chapter 12

12.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 12Chapter 12

Capital Budgeting Capital Budgeting and Estimating and Estimating

Cash FlowsCash Flows

Capital Budgeting Capital Budgeting and Estimating and Estimating

Cash FlowsCash Flows


After Studying Chapter 12, After Studying Chapter 12, you should be able to:you should be able to:

1. Define capital budgeting and identify the steps involved in the capital budgeting process.

2. Explain the procedure to generate long-term project proposals within the firm.

3. Justify why cash, not income, flows are the most relevant to capital budgeting decisions.

4. Summarize in a “checklist” the major concerns to keep in mind as one prepares to determine relevant capital budgeting cash flows.

5. Define the terms “sunk cost” and “opportunity cost” and explain why sunk costs must be ignored, while opportunity costs must be included, in capital budgeting analysis.

6. Explain how tax considerations, as well as depreciation for tax purposes, affects capital budgeting cash flows.

7. Determine initial, interim, and terminal period “after-tax, incremental, operating cash flows” associated with a capital investment project.


Capital Budgeting and Capital Budgeting and Estimating Cash FlowsEstimating Cash FlowsCapital Budgeting and Capital Budgeting and Estimating Cash FlowsEstimating Cash Flows

• The Capital Budgeting Process• Generating Investment Project

Proposals• Estimating Project “After-Tax

Incremental Operating Cash Flows”

• The Capital Budgeting Process• Generating Investment Project

Proposals• Estimating Project “After-Tax

Incremental Operating Cash Flows”


What is What is Capital Budgeting?Capital Budgeting?What is What is Capital Budgeting?Capital Budgeting?

The process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are

expected to extend beyond one year.

The process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are

expected to extend beyond one year.


Motives For Capital Expenditure


Basic Capital Budgeting Terminology

Independent projects vs. mutually exclusive projects.

Unlimited funds vs. capital rationing.

Accept-reject vs. ranking approaches.

Conventional vs. non conventional cash flow patterns.


Cash Flow Patterns


Relevant Cash Flows

The incremental after tax cash outflow and resulting subsequent inflows associated with a proposed capital project.

Incremental Cash Flows: the additional cash inflows and outflows expected from a proposed capital project.


The Capital The Capital Budgeting ProcessBudgeting ProcessThe Capital The Capital Budgeting ProcessBudgeting Process

• Generate investment proposals consistent with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash flows for the investment projects.

• Evaluate project incremental cash flows.

• Generate investment proposals consistent with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash flows for the investment projects.

• Evaluate project incremental cash flows.


The Capital The Capital Budgeting ProcessBudgeting ProcessThe Capital The Capital Budgeting ProcessBudgeting Process

• Select projects based on a value-maximizing acceptance criterion.

• Re-evaluate implemented investment projects continually and perform post-audits for completed projects.

• Select projects based on a value-maximizing acceptance criterion.

• Re-evaluate implemented investment projects continually and perform post-audits for completed projects.


Classification of Investment Classification of Investment Project ProposalsProject ProposalsClassification of Investment Classification of Investment Project ProposalsProject Proposals

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings

3. Research and development

4. Exploration

5. Other (e.g., safety or pollution related)

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings

3. Research and development

4. Exploration

5. Other (e.g., safety or pollution related)


Screening Proposals Screening Proposals and Decision Makingand Decision MakingScreening Proposals Screening Proposals and Decision Makingand Decision Making

1. Section Chiefs

2. Plant Managers

3. VP for Operations

4. Capital Expenditures Committee

5. President

6. Board of Directors

1. Section Chiefs

2. Plant Managers

3. VP for Operations

4. Capital Expenditures Committee

5. President

6. Board of Directors

AdvancementAdvancementto the nextto the next

level depends level depends on cost on cost

and strategicand strategicimportance.importance.


Estimating After-Tax Estimating After-Tax Incremental Cash FlowsIncremental Cash FlowsEstimating After-Tax Estimating After-Tax Incremental Cash FlowsIncremental Cash Flows

• CashCash (not accounting income) flowsflows

• OperatingOperating (not financing) flowsflows

• After-tax flowsAfter-tax flows

• Incremental flowsIncremental flows

• CashCash (not accounting income) flowsflows

• OperatingOperating (not financing) flowsflows

• After-tax flowsAfter-tax flows

• Incremental flowsIncremental flows

Basic characteristics of Basic characteristics of relevant project flowsrelevant project flows


Estimating After-Tax Estimating After-Tax Incremental Cash FlowsIncremental Cash FlowsEstimating After-Tax Estimating After-Tax Incremental Cash FlowsIncremental Cash Flows

• Ignore sunk costs sunk costs

• Include opportunity costsopportunity costs

• Include project-driven changes in changes in working capital working capital net of spontaneous changes in current liabilities

• Include effects of inflationeffects of inflation

• Ignore sunk costs sunk costs

• Include opportunity costsopportunity costs

• Include project-driven changes in changes in working capital working capital net of spontaneous changes in current liabilities

• Include effects of inflationeffects of inflation

Principles that must be adhered Principles that must be adhered to in the estimationto in the estimation


Tax Considerations Tax Considerations and Depreciationand Depreciation

• Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS).

• DepreciationDepreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.


Depreciation and the Depreciation and the MACRS MethodMACRS Method

• Everything else equal, the greater the depreciation charges, the lower the taxes paid by the firm.

• Depreciation is a noncash expense.

• Assets are depreciated (MACRS) on one of eight different property classes.

• Generally, the half-year convention is used for MACRS.


MACRS Sample ScheduleMACRS Sample Schedule

Recovery Property ClassYear 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%2 44.45 32.00 24.493 14.81 19.20 17.494 7.41 11.52 12.495 11.52 8.936 5.76 8.927 8.938 4.46


Depreciable BasisDepreciable Basis

In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over

time for tax purposes.

Depreciable BasisDepreciable Basis =

Cost of Asset Cost of Asset + Capitalized Capitalized Expenditures Expenditures


Capitalized Capitalized ExpendituresExpenditures

Capitalized Expenditures Capitalized Expenditures are expenditures that may provide

benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which

they were incurred.

Examples: Shipping and installation


Sale or Disposal of Sale or Disposal of a Depreciable Asseta Depreciable Asset

• Often historically, capital gains income has received more favorable US tax treatment than operating income.

• Generally, the sale of a “capital asset” (as defined by the IRS) generates a capital gain (asset sells for more than book value) or capital loss (asset sells for less than book value).


Corporate Capital Corporate Capital Gains / LossesGains / Losses

• Capital losses are deductible only against capital gains.

• Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%.


Calculating the Calculating the Incremental Cash FlowsIncremental Cash Flows

• Initial cash outflow Initial cash outflow – the initial net cash investment.

• Interim incremental net cash flows Interim incremental net cash flows ((Annual Operating Net Cash Inflow) – those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.

• Terminal-year incremental net cash Terminal-year incremental net cash flows flows – the final period’s net cash flow.


Cash Flow Components


Initial Cash OutflowInitial Cash Outflowa) Cost of “new” assetsCost of “new” assets

b) + Capitalized expenditures*

c) + (–) Increased (decreased) NWC

d) – Net proceeds from sale of “old” asset(s) if

replacement

e) + (–) Taxes (savings) due to the sale of “old” asset(s) if replacement

f)f) == Initial cash Initial cash outflowoutflow

* installation, freight and other costs needed * installation, freight and other costs needed to make the asset “ready for use”to make the asset “ready for use”


Incremental Cash FlowsIncremental Cash Flowsa) Net incr. (decr.) in operating

revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr.

b) – (+) Net incr. (decr.) in tax depreciation

c) = Net change in income before taxes

d) – (+) Net incr. (decr.) in taxes

e) = Net change in income after taxes

f) + (–) Net incr. (decr.) in tax depr. charges

g) == Incremental net cash flow for Incremental net cash flow for periodperiod


Terminal-Year Terminal-Year Incremental Cash FlowsIncremental Cash Flows

a) Calculate the incremental net cash incremental net cash flow flow for the terminal periodterminal period

b) + (–) Salvage value (disposal/reclamation costs) of any sold or disposed

assets

c) – (+) Taxes (tax savings) due to asset sale or disposal of “new” assets

d) + (–) Decreased (increased) level of “net” working capital

e) == Terminal year incremental net cash Terminal year incremental net cash flowflow


Issues When Using Relevant Cash Flows In Capital Budgeting

Interest and other financing costs are not included in projected annual cash flow calculations.

Opportunity and sunk costs are often mishandled or ignored.

International capital budgeting must consider political and currency risks.


Issues When Using Relevant Cash Flows In Capital Budgeting

Identifying cash flows for replacement decisions is more complex than for expansion decisions.


Example of an Asset Example of an Asset Expansion ProjectExpansion Project

Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The

machine will cost $50,000 plus $20,000 for shipping and installation and falls under the 3-

year MACRS class. NWC will rise by $5,000. Lisa Miller forecasts that revenues will increase by $110,000 for each of the next 4 years and the

asset will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends.

Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket.


