CHAPTER 7 Making Capital Investment Decisions


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CHAPTER
7

Making Capital Investment Decisions

In January 2006, Sharp Corporation, the world’s leading producer of flat panel LCD TVs, announced that it would spend an additional 200 billion yen ($1.75 billion) to build a new plant to produce LCD panels. This addition brought the total investment in the new plant to 350 billion yen ($3.07 billion). The extra investment increased the production capacity of the new plant from 30,000 glass substrates per month to 90,000 glass substrates per month, and the new plant would have the capacity to produce the equivalent of 22 million 32-inch TV sets by 2008. Just several days earlier, Matsushita Electric Industrial Co., the world’s leading plasma TV manufacturer, announced that it would invest 180 billion

yen ($1.57 billion) to build a new plant to produce plasma panels. The new plasma plant would more than double the company’s production capacity to 11.1 million units per year.
This chapter follows up on our previous one by delving more deeply into capital budgeting and the evaluation of projects such as these flat panel manufacturing facilities. We identify the relevant cash flows of a project, including initial investment outlays, requirements for net working capital, and operating cash flows. Further, we look at the effects of depreciation and taxes. We also examine the impact of inflation, and show how to evaluate consistently the NPV analysis of a project.

7.1 Incremental Cash Flows
Cash Flows—Not Accounting Income
You may not have thought about it, but there is a big difference between corporate finance courses and financial accounting courses. Techniques in corporate finance generally use cash flows, whereas financial accounting generally stresses income or earnings numbers. Certainly our text follows this tradition: Our net present value techniques discount cash flows, not earnings. When considering a single project, we discount the cash flows that the firm receives from the project. When valuing the firm as a whole, we discount dividends— not earnings—because dividends are the cash flows that an investor receives.
Relevant Cash Flows The Weber-Decker Co. just paid $1 million in cash for a building as part of a new capital budgeting project. This entire $1 million is an immediate cash outflow. However, assuming straight-line depreciation over 20 years, only $50,000 (ϭ$1 million/20) is considered an accounting expense in the current year. Current earnings are thereby reduced by only $50,000. The remaining $950,000 is expensed over the following 19 years. For capital budgeting purposes, the relevant cash outflow at date 0 is the full $1 million, not the reduction in earnings of only $50,000.
197

EXAMPLE 7.1

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Part II Valuation and Capital Budgeting

EXAMPLE 7.2

Always discount cash flows, not earnings, when performing a capital budgeting calculation. Earnings do not represent real money. You can’t spend out of earnings, you can’t eat out of earnings, and you can’t pay dividends out of earnings. You can do these things only out of cash flow.
In addition, it is not enough to use cash flows. In calculating the NPV of a project, only cash flows that are incremental to the project should be used. These cash flows are the changes in the firm’s cash flows that occur as a direct consequence of accepting the project. That is, we are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
The use of incremental cash flows sounds easy enough, but pitfalls abound in the real world. We describe how to avoid some of the pitfalls of determining incremental cash flows.
Sunk Costs
A sunk cost is a cost that has already occurred. Because sunk costs are in the past, they cannot be changed by the decision to accept or reject the project. Just as we “let bygones be bygones,” we should ignore such costs. Sunk costs are not incremental cash outflows.
Sunk Costs The General Milk Company is currently evaluating the NPV of establishing a line of chocolate milk. As part of the evaluation, the company had paid a consulting firm $100,000 to perform a test marketing analysis. This expenditure was made last year. Is this cost relevant for the capital budgeting decision now confronting the management of General Milk Company?
The answer is no. The $100,000 is not recoverable, so the $100,000 expenditure is a sunk cost, or spilled milk. Of course, the decision to spend $100,000 for a marketing analysis was a capital budgeting decision itself and was perfectly relevant before it was sunk. Our point is that once the company incurred the expense, the cost became irrelevant for any future decision.
Opportunity Costs
Your firm may have an asset that it is considering selling, leasing, or employing elsewhere in the business. If the asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can meaningfully be viewed as costs. They are called opportunity costs because, by taking the project, the firm forgoes other opportunities for using the assets.
Opportunity Costs Suppose the Weinstein Trading Company has an empty warehouse in Philadelphia that can be used to store a new line of electronic pinball machines. The company hopes to sell these machines to affluent Northeastern consumers. Should the warehouse be considered a cost in the decision to sell the machines?
The answer is yes. The company could sell the warehouse if the firm decides not to market the pinball machines. Thus, the sales price of the warehouse is an opportunity cost in the pinball machine decision.

