Chapter 10 More Capital Budgeting

1
Chapter 10 More Capital Budgeting

• Key Sections
• Guidelines for cash flows
• Classifications of cash flows
• Explain why interest and depreciation not
  included
• Are different discount rates needed?

2
Guidelines

• What will happen if the project is not carried
  out?
• Use after-tax cash flows, not accounting profits
• Only incremental cash flows count
• Look at whole firm with and without project
• Consider sales captured from competitors,
  synergies and cannibalization

3
More Guidelines

• Work in working capital requirements
• Incremental expenses training, rearrangement
• Cash flows not affected by sunk costs
• Opportunity costs give up something
• Are overhead costs incremental?
• Ignore interest expense

4
Measuring Costs and Benefits

• Initial outlays fully installed cost, less sale
  of old property and tax effect
• Differential cash flows increased
  revenues/savings adjusted for incremental tax
  effects interest is excluded
• Terminal cash flows cleanup, salvage, working
  capital recapture

5
Initial Outlay

• Purchase price 30
• Shipping 2
• Installation 3
• Employee training 2
• Tax on sale of old machine 1
• Increased inventory 5
• Total outflows 43
• Sale of old machine - 15
• Initial outlay 28

6
Differential Cash Flows

• Reduced salaries 10
• Reduced fringe 1
• Reduced defects 5
• Increased maintenance -4
• Increased depreciation NA
• Net savings 12
• Less tax effect -3
• Annual cash flow 9

7
Terminal Cash Flow

• Salvage Value 12
• Tax impact -1
• Cleanup/rearrangement -2
• Reduced inventory 3
• Terminal cash inflows 12

8
Risk in Capital Budgeting

• Risk potential variability in cash flows
• Uncertain outcome but can apply judgmental
  probabilities
• Risk adjusted discount rate adjusted upward to
  compensate for risk lowers NPV
• IRR cutoff rate increased

9
Ford Motor Co. Approach

• Normally, all investment proposals are expected
  to generate an after-tax, time-adjusted rate of
  return IRR of at least __. Proposals with
  higher than normal risk are expected to generate
  commensurately higher returns. For a number of
  overseas areas, the minimum return is higher than
  ___.