Capital Budgeting and Cash Flow Analysis

1
Chapter 8

• Capital Budgeting and Cash Flow Analysis

2
Introduction

• This chapter discusses capital budgeting and
  capital expenditures.
• It deals with the financial management of the
  assets on a firms balance sheet.

3
Meaning

• Capital Budgeting The process of planning for
  purchases of assets whose returns are expected to
  continue beyond a year
• Capital Expenditure A cash outlay expected to
  generate a flow of future cash benefits for more
  than a year.
• Examples of capital expenditures
• New equipment
• Advertising campaigns
• Research Development
• Acquisition of companies

4
Project Classification

• Independent
• Acceptance or rejection of the project has no
  effect on other projects
• Mutually Exclusive
• Acceptance of one automatically rejects the
  others
• Contingent
• Acceptance is dependent upon the selection of
  another

5
Our Focus

• Evaluation of investment projects accept or
  reject?
• This requires
• estimating expected CFs of projects (Ch 8)
• techniques for analyzing such CFs (Ch 9)

6
Cash Flows Types

• Net Investment (NINV)
• Initial investment
• Annual Net Cash Flows (NCF)
• Cash inflows minus cash outflows during each year
  of the projects life

7
Cash Flow Patterns

• Normal (Conventional)
• sign of future net cash flows changes only once
• Yr CF
• 0 -10
• 1 2
• 2 5
• 3 5
• 4 4

Sign change
8
Cash Flow Patterns

• Nonnormal (nonconventional)
• sign of future net cash flows changes more than
  once
• no sign change (all negative)
• Yr CF CF CF
• 0 -10 -10 -10
• 1 2 2 -2
• 2 5 2 -2
• 3 -2 1 -1
• 4 4 -1 -1

9
Principles of CF Estimation

• Measured on an incremental basis
• CF with the project - CF without the project
• Measured on an after-tax basis
• Include indirect effects on firms cash
  flows Ex revenue loss of another division
• Exclude sunk costs
• Ex feasibility studies
• Measure value of resources used in terms of their
  Opportunity costs

10
Principles of CF Estimation

• Treatment of After-tax salvage value
• Sale Price Book Value
• No Tax
• Sale Price lt Book Value
• Tax Savings ( Sale Price - Book Value ) x T
• Sale Price gt Book Value
• Tax Payable ( Sale Price - Book Value ) x T

11
Principles of CF Estimation

• Recovery of net working capital
• All new working capital investments made (a) at
  the beginning, and (b) during the projects life
  are recovered at the end of the project.
• Recovery of working capital is a cash inflow at
  the end of the projects life.

12
Principles of CF Estimation

• Interest charges are not deducted
• they represent cost of financing
• financing decision must be considered
  independently of the investment decision
• cost of financing is reflected in the discount
  rate (cost of capital of the firm)

13
Estimating the NINV

• Step 1 Cost plus installation and shipping
• Plus
• Step 2 Increases in net working capital
• Minus
• Step 3 Net proceeds from sale of existing
  assets
• Plus or minus
• Step 4 Taxes associated with the above
  sale
• Equals
• NINV

14
Estimating the NINV

• Some projects require outlays over a number of
  years. (Figure 8-3)
• Then, the NINV consists of
• NINV at time 0 plus
• PV of NINV in future years.
• PV is computed by discounting future outlays at
  the firms cost of capital.

15
Estimating the NINV Example

• A new machine will replace two older ones.
• Purchase cost of the new machine is 100,000.
• Shipping installation will cost additional
  20,000.
• Company has to incur new working capital of
  10,000 at the start of the project.
• One old machine (cost 70,000, book value 50,000)
  can be sold for 60,000.
• The other old machine (cost 50,000, book value
  20,000) can be sold for 15,000.
• Firms marginal corporate income tax rate is 40.

16
Estimating the NINV Example

• Purchase cost 100,000
• Shipping installation 20,000
• Increase in net working capital 10,000
• Sale of old machines
• machine 1 60,000
• machine 2 15,000 (75,000)
• Tax on Sale of old machines
• machine 1 Sale price 60,000
• Book value (50,000)
• Gain 10,000
• Tax payable 10,000 x 0.40
  4,000 machine 2 Sale price 15,000
• Book value (20,000)
• Loss (5,000)
• Tax saving (5,000) x 0.40
  (2,000) 2,000
• Net Investment 57,000

17
Estimating Net Cash Flows

• R Revenue w with project
• O Operating costs wo without project
• (excluding dep) ? change
• D Depreciation
• T Tax rate
• NWC Net working capital

18
Estimating NCFs Example

• ABC plans to buy a new machine (to replace an
  existing one).
• The installed cost will be 400,000.
• Additionally, it involves a 20,000 investment in
  new working capital at the start.
• Revenue is expected to increase by 100,000.
• Operating costs (excluding depreciation) are
  expected to increase by 20,000.
• Every year ABC will have to invest additional
  10,000 in working capital.
• Estimated life of the machine is 5 years.
• New machine will be depreciated on straight-line
  basis over the 5 years. The depreciation of the
  old machine is 50,000 per year.
• Salvage value is expected to be 50,000.
• Marginal tax rate of 40.

19
Estimating NCFs Example

• NCF for years 1-4
• ?R 100,000
• ?O 20,000
• Dep (new) Cost / 5
• 400,000/5 80,000
• Dep (old) 50,000
• ?Dep 80,000 - 50,000 30,000
• ?NWC 10,000
• T 0.40
• NCF (100,000 - 20,000 - 30,000)(1-0.40) 30,000
  - 10,000
• 50,000

20
Estimating NCFs Example

• NCF for year 5
• NCF4 50,000
• Recovery of net working capital
• Initial working capital 20,000
• Yearly working capital 10,000 x 5 50,000
• Total recovery 70,000
• Salvage value of the machine 50,000
• Tax payable on gain from sale
• (Sale Price - Book Value) x T
• (50,000 - 0) x 0.40 20,000
• NCF5 NCF4 Recovery of NWC Salvage Value -
  Tax on sale
• 50,000 70,000 50,000 - 20,000
  150,000

21
Example1

• What is the net investment for an extruder that
  costs 42,000, if shipping cost are 1,500 and
  installation is 4,800? Assume this machine is
  replacing an older extruder with a book and
  market value of zero. The replacement investment
  will reduce operating cost 6,600 a year.

22
Example 2

• Allen Company is considering an investment
  project that is expected to generate 100,000 in
  annual earnings before taxes. Annual depreciation
  will be 50,000. Allens marginal tax rate is
  40. Determine the projects annual net cash flows.