EXAMPLE 7.3

Side Effects
Another difficulty in determining incremental cash flows comes from the side effects of the proposed project on other parts of the firm. A side effect is classified as either erosion or 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.

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EXAMPLE 7.4

Synergies Suppose the Innovative Motors Corporation (IMC) is determining the NPV of a new convertible sports car. Some of the customers who would purchase the car are owners of IMC’s compact sedans. Are all sales and profits from the new convertible sports car incremental?
The answer is no because some of the cash flow represents transfers from other elements of IMC’s product line.This is erosion, which must be included in the NPV calculation. Without taking erosion into account, IMC might erroneously calculate the NPV of the sports car to be, say, $100 million. If half the customers are transfers from the sedan and lost sedan sales have an NPV of Ϫ $150 million, the true NPV is Ϫ$50 million (ϭ$100 million Ϫ $150 million).
IMC is also contemplating the formation of a racing team. The team is forecast to lose money for the foreseeable future, with perhaps the best projection showing an NPV of Ϫ$35 million for the operation. However, IMC’s managers are aware that the team will likely generate great publicity for all of IMC’s products. A consultant estimates that the increase in cash flows elsewhere in the firm has a present value of $65 million. Assuming that the consultant’s estimates of synergy are trustworthy, the net present value of the team is $30 million (ϭ$65 million Ϫ $35 million). The managers should form the team.
Allocated Costs
Frequently a particular expenditure benefits a number of projects. Accountants allocate this cost across the different projects when determining income. However, for capital budgeting purposes, this allocated cost should be viewed as a cash outflow of a project only if it is an incremental cost of the project.
Allocated Costs The Voetmann Consulting Corp. devotes one wing of its suite of offices to a library requiring a cash outflow of $100,000 a year in upkeep. A proposed capital budgeting project is expected to generate revenue equal to 5 percent of the overall firm’s sales. An executive at the firm, H. Sears, argues that $5,000 (ϭ5 percent ϫ $100,000) should be viewed as the proposed project’s share of the library’s costs. Is this appropriate for capital budgeting?
The answer is no. One must ask what the difference is between the cash flows of the entire firm with the project and the cash flows of the entire firm without the project. The firm will spend $100,000 on library upkeep whether or not the proposed project is accepted. Because acceptance of the proposed project does not affect this cash flow, the cash flow should be ignored when calculating the NPV of the project.

EXAMPLE 7.5

7.2

The Baldwin Company: An Example
We next consider the example of a proposed investment in machinery and related items. Our example involves the Baldwin Company and colored bowling balls.
The Baldwin Company, originally established in 1965 to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company introduced “High Flite,” its first line of high-performance golf balls. Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. Recently W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers. That market was for brightly colored bowling balls, and he believed many bowlers valued appearance and style above performance. He also believed that it would be difficult for competitors to take advantage of the opportunity because of both Baldwin’s cost advantages and its highly developed marketing skills.

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As a result, the Baldwin Company investigated the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling balls could achieve a 10 to 15 percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. (As we shall see later, this is a sunk cost and should not be included in project evaluation.)
In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be manufactured in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold for $150,000 after taxes.
Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000. The machine has an estimated market value at the end of five years of $30,000. Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based on Baldwin’s taxable income, that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent.
Net working capital is defined as the difference between current assets and current liabilities. Like any other manufacturing firm, Baldwin finds that it must maintain an investment in working capital. It will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. And, its credit sales will generate accounts receivable. Management determines that an immediate (year 0) investment in the different items of working capital of $10,000 is required. Working capital is forecast to rise in the early years of the project but to fall to $0 by the project’s end. In other words, the investment in working capital is to be completely recovered by the end of the project’s life.
Projections based on these assumptions and Meadows’s analysis appear in Tables 7.1 through 7.4. In these tables all cash flows are assumed to occur at the end of the year. Because of the large amount of information in these tables, it is important to see how the tables are related. Table 7.1 shows the basic data for both investment and income. Supplementary schedules on operations and depreciation, as presented in Tables 7.2 and 7.3, help explain where the numbers in Table 7.1 come from. Our goal is to obtain projections of cash flow. The data in Table 7.1 are all that are needed to calculate the relevant cash flows, as shown in Table 7.4.
An Analysis of the Project
Investments The investment outlays for the project are summarized in the top segment of Table 7.1. They consist of three parts:
1. The bowling ball machine: The purchase requires an immediate (year 0) cash outflow of $100,000. The firm realizes a cash inflow when the machine is sold in year 5. These cash flows are shown in line 1 of Table 7.1. As indicated in the footnote to the table, taxes are incurred when the asset is sold.

