tax deductible, thus reducing the tax liability of the business, the true cost of debt is the rate of interest on debt funds minus the tax savings. Equivalently, the true after-tax cost of debt can be calculated as the interest rate (K_{d}) times one minus the marginal tax rate (1 – t).

You multiply the costs of equity and debt funds by the respective proportions of equity and debt in the business to obtain the long-run cost of capital or the discount rate. You can obtain the proportions of debt and equity from your balance sheet, where W_{d }is calculated as total liabilities divided by total assets, and W_{e }is calculated as 1 – W_{d}. If your current balance sheet does not reflect the desired or expected long-run mix of equity and liabilities, you should make adjustments in W_{d }and W_{e}.

For example, the current amount of debt in the balance sheet may be higher than you desire or plan to have in the long run because of a recent investment, for instance, and you plan to pay the investment off as soon as possible. In this case, you should reduce the value of W_{d }calculated from the current balance sheet to reflect the proportion of debt that you expect to have in the long run. Thus, if the long-run optimal or desired amount of debt and equity is not currently reflected in your balance sheet, appropriate adjustments may be required.

By using the cost of capital as the estimate of the discount rate in the net present value computation, you are evaluating the returns for a particular investment compared to the cost of the debt and equity funds committed to that investment. Conse- quently, a particular investment is desirable only if it will return more income than the costs that will be incurred to finance the business.

Step 2. Calculate the present value of the cash outlay required to purchase the asset.

In most cases, the present value of the cash outlay will be equal to the purchase price of the asset because all the capital must be committed at the time the purchase is made. In some cases, however, an additional capital outlay will occur in future years in order, for example, to replace equipment that wears out before the end of the useful life of a building or facility. In this situation, you must discount these future capital outlays to the present and add them to the initial outlay.

In computing the capital outlay for a particular investment, it is important to include all additional outlays that may be

4

required. For example, if you were evaluating the construc- tion of a new retail building, the capital outlay would include not only the purchase price of the building, but also the cost of any additional inventories that might be required. In essence, these additional working capital commitments will be necessary to operate the larger facility, and you must consider them as part of the capital outlay for the new investment.

Step 3. Calculate the benefits or annual net cash flow or each year of the investment’s useful li e.

As suggested by the term “discounted cash flow,” the benefits to be included are the increased net cash flows that result from a particular investment. You should calculate these cash flows on an after-tax basis. Because depreciation is not a cash flow but only an accounting entry to allocate the cost of a capital item over its useful life, it does not enter directly in the computation of annual net cash flows. Instead, depreciation enters the calculations only as it influences the tax liability or the tax savings of a particular investment. In addition, since the discount rate reflects current expectations of inflation because the data used in the calculation come from current market rates, the estimation of future cash income and cash expenses should also reflect expected price increases for inputs and outputs. You can compute the annual net cash flows for an investment using the following format:

# Cash Revenue – Cash Expenses

+

Terminal Value – Income Taxes

# = Annual Net Cash Flow

You would calculate cash revenue for a particular investment as product sales from that particular investment times the expected prices, whereas cash expenses would include the cash costs of the inputs used in production. Note that interest on debt used to finance the investment is not included as a cash expense because it has already been included in the computation of the cost of capital (Step 1).

# You compute income taxes as:

# Cash Revenue

–

Cash Expenses

–

Depreciation

# = Net Income

Purdue Extension • Knowledge to Go