Lecture Notes 7: Capital Budgeting 10/12/22

Lecture Notes 7: Capital Budgeting

Introduction

We have now reached the final module for our course, and it brings together much of our
previous work to help answer the following question for the managers of a firm: How
should they decide on the various projects, proposals, and undertakings facing the firm?
Should they open a new plant, buy new machinery, invest in some research and
development plan, expand existing lines of business, or perhaps acquire an entire
business through purchase? We have already introduced a common name for this analysis
in the last module, capital budgeting.

Capital Budgeting is the investment decision of a firm. Although a corporation may

operate under a strategic business plan, which spells out in broad terms the strategy and
goals of the firm, there is a need for continuously evaluating projects both small and large
for their economic viability. Although a company can approve an insufficient proposal
for strategic reasons, it is always good to know if a project is economically sound. Some
examples of capital expenditure proposals include needed replacement of existing
equipment or facilities, expansion of product lines, expansion of markets, or even
purchases of another firm.

In our prior examinations of financial decisions, we have incorporated both the time
value of money as well as the risk consideration. Finance is about cash flows, and if they
occur at different points in time, one must adjust for the opportunity cost of cash. We
have also shown that there is a general preference for avoiding uncompensated risk by the
shareholders that are the ultimately owners of the corporation. The managers that run the
firm are theoretically just the agents of these owners and are under an obligation to act on
their behalf, but procedures must be in place to align the interests of managers and
shareholders so that the obligation actually becomes more like an economic force.

In the last module we have also shown how you would estimate the cost of capital for a
firm. This was not a dollar amount, but rather a rate of return, and took account of the
cost of different sources of capital, such as the cost of equity, the cost of debt, or the cost
of preferred shares, if the firm had those kinds of shares. We combined individual costs
(rates of return) into a single rate, and one way to do that is with a weighted average
calculation such as the weighted average cost of capital (WACC):

WACC = wdrd(1 – T) + wprp + wsrs

As you will see below, the ideal way to come up with an investment decision tool that
can signal “accept the project” or “reject the project” is to come up with an analysis that
takes the cost of capital into account because the firm needs to consider the investors that
have provided the capital. If the firm uses the credit obtained by borrowing, the investors
need to be paid back otherwise the firm can be declared in default, and bankruptcy
proceedings will start. But the shareholders also expect to be eventually paid, either
through dividends or the increase in share price. If the firm accepts unprofitable projects,

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Lecture Notes 7: Capital Budgeting 10/12/22

sooner or later shareholders will recognize this, and the share price will start to fall. If
there are no good opportunities present for firms to invest in, they should return excess
cash to the investors as either dividends or a share repurchases.

Before we move on to the actual decision criteria for projects, we want to again justify
the potential use of WACC as a minimum rate that would make the project acceptable,
plus mention when it might not be an acceptable rate to use for capital budgeting. First, it
combines the rate from all the sources of financing in the same proportion as the present
capital structure of the firm. By capital structure, we mean the proportion of debt,
equity, and preferred stock that the firm presently has. Let us assume for a minute that
the firm has no preferred stock and has 25% debt and 75% equity. If .25 and .75 are the
weights used in obtaining the WACC, and the decision criteria is to accept the project,
then if the firm needs to raise more cash to pay for the project, they can issue debt and
equity in the same 25% and 75% proportion. The capital structure of the firm will remain
the same and the decision criteria is based on an appropriate cost of capital as well.

We should also mention at this point that the use of a single rate of return to use in all
capital budgeting decisions is only appropriate if the project risk is very similar to the risk
of the firm presently. If not, then it needs to be adjusted. For example, if a beverage
company, like Coca Cola is applying capital budgeting to decide if adding another
bottling plant is appropriate, using WACC could be appropriate. But if they all of sudden
decide to diversify and build a factory making rockets to sell to NASA, that project may
require a completely different rate of return incorporating the greater risk of the venture.

The Decision Criteria

We have already calculated both a net present value (NPV) as well as an internal rate
of return (IRR) in the prior module. These two measures play a role in the two most
popular investment criteria used in capital budgeting. The third most popular rule,
payback, is the easiest to apply although this archaic investment criterion has fallen out
of favor in today’s computer world where NPV and IRR are quite easy to calculate.