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Table 7.1 The Worksheet for Cash Flows of the Baldwin Company (in $ thousands). (All cash flows occur at
the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:
(1) Bowling ball machine (2) Accumulated depreciation (3) Adjusted basis of machine
after depreciation (end of year) (4) Opportunity cost (warehouse) (5) Net working capital (end of year) (6) Change in net working capital (7) Total cash flow of investment
[(1) ϩ (4) ϩ (6)]
Income:
(8) Sales revenues (9) Operating costs (10) Depreciation (11) Income before taxes
[(8) ϩ (9) ϩ (10)] (12) Tax at 34 percent (13) Net income

Ϫ$100.00
Ϫ150.00 10.00
Ϫ10.00 Ϫ260.00

$ 20.00 80.00
10.00
$100.00 Ϫ50.00 Ϫ20.00
30.00 Ϫ10.20
19.80

$ 52.00 48.00
16.32 Ϫ6.32 Ϫ6.32
$163.20 Ϫ88.00 Ϫ32.00
43.20
Ϫ14.69 28.51

$ 71.20 28.80
24.97 Ϫ8.65 Ϫ8.65
$249.72 Ϫ145.20 Ϫ19.20
85.32
Ϫ29.01 56.31

$ 82.72 17.28
21.22 3.75 3.75
$212.20 Ϫ133.10 Ϫ11.52
67.58
Ϫ22.98 44.60

$21.76* 94.24 5.76
150.00 0 21.22
192.98
$129.90 Ϫ87.84 Ϫ11.52
30.54
Ϫ10.38 20.16

*We assume that the ending market value of the capital investment at year 5 is $30 (in thousands).The taxable amount is $24.24 (ϭ$30 Ϫ $5.76).The aftertax salvage value is $30 Ϫ [.34 ϫ ($30 Ϫ $5.76)] ϭ $21.76.

Table 7.2
Operating Revenues and Costs of the Baldwin Company

(1)
Year
1 2 3 4 5

(2) Quantity Produced
5,000 8,000 12,000 10,000 6,000

Prices rise at 2% a year. Unit costs rise at 10% a year.

(3)
Price
$20.00 20.40 20.81 21.22 21.65

(4) Sales Revenues
$100,000 163,200 249,720 212,200 129,900

(5) Cost Per Unit
$10.00 11.00 12.10 13.31 14.64

(6) Operating
Costs
$ 50,000 88,000 145,200 133,100 87,840

2. The opportunity cost of not selling the warehouse: If Baldwin accepts the bowling ball project, it will use a warehouse and land that could otherwise be sold. The estimated sales price of the warehouse and land is therefore included as an opportunity cost in year 0, as presented in line 4. Opportunity costs are treated as cash outflows for purposes of capital budgeting. However, note that if the project is accepted, management assumes that the warehouse will be sold for $150,000 (after taxes) in year 5. The test marketing cost of $250,000 is not included. The tests occurred in the past and should be viewed as a sunk cost.

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Table 7.3
Depreciation (in percent) under Modified Accelerated Cost Recovery System (MACRS)

Year
1 2 3 4 5 6 7 8 9 10 11 12–15 16 17–20 21

3 Years
.333 .444 .148 .074

Recovery Period Class

5 Years 7 Years 10 Years

.200

.143

.100

.320

.245

.180

.192

.175

.144

.115

.125

.115

.115

.089

.092

.058

.089

.074

.089

.066

.045

.066

.066

.066

.033

15 Years
.050 .095 .086 .077 .069 .062 .059 .059 .059 .059 .059 .059 .030

20 Years
.038 .072 .067 .062 .057 .053 .049 .045 .045 .045 .045 .045 .045 .045 .022

Depreciation is expressed as a percentage of the asset’s cost. These schedules are based on the IRS publication Depreciation. Details of depreciation are presented later in the chapter. Three-year depreciation actually carries over four years because the IRS assumes the purchase is made in midyear.

