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The Capital Budgeting Process: An Overview

Having just explored ways to efficiently manage working capital (current assets and their
supporting financing), we now turn our attention to decisions that involve long-lived assets.
These decisions involve both investment and financing choices, the first of which takes up the
next three chapters.
When a business makes a capital investment, it incurs a current cash outlay in the expecta-
tion of future benefits. Usually, these benefits extend beyond one year in the future. Examples
include investment in assets, such as equipment, buildings, and land, as well as the introduc-
tion of a new product, a new distribution system, or a new program for research and develop-
ment. In short, the firm’s future success and profitability depend on long-term decisions
currently made.
An investment proposal should be judged in relation to whether or not it provides a return
equal to, or greater than, that required by investors.1 To simplify our investigation of the
Capital budgeting methods of capital budgeting in this and the following chapter, we assume that the required
The process of return is given and is the same for all investment projects. This assumption implies that the
identifying, analyzing, selection of any investment project does not alter the operating, or business-risk, complexion
and selecting
investment projects of the firm as perceived by financing suppliers. In Chapter 15 we investigate how to determine
whose returns (cash the required rate of return, and in Chapter 14 we allow for the fact that different investment
flows) are expected projects have different degrees of business risk. As a result, the selection of an investment
to extend beyond project may affect the business-risk complexion of the firm, which, in turn, may affect the rate
one year. of return required by investors. For purposes of introducing capital budgeting in this and the
next chapter, however, we hold risk constant.

Take Note
Capital budgeting involves
l Generating investment project proposals consistent with the firm’s strategic objectives
l Estimating after-tax incremental operating cash flows for investment projects
l Evaluating project incremental cash flows
l Selecting projects based on a value-maximizing acceptance criterion
l Reevaluating implemented investment projects continually and performing postaudits
for completed projects

In this chapter, we restrict ourselves to a discussion of the first two items on this list.

Generating Investment Project Proposals

Investment project proposals can stem from a variety of sources. For purposes of analysis,
projects may be classified into one of five categories:
1. New products or expansion of existing products
2. Replacement of equipment or buildings
3. Research and development
4. Exploration
5. Other (for example, safety-related or pollution-control devices)
1
The development of the material on capital budgeting assumes that the reader understands the concepts covered in
Chapter 3 on the time value of money.

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For a new product, the proposal usually originates in the marketing department. A proposal
to replace a piece of equipment with a more sophisticated model, however, usually arises
from the production area of the firm. In each case, efficient administrative procedures are
needed for channeling investment requests. All investment requests should be consistent with
corporate strategy to avoid needless analysis of projects incompatible with this strategy.
(McDonald’s probably would not want to sell cigarettes in its restaurants, for example.)
Most firms screen proposals at multiple levels of authority. For a proposal originating in
the production area, the hierarchy of authority might run (1) from section chiefs, (2) to plant
managers, (3) to the vice president for operations, (4) to a capital expenditures committee
under the financial manager, (5) to the president, and (6) to the board of directors. How high
a proposal must go before it is finally approved usually depends on its cost. The greater the
capital outlay, the greater the number of “screens” usually required. Plant managers may
be able to approve moderate-sized projects on their own, but only higher levels of authority
approve larger ones. Because the administrative procedures for screening investment pro-
posals vary from firm to firm, it is not possible to generalize. The best procedure will depend
on the circumstances. It is clear, however, that companies are becoming increasingly sophis-
ticated in their approach to capital budgeting.

Estimating Project “After-Tax Incremental Operating Cash Flows”

l l l Cash-Flow Checklist
One of the most important tasks in capital budgeting is estimating future cash flows for a
project. The final results we obtain from our analysis are no better than the accuracy of our
cash-flow estimates. Because cash, not accounting income, is central to all decisions of the
firm, we express whatever benefits we expect from a project in terms of cash flows rather than
income flows. The firm invests cash now in the hope of receiving even greater cash returns
in the future. Only cash can be reinvested in the firm or paid to shareholders in the form of
dividends. In capital budgeting, good guys may get credit, but effective managers get cash. In
setting up the cash flows for analysis, a computer spreadsheet program is invaluable. It allows
one to change assumptions and quickly produce a new cash-flow stream.

