Slide 0Chapter Outline7.1 Incremental Cash FlowsCash Flows—Not Accounting Earnings.Incremental Cash FlowsSlide 6Estimating Cash FlowsInterest ExpenseProject Cash FlowsModified ACRS DepreciationModified ACRS Depreciation AllowancesProblem 7.3Problem 7.3: Compute OCFProblem 7.3: Cash Flow from AssetsProblem 7.3: Compute NPV7.2 The Baldwin Company: An ExampleDepreciationThe Worksheet for Cash Flows of the Baldwin CompanySalvage ValueSlide 20Working CapitalThe Worksheet for Cash Flows of the Baldwin Company (continued)Slide 23Slide 24Slide 25Incremental After Tax Cash Flows of the Baldwin CompanyTotal Cash Flow of InvestmentNPV Baldwin Company7.3 Inflation and Capital BudgetingExample of Capital Budgeting under InflationSlide 31Slide 32Year 1 After-tax Real Risky Cash FlowsYear 2 After-tax Real Risky Cash FlowsYear 3 After-tax Real Risky Cash FlowsYear 4 After-tax Real Risky Cash FlowsSlide 37Slide 387.3 The Boeing 777: A Real-World ExampleTable 7.5 Incremental Cash Flows: Boeing 777Slide 40Slide 42NPV Profile of the Boeing 777 ProjectBoeing 7777.4 Investments of Unequal Lives: The Equivalent Annual Cost MethodEAC with a CalculatorSlide 47Slide 48The Equivalent Annual Cost MethodInvestments of Unequal LivesInvestments of Unequal Lives: EACCadillac EAC with a CalculatorCheapskate EAC with a CalculatorExample of Replacement ProjectsSlide 55Slide 567.5 Summary and ConclusionsDorm Beds ExampleDorm Beds ExampleMcGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-1Corporate Finance Ross - Westerfield - JaffeSeventh EditionSeventh Edition7Chapter Seven Net Present Value and Capital BudgetingMcGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-2Chapter Outline7.1 Incremental Cash Flows7.2 The Baldwin Company: An Example7.3 The Boeing 777: A Real-World Example7.4 Inflation and Capital Budgeting7.5 Investments of Unequal Lives: The Equivalent Annual Cost Method7.6 Summary and ConclusionsMcGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-37.1 Incremental Cash Flows•Cash flows matter—not accounting earnings.•Sunk costs don’t matter.•Incremental cash flows matter.•Opportunity costs matter.•Side effects like cannibalism and erosion matter.•Taxes matter: we want incremental after-tax cash flows. •Inflation matters.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-4Cash Flows—Not Accounting Earnings.•Consider 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-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-5Incremental 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 we should not proceed.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-6Incremental 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.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-7Estimating Cash Flows•Cash Flows from Operations–Recall that:Operating Cash Flow = EBIT – Taxes + Depreciation•Net Capital Spending–Don’t forget salvage value (after tax, of course).•Changes in Net Working Capital–Recall that when the project winds down, we enjoy a return of net working capital.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-8Interest 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 (hence interest expense) is independent of the project at hand.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-9Project Cash Flows•T=0: Cost of new asset.–Sale of old asset.–Change in Net Working Capital.•T=1,n: Operating Cash Flows (in the simplest case)•T=n: Terminal Cash Flows–Salvage value–Change in Net Working Capital.McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-10Modified ACRS DepreciationClass Examples3-Year Equipment used in research5-Year Autos, computers7-Year Most industrial equipmentMcGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-11Modified ACRS Depreciation AllowancesYear 3-year class 5-year class 7-year class1 33.33% 20.00% 14.29%2 44.44% 32.00% 24.49%3 14.82% 19.20% 17.49%4 7.41% 11.52% 12.49%5 11.52% 12.49%6 5.76% 8.93%7 8.93%8 4.45%McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-12Problem 7.3•The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. (Cash flows are in $ thousands and the corporate tax rate is 34 percent.)Year 0 Year 1 Year 2 Year 3 Year 4Sales revenue 7,000 7,000 7,000 7,000Operating costs 2,000 2,000 2,000 2,000Investment -10,000Depreciation 2,500 2,500 2,500 2,500NWC (End of year) 200 250 300 200 0McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-13Problem 7.3: Compute OCF•Compute the incremental cash flow of the investment.•OCF = (R-C-D)(1-T)+D•The incremental cash flow is the same for each year.•OCF = (7,000-2,000-2,500)(1-.34)+2,500=$4,150McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-14Problem 7.3: Cash Flow from Assets•CFA = OCF – Net Capital Spending – Net Working Capital SpendingYear OCF Addition to assetsAddition to NWCCFA0 0 10,000 200 -10,2001 4,150 0 50 4,1002 4,150 0 50 4,1003 4,150 0 -100 4,2504 4,150 0 -200 4,350McGraw-Hill/IrwinCopyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.7-15Problem 7.3: Compute NPVYear CFA0 -10,2001 4,1002 4,1003 4,2504 4,350•NPV(12%) = $2,518.78•NPV >0•Project is