We will first discuss the NPV and IRR rule because although they are different, they also
have a lot in common. They both require an estimate of all the cash flows and the use of
a net present value equation. To use either measure you need a discount rate, which
should reflect the risk of the project. We often call the discount rate the appropriate cost
of capital. The steps in common for both these techniques are:

1. Estimate the cash flows including initial costs

2. Assess the riskiness of the cash flows
3. Determine the cost of capital or an even more appropriate (for the risk) discount rate r
4. Calculate either the NPV and/or the IRR
5. Accept the project if NPV > 0 or if IRR > r (for normal investing type projects) 1

1
A “normal” investing type cash flow has one or more cash flows outflows (negative) prior to a series of
cash inflows (positive). If the positive cash flows occur first, then accept the project if IRR < r.

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Lecture Notes 7: Capital Budgeting 10/12/22

Before we examine these techniques in more detail, we need to classify potential projects
by an important characteristic:

Independent Projects These are projects where the acceptance of one or more of
the projects does not preclude or affect the acceptance of
any of the other projects.

For example, a factory is considering the modernization of several machines it uses in

production. If it is possible to replace one or more of the machines, each replacement is
an independent project. Another example is a fast-food chain, considering expansions to
several different locations. We would consider each new restaurant an independent
project

Mutually Exclusive Projects These are projects where the acceptance of one
project will preclude the acceptance of the others.

For example, a real-estate developer owns some vacant land it is considering it for
development as an office building or as residential apartments. Each of these plans is
mutually exclusive since it requires the use of the same plot of land. Another potential
characteristic of mutually exclusive projects is the achievement of the same purpose for
the firm, as in the choice between two machines to perform the same task in a factory.

Net Present Value

The net present value of an investment is the present value of all future cash flows
discounted at the appropriate risk-adjusted cost of capital. We can represent this as:
n
NPV = ∑ Ct (1 + r ) − t
t =0

Or we can put the discount function in the denominator with a positive exponent, the
notation preferred by most textbook:
n
Ct
NPV = ∑ t
t = 0 (1 + r )

As you can see, both above forms include the initial cash flow under the summation sign,
although some textbooks would show the NPV equation as:
n
Ct
NPV = −C0 + ∑ t
t =1 (1 + r )

However, this last form assumes that the initial cash flow is negative, which is not always
the case. Cash flow for every t can either be positive (inflow) or negative (an outflow).

Since (1 + r)0 = 1, the most general and notation would serve us best:

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Lecture Notes 7: Capital Budgeting 10/12/22

n
NPV = ∑ Ct (1 + r ) − t
t =0

The NPV of a project is simply the present value of all cash flows associated with the
project, discounted at an appropriate rate r. The discussion related to WACC above
applies to the discount rate r in the NPV equation.

The NPV Criteria: For independent projects, choose all projects where NPV > 0.
For mutually exclusive projects, rank the NPVs and choose
the project with the highest NPV. 2

Good attributes of the NPV criteria are that it uses all the cash flows of the project,
properly discounts all the cash flows, and incorporates risk if an appropriate discount rate
is used. The assumption of the NPV calculation is that all cash flows are reinvested at the
discount rate, which is not a bad assumption for the firm’s majority of projects using the
WACC. On the balance, it is the best capital budgeting decision rule, because it avoids
some of the difficulties presented by the IRR technique.

Example: Consider the following two projects: “FAST” and “SLOW”

Cash flows for the two projects “FAST” and “SLOW”

Project/years t=0 t=1 t=2 t=3 t=4
FAST -$1,000 $500 $400 $300 $100
SLOW -$1,000 $100 $300 $400 $675

The project names “FAST” comes from the fact that after an outflow of $1,000, project
FAST has the cash flows being returned to the firm earlier compared to project SLOW
which has greater cash flows in the later years. But don’t forget that all future cash flows
must be discounted due the time value of money.