Take Note
For each investment proposal we need to provide information on operating, as opposed to
financing, cash flows. Financing flows, such as interest payments, principal payments, and
cash dividends, are excluded from our cash-flow analysis. However, the need for an invest-
ment’s return to cover capital costs is not ignored. The use of a discount (or hurdle) rate
equal to the required rate of return of capital suppliers will capture the financing cost dimen-
sion. We will discuss the mechanics of this type of analysis in the next chapter.

Cash flows should be determined on an after-tax basis. The initial investment outlay, as
well as the appropriate discount rate, will be expressed in after-tax terms. Therefore all fore-
casted flows need to be stated on an equivalent, after-tax basis.
In addition, the information must be presented on an incremental basis, so that we analyze
only the difference between the cash flows of the firm with and without the project. For
example, if a firm contemplates a new product that is likely to compete with existing
products, it is not appropriate to express cash flows in terms of estimated total sales of the
new product. We must take into account the probable “cannibalization” of existing products
and make our cash-flow estimates on the basis of incremental sales. When continuation of the

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status quo results in loss of market share, we must take this into account when analyzing what
happens if we do not make a new investment. That is, if cash flows will erode if we do not
invest, we must factor this into our analysis. The key is to analyze the situation with and with-
out the new investment and where all relevant costs and benefits are brought into play. Only
incremental cash flows matter.
Sunk costs In this regard, sunk costs must be ignored. Our concern lies with incremental costs and
Unrecoverable past benefits. Unrecoverable past costs are irrelevant and should not enter into the decision pro-
outlays that, as they cess. Also, we must be mindful that certain relevant costs do not necessarily involve an actual
cannot be recovered,
should not affect dollar outlay. If we have allocated plant space to a project and this space can be used for some-
present actions or thing else, its opportunity cost must be included in the project’s evaluation. If a currently
future decisions. unused building needed for a project can be sold for $300,000, that amount (net of any taxes)
Opportunity cost should be treated as if it were a cash outlay at the outset of the project. Thus, in deriving cash
What is lost by not flows, we need to consider any appropriate opportunity costs.
taking the next-best When a capital investment contains a current asset component, this component (net of any
investment spontaneous changes in current liabilities) is treated as part of the capital investment and not
alternative.
as a separate working capital decision. For example, with the acceptance of a new project it is
sometimes necessary to carry additional cash, receivables, or inventories. This investment
in working capital should be treated as a cash outflow at the time it occurs. At the end of a
project’s life, the working capital investment is presumably returned in the form of an addi-
tional cash inflow.
In estimating cash flows, anticipated inflation must be taken into account. Often there is a
tendency to assume erroneously that price levels will remain unchanged throughout the life
of a project. If the required rate of return for a project to be accepted embodies a premium
for inflation (as it usually does), then estimated cash flows must also reflect inflation. Such
cash flows are affected in several ways. If cash inflows ultimately arise from the sale of a
product, expected future prices affect these inflows. As for cash outflows, inflation affects
both expected future wages and material costs.
Table 12.1 summarizes the major concerns to keep in mind as we prepare to actually deter-
mine project “after-tax incremental operating cash flows.” It provides us with a “checklist” for
determining cash-flow estimates.

l l l Tax Considerations

Method of Depreciation. As you may remember from Chapter 2, depreciation is the sys-
tematic allocation of the cost of a capital asset over a period of time for financial reporting
purposes, tax purposes, or both. Because depreciation deductions taken on a firm’s tax return

