PowerPoint PresentationKey Concepts and SkillsChapter Outline8.1 Incremental Cash FlowsCash Flow: The Basis of Capital Budgeting DecisionsCash Flows ≠ Accounting IncomeIncremental Cash FlowsSlide 8Slide 9Slide 10Estimating Cash FlowsInterest Expense8.2 The Baldwin CompanyThe Baldwin CompanySlide 15Slide 16Slide 17Slide 18Slide 19Slide 20Incremental After Tax Cash FlowsNPV of Baldwin Company (Using Texas Instruments BA-II Plus Calculator)8.3 Inflation and Capital BudgetingInflation and Capital Budgeting8.4 Alternative Methods for Computing OCF8.5 Investments of Unequal LivesInvestments of Unequal LivesSlide 28Replacement Chain ApproachSlide 30Equivalent Annual Cost (EAC)Cadillac EAC with a CalculatorCheapskate EAC with a CalculatorQuick Quiz8-1MAKING CAPITAL INVESTMENT DECISIONSChapter 8Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.8-2KEY CONCEPTS AND SKILLS•Determine the relevant cash flows for various types of capital investments•Compute depreciation expense for tax purposes•Incorporate inflation into capital budgeting•Employ the various methods for computing operating cash flow•Apply the Equivalent Annual Cost approach8-3CHAPTER 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 Method8-48.1 INCREMENTAL CASH FLOWS•Cash flows matter—not accounting earnings.•Sunk costs don’t matter.•Incremental cash flows matter.•Opportunity costs matter.•Side effects like synergy, cannibalism and erosion matter.•Taxes matter: we want incremental after-tax cash flows. •Inflation matters.8-5CASH FLOW: THE BASIS OF CAPITAL BUDGETING DECISIONS•When performing capital budgeting analysis:•Always base calculations on cash flow, not income•Earnings ≠ Cash•Need cash for capital spending•Need cash for rewarding shareholders•Therefore, capital expenditure analysis must be based on cash8-6CASH FLOWS ≠ ACCOUNTING INCOME•Much of the work in evaluating a project lies in converting accounting income to cash flow•Examples of reconciling items:•Depreciation (most common example)•You never write a check made out to “depreciation.”•Amortization•Deferrals and Accruals8-7INCREMENTAL CASH FLOWS•Remember: Incremental cash flows arise as a consequence of selecting a project•Seems like a simple task•Not so, there are many pitfalls in identifying incremental cash flow8-8INCREMENTAL CASH FLOWS•Sunk costs are not relevant•Just 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 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.8-9INCREMENTAL CASH FLOWS•Side effects 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.8-10INCREMENTAL CASH FLOWS•Allocations•Overhead may be allocated to the new project•Allocations are only relevant if the project increases or decreases the cash outlay of the entire firm•Salvage Value•Don’t forget to treat salvage value (after tax, of course) as a cash inflow at the end of the project•Changes in Net Working Capital•Many projects require an increase in NWC (inventory, receivables, and other current assets) when initiated; this is a cash outlay at the beginning of the project•Don’t forget: To reduce NWC at the end of a project requiring increased NWC; this is a cash inflow at the end of the project8-11ESTIMATING CASH FLOWS•Cash Flow from Operations•Recall that:OCF = EBIT – Taxes + Depreciation8-12INTEREST EXPENSE•Later 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, it’s enough to assume that the firm’s level of debt (and, hence, interest expense) is independent of the project at hand.8-138.2 THE BALDWIN COMPANY•Costs of test marketing (already spent): $250,000•Current market value of proposed factory site (which we own): $150,000•Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year)•Increase in net working capital: $10,000•Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,0008-14THE BALDWIN COMPANY•Price 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 $10,000 changes with sales8-15THE BALDWIN COMPANY($ thousands) (All cash flows occur at the end of the year.)8-16THE BALDWIN COMPANYAt the end of the project, the warehouse is unencumbered, so we can sell it if we want to.8-17THE BALDWIN COMPANYYear 0 Year 1 Year 2 Year 3 Year 4 Year 5Income: (8) Sales Revenues 100.00 163.20 249.72 212.20 129.90 Recall that production (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 = $249,720.8-18THE BALDWIN COMPANYYear 0Year 1 Year 2 Year 3 Year 4 Year 5Income: (8) Sales Revenues 100.00 163.20 249.72 212.20 129.90 (9) Operating costs -50.00 -88.00 -145.20 -133.10 -87.84Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 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] = $88,0008-19THE BALDWIN COMPANYYear 0 Year 1 Year 2 Year 3 Year 4 Year 5Income: (8) Sales Revenues 100.00 163.20 249.72 212.20 129.90 (9) Operating costs -50.00 -88.00 -145.20 -133.10 -87.84 (10) Depreciation -20.00 -32.00 -19.20 11.52 -11.52Depreciation is calculated using the Modified Accelerated Cost Recovery System (shown at