Calculating the NPV of Project FAST using a 10% discount rate:

Although it may seem tedious to calculate NPV term by term, it is a useful exercise for
students for at least a few calculations so that they develop a good understanding of the
technique. Financial calculators have built in functions to calculate NPV, but you need to
learn how to enter the data appropriately, otherwise the wrong answer may result.
Spreadsheets can also easily calculate NPV, but again you need to be careful with the
cash flows. Because of an early error with the naming of the Excel function called NPV,
spreadsheets using the =NPV(rate,cell1:celln) function calculate just the present value of
all the cash flows starting with the cell1 at time t = 1, with no provision to include the t =
0 cash flow.
2
Of course, you might reject all the projects if the NPVs are all negative, or if you must choose one of the
projects regardless of how economically feasible it is, you still might take the one with the highest NPV.

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Lecture Notes 7: Capital Budgeting 10/12/22

To turn it into a true NPV function, you need to add the initial cash flow separately. As
an example, we will use Excel to calculate the NPV for the FAST project:

If you have the cash flows above for FAST, t = 1 through t = 4 entered in cells B1
through E1 in a spreadsheet, you can try =NPV(10%,B1:E1) -1000 in cell A1 and see if
you get the same answer as above. But also use the calculator and discount each
individual function so you have a way to check Excel when needed. You can also input
10% as 0.10 but make sure that the cells have the appropriate formatting if you are not
getting good results.

Now try the same exercise (both calculator and Excel) for the project SLOW. The NPV
for SLOW should be $100.40.

Please make sure you get both the $78.82 and the $100.40 for the NPV using both a
calculator and the present value formulas as well as using Excel.

The Net Present Value Criteria

Suppose that project FAST and SLOW are independent projects as defined above. Since
projects have a positive NPV using a 10% cost of capital, both are acceptable projects. If
either one of these would have a negative NPV you would not accept the project if your
cost of capital is 10%. If r = 15% the two NPV values are -$8.33 and -$37.26. Try doing
this yourself. You would reject both projects.

Now suppose that the two projects are mutually exclusive projects. You should choose
only the project with the higher NPV, but only if it is still positive. For our two projects
at a 10% cost of capital, you would accept SLOW because it has the higher NPV =
$100.4 > $78.82.

Internal Rate of Return

A project’s IRR is the discount rate that makes the NPV of all cash flows including the
initial t = 0 cash flow, equal to zero. As such, we just take the NPV equation, set it equal
to zero and solve for r.
n
0 = NPV = ∑ Ct (1 + r ) − t
t =0

In a few cases, we can solve for r algebraically, but often this is not possible because we
cannot isolate r one side of the equation. One can obtain it by using trial and error
techniques, and there are systematic search techniques to do this, but this is how a
financial calculator or spreadsheet finds the solution. For example, using the same
spreadsheet setup as above, we can find the IRR for projects FAST and SLOW as
follows: If you copy the above cash flows from row 1 and 2 to row 7 and 8 and insert the
cash outflow of -1000 into cells A7 and A8, as in:

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Lecture Notes 7: Capital Budgeting 10/12/22

A7 B7 C7 D7 E7
($1,000.00) 500 400 300 100

You can have the IRR function in any empty cell such as F7 formatted properly (see
below):

Project FAST: =IRR(A7:E7) = 0.1449 or 14.49%

Project SLOW: =IRR(A8:E8) = 0.1355 or 13.55%

You can control the format of the cell in which you calculate IRR to give you either a rate
or a percentage, and you can control the number of places displayed in the cell. It is not
acceptable to round to the nearest percentage since that is too rough. You should set the
cell to show at least four places to the right of the decimal point for rates or two for
percentages. Incidentally, it would be a useful exercise to take the IRR above and use it
to recalculate the NPV for each project. What do you expect to get? Do it!

Notice that you can calculate the IRR without first choosing a critical value of r, but to
use the IRR criteria to accept or reject projects, we need to choose a discount rate that
serves the same purpose as it did in the NPV investment decision. You would, of course
use the cost of capital as r.