Table 12.1 BASIC CHARACTERISTICS OF RELEVANT PROJECT FLOWS

Cash-flow checklist o
3 Cash (not accounting income) flows
o
3 Operating (not financing) flows
o
3 After-tax flows
o
3 Incremental flows
BASIC PRINCIPLES THAT MUST BE ADHERED TO
IN ESTIMATING “AFTER-TAX INCREMENTAL OPERATING CASH FLOWS”
o
3 Ignore sunk costs

o
3 Include opportunity costs

o
3 Include project-driven changes in working capital net of spontaneous changes in current
liabilities
o
3 Include effects of inflation

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Table 12.2 PROPERTY CLASS

RECOVERY
MACRS depreciation YEAR 3-YEAR 5-YEAR 7-YEAR 10-YEAR
percentages 1 33.33% 20.00% 14.29% 10.00%
2 44.45 32.00 24.49 18.00
3 14.81 19.20 17.49 14.40
4 7.41 11.52 12.49 11.52
5 11.52 8.93 9.22
6 5.76 8.92 7.37
7 8.93 6.55
8 4.46 6.55
9 6.56
10 6.55
11 3.28
Totals 100.00% 100.00% 100.00% 100.00%

are treated as expense items, depreciation lowers taxable income. Everything else being equal,
the greater the depreciation charges, the lower the taxes paid. Although depreciation itself is
a noncash expense, it does affect the firm’s cash flow by directly influencing the cash outflow
of taxes paid.
There are a number of alternative procedures that may be used to depreciate capital assets.
These include straight-line and various accelerated depreciation methods. Most profitable
firms prefer to use an accelerated depreciation method for tax purposes – one that allows for a
more rapid write-off and, therefore, a lower tax bill.
The Tax Reform Act of 1986 allows companies to use a particular type of accelerated depre-
ciation for tax purposes known as the Modified Accelerated Cost Recovery System (MACRS).
Under MACRS, machinery, equipment, and real estate are assigned to one of eight classes for
cost recovery (depreciation) purposes. As described in Chapter 2, the property category in
which an asset falls determines its depreciable life for tax purposes. As also described in that
chapter, the half-year convention must generally be applied to all machinery and equipment.
There is a half-year of depreciation in the year an asset is acquired and in the final year
that depreciation is taken on the asset. The Treasury publishes depreciation percentages of
original cost for each property class, which incorporate the half-year conventions. Table 12.2
presents the depreciation percentages for the first four property classes. These percentages
correspond to the principles taken up in Chapter 2, and they should be used for determining
depreciation.

Take Note
In Chapter 2, we noted that the “temporary” first-year 50 percent “bonus depreciation”
provision allowed under the recently enacted US Economic Stimulus Act (ESA) of 2008
would affect a company’s federal tax payments and capital budgeting decisions. However,
this “bonus depreciation” provision is scheduled to expire by the end of 2008. Therefore,
all of our examples and problems involving MACRS depreciation will ignore the “bonus
depreciation” provision.
But remember, a “temporary” bonus depreciation provision may very well return again
in your professional future – so be prepared. To learn more about the first-year 50 percent
“bonus depreciation” provision under ESA visit: (web.utk.edu/~jwachowi/hr5140.html).
And, to learn more about earlier “bonus depreciation” provisions visit the following web-
sites: Job Creation and Worker Assistance Act of 2002 (web.utk.edu/~jwachowi/hr3090.html)
and Jobs and Growth Tax Relief Reconciliation Act of 2003 (web.utk.edu/~jwachowi/hr2.html).

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Question Can MACRS depreciation be utilized by US companies on equipment used outside

the United States?

Answer No. Generally, MACRS depreciation is not allowed for equipment that is used pre-
dominantly outside the United States during the taxable year. For such equipment, the
Alternative Depreciation System (ADS) is required. ADS is a straight-line method of
depreciation (determined without regard to estimated future salvage value).

