Info

Net working capital Net fixed assets Total investment

$ 20,000 90,000 $110,000

$20,000 60,000 $80,000

$20,000

Fixed costs for the project, including such things as rent on the production facility, will run $12,000 per year.4 Further, we will need to invest a total of $90,000 in manufacturing equipment. For simplicity, we will assume that this $90,000 will be 100 percent depreciated over the three-year life of the project.5 Furthermore, the cost of removing the equipment will roughly equal its actual value in three years, so it will be essentially worthless on a market value basis as well. Finally, the project will require an initial $20,000 investment in net working capital, and the tax rate is 34 percent.

In Table 10.1, we organize these initial projections by first preparing the pro forma income statement. Once again, notice that we have not deducted any interest expense. This will always be so. As we described earlier, interest paid is a financing expense, not a component of operating cash flow.

We can also prepare a series of abbreviated balance sheets that show the capital requirements for the project as we've done in Table 10.2. Here we have net working capital of $20,000 in each year. Fixed assets are $90,000 at the start of the project's life (Year 0), and they decline by the $30,000 in depreciation each year, ending up at zero. Notice that the total investment given here for future years is the total book, or accounting, value, not market value.

At this point, we need to start converting this accounting information into cash flows. We consider how to do this next.

4By fixed cost, we literally mean a cash outflow that will occur regardless of the level of sales. This should not be confused with some sort of accounting period charge.

5We will also assume that a full year's depreciation can be taken in the first year.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

10. Making Capital Investment Decisions

© The McGraw-Hill Companies, 2002

CHAPTER 10 Making Capital Investment Decisions

Sales

$200,000

Variable costs

125,000

Fixed costs

12,000

Depreciation

30,000

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