The Internal Rate of Return Criteria

The IRR Criteria: For independent projects, choose all projects where IRR > r, if the
cash flows are “normal”. 3 For mutually exclusive projects, rank
the IRRs and choose the project with the highest NPV. 4

As you can see, if we assume independent projects, the IRR and NPV indicate the same
acceptance for both projects. But if we assume that these projects are mutually
exclusive, previously, using NPV we chose project SLOW, but now using IRR,
project FAST, with the higher IRR, appears to be better. This is one of the
problems with the IRR. There is a way to do this using only IRR, but this is optional
for this class, so I am putting it into a footnote! 5

3
As mentioned in footnote 1 above, this is true only for a “normal” investing type cash flow that has one or
more cash flows outflows (negative) prior to a series of cash inflows (positive). We call this an investment
type cash flow. Occasionally, the project cash flows are such that you receive all money before having to
return some. Think of borrowing money for a house as such a project. If you first get money and then pay
back, we will classify this as a “financing” project as opposed to an “investing” project, and your objective
is to obtain a low IRR rather than a high one. An acceptable “financing project” is when the IRR < r.
4
As before, you might reject all mutually exclusive projects if none of the IRRs exceed r.
5
Consider accepting project FAST tentatively, but now consider the difference between the two projects as
an additional project and check its IRR. SLOW – FAST cash flows are t = 0: zero, t = 1: -400, t = 2: -100, t
= 3: 100, and t = 4: -575. That IRR of the incremental is 11.98%, which means accept the incremental if r
= 10%. The interpretation of that is that you should just do project SLOW and not FAST for mutually
exclusive projects. Same conclusion as was obtained from the NPV method.

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Lecture Notes 7: Capital Budgeting 10/12/22

If the NPV analysis is always correct, why bother with the IRR? The IRR has one
advantage over the NPV. A rate of return is a universal standardized measure, easy to
understand and communicate to others regarding the value of the project. For example,
when the cost of capital is 10%, but the IRR of a project is 20%, that conveys a certain
quality to the project. 6 Of course, this is also the root of the problem regarding the
occasional false acceptance for mutually exclusive projects. 10% of a million-dollar
project is generally better than 20% of a $100,000 project.

So far, we have found several deficiencies with the IRR approach. The decision varies if
we are borrowing money instead of lending. The reinvestment assumption uses the IRR
rather than the more reasonable assumption of the cost of capital. The decision for
mutually exclusive problems becomes more difficult because projects where the scale of
the cash flows is quite different or the timing of the cash flows differs, such as in our
example, and will lead to an incorrect decision using the IRR.

To summarize, the advantage of the IRR decision criteria is that it can provide an
economic analysis that is essentially sound if care is taken to overcome the numerous
disadvantages. We can easily compare the IRR, which is a rate, to other investments;
therefore, it is easy to communicate the value of the project. On the other hand, it does
present several challenges, particularly when the projects are mutually exclusive, or when
the cash flows do not follow the normal pattern of outflows followed by inflows.

Payback

A third criterion for capital budgeting is called the payback period, and this measure
provides the number of years required for an investment’s cash flow to cover its initial
cost. The minimum number of years deemed acceptable for a project is set by
management. Consider project FAST above. The first year yields $500, and the next
yields $400. After 2 years, the full $1000 expenditure has not been recovered, but during
the third year, the remaining $100 is recovered after 1/3 year in terms of cash coming in
in year 3. This makes the payback of FAST equal to 2.33. The .33 comes from 100/300,
100 being the left-over part of the initial expenditure and 300 is what you recover in year
3.

For project SLOW, after 3 years, 100 + 300 + 400 = $800 has been recovered, leaving
$200 to be recovered in year 4. Since year 4 yields $675, the fraction of the year to be
added to the 3 years is 200/675 = .2963, therefore the payback equals 3.3.

If management uses two years as minimum payback, we will reject both projects. If they
use three years as minimum payback, only project FAST is acceptable. If management
uses four years as minimum and the projects are independent, we will accept both, but if
they are mutually exclusive, we only accept project FAST, since it has a higher payback.

6
Unfortunately, this is not quite true either, unless all cash flows are reinvested at the IRR rate, but there is
another calculation called the modified IRR or MIRR, that assumes reinvestment at a different rate.

