Capital Budgeting: Cash Flows and Techniques

Lecture Note Part 1

By

Abdullah Al Masud
Lecturer
Southeast Business School
Southeast University
Capital Budgeting: Introduction
Long-term investments represent sizable outlays of funds that commit a firm to some course of action.
Consequently, the firm needs procedures to analyze and select its long-term investments. Capital
budgeting is the process of evaluating and selecting long-term investments that are consistent with the
firm’s goal of maximizing owners’ wealth. Firms typically make a variety of long-term investments, but
the most common is in fixed assets, which include property (land), plant, and equipment. These assets,
often referred to as earning assets, generally provide the basis for the firm’s earning power and value.

A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period
of time greater than 1 year. Fixed-asset outlays are capital expenditures, but not all capital expenditures
are classified as fixed assets. A $60,000 outlay for a new machine with a usable life of 15 years is a
capital expenditure that would appear as a fixed asset on the firm’s balance sheet. A $60,000 outlay for
an advertising campaign that is expected to produce benefits over a long period is also a capital
expenditure, but it would rarely be shown as a fixed asset. Companies make capital expenditures for
many reasons. The primary motives for capital expenditures are to expand operations, to replace or
renew fixed assets, and to obtain some other, less tangible benefit over a long period.

An operating expenditure is an outlay resulting in benefits received within 1 year. Operating

expenditure is mainly done for purchase of raw materials, rent and utilities, wages and salaries,
accounting and legal fees, overhead costs such as selling, general, & administrative expense

Steps in the Capital Budgeting Process

The capital budgeting process consists of five distinct but interrelated steps:

1. Proposal generation: Proposals for new investment projects are made at all levels within a business
organization and are reviewed by finance personnel. Proposals that require large outlays are more
carefully scrutinized than less costly ones.

2. Review and analysis: Financial managers perform formal review and analysis to assess the merits of
investment proposals.

3. Decision making: Firms typically delegate capital expenditure decision making on the basis of dollar
limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often,
plant managers are given authority to make decisions necessary to keep the production line moving.

4. Implementation: Following approval, expenditures are made and projects implemented. Expenditures
for a large project often occur in phases.

5. Follow-up: Results are monitored, and actual costs and benefits are compared with those that were
expected. Action may be required if actual outcomes differ from projected ones.

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)

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
proposals 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 sophisticated in their
approach to capital budgeting.

Independent versus Mutually Exclusive Projects

Most investments can be placed into one of two categories: (1) independent projects or (2) mutually
exclusive projects. Independent projects are those with cash flows that are unrelated to (or
independent of) one another; the acceptance of one project does not eliminate the others from further
consideration. Mutually exclusive projects are those that have the same function and therefore
compete with one another. The acceptance of one eliminates from further consideration all other
projects that serve a similar function. For example, a firm in need of increased production capacity could
obtain it by (1) expanding its plant, (2) acquiring another company, or (3) contracting with another
company for production. Clearly, accepting any one option eliminates the immediate need for either of
the others.

Conventional Cash Flow (CF) Project

A conventional cash flow for a project or investment is typically structured as an initial outlay or outflow,
followed by a number of inflows over a period of time. In terms of mathematical notation, this would be
shown as -, +, +, +, +, +, denoting an initial outflow at time period 0, and inflows over the next five
periods.

Nonconventional Cash Flow Project

Non-conventional cash flow project is a project in which there are series of outflow and inflows over
time, i.e. in which there is more than one change in the cash flow direction. This contrasts with a
conventional cash flow, where there is only one change in cash flow direction. In terms of mathematical
notation - where the - sign represents an outflow and + denotes an inflow - an unconventional cash flow
would appear as -, +, +, +, -, + or alternatively +, -, -, +, -.

Capital Budgeting Cash Flows

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.
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 investment’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 dimension.

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 forecasted 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 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 without the new investment and where all relevant
costs and benefits are brought into play. Only incremental cash flows matter.

