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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 Budgeting Decision Process
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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Capital Budgeting Decision Process
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.
Capital Budgeting Decision Process
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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.
8.3 Finding the Initial Investment
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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)
8.3 Finding the Initial Investment
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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
8.3 Finding the Initial Investment
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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*
8.3 Finding the Initial Investment
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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
8.3 Finding the Initial Investment
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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.
8.3 Finding the Initial Investment
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D. Calculating the Initial Investment
Powell Corporation:
8.3 Finding the Initial Investment
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
8.3 Finding the Initial Investment
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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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8.4 Finding the Operating Cash Inflows
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.
8.4 Finding the Operating Cash Inflows
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
8.4 Finding the Operating Cash Inflows
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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8.4 Finding the Operating Cash Inflows
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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8.4 Finding the Operating Cash Inflows
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:
8.4 Finding the Operating Cash Inflows
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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8.5 Finding the Terminal Cash Flow
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.
8.5 Finding the Terminal Cash Flow
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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
8.5 Finding the Terminal Cash Flow
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8.5 Finding the Terminal Cash Flow
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