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Lecture Notes 7: Capital Budgeting 10/12/22

Payback’s only advantage is the ease you can calculate the payback years and the
intuitive understanding it provides regarding information related to risk and liquidity.
Since cash flows further away are riskier, payback is a primitive risk indicator.

Still, there are too many disadvantages to make payback a real serious contender to either
NPV or IRR. Payback disregards time value of money and cash flows that occur after the
payback period. Payback has a bias against long-term projects, and at the same time
ignores large negative outflows in the later years, such as the cleanup of facilities after
the conclusion of a project. In addition, the acceptance criteria set by management is
arbitrary.

There is a modified payback version, called discounted payback, that attempts to address
the lack of time value of money adjustments, but this then makes payback more
complicated to calculate, negating the ease of calculation advantage, and at the same
time, does not address the criteria’s other deficiencies. One could say, why bother, and
just calculate NPV.

Cash Flow Estimation

We have shown the leading capital budgeting methods, but before you can apply any of
the techniques, you need to estimate the cash flows. In this section, we discuss the issues
related to this topic as well as demonstrate several complete capital budgeting examples.

Cash Flow versus Accounting Income

We learned earlier that cash flows are more important in finance than accounting income.
In fact, we used a free cash flow formula, from the data available from a firm’s
accounting statement to estimate the annual free cash flow available to shareholders and
bondholders from the firm’s operations. We modified the operating income to reflect the
noncash expenditures of depreciation and amortization, and further adjusted it to account
for needed spending for capital expenditures and net changes to working capital to
determine the amount of cash available for withdrawal from the firm while keeping it
competitive with the needed expenditures. Recall the free cash flow formula from
Module 6:

FCF = EBIT + Depreciation – Current Taxes – Additions to NWC – Capital Expenditures

By the way, one could also write this as:

FCF = EBIT(1 – tax rate) + Depreciation– Additions to NWC – Capital Expenditures

You can go back to the example on page 4 and 6 of Module 6 Notes, where current taxes
were 71 so taxes are at the rate 71/219 = .324201 so 1 – tax rate = 0.6758 and redoing
page 6 like that: FCF = 219(.6758) + 90 – 23 – 173 = 42 (same as the other equation!)

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Lecture Notes 7: Capital Budgeting 10/12/22

When you estimate both the costs and the benefits of a project, you are essentially
looking at similar items as in the free cash flow formula, but at the project level rather
than for a whole firm. As in the free cash flow calculation, cash is more important than
accounting net profit. Depreciation is not a real cash expense but needs to be initially
included to get the true after-tax cash flows. We will demonstrate this with an example,
which follows after we identify a few key issues in the capital budgeting problem.

Incremental Analysis

The term incremental analysis is the key to the whole capital budgeting analysis.
Incremental means additional, either revenues or expenses, and these incremental cash
flows only exist if the project is accepted. For every year during the life of the project,
every substantial cash flow that is an incremental cost or benefit must be accounted for in
the capital budgeting analysis.

Timing of Cash Flows

At the initiation of the project, which we can call year 0, the firm will often need to pay
for increases to fixed assets or increases to working capital to support the project.
Assume that this point is t = 0, or the beginning of a fiscal year. Point t = 1 is then the
end of the first fiscal year or the beginning of the second fiscal year. At t = 1, 2, 3, etc.
the firm will have potential inflows (revenues) as well as expenses, and at each point we
need to calculate the incremental cash flows produced by the new project. In this
manner, a project with a life of four years will have five points in time: t = 0, t = 1, t = 2,
t = 3, t = 4 at which to consider incremental cash flows.

After-Tax Salvage Value

Perhaps new machinery is purchased at t = 0 for $100,000 and it is depreciated using a

straight-line depreciation for ten years. The project time-line need not be of the same
duration. Suppose we estimate the project will last only six years, after which we can sell
the machinery for $75,000. After six years, the cumulative depreciation on the machine
is equal to $60,000 (10,000 per year for six years), which means that the book value of
the machinery is $40,000 (100,000 – 60,000). Since the market price is 75,000 and the
book value is 40,000, there is a tax liability of a capital gains of 75,000 – 40,000 = 35,000
which will be taxed at the assumed tax rate of .40. The tax is then 35,000 x .40 = 14,000,
therefore the after-tax cash flow of salvage is 75,000 – 14,000 = 61,000. This
incremental cash flow occurring at t = 6 must be included in the analysis.

