Name: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041

Chapter 6. Making Capital Investment Decisions

6.1 Incremental Cash Flows: The Key to Capital Budgeting
CASH FLOWS—NOT ACCOUNTING INCOME: Techniques in corporate finance
generally use cash flows, whereas financial accounting generally stresses income or earnings
numbers.
SUNK COSTS: cost that has already occurred in the past and it’s not incremental cash
outflows
OPPORTUNITY COSTS is the benefit not received as a result of not selecting the next best
option
SIDE EFFECTS Effects of a proposed project on other parts of the firm. There is 2 types of
side effects: erosion and synergy. Erosion occurs when a new product reduces the sales and,
hence, the cash flows of existing products. Synergy occurs when a new project increases the
cash flows of existing projects.
ALLOCATED COSTS : A type of expense that is clearly associated with and so can be
readily assigned to a certain business process, project or department.
Net working capital is defined as the difference between current assets and current
liabilities. In Capital budgeting, we are most interested in inventory, accounts receivable,
accounts payable, and cash. An investment in net working capital arises whenever (1)
inventory is purchased, (2) cash is kept in the project as a buffer against unexpected
expenditures, and (3) sales are made on credit, generating accounts receivable rather than
cash. This is reversed for credit purchases, which reduce net working capital and generate
accounts payable. Such an investment in net working capital represents a cash outflow
because cash generated elsewhere in the firm is tied up in the project.
Net working capital= Accounts receivable-Accounts payable+Inventory+cash
Project analysis: The cash flow of a project follow a common patern. First, firms invest at
the beginning of the project, generating cash outflows. Second, product sales provide cash
inflows over the life of the project. Third, plant and equipment are sold off at the end of the
project, generating more cash inflow.

6.2Alternative Definitions of Operating Cash Flow

Proper calculation of cash flow is essential to capital budgeting.
Earnings before taxes (EBT) is: EBT=Sales−Cashcosts−Depreciation
The taxes for the year will be: Taxes=EBT×TC ; TC is the corporate tax rate
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

THE TOP-DOWN APPROACH: start at the top of the income statement and work our way
down to cash flow by subtracting costs, taxes, and other expenses.No need of depreciation
Because depreciation is not a cash outflow
The Operating Cash Flow (OCF): OCF= Sales−Cashcosts−Taxes
THE BOTTOM-UP APPROACH: ignoring any financing expenses, such as interest, in our
calculations of project OCF.
Project net income: Net income= EBT−Taxes
Next, depreciation is added back, giving us: OCF=Netincome+Depreciation
Expressing net income in terms of its components, we could write OCF more completely as:
OCF=(Sales−Cashcosts−Depreciation)(1−TC)+Depreciation
THE TAX SHIELD APPROACH: The tax shield approach is a variant of the top-down
approach.
OCF = Sales − Cash costs − (Sales − Cash costs − Depreciation) × TC
we can simplify it to : OCF = (Sales − Cash costs) × (1 − TC) + Depreciation × TC
This approach views OCF as having two components. The first part is what the project’s cash
flow would be if there were no depreciation expense. The second part of OCF in this
approach is the depreciation deduction multiplied by the tax rate. This is called the
depreciation tax shield.

6.3Some Special Cases of Discounted Cash Flow Analysis

EVALUATING COST-CUTTING PROPOSALS
Operating cash flow= EBIT + Depreciation – taxes
Aftertax salvage= final value × (1- tax rate)
SETTING THE BID PRICE
OCF= Total cash flow (periode 0)/ annuity factor
How to find out sales prices in an amount of OCF?
Operating cash flow= Net income + Depreciation
Net Income= (Sales-Costs- Depreciation) × (1-TC)
INVESTMENTS OF UNEQUAL LIVES: THE EQUIVALENT ANNUAL COST
METHOD
Suppose The Downtown Athletic Club must choose between two mechanical tennis ball
throwers. Machine A costs $500 and lasts three years. There will be aftertax maintenance
expenses of $120 to be paid at the end of each of the three years. Machine B costs $600 and
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

lasts four years. There will be aftertax maintenance expenses of $100 to be paid at the end of
each of the four years.
Machin 0 1 2 3 4
e
A −$500 −$120 −$120 −$120  
B −$600 −$100 −$100 −$100 −$100
Discount rate= 10%
$ 120 $ 120 $ 120
PV (Machine A)= −$ 500− − − = -$798.42
1.1 1.12 1.13
$ 100 $ 100 $ 100 $ 100
PV (Machine B)=−$ 600− − − − = -$916.99
1.1 1.12 1.13 1.14
Then we can calculate the Annuity payment per year
−$798.42 = C × PVIFA10%,3 => C= −$798.42/2.4869= -$321.6 is the equicalent annual cost
(EAC) of machine A
−$916.99 = C × PVIFA10%,4 =>C= −$916.99/2.4869= -$289,28
conclusion: Machine B is the preferred choice.

6.4 Inflation and Capital Budgeting

Inflation (or deflation) can affect both cash flows and discount rates in capital budgeting.
INTEREST RATES AND INFLATION
1+ Nominal interest rate
Real interest rate= −1
1+ inflation rate
The real interest rate is the rate of interest an investor, saver or lender receives (or expects
to receive) after allowing for inflation. It can be described more formally by the Fisher
equation, which states that the real interest rate is approximately the nominal interest
rate minus the inflation rate. So it can be expressed by the following equation:

Real interest rate ≅ Nominal interest rate − Inflation rate

CASH FLOW AND INFLATION
Capital budgeting requires data on cash flows as well as on interest rates. Like interest rates,
cash flows can be expressed in either nominal or real terms. A nominal cash flow refers to the
actual dollars to be received (or paid out). A real cash flow refers to the cash flow’s
purchasing power in relation to a base year.
Nominal cash flow is the true dollar amount of future revenues the company expects to
receive and expenses it expects to pay out, without any adjustments for inflation. On the other
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

hand, real cash flow is adjusted for inflation in order to reflect the change in the value of
money over time. Because inflation can vary significantly from year to year.
Depreciation is an accounting method of allocating the cost of a tangible or physical asset
over its useful life or life expectancy. Depreciation represents how much of an asset's value
has been used up. 
DISCOUNTING: NOMINAL OR REAL?
Cash flows can be expressed in either nominal or real terms.
Inflation must be handled consistently. One approach is to express both cash flows and the
discount rate in nominal terms. The other approach is to express both cash flows and the
discount rate in real terms. Because both approaches yield the same NPV calculation, the
simpler method should be used. The simpler method will generally depend on the type of
capital budgeting problem. This idea is illustrated in the two clear examples in the book.