Capital Budgeting &

Estimating Cash Flows

What is Capital Budgeting?

Investment is made on

Assets/Resource

Long term asset/Fixed Asset/capital

Current asset/short term Asset

capital budgeting =long-term investment decision i.e. making capital expenditure.

The expenditure on fixed asset such as land and building, furniture and fixtures, plant and machinery etc. is called capital expenditure.

The life of these fixed assets is more than one year.

So, capital budgeting decision is concerned with long-term planning.

The Capital Budgeting Process

Generating IdeasStep 1• Generate ideas from inside or outside of the company

Analyzing Individual ProposalsStep 2• Collect information• Estimate after-tax incremental operating cash flows for the investment projects.• Select projects based on a value-maximizing acceptance criterion.

Planning the Capital BudgetStep 3

• Analyze the fit of the proposed projects with the company’s strategy

Monitoring and Post AuditingStep 4• Compare expected and realized results and explain any deviations

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Classifying projects

Replacement Projects Expansion Projects New Products and

Services

Regulatory, Safety, and Environmental

ProjectsOther

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3. Basic principles of Capital Budgeting

Decisions are based on cash flows.

The timing of cash flows is crucial.

Cash flows are incremental.

Cash flows are on an after-tax basis.

Financing costs are ignored.

The Capital Budgeting – Common Terms

The Capital Budgeting – calculation of cash flow

The Capital Budgeting – Major cash flow component

The goal is to estimate the incremental cash flows of the firm for each year in the project’s useful life.

0 1 2 3 4 5| | | | | || | | | | |

Investment Outlay

After-Tax Operating Cash

Flow

After-Tax Operating Cash

Flow

After-Tax Operating Cash

Flow

After-Tax Operating Cash

Flow

After-Tax Operating Cash

Flow+

Terminal Nonoperating

Cash Flow

The Capital Budgeting – Estimation of cash flow

Costs: include or exclude?

A sunk cost is a cost that has already occurred, so it cannot be part of the incremental cash flows of a capital budgeting analysis.

An opportunity cost is what would be earned on the next-best use of the assets.

An incremental cash flow is the difference in a company’s cash flows with and without the project.

An externality is an effect that the investment project has on something else, whether inside or outside of the company.

Cannibalization is an externality in which the investment reduces cash flows elsewhere in the company (e.g., takes sales from an existing company project).

The Capital Budgeting – Estimation of cash flow

Ignore sunk costs Include opportunity costs Include project-driven changes in working

capital net of spontaneous changes in current liabilities

Include effects of inflation

Tax Considerations and Depreciation

• Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS)(page 117)

Depreciation is a noncash expense. Depreciation will not be considered in the

cash flow calculation.

Depreciation and the MACRS Method

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

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

MACRS 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 BasisIn 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 Basis =

Cost of Asset + Capitalized Expenditures Shipping and installation

Sale or Disposal of a Depreciable Asset

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).

Calculating the Incremental Cash Flows

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

• Interim incremental net cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.

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

The Capital Budgeting – Estimation of Initial Investment cash out flow/ Initial Project cost

Installed cost= New asset purchase price (+) Capitalized expenditure/ shipping, installation cost.

(-) After tax proceed from sale of old asset Proceeds from sale of “old” asset(s) if replacement

(-) tax on sale of old asset

(±) change in NWC= Initial cash outflow

The Capital Budgeting – Estimation of Initial Investment cash out flow/ Initial Project cost

(±) change in NWC

Example-11.4 -436 page

Example of an Asset Expansion Project without replacement

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 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.

The Capital Budgeting – Estimation of Initial Investment cash out flow/ Initial Project cost

Installed cost = -70000 New asset purchase price = -$50,000(+) Capitalized expenditure/ = -$20000 shipping, installation cost.

(±) change in NWC= - 5000 Initial cash outflow = -75000

Example of an Asset Expansion Project with replacement

New machine

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

Old machine

The original basis of the machine was $30,000 and depreciated using straight-line over five years ($6,000 per year). BW can sell the current machine for $6,000. NWC will rise to $10,000 from $5,000 (old). next four years. BW is in the 40% tax bracket.

The Capital Budgeting – Estimation of Initial Investment cash out flow/ Initial Project cost

Installed cost = -70000 New asset purchase price = -$50,000(+) Capitalized expenditure/ = -$20000 shipping, installation cost. (-) After tax proceed from =3600 sale of old asset Proceeds from sale of “old” = $6000 asset(s) if replacement (-) tax on sale of old asset = -$2400

(±) change in NWC=- 5000 Initial cash outflow = -71400

The Capital Budgeting – Estimation of Operating Cash Flow

Those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.Incremental and After – tax Interest expense will not be included here.

Incremental Cash Flowsa) Net increase in revenueb) - Net increase in expenses (excluding

depreciation and interest)c) = EBDITd) - Net incr in depreciatione) = EBITf) - Net incr. in tax Operating profit after tax + [[Net incr in depreciation

g) = Incremental net operating cash flow for period

Example of an Asset Expansion 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. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket. then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends.

Incremental Cash Flows Year 1 Year 2 Year 3 Year 4

a) $40,000 $40,000 $40,000 $40,000b) - 23,331 31,115 10,367 5,187c) = $16,669 $ 8,885 $29,633 $34,813d) - 6,668 3,554 11,853 13,925e) = $10,001 $ 5,331 $17,780 $20,888f) + 23,331 31,115 10,367 5,187g) = $33,332 $36,446 $28,147 $26,075

Terminal-Year Incremental Cash Flows

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

Example of an Asset Expansion 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. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket. then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends.

Terminal-Year Incremental Cash Flows

a) $26,075 The 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 Terminal-year incremental

cash flow.

Summary of Project Net Cash Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3 Year 4-$75,000* $33,332 $36,446 $28,147 $37,075

* Notice again that this value is a negative cash flow as we calculated it as the initial cash OUTFLOW in slide 12-18.

Example of an Asset Replacement 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 Outflowa) $50,000b) + 20,000c) + 5,000d) - 6,000 (sale of “old” asset)e) - 2,400 <----f) = $66,600 (tax savings from

loss on sale of“old” asset)

Calculation of the Change in Depreciation

Year 1 Year 2 Year 3 Year 4a) $23,331 $31,115 $10,367 $ 5,187b) - 6,000 6,000 0 0c) = $17,331 $25,115 $10,367 $ 5,187

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

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

c) Net change in tax depreciation charges.

Incremental Cash Flows Year 1 Year 2 Year 3 Year 4

a) $10,000 $10,000 $10,000 $10,000b) - 17,331 25,115 10,367 5,187c) = $ -7,331 -$15,115 $ -367 $ 4,813d) - -2,932 -6,046 -147 1,925e) = $ -4,399 $ -9,069 $ -220 $ 2,888f) + 17,331 25,115 10,367 5,187g) = $12,932 $16,046 $10,147 $ 8,075

Terminal-Year Incremental Cash Flows

a) $ 8,075 The 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 Terminal-year incremental

cash flow.

Summary of Project Net Cash Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3 Year 4-$75,000 $33,332 $36,446 $28,147 $37,075

Asset Replacement Year 0 Year 1 Year 2 Year 3 Year 4-$66,600 $12,933 $16,046 $10,147 $19,075