If you were to consider only the purchase of the machinery and its salvage on the NPV of
the project, you would include – $100,000 at t = 0 and + 61,000 at t = 6.

Additions to Working Capital

Often the acceptance of a project requires addition working capital. For example,
suppose a store with 25 checkout lines doubles their checkout lines, and therefore will

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Lecture Notes 7: Capital Budgeting 10/12/22

need to add 25 new cash registers that require cash for making change. If it is only $200
per register, there still is a need for an additional $5,000 for the duration of the project.
We treat any increase of working capital, such as inventory, in exactly this manner.
Since generally we do not deplete working capital over the life of the project, we can
recover it. The firm can use the cash for other purposes, and they can sell the inventory.
This end of project action is the recovery of working capital.

Suppose the life of this project is also six years. If you were to consider the additions to
working capital in isolation, you would include a – $5,000 at t = 0 and a + 5,000 at t = 6.
If there is no time value of money (interest rate equal to zero), this would be a wash, but
if interest rates are positive the incremental net present value of increases to working
capital is negative. The money invested in working capital is not earning potential
interest, and that is the incremental cost of additions to working capital.

Sunk Costs

Sunk costs are never incremental because the money is gone. Suppose the firm pays
$100,000 for a feasibility study for the introduction of a product line. Based on the
encouraging results of the study, a comprehensive capital budgeting analysis investigates
the economic viability of starting up production of the new product. Should the financial
analyst include the $100,000 expenditure for the feasibility study as a cost? The money
has already been spent; therefore, the answer is no, it is a sunk cost.

Opportunity Costs

Suppose that a firm has an unutilized empty warehouse, perfect for the new project. Can
it be omitted from the capital budgeting analysis? It must be included as an expense
because the firm can rent it out or sell it, even if that action has not happened in the past.
We call this type of expenditure an opportunity cost.

Externalities

Externalities are any economic effects on either the firm or the environment, which may
indirectly affect the firm that would not occur if the project were not accepted. One type
of externality is cannibalization, where the acceptance of one project has an adverse
effect on the firm’s existing product line. Perhaps a car manufacturer wants to introduce
a new compact car, but it already has an existing compact car. If it is planning to keep
the old model, it must recognize that the new model may affect the sales of the older
model.

If a project has an impact on the environment, which will have a negative economic
effect on the firm, then this type of externality must also be included in the capital
budgeting problem.

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Lecture Notes 7: Capital Budgeting 10/12/22

Analysis of an Expansion Project

Previously in these notes and in the textbook, we considered project FAST, which had a
given set of cash flows. We decided that at 10% cost of capital, it is an acceptable
project. In the example here, the details of the project are examined which leads to
precisely the same cash flows as project FAST. 7

The project is an expansion project requiring the purchase of equipment for $900, an
increase to working capital of $100 and will last for four years over which time it will
have the revenues and expenses as stated below. The firm will fully depreciate the
equipment over the four years and will sell it for salvage for $50. It will also fully recover
the working capital at time t = 4. Their tax rate for both capital gains and income is .40.

We will show this capital budgeting problem two different ways regarding how fast the
firm will depreciate the outlay for the buildings and equipment. One way is straight-line
depreciation, were you take the 900 outlays for equipment, and divide it by the life of the
project. In this case the per year depreciation is 900/4 = 225. A second way is using
accelerated depreciation, which depreciates the earlier years faster. The schedule for four
years would be 33% in year 1, 45% in year 2, 15% in year 3 and 7% in year 4. Notice
that the amount depreciated is the same but comes faster in te early years. For 900 it is
297 = (900*.33) , followed by 405, 135, 63. We start with the accelerated depreciation
way: (rounding to nearest $1,000 and show in units of $1,000):

