Capital Budgeting Cash Flows

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Capital Budgeting Cash Flows

• Prepared by Keldon Bauer
• FIL 240

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Capital Budgeting Decision

• Capital Budgeting
• The process of evaluating and selecting long-term
  investments.
• Capital Expenditure
• An outlay expected to benefit the firm over at
  least 1 year.
• Operating expenditures benefit the firm over a
  period less than 1 year.

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Capital Budgeting Decision

• Steps in the Process
• Proposal generation.
• Review and analysis.
• Decision making.
• Implementation.
• Follow-up.

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Basic Terminology

• Independent versus Mutually Exclusive.
• Unlimited Funds versus Capital Rationing.
• Accept-Reject versus Ranking .
• Conventional versus Non-Conventional Cash Flow
  Patterns.

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Relevant Cash Flows

• Incremental Cash Flows
• Marginal cash flow associated with adopting the
  proposed project.
• Major Cash Flow Components
• Initial Cash Flow
• Operating Cash Flow
• Terminal Cash Flow

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Relevant Cash Flows

• Expansion versus Replacement Decisions.
• Sunk Costs and Opportunity Costs.
• Sunk costs are ignored (incremental costs are
  zero).
• Opportunity costs are included, since they
  represent costs (or revenues) forgone.

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Clicker Question Set-up

• Given the following costs related to a proposed
  project, identify whether each of these should be
  treated as a sunk or opportunity cost associated
  with that replacement decision

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1. Initial Cash Flow

• Cost of New Asset
• Include shipping and installation.
• After-tax Proceeds from Sale of Old Asset
• Removal/Sale
• Cleanup costs
• Net of tax effect
• Book value, tax profit (recaptured depreciation.

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1. Initial Cash Flow

• Change in Net Working Capital.
• Summary
• Installed cost of new assets
• After-tax proceeds from sale of old assets.
• Change in net working capital
• Initial Cash Flow

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Example

• Germantown Manufacturing is considering replacing
  one machine with another. The old machine was
  purchased 3 years ago for an installed cost of
  10,000. The firm is depreciating the machine
  under MACRS, using a 5 year recovery period. The
  new machine costs 24,000 in installation costs.
  The firms marginal tax rate is 40. What is the
  initial cash flow if the old machine sells for
  7,000?

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Example
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Example
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Example
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2. Operating Cash Flows

• After-tax Incremental Cash Flows from Operations.
• Be careful, especially under replacement
  decisions.
• Usually compared to not replacing now.
• After-tax usually is earnings less the
  depreciation shielded tax.
• Generally assume accelerated depreciation.
• See page 73 (chapter 4) for MACRS table.

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2. Operating Cash Flows

• Summary
• Operating Cash Flow NOPAT Deprec.
• If relevant, find the incremental cash flow, by
  finding the difference between the OCF for the
  proposed project and the OCF of the best
  alternative (what you are currently doing).

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Example

• A replacement machine will reduce operating
  expenses by 16,000 per year for each of the 5
  years the new machine is expected to last.
  Although the old machine has zero book value, it
  can be used for 5 more years. The depreciable
  value of the new machine is 48,000. The firm
  will depreciate the machine under MACRS using a
  five year recovery period, and is subject to a
  40 tax rate.

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Example
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Example
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3. Terminal Cash Flow

• Proceeds from Sale of Assets
• Net of sale, removal and cleanup.
• Taxes on Sale of Assets
• Book value and profit.
• Change in Net Working Capital
• Typically, setting net working capital back the
  way it was.

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Example

• A new machine costs 160,000 and requires 20,000
  in installation. Purchase of this machine is
  expected to result in an increase in net working
  capital of 30,000 to support the expanded level
  of operations. The firm plans to depreciate the
  machine under MACRS using a 5-year period, and
  expects to sell the machine in 5 years for a net
  of 10,000 before taxes. Assume a 40 tax rate.

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Example
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Example
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Summarizing Relevant CFs

• Use a cash flow timeline.
• Rather than using the format presented in the
  text, bring net inflows and outflows down
• Make outflows negative,
• Make inflows positive.

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Example

• If all the examples presented so far were for one
  project (which they arent)