Initial Cash OutflowInitial Cash Outflow

a) $50,000

b) + 20,000

c) + 5,000

d) – 0 (not a replacement)

e) + (–) 0 (not a replacement)

f) == $75,000*$75,000*

* Note that we have calculated this value as a “positive” because it is a cash OUTFLOW (negative).


Incremental Cash FlowsIncremental Cash Flows

Year 1 Year 2 Year 3 Year 4

a) NCF $40,000 $40,000 $40,000 $40,000

b) - Depn 23,331 31,115 10,367 5,187

c) = $16,669 $ 8,885 $29,633 $34,813

d) - Tax 6,668 3,554 11,853 13,925

e) = $10,001 $ 5,331 $17,780 $20,888

f) + Depn 23,331 31,115 10,367 5,187

g) == $33,332 $36,446 $28,147 $33,332 $36,446 $28,147 $26,075$26,075



a) $26,075$26,075 The incremental cash flow incremental cash flow from the previous

slide in Year 4.

b) + 10,000 Salvage Value.

c) – 4,000 .40*($10,000 - 0) Note, the asset is fully

depreciated at the end of Year 4.

d) + 5,000 NWC - Project ends.

e) == $37,075$37,075 Terminal-year incremental Terminal-year incremental cash flow.cash flow.


Summary of Project Summary of Project Net Cash FlowsNet Cash Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3 Year 4

––$75,000*$75,000* $33,332$33,332 $36,446 $28,147 $36,446 $28,147 $37,075$37,075

* Notice again that this value is a negativenegative cash flow as we calculated it as the initial cash OUTFLOW in slide 12-26.


RememberRemember, you can use , you can use Excel - Very Valuable!!Excel - Very Valuable!!

Refer to the spreadsheet

‘VW13E-12b.xlsx’ on

the ‘New Asset’ tab for

this spreadsheet.

Try changing Try changing information in information in

the the spreadsheet spreadsheet

to see the to see the impact!impact!

New Asset Cost: 50,000$ Old Asset current market value: -$ Capitalized Expenditures: 20,000$ Old' Asset current book value: -$

Initial Net Working Capital: 5,000$

1 2 3 4 Remaining Depreciation at end of period 423,331$ 31,115$ 10,367$ 5,187$ -$

-$ -$ -$ -$ 23,331$ 31,115$ 10,367$ 5,187$

ICONew Asset Cost: 50,000$

Capitalized Expenditures: 20,000$ Initial Net Working Capital: 5,000$

Proceeds from sale of 'old' assets: -$ No need on a NEW asset, so $0 valueTax on proceeds relative to book value: -$ No need on a NEW asset, so $0 value

75,000$

Δ in oper revenue: 110,000$ Δ in oper expense: 70,000$

Tax rate: 40%

0 1 2 3 4Δ in oper revenue - Δ in oper expense: 40,000$ 40,000$ 40,000$ 40,000$

subtract Δ in depreciation: 23,331$ 31,115$ 10,367$ 5,187$ 0 (75,000)$ equals Δ in income before taxes: 16,669$ 8,885$ 29,633$ 34,813$ 1 33,332$

subtract Δ in taxes: 6,668$ 3,554$ 11,853$ 13,925$ 2 36,446$ equals Δ in income after taxes: 10,001$ 5,331$ 17,780$ 20,888$ 3 28,147$

add back non-cash Δ in depreciation: 23,331$ 31,115$ 10,367$ 5,187$ 4 37,075$

Incremental cash flow: 33,332$ 36,446$ 28,147$ 26,075$

0 1 2 3 4Incremental cash flow: 26,075$

add positive salvage value: 10,000$ subtract incr in tax liability: 4,000$

subtract Δ in net working capital: 5,000$ equals Δ in income after taxes: 37,075$

Year:

Initial Cash Outflow:

Interim Cash Flows:

Terminal Year Cash Flow Adjustments:

Year Cash Flow

Depreciation Schedule for "New" asset:Depreciation Schedule for "Old" asset:

Additional (marginal) depreciation on project:


Example of an Asset Example of an Asset Replacement ProjectReplacement Project

Let us assume that previous asset expansion project is actually an asset replacement project.

The original basis of the machine was $30,000 and depreciated using straight-line over five years

($6,000 per year). The machine has two years of depreciation and four years of useful life remain-ing. BW can sell the current machine for $6,000.

The new machine will not increase revenues (remain at $110,000) but it decreases operating

expenses by $10,000 per year (old = $80,000). NWC will rise to $10,000 from $5,000 (old).


