CAPITAL BUDGETING

PROJECTS WITH UNEQUAL LIVES

• When comparing two mutually exclusive
projects, the project with the highest NET
PRESENT VALUE will be selected

• A problem may happen if the projects have

different live times.

• You may be biased towards the longest living

project, if the Cash Flows are positive.
 PROJECTS WITH UNEQUAL LIVES
EXAMPLE

• Toyota engineers have produced an innovative shock

absorption prototype to incorporate in all its cars
• There are two models to chose from. One would cost
$12m and last 5 years; the other cost $16m and last for
10 years.
• Both have additional maintenance costs $5m per year.
• Which model should Toyota chose if their cost of
capital is 12%
 PROJECTS WITH UNEQUAL LIVES
• This example will work differently than an usual NET
PRESENT VALUE problem.

• We are only dealing with Costs. So, we will have a

negative NET PRESENT VALUE.

• This does not mean we won’t choose any of the two.

• We will choose the project with the lowest NET

PRESENT VALUE of Costs.
 PROJECTS WITH UNEQUAL LIVES
• The Cash Flows will be the following

0 1 2 3 4 5 6 7 8 9 10
Model 1 -12 -5 -5 -5 -5 -5 0 0 0 0 0
Model 2 -16 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5

• NPV1=-$30.024
• NPV2=-$44.251
 PROJECTS WITH UNEQUAL LIVES
• The choice is to pick Model 1.

• But is it the right decision?

• In this case, since the cash flows are negative, the

longer project is hurt in the analysis.

• If you chose Model 1, at year 6 you need to start

it over again.
 REPLACEMENT CHAINS
• In this method you repeat both Projects as
many times you have to until the time horizon
matches.

• In this case you would repeat Model 1 a

second time. Both projects will take 10 years
 REPLACEMENT CHAINS
• NPV1=-$30.024-$30.024/(1.12)5=-$47.060

• NPV2=-$44.251

• The decision is reversed!!!

 EAC METHOD
• EAC means Equivalent Annual Cost Method

• You transform the Present Value of each

Project into an Annuity that lasts for the same
time as the corresponding Project.

• In this example NPV1 will be transformed into

a 5 year annuity and NPV2 will be transformed
into a 10 year annuity
 EAC METHOD
• You will chose the option with the lowest annual
cost.

• Project 1: -$30.024 at period zero is equivalent to

a 5 year annuity of -$8.329

• Project 2: -$44.251 at period zero is equivalent to

a 10 year annuity of -$7.832

• You should pick Model 2 instead.

 CASE STUDY: GOODWEEK TIRES
• After extensive research, GT developed a new
tire, Super Tread, and must decide whether to
invest in order to produce and market it.
• Research and Development Cost so far have
totaled $10m. Super Tread is to be put in the
market beginning this year and for 4 years.
Marketing tests costing $5m shown there is a
market for these tires.
• You must decide whether or not to launch the
tires. All Cash Flows are assumed in the end of
the year except for the initial investment.
 CASE STUDY: GOODWEEK TIRES
• GT initially will invest $120m in production equipment.
This equipment can be sold for $51m at the end of the
4 years.
• The tires will be sold in two markets
– OE Market: for the main manufacturers. The expected
price is $36 per tire. The variable cost is $18 per tire
– R Market: Tires are sold alone. The expected price is $59
with the same variable costs.
• GT plans to raise the prices 1% above the inflation rate.
The same will happen to the variable costs. Additional
marketing costs are expected to be $25m in the first
year and growing at the inflation rate.
 CASE STUDY: GOODWEEK TIRES
• GT corporate tax is 40%. Annual inflation is 3.25%
for the entire period. The discount rate is 15.9%.
• In the OE Market, 2m cars are expected to be
produced this year and grow by 2.5%. GT plans to
earn a share of 11%.
• In the R Market, 14m tires are sold and will grow
by 2%. GT plans to earn a share of 8%.
• Depreciation follows a 7 year MACRS. Initial NWC
needs is $11m and become 15% of sales.
 CASE STUDY: GOODWEEK TIRES
• After extensive research, GT developed a new
tire, Super Tread, and must decide whether to
invest in order to produce and market it.
• Research and Development Cost so far have
totaled $10m. Super Tread is to be put in the
market beginning this year and for 4 years.
Marketing tests costing $5m shown there is a
market for these tires.
• You must decide whether or not to launch the
tires. All Cash Flows are assumed in the end of
the year except for the initial investment
 CASE STUDY: GOODWEEK TIRES
• GT initially will invest $120m in production equipment.
This equipment can be sold for $51m at the end of the
4 years.
• The tires will be sold in two markets
– OE Market: for the main manufacturers. The expected
price is $36 per tire. The variable cost is $18 per tire
– R Market: Tires are sold alone. The expected price is $59
with the same variable costs.
• GT plans to raise the prices 1% above the inflation rate.
The same will happen to the variable costs. Additional
marketing costs are expected to be $25m in the first
year and growing at the inflation rate.
 CASE STUDY: GOODWEEK TIRES
• GT corporate tax is 40%. Annual inflation is 3.25%
for the entire period. The discount rate is 15.9%.
• In the OE Market, 2m cars are expected to be
produced this year and grow by 2.5%. GT plans to
earn a share of 11%.
• In the R Market, 14m tires are sold and will grow
by 2%. GT plans to earn a share of 8%.
• Depreciation follows a 7 year MACRS. Initial NWC
needs is $11m and become 15% of sales.
 DETERMINE THE CASH FLOWS
CAPITAL SPENDING