In this regard, sunk costs [Sunk Cost: Unrecoverable past outlays that, as they cannot be recovered,
should not affect present actions or future decisions] must be ignored. Our concern lies with
incremental costs and benefits. Unrecoverable past costs are irrelevant and should not enter into the
decision process. Also, we must be mindful that certain relevant costs do not necessarily involve an
actual dollar outlay. For Example: Green Metro, Inc. is a company interested in public transportation
projects in developing countries. The company recently completed a traffic modelling study of a South
Asian city at a cost of $5 million, which unveiled some attractive investment areas for the company to
consider. Here, traffic modelling study cost should not be included in the net investment outlay because
it is a sunk cost. The study was conducted before taking any investment decision and it doesn’t affect
any future cash flows of the project.

If we have allocated plant space to a project and this space can be used for something else, its
opportunity cost [Opportunity Cost: What is lost by not taking the next-best investment alternative]
must be included in the project’s evaluation. For example: If a currently unused building needed for a
project can be sold for $300,000, that amount (net of any taxes) should be treated as if it were a cash
outlay at the outset of the project. Thus, in deriving cash flows, we need to consider any appropriate
opportunity costs.

When a capital investment contains a current asset component, this component (net of any
spontaneous changes in current liabilities) is treated as part of the capital investment and not 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 additional 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.

The figure below summarizes the major concerns to keep in mind as we prepare to actually determine
project “after-tax incremental operating cash flows.” It provides us with a “checklist” for determining
cash-flow estimates.

Figure 1 Cash Flow Checklist

Major Cash Flow Components

The cash flows of any project may include three basic components: (1) an initial investment, (2)
operating cash flows (which may be inflows or outflows), and (3) terminal cash flow. All projects—
whether for expansion, replacement or renewal, or some other purpose—have the first two
components. Some, however, lack the final component, terminal cash flow.

1. Initial investment: The relevant cash outflow for a proposed project at time zero.
2. Operating cash inflows: The incremental after-tax cash inflows resulting from implementation
of a project during its life.
3. Terminal cash flow: The after-tax non-operating cash flow occurring in the final year of a
project. It is usually attributable to liquidation of the project.
Figure 2 Time Line for Major Cash Flow Components

The initial investment for the proposed project is $50,000, the relevant cash outflow at time zero. The
operating cash flows, which are the net incremental after-tax cash inflows and outflows resulting from
implementation of the project during its life, gradually increase from $4,000 in its first year to $10,000 in
its tenth and final year. For the project depicted in the Figure 2, the net operating cash flows are all
positive, but that is not necessarily the case for every investment opportunity. The terminal cash flow is
the after-tax non-operating cash flow occurring in the final year of the project. It is usually attributable
to liquidation of the project. In this case, it is $25,000, received at the end of the project’s 10-year life.
Note that the terminal cash flow does not include the $10,000 operating cash inflow for year 10.

Capitalized Expenditure

Capitalized Expenditures are expenditures that may provide benefits into the future and therefore are
treated as capital outlays and not as expenses of the period in which they were incurred.

Capital Budgeting Cash Flow Estimation for Replacement Projects

Finding the Initial Investment

The term initial investment as used here refers to the relevant cash outflows to be considered when
evaluating a prospective capital expenditure. Our discussion of capital budgeting will focus on projects
with initial investments that occur at time zero, the time at which the expenditure is made. The initial
investment is calculated by subtracting all cash inflows occurring at time zero from all cash outflows
occurring at time zero.

The cash flows that must be considered when determining the initial investment associated with a
capital expenditure are the installed cost of the new asset, the after-tax proceeds (if any) from the sale
of an old asset, and the change (if any) in net working capital. Note that if there are no installation costs
and the firm is not replacing an existing asset, the cost (purchase price) of the new asset, adjusted for
any change in net working capital, is equal to the initial investment.

Installed Cost of New Asset

The installed cost of new asset, calculated by adding the cost of new asset to its installation costs, equals
its depreciable value.

After-Tax Proceeds from Sale Of Old Asset

The after-tax proceeds from sale of old asset decrease the firm’s initial investment in the new asset.
These proceeds are the difference between the old asset’s sale proceeds and any applicable taxes or tax
refunds related to its sale. The proceeds from sale of old asset are the net cash inflows it provides.

This amount is net of any costs incurred in the process of removing the asset. Included in these removal
costs are cleanup costs, such as those related to removal and disposal of chemical and nuclear wastes.
These costs may not be trivial, and in some cases they may outweigh any sale proceeds received from
the old asset. In other words, the net proceeds from selling or disposing of the old asset may be positive
or negative.