Take Note
Depreciable Basis. Computing depreciation for an asset requires a determination of the
Depreciable basis asset’s depreciable basis. This is the amount that taxing authorities allow to be written off
In tax accounting, the for tax purposes over a period of years. The cost of the asset, including any other capitalized
fully installed cost of expenditures – such as shipping and installation – that are incurred to prepare the asset for
an asset. This is the
its intended use, constitutes the asset’s depreciable basis under MACRS. Notice that under
amount that, by law,
may be written off MACRS the asset’s depreciable basis is not reduced by the estimated salvage value of the asset.
over time for tax
purposes.
Capitalized Sale or Disposal of a Depreciable Asset. In general, if a depreciable asset used in busi-
expenditures ness is sold for more than its depreciated (tax) book value, any amount realized in excess of
Expenditures that book value but less than the asset’s depreciable basis is considered a “recapture of deprecia-
may provide benefits tion” and is taxed at the firm’s ordinary income tax rate. This effectively reverses any positive
into the future and
therefore are treated tax benefits of having taken “too much” depreciation in earlier years – that is, reducing (tax)
as capital outlays and book value below market value. If the asset happens to sell for more than its depreciable basis
not as expenses of (which, by the way, is not too likely), the portion of the total amount in excess of the depre-
the period in which ciable basis is taxed at the capital gains tax rate (which currently is equal to the firm’s ordinary
they were incurred. income tax rate, or a maximum of 35 percent).
If the asset sells for less than (tax) book value, a loss is incurred equal to the difference
between sales price and (tax) book value. In general, this loss is deducted from the firm’s ordin-
ary income. In effect, an amount of taxable income equal to the loss is “shielded” from being
taxed. The net result is a tax-shield savings equal to the firm’s ordinary tax rate multiplied by
the loss on the sale of the depreciable asset. Thus a “paper” loss is cause for a “cash” savings.
Our discussion on the tax consequences of the sale of a depreciable asset has assumed no
additional complicating factors. In actuality, a number of complications can and often do
occur. Therefore the reader is cautioned to refer to the tax code and/or a tax specialist
when faced with the tax treatment of a sale of an asset. In examples and problems, for ease of
calculation we will generally use a 40 percent marginal ordinary income tax rate.

l l l Calculating the Incremental Cash Flows

We now face the task of identifying the specific components that determine a project’s rele-
vant cash flows. We need to keep in mind both the concerns enumerated in our “cash-flow
checklist” (Table 12.1) as well as the various tax considerations just discussed. It is helpful to
place project cash flows into three categories based on timing:
1. Initial cash outflow: the initial net cash investment.
2. Interim incremental net cash flows: those net cash flows occurring after the initial cash
investment but not including the final period’s cash flow.

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3. Terminal-year incremental net cash flow: the final period’s net cash flow. (This period’s
cash flow is singled out for special attention because a particular set of cash flows often
occurs at project termination.)
Initial Cash Outflow. In general, the initial cash outflow for a project is determined as
follows in Table 12.3. As seen, the cost of the asset is subject to adjustments to reflect the
totality of cash flows associated with its acquisition. These cash flows include installation
costs, changes in net working capital, sale proceeds from the disposition of any assets replaced,
and tax adjustments.
Interim Incremental Net Cash Flows. After making the initial cash outflow that is neces-
sary to begin implementing a project, the firm hopes to benefit from the future cash inflows
generated by the project. Generally, these future cash flows can be determined by following
the step-by-step procedure outlined in Table 12.4.
Notice that we first deduct any increase (add any decrease) in incremental tax deprecia-
tion related to project acceptance – see step (b) – in determining the “net change in income
before taxes.” However, a few steps later we add back any increase (deduct any decrease)
in tax depreciation – see step (f) – in determining “incremental net cash flow for the period.”
What is going on here? Well, tax depreciation itself, as you may remember, is a noncash
charge against operating income that lowers taxable income. So we need to consider it as
we determine the incremental effect that project acceptance has on the firm’s taxes. However,
we ultimately need to add back any increase (subtract any decrease) in tax depreciation to
our resulting “net change in income after taxes” figure so as not to understate the project’s
effect on cash flow.