t=0 t=1 t=2 t=3 t=4

Building and equipment -900
Addition to working capital -100
Sales revenue 5370 5200 5050 4900
less costs 4735 4803 4640 4992
less depreciation 297 405 135 63
EBIT or operating income 338 -8 275 -155
Taxes at 40% 135 -3 110 -62
EBIT(1-.4) (After tax income) 202 -5 165 -93
Add back depreciation 297 405 135 63
EBIT(1 – tax rate) + Depreciation. 500 400 300 -30
Salvage Value 50
tax on salvage .4(50 – 0) 20
After tax salvage 30
Recovery of Working Capital 100
-1000 500 400 300 100

The above cash flows bottom of the table leads to NPV of 78.82 and IRR of 14.49% as
we demonstrated on page 4 and 6 above. The initial cash flows at t = 0 are for the capital

7
The numbers were low to be a realistic real-world project, but you can assume each number represented
$1,000.

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Lecture Notes 7: Capital Budgeting 10/12/22

outlay for the equipment as well as the addition to working capital. In years one through
four, the following equation takes care of the after-tax value of revenues less expenses
with the addition back of the depreciation since that is not a real expense. We subtract
depreciation as an expense initially because it is a tax deduction, but then we add it back.
This should remind you of EBIT(1 – T) + D in the free cash flow calculation.

The annual cash flow for incremental operating cash flow is:

Cash Flow = (R – C – D)( 1 – T) + D where R stands for revenue, C for costs, D for
depreciation, and T for tax rate. For example, for t = 1: R = 5,370; C = 2,735 + 2,000 =
4,735; D = 297:

(R – C – D)( 1 – T) + D = (5,370 – 4,735 – 297)(.6) + 297 = 499.8 or rounded to 500 in

table above.

These calculations are continued for all four years; The t = 4 terminal point has additional
positive cash flows for after tax value of salvage and the recovery of the working capital.
This yields the same cash flows and analysis as project FAST above using a WACC of
10%.

We will repeat the calculation in a more simplified way and show how you could get the
NPV. Assume Sales are the same for all four years of 5000, costs not including
depreciation are 4,500, outlay for 1,000 is only for equipment with no outlay for working
capital, and straight-line depreciation, meaning 1,000/4 =250 every year. Assume zero
salvage after four years. Taxes are still at the 40% rate.

Ever year will be identical:

(R – C – D)( 1 – T) + D = (5000 – 4500 – 250)(1 - .4) + 250 = 250(.6) + 250 = 400

NPV = -1,000 +400[(1 – (1.1)-4)/.1] = -1000 + 400(3.169865) = 267.95

Perhaps you recognize the annuity formula in the NPV equation! This simplified
problem only took a few minutes with that or same quick time using Excel. You need to
use Excel or financial functions to get the IRR = 21.86%. Either way, you would accept
the project.

PRACTICE PROBLEMS

To complete this set of notes, I end with some practice problems. On the final page of
the notes, the solutions are shown. You should do these problems using paper, pencil,
and calculator, and then check the answers. If you have the wrong answers, do not focus
too much on the solution because it is a better study technique to go back to the notes and
redo the problem until you get the correct answer.

FINA.3010/5010 Steven Freund 12

Lecture Notes 7: Capital Budgeting 10/12/22

1. Larry's Inc. is considering a project that has the following cash flow and WACC
data. What is the project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.

WACC: 10.25%
Year 0 1 2 3 4 5
Cash flows -$1,000 $300 $300 $300 $300 $300

2. Fred Corp. is considering a project that has the following cash flow data. What is
the project's IRR? Note that a project's projected IRR can be less than the WACC
or negative, in both cases it will be rejected.

Year 0 1 2 3
Cash flows -$1,000 $425 $425 $425

3. Haggard Inc. is considering a project that has the following cash flow data. What
is the project's payback?

Year 0 1 2 3
Cash flows -$1,150 $500 $500 $500

4. As assistant to the CFO of Magnolia Inc., you must estimate the Year 1 cash flow
for a project with the following data. What is the Year 1 cash flow?

