Textbook Materials - ch11

Principles of Managerial Finance
Fifteenth Edition, Global Edition
Chapter 11
Capital Budgeting Cash
Flows
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Learning Goals
LG 1 Discuss net and incremental cash flows, and describe the three
major types of net cash flows.
LG 2 Discuss replacement versus expansion decisions, sunk costs and
opportunity costs, and international capital budgeting.
LG 3 Calculate the initial investment associated with a proposed
investment project.
LG 4 Discuss the tax implications associated with the sale of an old
asset.
LG 5 Find the operating cash flows associated with a proposed
investment project.
LG 6 Determine the terminal cash flow associated with a proposed
investment project.

11.1 Project Cash Flows (1 of 5)
• Net Cash Flows
– The net (or the sum of) incremental after-tax cash flows over
a project’s life
• Incremental Cash Flows
– The additional after-tax cash flows—outflows or inflows—
that will occur only if the investment is made

https://knowledge.wharton.upenn.edu/article/saturn-a-wealth-of-lessons-from-failure/
http://autotrends.org/2019/07/01/the-life-and-death-of-the-saturn-brand/
Copyright © 2019 Pearson Education, Ltd. All Rights
https://www.forbes.com/2010/03/08/saturn-gm-innovation-leadership-managing- Reserved.
failure.html?sh=4a9f73a76ee3
The Importance of Capital Budgeting Decisions.
Saturn Case at a Glance
• Saturn was developed by GM as a separate brand and

independent subsidiary in the late 1980s, to deal with
the shrinking domestic market share for passenger
cars. Saturn started strong, building a company
centered on making a small car of superior quality and
value as efficiently as possible, while combining the
most advanced technology with the newest approaches
to management.
• Capital spending for the project ~ $ 6 billion

• 1990 – the first Saturn car leaves the line
• In 1994 sales began to drop and was attributed to several factors:

Narrow product line, lack of innovation and adaptation to market
trends, resistance to expand the dealer network, and formidable
competition from domestic and foreign rivals.
• It was reported GM is losing about $3,000 per car.
• 2010 GM has announced the cancelation of its production, with
losses of about $ 20 billion from this project.

• Major Cash Flow Types
– Initial Investment
 The incremental cash flows for a project at time zero
– Operating Cash Flows
 The net incremental after-tax cash flows occurring each period
during the project’s life
– Terminal Cash Flows
 The net after-tax cash flow occurring in the final year of the
project

• Replacement versus Expansion Decisions
– Expansion decisions include investments designed to
increase the capacity of a factory, to launch a product in a
new market, or to open a new location
 Identifying incremental cash flows along with developing net
cash flow estimates is relatively straightforward
– Replacement decisions are perhaps even more common
 The firm must decide whether to replace some asset that it
already owns with a new asset
 Identifying incremental cash flows for these sorts of investment
projects is more complicated because the firm must compare
the cash flows that result from the new investment to the cash
flows that would have occurred if no investment had been
made
Figure 11.2 Relevant Net Cash Flows for
Replacement Decisions

• Sunk Costs and Opportunity Costs
– Sunk Costs
 Cash outlays that have already been made (past outlays) and
cannot be recovered, whether or not the firm follows through
and makes an investment
 Sunk costs are irrelevant and should not be included in a
project’s incremental cash flows
– Opportunity Costs
 Cash flows that could have been realized from the best
alternative use of an owned asset
 Opportunity costs are relevant and should be included as part
of the cash flow projections when determining a project’s net
cash flows

Example 11.1 (1 of 2)
Jankow Equipment is considering enhancing its drill press
X12, which it purchased 3 years earlier for $237,000, by
retrofitting it with the computerized control system from an
obsolete piece of equipment it owns. The obsolete
equipment could be sold today for $42,000, but without its
computerized control system, it would be worth nothing.
Jankow is in the process of estimating the labor and
materials costs of retrofitting the system to drill press X12
and the benefits expected from the retrofit. The $237,000
cost of drill press X12 is a sunk cost because it represents
an earlier cash outlay.

It would not be included as a cash outflow when determining
the cash flows relevant to the retrofit decision. However, if
Jankow uses the computerized control system of the
obsolete machine, then Jankow will have an opportunity cost
of $42,000, which is the cash the company could have
received by selling the obsolete equipment in its current
condition. By retrofitting the drill press, Jankow gives up the
opportunity to sell the old equipment for $42,000. This
opportunity cost would be included as a cash outflow
associated with using the computerized control system.

