Capital Budgeting - Complete Chp 8

8/3/2019 Capital Budgeting - Complete Chp 8

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Capital Budgeting

Cash Flows

Chapter

8


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Learning Goals

1. Understand key objectives of capital expenditure andsteps in the capital budgeting process.

2. Define Basic capital budgeting terminology.

3. Discuss relevant cash flows, expansion vsreplacement decisions, sunk costs & opportunitycosts, and international capital budgeting.

4. Learn about initial investment, operating cash flows,

and terminal cash flows.


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What is Capital Budgeting?

It is a process of evaluating and selecting long-terminvestments that are consistent with the firms goal of

maximizing owners wealth.

Most common long-term investments for manufacturingfirms is in fixed assets (land, factory & equipment).These assets are often referred to as earning assets.

Our focus in this chapter is on Capital Budgeting(investment) and not on financing decision.

Capital Budgeting Decision Process


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Capital expenditure is an outlay offunds by the firm that is expectedto produce benefits over a period

of time greater than 1 year.

Operating expenditure is an outlayresulting in benefits received

within I year.


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Steps in Capital Budgeting Process:

1. Proposal generation from all levels & reviewed by

Finance Department.

2. Review and Analysis for appropriateness &

economic viability. Prepare summary report to

decision makers.

3. Decision making.4. Implementation.

5. Follow-up.


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Basic Terminology

1. Independent vs Mutually Exclusive ProjectsIndependent : Cash flows are unrelated or independent of one another. Theacceptance of one project, does not eliminate the others.

2. Unlimited Funds vs Capital RationingLimited funds means capital rationing.

3. Accept-Reject vs Ranking Approaches (decision process)a) The Accept-Reject approach evaluates capital expenditure proposals todetermine whether they meet the firms minimum acceptance criterion.

b) The ranking approach ranks projects on the basis of predetermined measure such as rate of return.

4. Conventional vs Nonconventional cash flow pattern

a) Conventional cash flow pattern initial outlay, followed by a series of inflows(annuity or mixed streams).

b) Noncenventional cash flow pattern has an initial outflow, followed by a seriesof inflows and outflows.



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Which cash flows are relevant in evaluating capital expenditurealternatives?

The incremental cash outflow (investment) and resultingsubsequent inflows are the only relevant cash flows.

The incremental cash flows represent the additional cash flows

- outflows or inflows expected to result from a proposed capitalexpenditure. Cash flows directly affect the firms ability to pay

expenses/bills and purchase assets.

Cash Flows of any project with conventional pattern can include

3 basic components: -

i) An initial investment

ii) Operating cash inflows

iii) Terminal cash flow

Relevant Cash Flows


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Relevant Cash Flows

$100,000

Initial investment

Cash inflow

$30,000 $30,000 $30,000 $30,000 $30,000

End of year

$20,000Terminal cash flow >


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Expansion vs Replacement Decisionsa) Expansion decisions cash flow estimates from this

decision is most straight forward. Initial investment,operating cash inflows, and terminal cash flows are merelyafter-tax cash outflow and inflow associated with the

proposed capital expenditure.

b) Replacement decisions - more complicated.

We must identify the incremental cash outflow and inflowsthat would result from the replacement proposal.

Relevant Cash Flows

Initial

Investment

Initial Investment to

acquire new asset

After-tax cash inflows

from sales of old

asset= -


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Replacement Decisions (cont.)

Relevant Cash Flows

Operating Cash

Inflows =Operating Cash

Inflows from

new asset

Operating Cash

Inflows from

old asset-

Terminal Cash

Flow=

After-tax Cash

Flows from

Termination ofnew asset

After-tax Cash

Flows from

Termination ofold asset

-


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Sunk costs and Opportunity Costs

Sunk costs are cash expenditures or outlays that have alreadybeen made (past outlays) and therefore have no effect on the cashflows relevant to our current decision.

Therefore sunk costs should not be included in a projects

incremental cash flows.

Opportunity costs are cash flows that could be realized from the

best alternative use of an asset that is owned by us. These arecash flows that will not be realized as a result of employing thatasset in the proposed project. Hence, opportunity costs should beincluded as cash outflows when we consider a projects

incremental cash flows.

Relevant Cash Flows


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International Capital Budgeting is different from domestic capitalbudgeting because:-

i)Cash outflows and inflows occur in a foreign currency

ii)Foreign investments contain potentially significant political risk.

Companies also experience both long-term and short-termcurrency risks. Long-term currency risks can be minimised withpartial financing in the local capital markets. Short-term currencyfluctuations can be protected by using futures, forwards and

options market instruments.