The proceeds from the sale of an old asset are normally subject to some type of tax. This tax on sale of
old asset depends on the relationship between its sale price and book value and on existing government
tax rules.

Book Value

The book value of an asset is its strict accounting value. It can be calculated by the equation.

Book value = Historical Installed cost of asset - Accumulated depreciation

The sale of the asset for more than its book value: The capital gain is the portion of the sale price that is
greater than book value. All gains above book value are taxed as ordinary income.

Loss on sale of asset (Amount by which sale price is less than book value): if tax rate is 40%, 40% of loss
is a tax savings

The sale of the asset for its book value: No tax results from selling an asset for its book
value; so there is no tax effect on the initial investment in the new asset

Finding the Incremental Operating Cash Inflows

In case of replacement projects, cash flow estimation requires incremental (or additional) cash flows
coming from new projects to be included only, not the whole cash flows coming from new projects.

Finding Terminal Cash Flows

Calculation of terminal cash flow is almost same as expansion projects except in any possible salvage
value derived from old asset will be deducted as opportunity cost.
Initial Investment

Operating Cash Flow

Incremental Operating Cash Inflow For Replacement projects

Terminal Incremental Cash Flow

Practice Example 1

Example: Replacement Project

A machine currently in use was originally purchased 2 years ago for $40,000. The machine is being
depreciated under SLM using a 5-year recovery period; it has 3 years of usable life remaining. The
current machine can be sold today to net $42,000 after removal and cleanup costs. A new machine can
be purchased at a price of $140,000. It requires $10,000 to install and has a 3-year usable life. If the new
machine is acquired, the investment in accounts receivable will be expected to rise by $10,000, the
inventory investment will increase by $25,000, and accounts payable will increase by $15,000. Earnings
before depreciation, interest, and taxes are expected to be $70,000 for each of the next 3 years with the
old machine and to be $120,000 in the first year and $130,000 in the second and third years with the
new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new
machine could be sold to net $35,000 before taxes. The firm is subject to a 40% tax rate.
a. Determine the initial investment associated with the proposed replacement decision.

b. Calculate the incremental operating cash flows for years 1 to 3 associated with the proposed
replacement.

c. Calculate the terminal cash flow associated with the proposed replacement decision.

d. Depict on a time line the relevant cash flows found in parts a, b, and c that are associated with the
proposed replacement decision, assuming that it is terminated at the end of year 3.

Solution

a)

T-0
Cost of New Assets (140,000)
+ Capitalized Expenditure (10,000)
+ (-) Increase in Net Working Capital (20,000)
- Net Proceeds from Sale of Old Asset 42,000
+ (-) Tax expense (savings) due to sale of old asset (7,200)
Initial Investment (135,200)

Rough Works

Increase in Net Working Capital= Increase in Current Assets – Increase in Current Liabilities

= 10,000+25,000 -15,000= 20,000

Annual Depreciation for Old Asset = 40,000/5= 8,000

Historical Cost of Old Asset = 40,000

(-) Accumulated Depreciation (8,000*2)= 16,000

Book value of old asset = 24,000

Capital gain on old asset= Sale price- book value of old asset= 42,000-24,000= 18,000

Tax on Sale of Old Asset= Capital gain on old asset * tax rate= 18,000*40%= 7,200

Rough works
 Y-1 Y-2 Y-3
EBDIT: New 120,000 130,000 130,000
(-) EBDIT: Old (70,000) (70,000) (70,000)
Incremental EBDIT 50,000 60,000 60,000

Depreciable basis for New Asset= Cost of New Asset + Capitalized Expenditure = 140000+10000=
150,000

Annual Depreciation for New Asset= 150,000/3 = 50,000

Y-1 Y-2 Y-3

Depreciation: New 50,000 50,000 50,000
(-) Depreciation: Old (8000) (8000) (8000)
Incremental 42,000 42,000 42,000
Depreciation

Incremental Operating Cash Flow

Y-1 Y-2 Y-3

Incremental EBDIT 50,000 60,000 60,000
(-) Incremental Depreciation (42,000) (42,000) (42,000)
Incremental EBIT 8,000 18,000 18,000
(-) + Tax Expense (Tax Savings) @40% (3,200) (7,200) (7,200)
(+) Add back Incremental Depreciation 42,000 42,000 42,000
Incremental Operating Cash Flows 46,800 52,800 52,800