Table 11.1 The Basic Format for Determining
Initial Investment
(1) Installed cost of the new asset =
Cost of the new asset
+ Installation costs
(2) After-tax proceeds from the sale of the old asset =
Proceeds from the sale of the old asset
±Tax on the sale of the old asset
(3) Change in net working capital
Initial Investment = (1) − (2) ± (3)

11.2 Finding the Initial Investment (4 of 5)
• Change in Net Working Capital
– Net Working Capital
 The difference between the firm’s current assets and its current
liabilities
– Change in Net Working Capital
 The difference between the change in current assets and the
change in current liabilities

Table 11.3 Calculation of Change in Net
Working Capital for Danson Company
Current account Change in balance Blank
Cash + $ 4,000 Blank
Accounts receivable + 10,000 Blank
Inventories + 8,000 Blank
(1) Current assets Blank + $22,000
Accounts payable + $ 7,000 Blank
Expense accruals + 2,000 Blank
(2) Current liabilities Blank + $ 9,000
Change in net working capital= (1) − (2) Blank + $13,000

Powell Corporation is trying to determine the initial
investment required to replace an old machine with a new
one. The new machine costs $380,000, and an additional
$20,000 will be necessary to install it. It will be depreciated
under MACRS, using a 5-year recovery period. The old
machine was purchased 3 years ago at a cost of $240,000
and was being depreciated under MACRS, using a 5-year
recovery period. The firm can sell the old machine for
$280,000. The firm expects that a $35,000 increase in
current assets and an $18,000 increase in current liabilities
will accompany the replacement, resulting in a $17,000
($35,000 − $18,000) increase in net working capital. The
firm’s tax rate is 21%.
The only component of the initial investment calculation that
is difficult to obtain is taxes. The tax consequences of the
sale of the old machine depend on the selling price relative
to the asset’s book value. To find the book value of the old
machine, use the depreciation percentages from Table 4.2
of 20%, 32%, and 19% for years 1, 2, and 3, respectively.
The book value is the difference between the original
$240,000 purchase price and the accumulated depreciation
over the 3 years that the asset was in use. The resulting
book value is
$240, 000   (0.20  0.32  0.19)  $240, 000  $69, 600

Powell Corporation realizes a gain of $210,400
($280,000 − $69,600) on the sale. The total taxes on the
gain are $44,184 (0.21 × $210,400). Powell’s financial
analysts must subtract these taxes from the $280,000
sale price of the old machine to calculate the after-tax
proceeds from its sale.
Substituting the relevant amounts into the format in Table
11.1 results in an initial investment of $181,184, which
represents the net cash outflow required at time zero.

Installed cost of new machine Blank Blank
Cost of new machine $380,000 Blank
+ Installation costs 20,000 Blank
Total installed cost Blank $400,000
− After-tax proceeds from the sale of the old machine Blank Blank
Proceeds from the sale of the old machine $280,000 Blank
− Tax on the sale of the old machine 44,184 Blank
Total after-tax proceeds Blank 235,816
+ Change in net working capital Blank 17,000
Initial investment Blank 181,184

11.3 Finding the Operating Cash Flows
(1 of 4)
• Interpreting the Term Cash Flows

– All costs and benefits expected from a proposed project
must be measured on a cash flow basis
 Cash outflows represent costs incurred by the firm, and cash
inflows represent dollars that the firm receives and can then
spend
 Cash flows generally are not equal to accounting profits

(2 of 4)
• Interpreting the Term After-Tax

– Cash flows that result from investment projects must be
measured on an after-tax basis because the firm will not
have the use of any cash flows until it has both satisfied the
government’s tax claims and captured the government’s tax
refunds, credits, or other tax breaks
– Firms can use only the after-tax cash flows to pay returns to
lenders and shareholders, so when making investment
decisions, analysts must take care to measure incremental
cash flows after taxes

Powell Corporation’s estimates of its revenue and expenses
(excluding depreciation and interest), with and without the proposed
new machine described in Example 11.5, are given in Table 11.4.
Note that both the expected usable life of the new machine and the
remaining usable life of the old machine are 5 years. The new
machine’s depreciable value is the sum of the $380,000 purchase
price and the $20,000 installation cost. The firm calculates annual
depreciation deductions on the new machine, using the MACRS
percentages based on a 5-year recovery period. The resulting
depreciation on this machine for each of the 6 years, as well as the
remaining 3 years of depreciation (years 4, 5, and 6) on the old
machine, are calculated in Table 11.5.

