CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 9:

Capital Budgeting and Cash Flow Analysis

INTRODUCTION

This chapter discusses capital budgeting and capital expenditures

It deals with the financial management of the assets on a firm’s balance sheet

2

CAPITAL BUDGETING

The process of planning for purchases of assets whose useful lives are expected to continue beyond a year

Capital Expenditure A cash outlay expected to generate a flow of future cash

benefits for more than one year

Capital budgeting decisions can be among the most complex decisions facing management

3

EXAMPLES OF CAPITAL EXPENDITURES

Expand an existing product line

Increase or decrease working capital

Refund an issue of debt

Leasing versus buying an asset

Mergers and acquisitions

Enter a new line of business

Repair versus replacing a machine

Advertising campaigns

Research and Development activities 4

TYPES OF INVESTMENT PROJECTS Growth opportunities

Cost reduction opportunities

Required to meet legal requirements

Required to meet health and safety standards

5

HOW PROJECTS ARE CLASSIFIED

Independent Acceptance or rejection has no effect on other projects

Mutually Exclusive Acceptance of one automatically rejects the others (replace

versus repair)

Contingent Acceptance of one project is dependent upon the selection of

another

6

COST OF CAPITAL

Firm’s overall cost of funds, often referred to WACC or Weighted Average Cost of Capital

Equal to a weighted average of the investors’ required rates of return

The discount rate used to analysis capital budgeting proposals

7

OPTIMAL CAPITAL BUDGET Expand output until marginal revenue equals marginal cost

Invest in the most profitable projects first

Continue accepting projects as long as the rate of return exceeds the marginal cost of capital (MCC)

8

THE OPTIMAL CAPITAL BUDGET

9Funding available

MCC

Rate

Return exceeds cost

Cost exceeds returnFund these projects

Project Return

CAPITAL BUDGETING PROBLEMS

All projects may not be known at one time

Changing markets, technology, and corporate strategies can quickly make current projects obsolete and make new ones profitable

Difficulty in determining the behavior of the marginal cost of capital (MCC)

Estimates of project cash flows have varying degrees of uncertainty

10

CAPITAL BUDGETING PROCESS

Step 1: Generate proposals

Step 2: Estimate the cash flows

Step 3: Evaluate alternatives and select projects

Step 4: Review prior decisions

11

ESTIMATING CASH FLOWS Calculate only the incremental cash flows.

Measure on an after-tax basis.

All indirect effects should be included.

Sunk costs should not be considered

Value of resources should be measured in terms of their opportunity cost rather than their actual cost.

12

THE CAPITAL BUDGETING DECISION

The capital budgeting decision involves six steps:

1 Calculate initial investment

2 Calculate PV of the annual after-tax cashflows attributable to the new asset

3 Calculate PV of the tax-shield due to Capital Cost Allowance (CCA)

4 Calculate PV of salvage value

5 Calculate PV of the tax shield lost due to salvage

6 Calculate PV of any changes in working capital

13

1: CALCULATE INITIAL INVESTMENT

The initial investment includes:

The cost of the new asset Plus shipping & installation costs Less any trade-in value received from an old asset If expenditures on the new asset occur over a period of time,

present value all costs back to time period zero

14

2: PV OF ANNUAL AFTER-TAX CFS

( ) ( )( )∑

N

Cash Flow tt=1

Revenue - Expenses 1 - TPV =

1 + k

15

T = corporate marginal tax ratek = WACC or discount ratet = year 1 through year N

3: PV OF TAX SHIELD DUE TO CCA

CapitalCostAllowance

dT 1 + 0.5kPV Tax Shield = UCC

d + k 1 + k

16

UCC = Undepreciated capital cost (cost - trade-in received)d = Capital cost allowance rateT = Corporate tax ratek = Firm’s cost of capital

4: CALCUATE PV OF SALVAGE

( )Salvage t

SalvagePV =

1 + k

17

Salvage = the expected future salvage valuek = the WACC or discount ratet = the number of years until the asset is salvaged

5: PV OF TAX SHIELD LOST FROM SALVAGE

( ) ÷ ÷

Tax-shield tLost due toSalvage

dT 1PV = -Salvage Value

d + k 1 + k

18

d = CCA rateT = Corporate tax ratek = WACC or discount ratet = number of years

6: PV OF CHANGE IN WORKING CAPITAL

↓

↑

Change inWorkingCapital

Change inWorkingCapital

PV = +PV WorkingCapital

PV = - PV WorkingCapital

19

Working Capital = Current assets - current liabilities↑ = Increase in working capital↓ = Decrease in working capital

or

CAPITAL BUDGETING: EXAMPLE Alki Dyes Ltd. buys a new tank for $18,000, including

installation. The estimated salvage value at the end of its 3-year useful life is $1,000. CCA is charged at a 50% rate. The tank is expected to increase the firm’s pre-tax cash flows by $10,000/year for the three years of useful life. Working capital is expected to increase by $1,000 at the end of the first year. The firm’s tax rate and WACC are 46% and 14% respectively. What is the NPV of the new investment?

20

CAPITAL BUDGETING: SOLUTION

( ) ( )( )

( )( )

( )( )

( )( )

=

− − −= + +

=

∑N

Cash Flow tt=1

2 3

Revenue - Expenses 1 - TPV

1 + k

10,000 1 0.46 10,000 1 0.46 10,000 1 0.46

1.14 1.14 1.14

12,536.81

21

Step 1: Initial investment

Cash flow from tank purchase: -$18,000

Step 2: PV of annual cash flows

CAPITAL BUDGETING: SOLUTION

22

( ) ( ) ( )

= +

= + =

CapitalCostAllowance

dT 1 + 0.5kPV Tax Shield UCC

d + k 1 + k

0.50 0.46 1 0.5 0.1418,000

0.50 0.14 1.14

$6,071.55

Step 3: PV of tax-shield due to CCA

CAPITAL BUDGETING: SOLUTION

( )

( )

=

=

=

Salvage t

3

SalvagePV

1 + k

1,000

1.14

674.97

23

Step 4: PV of salvage

CAPITAL BUDGETING: SOLUTION

( )( ) ( )

( )

÷ ÷ ÷= − ÷+

= −

Tax-shield tLost due toSalvage

3

dT 1PV = -Salvage Value

d + k 1 + k

0.50 0.46 11,000

0.50 0.14 1.14

$242.57

24

Step 5: PV of the tax-shield lost due to salvage

CAPITAL BUDGETING: SOLUTION

( )

= − ↑

= −

= −

Change inWorkingCapital

PV PV WorkingCapital

1,0001.14

877.19

25

Step 6: PV of the change in Working Capital

CAPITAL BUDGETING: SOLUTION

26

-$18,000.00

+$12,536.81

+$6,071.55

+$674.97

-$242.57

-$877.19

+$163.57

Step 1:

Step 2:

Step 3:

Step 4:

Step 5:

Step 6:

NPV

ETHICAL ISSUES: BIASED CF ESTIMATES The outcome of any capital budgeting exercise is only as

good as the estimates used as inputs. Problems may arise from:

Overestimated revenues Underestimated costs Unrealistic salvage values Ignoring necessary changes in working capital

27

MAJOR POINTS

Firms make investment decisions using a capital budgeting framework.

The capital budgeting process captures all of the incremental costs and benefits of undertaking a project.

If capital is unlimited, the firm will accept all positive NPV projects and reject all negative NPV projects.

28