Table 12.3
(a) Cost of “new” asset(s)
Basic format for
(b) + Capitalized expenditures (for example, installation costs, shipping expenses, etc.)*
determining initial
cash outflow (c) +(−) Increased (decreased) level of “net” working capital**
(d) − Net proceeds from sale of “old” asset(s) if the investment is a replacement decision
(e) +(−) Taxes (tax savings) due to the sale of “old” asset(s) if the investment is a replacement
decision
(f) = Initial cash outflow

*Asset cost plus capitalized expenditures form the basis on which tax depreciation is computed.
**Any change in working capital should be considered “net” of any spontaneous changes in current
liabilities that occur because the project is implemented.

Table 12.4
(a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in
Basic format for operating expenses, excluding depreciation
determining interim
(b) −(+) Net increase (decrease) in tax depreciation charges
incremental net cash
flow (per period) (c) = Net change in income before taxes
(d) −(+) Net increase (decrease) in taxes
(e) = Net change in income after taxes
(f) +(−) Net increase (decrease) in tax depreciation charges
(g) = Incremental net cash flow for the period

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Table 12.5
(a) Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in
Basic format for operating expenses, excluding depreciation
determining terminal
(b) −(+) Net increase (decrease) in tax depreciation charges
year incremental net
cash flow (c) = Net change in income before taxes
(d) −(+) Net increase (decrease) in taxes
(e) = Net change in income after taxes
(f) +(−) Net increase (decrease) in tax depreciation charges
(g) = Incremental cash flow for the terminal year before project windup considerations
(h) +(−) Final salvage value (disposal/reclamation costs) of “new” asset(s)
(i) −(+) Taxes (tax savings) due to sale or disposal of “new” asset(s)
(j) +(−) Decreased (increased) level of “net” working capital*
(k) = Terminal year incremental net cash flow

*Any change in working capital should be considered “net” of any spontaneous changes in current
liabilities that occur because the project is terminated.

Take Note
Project-related changes in working capital are more likely to occur at project inception
and termination. Therefore Table 12.4 does not show a separate, recurring adjustment for
working capital changes. However, for any interim period in which a material change in
working capital occurs, we would need to adjust our basic calculation. We should therefore
include an additional step in the “interim incremental net cash flow” determination. The
following line item would then appear right after step (f ): + (−) Decreased (increased) level
of “net” working capital – with any change in working capital being considered “net” of any
spontaneous changes in current liabilities caused by the project in this period.

Terminal-Year Incremental Net Cash Flow. Finally, we turn our attention to determin-
ing the project’s incremental cash flow in its final, or terminal, year of existence. We apply the
same step-by-step procedure for this period’s cash flow as we did to those in all the interim
periods. In addition, we give special recognition to a few cash flows that are often connected
only with project termination. These potential project windup cash flows are (1) the salvage
value (disposal/reclamation costs) of any sold or disposed assets, (2) taxes (tax savings) related
to asset sale or disposal, and (3) any project-termination-related change in working capital –
generally, any initial working capital investment is now returned as an additional cash inflow.
Table 12.5 summarizes all the necessary steps and highlights those steps that are reserved
especially for project termination.

l l l Example of Asset Expansion

To illustrate the information needed for a capital budgeting decision, we examine the follow-
ing situation. The Faversham Fish Farm is considering the introduction of a new fish-flaking
facility. To launch the facility, it will need to spend $90,000 for special equipment. The equip-
ment has a useful life of four years and is in the three-year property class for tax purposes.
Shipping and installation expenditures equal $10,000, and the machinery has an expected
final salvage value, four years from now, of $16,500. The machinery is to be housed in an
abandoned warehouse next to the main processing plant. The old warehouse has no alterna-
tive economic use. No additional “net” working capital is needed. The marketing department

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