market value of common stock (MCap = P*shares outstanding)
D = the market value of the company’s debt. This is hard to estimate so we
usually use book values of debt: LTD+STD = Debt Value used in the formula.
MVofPS = the market value of the company’s preferred stock. It is calculated
similar to the market value of common stock, based on the price and outstanding
shares of preferred stock (if any).
V = The total value of the company’s MCap + TD + MVofPS.

Example 4:
Company A raises 70% of its financing using common stock, 10% using preferred
stock and the rest from debt. Company A has a cost of common stock 11%, cost of
preferred stock is 7%, and cost of debt of 4% and tax rate of 35%.

Then the cost of capital for Company A will be:

Cost of capital (WACC) = 11% (0.70) + 7%(0.10) + 4%(1-0.35) (0.20) = 8.92%

Note:
- Only debt is tax deductible, because interest expense is deducted before taxes
are paid. This is why we need to count for the after-tax cost of debt in the
calculation of WACC.
- Interest expense is not used to calculate NI (and OCF). Instead, the effect of
interest expense is counted in the calculation of the cost of debt.
- We will learn how to estimate cost of debt when we discuss bonds and we
will learn how to estimate cost of common stock and preferred stock when
we discuss equity.

DCF analysis is used in the valuation of the following types of projects:

14
BOS 360 – Finance

- Evaluating the feasibility of a new product/line/segment etc.

- Evaluating Cost-Cutting Proposals – usually the information is given in terms of cost
cuts instead of revenues.
- Setting the Bid Price - The lowest acceptable bid price is the one that makes the NPV
= 0. At that price, you expect to just earn your required return.
- Evaluating Equipment with Different Lives - If in the capital budgeting analysis, we
are trying to minimize costs, the NPV with the smaller value should be chosen.
Since the projection of CFs requires a lot of detailed estimations this analysis is best done
using Excel or some other sophisticated software.

Reference:
Stephen A. Ross, Randolph W. Westerfield and Bradford D. Jordan (2020).
Fundamentals of Corporate Finance (13th edition). New York, NY:
McGraw-Hill/Irwin.

15
BOS 360 – Finance

PRACTICE EXERCISES
1. An investment project has the following annual cash flows. Assume that the discount
rate is 10%. Decide whether you will accept this project or not based on:

Year CF
0 -$16,400
1 7,100
2 8,400
3 6,900
a. The NPV analysis.
b. The payback period analysis.
c. The discounted payback period analysis.
d. The IRR analysis.
e. The profitability index analysis.
f. What is the NPV at a discount rate of 20%? Can you come up with a general rule
on how does the NPV analysis relate to IRR analysis?

2. Garage, Inc., has identified the following two mutually exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -28,300 -28,300
1 13,700 3,950
2 11,600 9,450
3 8,850 14,500
4 4,750 16,100

a. What is the IRR for each of these projects? Using the IRR decision rule, which project
should the company accept?
b. If the required return is 10%, what is the NPV for each of these projects? Which project
will the company choose if it applies the NPV decision rule?
c. At what discount rate would the company be indifferent between these two projects?

16
BOS 360 – Finance

3. Consider the following two mutually exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -348,000 -348,000
1 47,000 24,200
2 67,000 22,200
3 67,000 19,700
4 442,000 556,900

Whichever project you choose, if any, you require 14% return on your investment.
a. What is the payback period for each project? If you apply the payback criterion,
which investment will you choose?
b. What is the discounted payback period for each project? If you apply the
discounted payback criterion, which investment will you choose?
c. What is the NPV for each project? If you apply the NPV criterion, which
investment will you choose?
d. What is the IRR for each project? If you apply the IRR criterion, which
investment will you choose?
e. What is the profitability index for each project? If you apply the PI criterion,
which investment will you choose?
f. Based on your answers in (a) through (e), which project will you finally choose?