Table 7.4 Incremental Cash Flows for the Baldwin Company (in $ thousands)

Year 0

Year 1 Year 2 Year 3

(1) Sales revenue [line 8, Table 7.1]

(2) Operating costs [line 9, Table 7.1]

(3) Taxes [line 12, Table 7.1]

(4) Cash flow from operations

[(1) ϩ (2) ϩ (3)]

(5) Total cash flow of investment

[line 7, Table 7.1]

(6) Total cash flow of project

[(4) ϩ (5)]

NPV @

4%

$123.641

10%

$51.588

15%

$5.472

15.67%

$0

20% Ϫ$31.351

Ϫ$260.00 Ϫ260.00

$100.00 Ϫ50.00 Ϫ10.20
39.80
39.80

$163.20 Ϫ88.00 Ϫ14.69
60.51
Ϫ6.32
54.19

$249.72 Ϫ145.20 Ϫ29.01
75.51
Ϫ8.65
66.86

Year 4
$212.20 Ϫ133.10 Ϫ22.98
56.12
3.75
59.87

Year 5
$129.90 Ϫ87.84 Ϫ10.38
31.68
192.98
224.66

3. The investment in working capital: Required working capital appears in line 5. Working capital rises over the early years of the project as expansion occurs. However, all working capital is assumed to be recovered at the end, a common assumption in capital budgeting. In other words, all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected. Increases in working capital in the early years must be funded by cash generated elsewhere in the firm. Hence, these increases are viewed as cash outflows. To reiterate, it is the increase in working capital over a year that leads to a cash outflow in that year. Even if working

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capital is at a high level, there will be no cash outflow over a year if working capital stays constant over that year. Conversely, decreases in working capital in the later years are viewed as cash inflows. All of these cash flows are presented in line 6 of Table 7.1. A more complete discussion of working capital is provided later in this section.
To recap, there are three investments in this example: the bowling ball machine (line 1 in Table 7.1), the opportunity cost of the warehouse (line 4), and the changes in working capital (line 6). The total cash flow from these three investments is shown in line 7.
Income and Taxes Next the determination of income is presented in the bottom segment of Table 7.1. While we are ultimately interested in cash flow—not income—we need the income calculation to determine taxes. Lines 8 and 9 of Table 7.1 show sales revenues and operating costs, respectively. The projections in these lines are based on the sales revenues and operating costs computed in columns 4 and 6 of Table 7.2. The estimates of revenues and costs follow from assumptions made by the corporate planning staff at Baldwin. In other words, the estimates critically depend on the fact that product prices are projected to increase at 2 percent per year and costs per unit are projected to increase at 10 percent per year.
Depreciation of the $100,000 capital investment is shown in line 10 of Table 7.1. Where do these numbers come from? Depreciation for tax purposes for U.S. companies is based on the Modified Accelerated Cost Recovery System (MACRS). Each asset is assigned a useful life under MACRS, with an accompanying depreciation schedule as shown in Table 7.3. The IRS ruled that Baldwin is to depreciate its capital investment over five years, so the second column of the table applies in this case. Because depreciation in the table is expressed as a percentage of the asset’s cost, multiply the percentages in this column by $100,000 to arrive at depreciation in dollars.
Income before taxes is calculated in line 11 of Table 7.1. Taxes are provided in line 12 of this table, and net income is calculated in line 13.
Salvage Value In calculating depreciation under current tax law, the expected economic life and future value of an asset are not issues. As a result, the book value of an asset can differ substantially from its actual market value. For example, consider the bowling machine the Baldwin Company is considering for its new project. The book value after the first year is $100,000 less the first year’s depreciation of $20,000, or $80,000. After six years, the book value of the machine is zero.
Suppose, at the end of the project, Baldwin sold the machine. At the end of the fifth year, the book value of the machine would be $5,760; but based on Baldwin’s experience, it would probably be worth about $30,000. If the company actually sold it for this amount, then it would pay taxes at the ordinary income tax rate on the difference between the sale price of $30,000 and the book value of $5,760. With a 34 percent tax rate, the tax liability would be .34 ϫ ($30,000 Ϫ 5,760) ϭ $8,241.60. So, the aftertax salvage value of the equipment, a cash inflow to the company, would be $30,000 Ϫ 8,241.60 ϭ $21,758.40.
Taxes must be paid in this case because the difference between the market value and the book value is “excess” depreciation, and it must be “recaptured” when the asset is sold. In this case, Baldwin would have over depreciated the asset by $30,000 Ϫ 5,760 ϭ $24,240. Because the depreciation was too high, the company paid too little in taxes.
Notice this is not a tax on a long-term capital gain. Further, what is and what is not a capital gain is ultimately up to taxing authorities, and the specific rules can be very complex. We will ignore capital gains taxes for the most part.