The income statement format in Table 11.6 illustrates how to
calculate the operating cash flows each year. Note that we
exclude interest because we are focusing purely on the
“investment decision.” The interest is relevant to the
“financing decision,” which we will address later in this text.
Because we exclude interest expense, “earnings before
interest and taxes” (EBIT) is equivalent to “net profits before
taxes,” and the calculation of “operating cash flow” (OCF) in
Table 11.6 is identical to the definition that we provided in
Chapter 4 (defined in Equation 4.3).

Substituting the data from Tables 11.4 and 11.5 into this
format and assuming a 21% tax rate, we get Table 11.7,
which demonstrates the calculation of operating cash flows
for each year for both the new and the old machines.
Because the new machine is depreciated over 6 years, the
analysis must be performed over the 6-year period to
account for all the tax benefits of depreciation. The resulting
operating cash flows appear in the final row of Table 11.7 for
each machine. The $4,200 year-6 operating cash inflow for
the new machine results solely from the tax benefit of its
year-6 depreciation deduction.

Table 11.4 Powell Corporation’s Revenue
and Expenses (Excluding Depreciation
and Interest) for New and Old Machines
Bl
With new machine With old machine

a
nk
Expenses (excl. Expenses

Year Revenue depr. and int.) Year Revenue (excl. depr. and 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

Table 11.5 Depreciation Expense for New
and Old Machines for Powell Corporation

Table 11.6 Calculation of Operating Cash
Flows Using the Income Statement Format
Revenue
− Expenses (excluding depreciation and interest)
Earnings before interest, taxes, depreciation, and amortization (EBITDA)
− Depreciation
Earnings before interest and taxes (EBIT)
− Taxes (rate = T)
Net operating profit after taxes [NOPAT = EBIT × (1 − T)]
+ Depreciation
Operating cash flows (OCF) (same as OCF in Equation 4.3)

Table 11.7 Calculation of Operating Cash Flows for
Powell Corporation’s New and Old Machines (1 of 2)

Table 11.7 Calculation of Operating Cash Flows for
Powell Corporation’s New and Old Machines (2 of 2)

(4 of 4)
• Interpreting the Term Incremental

– The final step in estimating the net operating cash flows for
a proposed replacement project is to calculate the
incremental cash flows
– The differences in cash flows that occur with the new
machines compared to cash flows that occurred with the old
machine are incremental cash flows

Table 11.8 Operating Cash Flows for
Powell Corporation
blank Operating cash flows
Year New machinea Old machinea Net OCF
1 $190,600 $171,948 $190,600 − $171,948 = $18,652
2 200,680 156,148 $200,680 − $156,148 = $44,532
3 189,760 136,820 $189,760 − $136,820 = $52,940
4 183,880 118,500 $183,880 − $118,500 = $65,380
5 183,880 102,700 $183,880 − $102,700 = $81,180
6 4,200 0 $ 4,200 − $ 0 = $ 4,200

aFrom final row for respective machine in Table 11.7.

11.4 Finding the Terminal Cash Flow
(1 of 6)
• A project’s terminal cash flow is the cash flow resulting

from termination and liquidation of a project at the end of
its economic life
• It represents the after-tax cash flow, exclusive of operating
cash flows, that occurs in the final year of the project
– For replacement projects, analysts must take into account
the proceeds from both the new asset and the old asset
– The proceeds from the sale of the new and the old asset,
often called “salvage value,” represent the amount net of
any removal costs expected on termination of the project
– For expansion types of investment projects, the proceeds
from the old asset are zero
(2 of 6)
• Regardless of the project type, a change in new working

capital often takes place at the end of a project life, so this
incremental cash flow, too, must be included in the
terminal cash flow

Table 11.9 The Basic Format for
Determining Terminal Cash Flow
(1) After-tax proceeds from the sale of the new asset =
Blank
Proceeds from the sale of the new asset