4. An ABC poll in the spring of 2015 found that one-third of students 12 – 17 admitted
to cheating and the percentage increased as the students got older and felt more grade
pressure. JP publishing company is considering to offer a new book “How to Cheat:
A User’s Guide.” The company has a cost of capital of 8% and estimates it could sell
10,000 volumes by the end of year one and 5,000 volumes in each of the following
two years. The immediate printing costs for the 20,000 volumes would be $20,000.
The book would sell for $7.50 per copy and net the company a profit of $6 per copy
after royalties, marketing costs and taxes. Year one net would be $60,000. From a
capital budgeting standpoint, is it financially wise to buy the publication rights? What
is the NPV of this investment?

5. A firm is considering a $5,000 project that will generate an annual cash flow of
$1,000 for the next 8 years. The firm has the following financial data:
o Debt/equity ratio is 50%.
o Cost of equity capital (ke)is 15%.
o Cost of new debt (kd) is 9%.
o Tax rate (t) is 33%.
Determine the project's net present value (NPV) and whether or not to accept it.
Note: WACC (weighted average cost of capital) = wd*(1-t)kd + weke

17
BOS 360 – Finance

6. Hungry Hoagie's has identified the following two mutually exclusive projects. Both
projects will be depreciated using straight-line depreciation to a zero book value over
the life of the project. Neither project has any salvage value.

a. Should you accept or reject these projects based on net present value analysis?
Assume that the required rate of return for project A is 15% and for project B is
17%.
b. Should you accept or reject these projects based on payback analysis? Assume
that the required payback period is 2.7 years for both projects.
c. Should you accept or reject these projects based on the discounted payback
analysis? Assume that the required discounted payback period is 2.5 years for
both projects.
d. Should you accept or reject these projects based on the average accounting return?
Assume that the required accounting return is 15% and 17% for projects A and B,
respectively.
e. Should you accept or reject these projects based on the IRR analysis?
f. Should you accept or reject these projects based on the profitability index (PI)
analysis?
g. At what rate would you be indifferent between these two projects?

7. A project that provides annual cash flows of $12,600 for 12 years costs $65,000
today. At what rate would you be indifferent between accepting the project and
rejecting it?

8. You are on the staff of O'Hara Inc. The CFO believes project acceptance should be
based on the NPV, but Andrew O'Hara, the president, insists that no project should be
accepted unless its IRR exceeds the project's risk-adjusted WACC. Now you must
make a recommendation on a project that has a cost of $15,000 and two cash flows:
$110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and
the CFO both agree that the appropriate WACC for this project is 10%. Make the
appropriate recommendation based on NPV and IRR.

9. Blue Water Systems is analyzing a project with the following cash flows. Should this
project be accepted based on the modified internal rate of return (MIRR) if the
discount rate is 14 percent? Why or why not?
Note: There are different methods to calculate MIRR. You may pick one of them to
solve for this problem.

18
BOS 360 – Finance

10. An asset used in a four-year project falls in the five-year MACRS class for tax
purposes. The asset has an acquisition cost of $6,000,000 and will be sold for
$1,200,000 at the end of the project. If the tax rate is 34 percent, what is the after-tax
salvage value of the asset?

Year 1 2 3 4 5 6
MACRS rates 20% 32% 19.2% 11.52% 11.52% 5.76%

11. A proposed new project has projected sales of $125,000, costs of $59,000, and
depreciation of $12,800. The tax rate is 35 %. Calculate the operating cash flow of
this project.

12. Keiper, Inc., is considering a new three-year expansion project that requires an initial
fixed asset investment of $2.85 million. The fixed asset will be depreciated straight-
line to zero over its three-year tax life, after which time it will be worthless. The
project is estimated to generate $2,130,000 in annual sales, with costs of $825,000.
The tax rate is 34% and the required return on the project is 11%. What is the
project’s NPV?