Political risk can be minimised through the use of operating andfinancial strategies. Use of local well-connected partner and debt-financing (instead of purely equity).

International Capital Budgeting & Long-termInvestment


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Under conventional cash flows, initial investment occurs attime zero (the time the initial investment is made). Initialinvestment is equal to all cash outflows minus all cash inflowsoccurring at time zero.

Initial Investment Format

Installed cost of new asset

= cost of new asset + installation costs

- After-tax proceeds from sale of old asset= proceeds from sale of old asset tax on old asset

change in net working capital

8.3 Finding the Initial Investment


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A.Installed Cost of New Asset

Cost of new asset + installation costs.

In US, IRS requires the firm to add installation costs to thepurchase price of an asset to determine its depreciable value.

Cost of new asset + installation costs = depreciable value.

B. After-tax Proceeds from Sale of Old Asset

These proceeds is the difference between the old assets sale

proceeds and any applicable taxes or tax refunds related to itssale (net cash inflows). Net of removal and cleanup costs.



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Book Value

The book value of an asset is strictly its accounting value (afterdepreciation charges)

Book Value = Installed cost of asset Accumulated depreciation

Under US tax law:

Cost of new asset = 90,000

Installation Cost = 10,000 ( Assume it has

Installed Cost 100,000 5-year recovery period)

Find its Book Value at end of year 2:Under 5-year recovery period, 20% is depreciated in year-1, and32% is depreciated in year-2.

Book Value = $ 100,000 52,000 (52% x 100,000)

= $ 48,000 (end of year-2)



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Basic Tax Rules

When a firm sells an asset, there are three possible tax situations.The asset may be sold:-

i) For more than its book value

ii) For its book value, or

iii)For less than its book value

For example :-

Installed Cost = 100,000 (total cost)

Book Value = 48,000

Cases: 1 - Asset sold at $110,000

2 - sold at $70,000

3 - sold at its Book Value

4 - sold at $30,000



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Case 1- Asset sold for 110,000

a) 110,000 100,000 = 10,000 (capital gain)

b) 100,000 48,000 = 52,000 (recaptured depreciation)

62,000

This total gain of 62,000 is taxed as ordinary income at

40% rate.

62,000 x 40% = 24,800* (to be used in calculating initialinvestment)

Case 2 - Asset sold at 70,000

70,000 48,000 = 22,000 (recaptured depreciation)

Tax = 22,000 x 40%

= 8,800*



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Case 3 - Asset sold for its book value.No tax involved as asset is sold for its book value.

Case 4 - Asset sold for less than its book value.

30,000 48,000 = -18,000

If the loss arises from sales of a depreciable asset used in thebusiness, use the loss to offset ordinary operating income.

(otherwise, use it to offset only capital gains).

Tax savings = - 18,000 x 40%

= - 7,200



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C. Change in Net Working Capital

Net working Capital = Current Assets - Current liabilities

Changes in net working capital often accompany capitalexpenditure decisions.

Increases in cash, accounts receivable,

and inventories outflows of cash.

Increases in accounts payable inflows of cash

& accrual

Change in net working capital is the difference between change incurrent assets and the change in current liabilities. Generally,current assets increase more than current liabilities, resulting inincreased investment and is treated as initial outflow.



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D. Calculating the Initial Investment

Powell Corporation:


Purchase price of new machine = 380,000

Cost of installation = 20,000

Purchased price of old machine = 240,000

Depreciated (MACRS-5-year)Date of purchase = 3 years ago

Sale price of old machine = 280,000

Removal expenses = 0

Increase in current assets = 35,000

Increase in current liabilities = 18,000

Tax rate of the firm = 40%


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Installed cost of proposed machine

Cost of proposed machine $380,000

+ Installation cost 20,000

Total installed cost proposed

(depreciable value) 400,000- After-tax proceeds from sale of present machine

Proceeds from sale of present machine 280,000

- Tax on sale of present machine 84,160

Total after-tax proceedspresent - 195,840

+ Change in net working capital 17,000

Initial investment $221,160



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Operating Cash Inflows are after-tax, cash inflows, andincremental.

a) The benefits expected to result from proposed capital

expenditures must be measured on an after-tax basis.b) All benefits expected from a proposed project must be

measured on a cash flows basis.

8.4 Finding the Operating Cash Inflows


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With proposed machine With Present Machine

Year Revenue Expenses(excl dep & int) Year Revenue Expenses(excl dep &int)

1 2,520,000 2,300,000 1 2,200.000 1,990,000

2 2,520,000 2,300,000 2 2,300,000 2,110,000

3 2,520,000 2,300,000 3 2,400,000 2,230,000

4 2,520,000 2,300,000 4 2,400,000 2,250,000

5 2,520,000 2,300,000 5 2,250,000 2,120,000

Powell Corporation Revenue & Expenses (excluding Depreciation andInterest) for Proposed & Present Machine


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Depreciation Expenses for Proposed and

Present Machines for Powell Corp.