Bl
± Tax on the sale of the new asset

an
k
(2) After-tax proceeds from the sale of the old asset =

Blank
Proceeds from the sale of the old asset

Blan
k
± Tax on the sale of the old asset

(3) Change in net working capital
Bl
Terminal cash flow = (1) − (2) ± (3)

an
k

(5 of 6)

– When we calculated the initial investment, we took into
account any change in net working capital that is attributable
to the new asset
– Now, when we calculate the terminal cash flow, the change
in net working capital represents the reversion of any initial
net working capital investment
– Most often, this will show up as a cash inflow due to the
reduction in net working capital; with termination of the
project, the need for the increased net working capital
investment usually ends

(6 of 6)

– As long as no changes in working capital occur after the
initial investment, the amount recovered at termination will
equal the amount shown in the calculation of the initial
investment
– If working capital changes year to year as a firm expands or
contracts operations, then those changes should be
incorporated into the yearly operating cash flows
– Changes to working capital by themselves do not trigger
incremental taxes, so there are no tax consequences to
consider

Continuing with the Powell Corporation example, assume
that the firm expects to liquidate the new machine at the end
of its 5-year usable life, to net $50,000 after paying removal
and cleanup costs. Had the new machine not replaced the
old machine, the old machine would have been liquidated
after 5 years to net $10,000. The firm expects to recover its
$17,000 net working capital investment upon termination of
the project. The firm pays taxes at a rate of 21%.

From the analysis of the operating cash flows presented
earlier, we can see that the new machine will have a book
value of $20,000 (equal to the year-6 depreciation) after 5
years. The old machine would have been fully depreciated
and therefore would have a book value of zero after 5 years.
Because the sale price of $50,000 for the new machine is
below its initial installed cost of $400,000, but greater than its
book value of $20,000, the firm will pay taxes only on the
recaptured depreciation of $30,000 ($50,000 sale proceeds
− $20,000 book value). Applying the ordinary tax rate of 21%
to this $30,000 results in a tax of $6,300 (0.21 × $30,000) on
the sale of the new machine.

Its after-tax sale proceeds would therefore equal $43,700
($50,000 sale proceeds − $6,300 taxes). Because the old
machine would have been sold for $10,000 at termination,
which is less than its original purchase price of $240,000 and
above its book value of zero, it would have experienced a
taxable gain of $10,000 ($10,000 sale price − $0 book value).
Applying the 21% tax rate to the $10,000 gain, the firm would
have owed a tax of $2,100 (0.21 × $10,000) on the sale of
the old machine at the end of year 5. The firm’s after-tax sale
proceeds from the old machine would have equalled $7,900
($10,000 sale price − $2,100 taxes). Substituting the
appropriate values into the format in Table 11.9 results in the
terminal cash inflow of $52,800.
After-tax proceeds from the sale of the new machine Blank Blank
Proceeds from the sale of the new machine $50,000 Blank
− Tax on sale of the new machine 6,300 Blank
Total after-tax proceeds: new machine Blank $43,700
− After-tax proceeds from the sale of the old machine Blank Blank
Proceeds from the sale of the old machine $10,000 Blank
− Tax on the sale of the old machine 2,100 Blank
Total after-tax proceeds: old machine Blank 7,900
+ Change in net working capital Blank 17,000
Terminal cash flow Blank $52,800

11.5 Summarizing the Net Cash Flows
• The initial investment, operating cash flows, and terminal
cash flow together represent a project’s net cash flows
• We can view these cash flows as the net after-tax cash
flows attributable to the proposed project
• They represent, in a cash flow sense, how much better or
worse off the firm will be if it chooses to implement the
proposal
• With the cash flow estimates in hand, a financial manager
could then calculate the investment’s NPV or IRR using
the techniques covered in Chapter 10

Example 11.9
Below we depict the relevant net cash flows for Powell
Corporation’s proposed replacement project on a timeline.
Note that because Powell plans to sell the new asset at the
end of its 5-year usable life, the $4,200 year-6 operating cash
inflow calculated in Table 11.8 has no relevance; the terminal
cash flow effectively replaces this value in the analysis.