13. Fitzgerald Computers is considering a new project whose data are shown below.
Initial equipment cost (depreciable basis) $63,000
Required tax life for the equipment (fully depreciated, straight line) 3 years
Sales revenues, each year $60,000
Operating Cost (excluding depreciation), each year $25,000
Interest Expense, each year $2,000
Tax Rate, each year 30.0%
Cost of capital 10.0%
The equipment is expected to be sold at 10% of its cost in 3 years.
Initial increase in Inventory is estimated to be 5% of the first year estimated sales. Only
half of this investment will be recovered at the end of the period.
a. Estimate the annual depreciation.
b. Estimate the annual EBIT.
c. Estimate the annual taxes.
d. Estimate the annual operating cash flows.
e. Estimate initial and recovered NWC.
f. Estimate the after-tax salvage value.
g. Estimate the CFA for this project. Fill out the table.

19
BOS 360 – Finance

year 0 year 1 year 2 year 3

OCF
NWC
Cap Spending
CFA

h. Conclude whether you should go forward with this project or not. Justify your
work using the proper calculations.

Practice Exercises using Excel2

1. Evaluating the feasibility of a new line

General Electric is investigating the feasibility of a new line of countertop microwave
ovens. Based on exploratory conversations with buyers of large supermarkets, GE
projects unit sales as follows:
Year Unit Sales
1 3,000
2 5,000
3 6,000
4 6,500

The new countertop microwave oven will sell for $120 per unit to start. But, GE
anticipates that the price will drop to $110 after the first two years.
This project will require an increase of $10,000 in net working capital at the start.
Subsequently, total net working capital increases at the end of each year by 5% of sales
for that year. The remaining NWC (last year) will be fully recovered at the end of the
project’s life.
The variable cost per unit is $60, and total fixed costs are $25,000 per year.
It will cost about $600,000 to buy the equipment necessary to begin production. This
investment is primarily in industrial equipment, which qualifies as three-year MACRS
property. The equipment will actually be worth about 20% of its cost in 4 years.

Year 1 2 3 4
MACRS rates 33.33% 44.45% 14.81% 7.41%
2
These exercises require you to use Excel.

20
BOS 360 – Finance

The relevant tax rate is 34%, and the required return is 15%.
Based on this information, should GE proceed with the project?

2. Evaluating Cost-Cutting Proposals

Consider a $10,000 machine that will reduce pretax operating costs by $3,000 per year
over the next five years. It will not require any changes in net working capital and is
expected to have a salvage value of $1,000 in year 5. Assume 5-year MACRS and a tax
rate of 34%. The discount rate is 10%. Based on this information should the machine be
purchased?

Year 1 2 3 4 5 6
MACRS rates 20% 32% 19.2% 11.52% 11.52% 5.76%

3. Set Bid-Price
Your company has been approached to bid on a contract to sell 4,500 voice recognition
(VR) computer keyboards a year for four years. Due to technological improvements,
beyond that time they will be outdated and no sales will be possible. The equipment
necessary for the production will cost $4.1 million and will be depreciated on a straight-
line basis to a zero book salvage value. Production will require an investment in net
working capital of $98,000 to be returned at the end of the project, and the equipment can
be sold for $278,000 at the end of production. Fixed costs are $643,000 per year, and
variable costs are $158 per unit. In addition to the contract, you feel your company can
sell 9,800, 10,700, 12,800, and 10,100 additional units to companies in other countries
over the next four years, respectively, at a price of $325. This price is fixed. The tax rate
is 40 percent, and the required return is 10 percent. Additionally, the president of the
company will undertake the project only if it has an NPV of $100,000. What bid price
should you set for the contract?

4. Evaluating Equipment with Different Lives

Lang Industrial Systems Company (LISC) is trying to decide between two different
conveyor belt systems. System A costs $204,000, has a four-year life, and requires
$66,000 in pretax annual operating costs. System B costs $288,000, has a six-year life,
and requires $60,000 in pretax annual operating costs. Both systems are to be depreciated
straight-line to zero over their lives and will have zero salvage value. Whichever project
is chosen, it will not be replaced when it wears out. The tax rate is 35 percent and the
discount rate is 10 percent. Which conveyor belt system should the firm choose?

21