Terminal Cash Flows

Y-3
Salvage value of new asset 35,000
(-) Tax (40%) (14,000)
+ (-) Decrease (Increase) In Net Working Capital 20,000
Terminal Cash Flow 41,000

Summary (Relevant) Cash Flow

Y-0 Y-1 Y-2 Y-3

Initial Investment (135,200)
Incremental Operating Cash Inflows 46,800 52,800 52,800
Terminal Cash Flow 41,000
Relevant Cash Flows (135,200) 46,800 52,800 93,800
Practice Math 2: Replacement Project Cash Flow Calculation

Irvin Enterprises is considering the purchase of a new piece of equipment to replace the current
equipment. The new equipment costs $75,000 and requires $5,000 in installation costs. It will be
depreciated under SLM having a 5-year usable life. The old piece of equipment was purchased 4 years
ago for an installed cost of $50,000; it was being depreciated under SLM having a 5-year usable life. The
old equipment can be sold today for $55,000 net of any removal or cleanup costs. As a result of the
proposed replacement, the firm’s investment in net working capital is expected to increase by $15,000.
The firm pays taxes at a rate of 40%.

Calculate Initial Investment.

Solution:

Annual Depreciation for Old Asset = 50,000/5= 10,000

Historical Cost of Old Asset = 50,000

(-) Accumulated Depreciation(10,000*4)= 40,000

Book value of old asset = 10,000

Capital gain on old asset= Sale price- book value of old asset= 55,000-10,000= 45,000

Tax on Sale of Old Asset= Capital gain on old asset * tax rate= 45,000*40%= 18,000

Practice Math 3: Replacement Project

Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the
existing grinder. The existing grinder was purchased 2 years ago at an installed cost of $60,000; it was
being depreciated under straight line method (SLM) using a 5-year maturity period. The existing grinder
is expected to have a usable life of 3 more years. The new grinder costs $105,000 and requires $5,000 in
installation costs; it has a 5-year usable life and would be depreciated under (SLM) using a 5-year
recovery period. Lombard can currently sell the existing grinder for $70,000 without incurring any
removal or cleanup costs. To support the increased business resulting from purchase of the new grinder,
accounts receivable would increase by $40,000, inventories by $30,000, and accounts payable by
$58,000. At the end of 5 years, the existing grinder would have a market value of zero; the new grinder
would be sold to net $29,000 after removal and cleanup costs and before taxes. The firm is subject to a
40% tax rate. The estimated earnings before depreciation, interest, and taxes over the 5 years for both
the new and the existing grinder are shown in the following table.
a. Calculate the initial investment associated with the replacement of the existing grinder by the new
one.
b. Determine the incremental operating cash flows associated with the proposed grinder replacement.
c. Determine the terminal cash flow expected at the end of year 5 from the proposed grinder
replacement.
d. Depict on a time line the relevant cash flows associated with the proposed grinder replacement
decision.

Practice Math 4: Replacement Project

Holliday Manufacturing is considering the replacement of an existing machine. The new machine costs
$1,200,000 and requires installation costs of $150,000. The existing machine can be sold currently for
$185,000 before taxes. It is 2 years old, cost $800,000 new and a remaining useful life of 5 years. It was
being depreciated under SLM using a 7 year maturity. If it is held for 5 more years, the machine’s market
value at the end of year 5 will be $0. Over its 5-year life, the new machine should increase EBDIT by
$350,000 per year. The new machine will be depreciated under SLM using a 5-year maturity period. The
new machine can be sold for $200,000 net of removal and cleanup costs at the end of 5 years. An
increased investment in net working capital of $25,000 will be needed to support operations if the new
machine is acquired. Assume that the firm has adequate operating income against which to deduct any
loss experienced on the sale of the existing machine. The firm has a 9% cost of capital and is subject to a
40% tax rate.

a. Develop the relevant cash flows needed to analyze the proposed replacement.

b. Determine the net present value (NPV) of the proposal.

c. Determine the internal rate of return (IRR) of the proposal.

d. Make a recommendation to accept or reject the replacement proposal, and justify your answer.