I.1 Capital Budgeting
Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 1 / 21
outline for Today
1. Capital Budgeting
I Motivating Example
I Key principles and one main formula
I Understanding the main formula
I Solve the motivating example - MiniCase (time permitting)
Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 2 / 21
Motivating Example (UPC)
United Printing Company (UPC) provides printing services and is considering replacing
its printing machine. The CEO is upset about frequent costly repairs that cause delivery
delays. She also thinks UPC could provide better quality with a new machine. She hired
a consultant who determined the following.
The new machine:
A state of the art machine would cost $350,000 today.
The new machine would last 10 years at which time it could be sold for $30,000.
With the new machine, sales would be $50,000 higher per year than with the
current machine. Repairs would be $2,000 per year.
Labor costs would be $20,000 lower per year.
With the new machine, accounts receivable would increase by $10,000 at the end of
the current year and would decrease by $10,000 at the end of year 11.
The new machine would be depreciated straight-line over 5 years to a salvage value
of zero.
Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 3 / 21
Motivating Example (UPC cont’d)
The current machine:
Has a market value today of $15,000. With repairs of $8,000 per year, the current
machine could last another 10 years at which time it would have zero market
value.
The book value of the current machine is $10,000. This will be depreciated in
year 1 if the machine is not sold now.
Additional information:
UPC owes the consultant $10,000 for his work.
UPC faces a corporate tax rate of 35%.
UPC is an equity financed firm. The cost of equity capital is 10%.
Cash flows are end of year unless noted.
Question: Should UPC buy the new machine?
Conceptually, we already know how to do this:
I Calculate the NPV of the cash flows associated with the project.
But, getting to the cash flows will require some work.
Donatella Taurasi (Fung Institute) Accounting and Finance for Engineers – Lecture Notes Spring 2019 4 / 21
What should our cash flow measure capture?
1. Is has to rely on some measure of accounting earnings.
I We need these in order to get the taxes right.
2. It should recognize that accrual accounting (e.g., GAAP) does not
accurately portray the timing of cash flows.
I Accrual accounting allows you to get a sense of whether the firm is making
money from one year of data. Useful, but not what we need for PVs.
3. When evaluating projects, it should focus on incremental cash flows.
I How much do cash flows change by making the investment?
I Include opportunity cost, externalities and competitive effects.
I Do not account for sunk costs or overhead costs unaffected by the project.
Donatella Taur...