• Depreciation Schedule
– 1st year: 14.3% or $17.16m
– 2nd year: 24.5% or $29.4m
– 3rd year: 17.5% or $21m
– 4th year: 12.5% or $15m

• Book Value at the end of year 4: $37.44m

 DETERMINE THE CASH FLOWS
CAPITAL SPENDING

• Year 0: -$120m

• Year 4: $51m – 40%*($51m-

$37.44m)=$45.576m
 DETERMINE THE CASH FLOWS
OPERATING CASH FLOWS
• Determine Sales
– OE Market
Year 1 Year 2 Year 2 Year 4
Cars Sold 2,000,000 2,050,000 2,101,250 2,153,781
Tires Needed 8,000,000 8,200,000 8,405,000 8,615,125
ST Tires sold 880,000 902,000 924,550 947,664

– R Market
Year 1 Year 2 Year 3 Year 4
Tires sold 14,000,000 14,280,000 14,565,6000 14,856,912
ST Tires sold 1,120,000 1,142,400 1,165,248 1,188,553
 DETERMINE THE CASH FLOWS
OPERATING CASH FLOWS

• Determine Prices
– Growth Rate of Prices: Real Growth Rate is 1%, so
nominal growth rate is (1.01)(1.0325)=1.0428
– Evolution of the Prices
Year 1 Year 2 Year 3 Year 4
OE Market $36.00 $37.54 $39.15 $40.82
R Market $59.00 $61.53 $64.16 $66.90
 DETERMINE THE CASH FLOWS
OPERATING CASH FLOWS

• Determine Value of Sales

Year 1 Year 2 Year 3 Year 4
OE Market $31,680,000 $33,861,802 $36,193,864 $38,686,535
R Market $66,080,000 $70,286,388 $74,760,539 $79,519,496
Total $97,760,000 $104,148,190 $110,954,403 $118,206,031
 DETERMINE THE CASH FLOWS
OPERATING CASH FLOWS
Year 1 Year 2 Year 3 Year 4
Revenue $97,760,000 $104,148,190 $110,954,403 $118,206,031
Variable costs $36,000,000 $38,374,206 $40,905,232 $43,603,453
Mkt. costs $25,000,000 $25,812,500 $26,651,406 $27,517,577
Depreciation $17,160,000 $29,400,000 $21,000,000 $15,000,000
Earn. Before Taxes $19,600,000 $10,561,484 $22,397,765 $32,085,001
Taxes $7,840,000 $4,224,594 $8,959,106 $12,834,000
Net Income $11,760,000 $6,336,891 $13,438,659 $19,251,001
Operating CF $28,920,000 $35,736,891 $34,438,659 $34,251,001
 DETERMINE THE CASH FLOWS
ADDITIONS TO NET WORKING CAPITAL
Year 0 Year 1 Year 2 Year 3 Year 4
Beginning $0 $11,000,000 $14,664,000 $15,622,229 $16,643,160
Ending $11,000,000 $14,664,000 $15,622,229 $16,643,160 $0
NWC CF -$11,000,000 -$3,664,000 -$958,229 -$1,020,932 $16,643,160
 DETERMINE THE CASH FLOWS
CASH FLOWS
Year 0 Year 1 Year 2 Year 3 Year 4
Operating CF $0 $28,920,000 $35,736,891 $34,438,659 $34,251,001
Capital Spending -$120,000,000 $0 $0 $0 $45,576,000
Var. NWC -$11,000,000 -$3,664,000 -$958,229 -$1,020,932 $16,643,160
Total CF -$131,000,000 $25,256,000 $34,778,662 $33,417,727 $96,470,161
PV of CF -$131,000,000 $21,791,199 $25,890,832 $21,464,788 $53,463,731

• NPV=-$8,389,451 (<0). Don’t launch the new

line of Tires.