Year Cost Applicable MACRSdep. percentages

Depreciation

With Proposed Machine

1 400,000 20% 80,000

2 400,000 32% 128,000

3 400,000 19% 76,000

4 400,000 12% 48,000

5 400,000 12% 48,000

6 400,000 5% 20,000

100% 400,000


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Depreciation Expenses for Present Machine


Yr Cost ApplicableMACRS dep %

Depreciation

1 240,000 12% (yr-4 dep) 28,800

2 240,000 12% (yr-5 dep) 28,800

3 240,000 5% (yr-6 dep) 12,000

4 NA 0

5 NA 0

6 NA 0

Total 69,600


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Calculation of Operating Cash InflowsUsing the Income Statement Format (Table 8.7),refer to spread sheet

Revenue

- Expenses (excl dep. & int)Earnings before depreciation, interest and taxes (EBDIT)

- Depreciation

Earnings before interest and taxes (EBIT)

- Taxes (rate = T )

Net operating profit after taxes (NOPAT = EBIT x ( I T ))

+ Depreciation

Operating Cash Inflows (OCF)


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Interpreting the Term Incremental

Incremental in this context means relevant cash inflows.

Incremental cash inflows are needed because our

concern is only with the change in operating cash inflowsthat result from the proposed project.


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Incremental (relevant) Operating Cash Inflows

for Powell Corporation:


Yr Proposedmachine

PresentMachine

Incremental(relevant)

1 $164,000 $137,520 $ 26,480

2 183,200 125,520 57,680

3 162,400 106,800 55,600

4 151,200 90,000 61,200

5 151,200 78,000 73,200

6 8,000 0 8,000


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8.5 Finding the Terminal Cash Flow

Terminal cash flow is the cash flow resulting from terminationand liquidation of a project at the end of its economic life. It isthe after-tax cash flow exclusive of operating cash inflows, at

the final year.

A. Proceeds from Sale of Assets

This salvage value from sale of the new and old asset must

be net of removal or cleanup costs. For replacement projects,

proceeds from both the new asset and the old asset must be

considered. For expansion and renewal types, proceeds of old

asset is zero.


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B. Taxes on Sale of AssetsTaxes must be considered on the terminal sale of both the new

and old asset for replacement projects, and only the new asset

in other cases.

Basic Format for Determining Terminal Cash Flow:

After-tax proceeds from sale of new asset

= Proceeds from sale of new asset

Tax on sale of new asset

- After-tax proceeds from sale of old asset

= Proceeds from sale of old assetTax on sale of old asset

Change in net working capital

-----------------------------------------------------------------

Terminal Cash Flow


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If the value of the asset sold (at the termination of theproject) exceeds its book value, we have to pay tax, and isshown as an outflow of the sale proceeds.

No taxes due if the asset is sold at book value.



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C. Change in Net Working Capital.

We have considered net working capital when calculating the initialinvestment earlier. When, calculating terminal cash value, the change innet working capital represents the reversion of any initial net workingcapital investment.

Example:

Powell Corporation Terminal Cash Flow.

Sale price of new machine 50,000

Sale price of old machine 10,000

Book Value of new machine (5 yr) 20,000

Book Value of old machine (5 yr) 0

Therefore, Recaptured Depreciation for new machine

= 50,000 20,000 = 30,000

Tax on R.D. = 30,000 x 40% = 12,000

After-tax sale proceeds of new machine

= 50,000 12,000 = 38,000



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Using the Basic Format for Terminal Cash Flow

After-tax proceeds from sale of proposed machine

Proceeds from sale of proposed machine 50,000

- Tax on sale 12,000

38,000

- After-tax proceeds from sale of present machine

Proceeds from sale of present machine 10,000

- Tax on sale 4,000

6,000

Change in Net Working Capital 17,000

Terminal Cash Flow 49,000


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The relevant cash flows are: -i) the initial investment,ii) operating cash inflows, andiii) the terminal cash flow.

Hence, we can now decide if the new project is better orworse off for the firm.

8.6 Summarizing Relevant Cash Flows


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Relevant Cash Flows

$221,160

Initial investment

Cash inflow

$26,480 $57,680 $55,600 $61,200

$49,000 TCF

73,200 OCF

122,200

End of year

0

1 2 3 4 5

Time line for Powell Corp.s relevant cash flows

with proposed machine

Documents

Capital Budgeting - Complete Chp 8