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12.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 12Chapter 12Capital Budgeting Capital Budgeting
and Estimating and Estimating Cash FlowsCash Flows
12.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
12.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital 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”
12.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
12.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The 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.
12.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Capital The Capital Budgeting ProcessBudgeting Process
• Select projects based on a value-maximizing acceptance criterion.
• Reevaluate implemented investment projects continually and perform postaudits for completed projects.
12.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Classification 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 development4. Exploration5. Other (e.g., safety or pollution related)
12.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Screening Proposals Screening Proposals and Decision Makingand Decision Making
1. Section Chiefs2. Plant Managers3. VP for Operations4. Capital Expenditures
Committee5. President6. Board of Directors
AdvancementAdvancementto the nextto the next
level depends level depends on cost on cost
and strategicand strategicimportance.importance.
12.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Estimating 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
Basic characteristics of Basic characteristics of relevant project flowsrelevant project flows
12.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Estimating 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
Principles that must be adhered Principles that must be adhered to in the estimationto in the estimation
12.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
12.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
12.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
MACRS Sample ScheduleMACRS Sample ScheduleRecovery Property Class
Year 3-Year 5-Year 7-Year1 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
12.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Depreciable BasisDepreciable 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 BasisDepreciable Basis =
Cost of Asset Cost of Asset + Capitalized Capitalized Expenditures Expenditures
12.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalized Capitalized ExpendituresExpendituresCapitalized 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
12.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
12.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%.
12.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 – 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.
12.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash OutflowInitial Cash Outflowa) Cost of “new” assetsCost of “new” assetsb) + Capitalized expendituresc) + (–) Increased (decreased) NWCd) – Net proceeds from sale of “old”
asset(s) if replacemente) + (–) Taxes (savings) due to the sale
of “old” asset(s) if replacementf) == Initial cash Initial cash outflowoutflow
12.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 depreciationc) = Net change in income before taxesd) – (+) Net incr. (decr.) in taxese) = Net change in income after taxesf) + (–) Net incr. (decr.) in tax depr.
chargesg) == Incremental net cash flow for Incremental net cash flow for
periodperiod
12.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
assetsc) – (+) Taxes (tax savings) due to asset sale
or disposal of “new” assetsd) + (–) Decreased (increased) level of “net”
working capitale) == Terminal year incremental net cash Terminal year incremental net cash
flowflow
12.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 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.
12.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash OutflowInitial Cash Outflowa) $50,000b) + 20,000c) + 5,000d) – 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).
12.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Incremental Cash FlowsIncremental Cash Flows Year 1 Year 2 Year 3 Year
4a) $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 $33,332 $36,446 $28,147
$26,075$26,075
12.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Terminal-Year Terminal-Year Incremental Cash FlowsIncremental Cash Flows
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.
12.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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$37,075
* Notice again that this value is a negativenegative cash flow as we calculated it as the initial cash OUTFLOW in slide 12-23.
12.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
RememberRemember, you can use , you can use Excel - Very Valuable!!Excel - Very Valuable!!
Refer to the spreadsheet
‘VW13E-12b.xlsx’ on
the ‘New Asset’ tab for
this spreadsheet.
Try changing Try changing information in information in
the the spreadsheet spreadsheet
to see the to see the impact!impact!
New Asset Cost: 50,000$ 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:
12.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
12.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash OutflowInitial Cash Outflowa) $50,000b) + 20,000c) + 5,000d) – 6,000 (sale of “old” asset)e) – 2,400 <----f) == $66,600$66,600
(tax savings fromloss on sale of
“old” asset)
12.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculation of the Calculation of the Change in DepreciationChange in Depreciation
Year 1 Year 2 Year 3 Year 4
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.
12.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Incremental Cash FlowsIncremental Cash Flows Year 1 Year 2 Year 3 Year
4a) $10,000 $10,000 $10,000
$10,000b) – 17,331 25,115 10,367 17,331 25,115 10,367
5,1875,187c) = $ –7,331 –$15,115 $ –367 $
4,813d) – –2,932 –6,046 –147
1,925e) = $ –4,399 $ –9,069 $ –220 $
2,888f) + 17,331 17,331 25,115 25,115 10,367 10,367
5,1875,187g) == $12,932 $16,046 $10,147 $ $12,932 $16,046 $10,147 $
8,0758,075
12.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Terminal-Year Terminal-Year Incremental Cash FlowsIncremental Cash Flows
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$19,075 Terminal-year incremental Terminal-year incremental
cash flow. cash flow.
12.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
RememberRemember, you can use , you can use Excel - Very Valuable!!Excel - Very Valuable!!
Refer to the spreadsheet
‘VW13E-12b.xlsx’ on the ‘Asset
Replacement’ tab for this
spreadsheet.
Try changing Try changing information in information in
the the spreadsheet spreadsheet
to see the to see the impact!impact!
New Asset Cost: 50,000$ 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:
12.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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