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Finally, if the book value exceeds the market value, then the difference is treated as a loss for tax purposes. For example, if Baldwin sold the machine for $4,000, then the book value exceeds the market value by $1,760. In this case, a tax savings of .34 ϫ $1,760 ϭ $598.40 occurs.
Cash Flow Cash flow is finally determined in Table 7.4. We begin by reproducing lines 8, 9, and 12 in Table 7.1 as lines 1, 2, and 3 in Table 7.4. Cash flow from operations, which is sales minus both operating costs and taxes, is provided in line 4 of Table 7.4. Total investment cash flow, taken from line 7 of Table 7.1, appears as line 5 of Table 7.4. Cash flow from operations plus total cash flow of the investment equals total cash flow of the project, which is displayed as line 6 of Table 7.4.
Net Present Value The NPV of the Baldwin bowling ball project can be calculated from the cash flows in line 6. As can be seen at the bottom of Table 7.4, the NPV is $51,588 if 10 percent is the appropriate discount rate and Ϫ$31,351 if 20 percent is the appropriate discount rate. If the discount rate is 15.67 percent, the project will have a zero NPV. In other words, the project’s internal rate of return is 15.67 percent. If the discount rate of the Baldwin bowling ball project is above 15.67 percent, it should not be accepted because its NPV would be negative.
Which Set of Books?
It should be noted that the firm’s management generally keeps two sets of books, one for the IRS (called the tax books) and another for its annual report (called the stockholders’ books). The tax books follow the rules of the IRS. The stockholders’ books follow the rules of the Financial Accounting Standards Board (FASB), the governing body in accounting. The two sets of rules differ widely in certain areas. For example, income on municipal bonds is ignored for tax purposes while being treated as income by the FASB. The differences almost always benefit the firm: The rules permit income on the stockholders’ books to be higher than income on the tax books. That is, management can look profitable to the stockholders without needing to pay taxes on all of the reported profit. In fact, plenty of large companies consistently report positive earnings to the stockholders while reporting losses to the IRS.
A Note about Net Working Capital
The investment in net working capital is an important part of any capital budgeting analysis. While we explicitly considered net working capital in lines 5 and 6 of Table 7.1, students may be wondering where the numbers in these lines came from. 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) credit sales are made, generating accounts receivable rather than cash. (The investment in net working capital is reduced by credit purchases, which generate accounts payable.) This investment in net working capital represents a cash outflow because cash generated elsewhere in the firm is tied up in the project.
To see how the investment in net working capital is built from its component parts, we focus on year 1. We see in Table 7.1 that Baldwin’s managers predict sales in year 1 to be $100,000 and operating costs to be $50,000. If both the sales and costs were cash transactions, the firm would receive $50,000 (ϭ$100,000 Ϫ $50,000). As stated earlier, this cash flow would occur at the end of year 1.
Now let’s give you more information. The managers:
1. Forecast that $9,000 of the sales will be on credit, implying that cash receipts at the end of year 1 will be only $91,000 (ϭ$100,000 Ϫ $9,000). The accounts receivable of $9,000 will be collected at the end of year 2.

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2. Believe that they can defer payment on $3,000 of the $50,000 of costs, implying that cash disbursements at the end of year 1 will be only $47,000 (ϭ$50,000 Ϫ $3,000). Baldwin will pay off the $3,000 of accounts payable at the end of year 2.
3. Decide that inventory of $2,500 should be left on hand at the end of year 1 to avoid stockouts (that is, running out of inventory).
4. Decide that cash of $1,500 should be earmarked for the project at the end of year 1 to avoid running out of cash.
Thus, net working capital at the end of year 1 is:

$9,000 Accounts receivable

Ϫ $3,000 ϩ $2,500 ϩ $1,500 ϭ $10,000

Accounts

Inventory

Cash

Net working

payable

capital

Because $10,000 of cash generated elsewhere in the firm must be used to offset this requirement for net working capital, Baldwin’s managers correctly view the investment in net working capital as a cash outflow of the project. As the project grows over time, needs for net working capital increase. Changes in net working capital from year to year represent further cash flows, as indicated by the negative numbers for the first few years on line 6 of Table 7.1. However, in the declining years of the project, net working capital is reduced—ultimately to zero. That is, accounts receivable are finally collected, the project’s cash buffer is returned to the rest of the corporation, and all remaining inventory is sold off. This frees up cash in the later years, as indicated by positive numbers in years 4 and 5 on line 6.
Typically corporate worksheets (such as Table 7.1) treat net working capital as a whole. The individual components of working capital (receivables, inventory, and the like) do not generally appear in the worksheets. However, the reader should remember that the working capital numbers in the worksheets are not pulled out of thin air. Rather, they result from a meticulous forecast of the components, just as we illustrated for year 1.

A Note about Depreciation
The Baldwin case made some assumptions about depreciation. Where did these assumptions come from? Assets are currently depreciated for tax purposes according to the provisions of the 1986 Tax Reform Act. There are seven classes of depreciable property:
• The three-year class includes certain specialized short-lived property. Tractor units
and racehorses over two years old are among the very few items fitting into this class.
• The five-year class includes (a) cars and trucks; (b) computers and peripheral equip-
ment, as well as calculators, copiers, and typewriters; and (c) specific items used for research.
• The seven-year class includes office furniture, equipment, books, and single-purpose
agricultural structures. It is also a catchall category because any asset not designated to be in another class is included here.
• The 10-year class includes vessels, barges, tugs, and similar equipment related to
water transportation.
• The 15-year class encompasses a variety of specialized items. Included are equip-
ment of telephone distribution plants and similar equipment used for voice and data communications, and sewage treatment plants.

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• The 20-year class includes farm buildings, sewer pipe, and other very long-lived
equipment.
• Real property that is depreciable is separated into two classes: residential and non-
residential. The cost of residential property is recovered over 27½ years and nonresidential property over 31½ years.
Items in the three-, five-, and seven-year classes are depreciated using the 200 percent declining-balance method, with a switch to straight-line depreciation at a point specified in the Tax Reform Act. Items in the 15- and 20-year classes are depreciated using the 150 percent declining-balance method, with a switch to straight-line depreciation at a specified point. All real estate is depreciated on a straight-line basis.
All calculations of depreciation include a half-year convention, which treats all property as if it were placed in service at midyear. To be consistent, the IRS allows half a year of depreciation for the year in which property is disposed of or retired. The effect of this is to spread the deductions for property over one year more than the name of its class—for example, six tax years for five-year property.
Interest Expense
It may have bothered you that interest expense was ignored in the Baldwin example. After all, many projects are at least partially financed with debt, particularly a bowling ball machine that is likely to increase the debt capacity of the firm. As it turns out, our approach of assuming no debt financing is rather standard in the real world. Firms typically calculate a project’s cash flows under the assumption that the project is financed only with equity. Any adjustments for debt financing are reflected in the discount rate, not the cash flows. The treatment of debt in capital budgeting will be covered in depth later in the text. Suffice it to say at this time that the full ramifications of debt financing are well beyond our current discussion.

7.3

Inflation and Capital Budgeting
Inflation is an important fact of economic life, and it must be considered in capital budgeting. We begin our examination of inflation by considering the relationship between interest rates and inflation.

Interest Rates and Inflation
Suppose a bank offers a one-year interest rate of 10 percent. This means that an individual who deposits $1,000 will receive $1,100 (ϭ$1,000 ϫ 1.10) in one year. Although 10 percent may seem like a handsome return, one can put it in perspective only after examining the rate of inflation.
Imagine that the rate of inflation is 6 percent over the year and it affects all goods equally. For example, a restaurant that charges $1.00 for a hamburger today will charge $1.06 for the same hamburger at the end of the year. You can use your $1,000 to buy 1,000 hamburgers today (date 0). Alternatively, if you put your money in the bank, you can buy 1,038 (ϭ$1,100/$1.06) hamburgers at date 1. Thus, lending increases your hamburger consumption by only 3.8 percent.
Because the prices of all goods rise at this 6 percent rate, lending lets you increase your consumption of any single good or any combination of goods by only 3.8 percent. Thus, 3.8 percent is what you are really earning through your savings account, after adjusting for

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CHAPTER 7 Making Capital Investment Decisions