Review of Learning Goals (1 of 6)
• LG 1
– Discuss net and incremental cash flows, and describe the
three major types of net cash flows.
 A project’s net cash flows are the net (or the sum of)
incremental after-tax cash flows over a project’s life
 The incremental cash flows represent the additional after-tax
cash flows—outflows or inflows—that will occur only if the
investment is made
 The three major net cash flow types of any project include (1)
an initial investment, (2) operating cash flows, and (3) terminal
cash flow
 The initial investment occurs at time zero, the operating cash
flows occur during the project’s life, and the terminal cash flow
occurs at the end of the project
• LG 2
– Discuss replacement versus expansion decisions, sunk
costs and opportunity costs, and international capital
budgeting.
 For replacement decisions, the differences between the cash
flows of the new asset and the old asset are incremental cash
flows
 Expansion decisions are viewed as replacement decisions in
which all cash flows from the old asset are zero
 When estimating relevant cash flows, ignore sunk costs and
include opportunity costs as cash outflows
 In international capital budgeting, currency risks and political
risks can be minimized through careful planning

• LG 3
– Calculate the initial investment associated with a proposed
investment project.
 The initial investment is the initial cash flow required, taking into
account the installed cost of the new asset, the after-tax proceeds
from the sale of the old asset, and any change in net working capital
 The after-tax proceeds from the sale of the old asset reduce the initial
investment required to launch an investment project
 Taxes on the sale of the old asset depend on the selling price relative
to the asset’s book value
 A gain or a loss can result from the sale of an asset, depending on
whether the asset sells for (1) more than book value, (2) book value,
or (3) less than book value
 The change in net working capital is the difference between the
change in current assets and the change in current liabilities expected
to accompany a given investment decision
• LG 4
– Discuss the tax implications associated with the sale of an
old asset.
 There is typically a tax implication from the sale of an old asset
 The tax implication depends on the relationship between its
sale price and book value and on existing government tax
rules
 Generally, if the old asset sells for more than its book value,
the difference is subject to a capital gains tax, and if the old
asset sells for less than its book value, the company is entitled
to a tax deduction equal to the difference

• LG 5
– Find the operating cash flows associated with a proposed
investment project.
 The operating cash flows are the sum of incremental after-tax
cash flows occurring each period during the project’s life
 The income statement format adds depreciation back to net
operating profit after taxes to calculate an investment’s annual
operating cash inflows
 The net cash flows for a replacement project are the difference
between the operating cash flows of the new project and those
of the old project

• LG 6
– Determine the terminal cash flow associated with a
proposed investment project.
 The terminal cash flow represents the after-tax cash flow
(exclusive of operating cash inflows) that is expected from
liquidation of a project
 It is calculated for replacement projects by finding the
difference between the after-tax proceeds from the sale of the
new and the old asset at termination and then adjusting this
difference for any change in net working capital
 Sale price and depreciation data are used to find the taxes and
the after-tax sale proceeds on the new and old assets
 The change in net working capital typically represents the
reversion of any initial net working capital investment

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Principles of Managerial Finance

Fifteenth Edition, Global Edition

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• Saturn was developed by GM as a separate brand and

• Capital spending for the project ~ $ 6 billion

• In 1994 sales began to drop and was attributed to several factors:

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

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$240, 000   (0.20  0.32  0.19)  $240, 000  $69, 600

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Cost of new machine $380,000 Blank

+ Installation costs 20,000 Blank

Total installed cost Blank $400,000

Proceeds from the sale of the old machine $280,000 Blank

− Tax on the sale of the old machine 44,184 Blank

Total after-tax proceeds Blank 235,816

+ Change in net working capital Blank 17,000

Initial investment Blank 181,184

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• Interpreting the Term Cash Flows

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• Interpreting the Term After-Tax

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With new machine With old machine

Expenses (excl. Expenses

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• Interpreting the Term Incremental

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Year New machinea Old machinea Net OCF

1 $190,600 $171,948 $190,600 − $171,948 = $18,652

2 200,680 156,148 $200,680 − $156,148 = $44,532

3 189,760 136,820 $189,760 − $136,820 = $52,940

4 183,880 118,500 $183,880 − $118,500 = $65,380

5 183,880 102,700 $183,880 − $102,700 = $81,180

6 4,200 0 $ 4,200 − $ 0 = $ 4,200

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• A project’s terminal cash flow is the cash flow resulting

• Regardless of the project type, a change in new working

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Proceeds from the sale of the new asset

± Tax on the sale of the new asset

(2) After-tax proceeds from the sale of the old asset =

Proceeds from the sale of the old asset

± Tax on the sale of the old asset

Terminal cash flow = (1) − (2) ± (3)

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