Initial Cash OutflowInitial Cash Outflow

a) $50,000

b) + 20,000

c) + 5,000

d) – 6,000 (sale of “old” asset)*

e) – 2,400 <----

f)f) == $66,600$66,600g)g) * BV of old asset = $12,000* BV of old asset = $12,000

(tax savings fromloss on sale of

“old” asset)


Calculation of the Calculation of the Change in DepreciationChange in Depreciation


a) $23,331 $31,115 $10,367 $ 5,187

b) – 6,000 6,000 0 0

c) = $17,331 $25,115 $10,367 $ $17,331 $25,115 $10,367 $ 5,1875,187

a) Represent the depreciation on the “new” project.

b) Represent the remaining depreciation on the “old” project.

c) Net changechange in tax depreciation charges.


Incremental Cash FlowsIncremental Cash Flows


a) $10,000 $10,000 $10,000 $10,000

b) – 17,331 25,115 10,367 17,331 25,115 10,367 5,1875,187

c) = $ –7,331 –$15,115 $ –367 $ 4,813

d) – –2,932 –6,046 –147 1,925

e) = $ –4,399 $ –9,069 $ –220 $ 2,888

f) + 17,331 17,331 25,115 25,115 10,367 10,367 5,1875,187

g) == $12,932 $16,046 $10,147 $ $12,932 $16,046 $10,147 $ 8,0758,075



a) $ 8,075$ 8,075 The incremental cash flow incremental cash flow from the previous

slide in Year 4.

b) + 10,000 Salvage Value.

c) – 4,000 (.40)*($10,000 – 0). Note, the asset is fully depreciated at the end of Year 4.

d) + 5,000 Return of “added” NWC.

e) == $19,075$19,075 Terminal-year incremental Terminal-year incremental cash flow. cash flow.


RememberRemember, you can use , you can use Excel - Very Valuable!!Excel - Very Valuable!!

Refer to the spreadsheet

‘VW13E-12b.xlsx’ on the ‘Asset

Replacement’ tab for this

spreadsheet.

Try changing Try changing information in information in

the the spreadsheet spreadsheet

to see the to see the impact!impact!

New Asset Cost: 50,000$ Old Asset current market value: 6,000$ Capitalized Expenditures: 20,000$ Old' Asset current book value: 12,000$

Initial Net Working Capital: 5,000$

1 2 3 4 Remaining Depreciation at end of period 423,331$ 31,115$ 10,367$ 5,187$ -$

6,000$ 6,000$ -$ -$

17,331$ 25,115$ 10,367$ 5,187$

ICONew Asset Cost: 50,000$

Capitalized Expenditures: 20,000$ Initial Net Working Capital: 5,000$

Proceeds from sale of 'old' assets: 6,000$ No need on a NEW asset, so $0 valueTax on proceeds relative to book value: (2,400)$ No need on a NEW asset, so $0 value

66,600$

Δ in oper revenue: -$ <== both are at $110,000Δ in oper expense: (10,000)$ <== oper expenses reduced from $80K to $70K

Tax rate: 40%

0 1 2 3 4Δ in oper revenue - Δ in oper expense: 10,000$ 10,000$ 10,000$ 10,000$

subtract Δ in depreciation: 17,331$ 25,115$ 10,367$ 5,187$ 0 (66,600)$

equals Δ in income before taxes: (7,331)$ (15,115)$ (367)$ 4,813$ 1 12,932$ subtract Δ in taxes: (2,932)$ (6,046)$ (147)$ 1,925$ 2 16,046$

equals Δ in income after taxes: (4,399)$ (9,069)$ (220)$ 2,888$ 3 10,147$ add back non-cash Δ in depreciation: 17,331$ 25,115$ 10,367$ 5,187$ 4 19,075$

Incremental cash flow: 12,932$ 16,046$ 10,147$ 8,075$

0 1 2 3 4Incremental cash flow: 8,075$

add positive salvage value: 10,000$

subtract incr in tax liability: 4,000$ subtract Δ in net working capital: 5,000$

equals Δ in income after taxes: 19,075$

Terminal Year Cash Flow Adjustments:

Cash FlowYear

Year:Depreciation Schedule for "New" asset:Depreciation Schedule for "Old" asset:

Additional (marginal) depreciation on project:

Initial Cash Outflow:

Interim Cash Flows:


Summary of Project Summary of Project Net Cash FlowsNet Cash Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3 Year 4

––$75,000$75,000 $33,332$33,332 $36,446 $28,147 $36,446 $28,147 $37,075$37,075

Asset Replacement Year 0 Year 1 Year 2 Year 3 Year 4

––$66,600$66,600 $12,933$12,933 $16,046 $10,147 $16,046 $10,147 $19,075$19,075

chapter 12

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