Sales revenues $13,000

Depreciation $4,000
Other operating costs $6,000
Tax rate 35.0%

5. Lowell Corp. is considering a new project whose data are shown below. The
equipment that would be used has a 3-year tax life, would be depreciated by the
straight-line method over its 3-year life, and would have a zero salvage value. No
change in net operating working capital would be required. Revenues and other
operating costs are expected to be constant over the project's 3-year life. What is
the project's NPV?

Risk-adjusted WACC 10.0%

Net investment cost (depreciable basis) $65,000
Straight-line depreciation rate 33.3333%
Sales revenues, each year $65,500
Annual operating costs (excl. depreciation) $25,000
Tax rate 35.0%

Answers Only: Look at the solutions on the next page only after spending sufficient
time working out the answers. Instead, look back at the examples in the Notes
above. 1) $130.01 2) 13.21% 3) 2.30 years 4) $5,950 5) $19,325

FINA.3010/5010 Steven Freund 13

Lecture Notes 7: Capital Budgeting 10/12/22

Practice Problems with Solutions:

1. Larry's Inc. is considering a project that has the following cash flow and WACC
data. What is the project's NPV? Note that if a project's projected NPV is
negative, it should be rejected.

WACC: 10.25%
Year 0 1 2 3 4 5
Cash flows -$1,000 $300 $300 $300 $300 $300

One way to solve this problem is to use the annuity formula:

NPV = -1000 + 300[{1 - (1.1025)-5}/0.1025] = -1000 + (300)(3.766699) = 130.01

2. Fred Corp. is considering a project that has the following cash flow data. What is
the project's IRR? Note that a project's projected IRR can be less than the WACC
or negative, in both cases it will be rejected.

Year 0 1 2 3
Cash flows -$1,000 $425 $425 $425

You could use a financial calculator, or Excel’s IRR function; Put values into
cells B1 through E1, and then =IRR(B1:E1) in any cell. It is best to format as
a number with sufficient significant places (say five or more). Answer then is
0.13205 or 13.21%. To round to the nearest percentage, like 13%, is not
accurate enough! As a check you can try the IRR in an NPV formula and it
should come out close to zero.

3. Haggard Inc. is considering a project that has the following cash flow data. What
is the project's payback?

Year 0 1 2 3
Cash flows -$1,150 $500 $500 $500

After two years, 1000 has been paid back, leaving 150 still to be paid back. From
the third cash flow of 500, 150/500 = .3, so payback is 2 + .3 = 2.3.

FINA.3010/5010 Steven Freund 14

Lecture Notes 7: Capital Budgeting 10/12/22

4. As assistant to the CFO of Magnolia Inc., you must estimate the Year 1 cash flow
for a project with the following data. What is the Year 1 cash flow?

Sales revenues $13,000

Depreciation $4,000
Other operating costs $6,000
Tax rate 35.0%

Answer:
Sales revenues $13,000
Depreciation -$4,000
Other operating costs -$6,000
$3,000
Tax rate x .35
-$1,050
$1,950
Add back depreciation +$4,000
$5,950

5. Lowell Corp. is considering a new project whose data are shown below. The
equipment that would be used has a 3-year tax life, would be depreciated by the
straight-line method over its 3-year life, and would have a zero salvage value. No
change in net operating working capital would be required. Revenues and other
operating costs are expected to be constant over the project's 3-year life. What is
the project's NPV?

Risk-adjusted WACC 10.0%

Net investment cost (depreciable basis) $65,000
Straight-line depreciation rate 33.3333%
Sales revenues, each year $65,500
Annual operating costs (excl. depreciation) $25,000
Tax rate 35.0%

First, we need the per year cash flow:

Sales revenues $65,500
Depreciation 65000(.333333) -$21,667
Other operating costs -$25,000
$18,833
Tax rate x .35
-$6,592
$12,241
Add back depreciation +$21,667
$33,908
Now, discounting:

NPV =-65000 + 33908[{1 - (1.10)-3}/0.10] = -65000 + 33908(2.486852) = 19,325

FINA.3010/5010 Steven Freund 15