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Capital

Capital Budgeting
Budgeting
&
&
Estimating
Estimating Cash
Cash Flows
Flows

What
What is
is Capital
Capital Budgeting?
Budgeting?
Investment is made on
Assets/Resource

Long term asset/Fixed


Asset/capital

Current asset/short
term Asset

capital budgeting =long-term investment decision i.e. making capital


expenditure.
The expenditure on fixed asset such as land and building, furniture and
fixtures, plant and machinery etc. is called capital expenditure.
The life of these fixed assets is more than one year.
So, capital budgeting decision is concerned with long-term planning.

The
The Capital
Capital Budgeting
Budgeting Process
Process
Step 1

Generating Ideas

Generate ideas from inside or outside of the company

Step 2

Analyzing Individual Proposals

Collect information
Estimate after-tax incremental operating cash flows for the
investment projects.
Select projects based on a value-maximizing acceptance criterion.

Step 3

Planning the Capital Budget

Analyze the fit of the proposed projects with the companys strategy

Step 4

Monitoring and Post Auditing

Compare expected and realized results and explain any deviations

Classifying projects
Replacement
Projects

Expansion
Projects

Regulatory,
Safety, and
Environmental
Projects

New Products
and Services

Other

Copyright 2013 CFA Institute

3. Basic principles of Capital


Budgeting
Decisions are
based on cash
flows.

The timing of
cash flows is
crucial.

Cash flows are


incremental.

Cash flows are


on an after-tax
basis.

Financing costs
are ignored.
Copyright 2013 CFA Institute

The
The Capital
Capital Budgeting
Budgeting Common
Common Terms
Terms

The
The Capital
Capital Budgeting
Budgeting calculation
calculation of
of cash
cash flow
flow

The
The Capital
Capital Budgeting
Budgeting Major
Major cash
cash flow
flow
component
component
The goal is to estimate the incremental cash flows of the
firm for each year in the projects useful life.
0

Investment
Outlay

After-Tax
Operating
Cash Flow

After-Tax
Operating
Cash Flow

After-Tax
Operating
Cash Flow

After-Tax
Operating
Cash Flow

After-Tax
Operating
Cash Flow
+
Terminal
Nonoperatin
g Cash Flow

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of cash
cash flow
flow
Costs: include or exclude?
A sunk cost is a cost that has already occurred, so it cannot be part
of the incremental cash flows of a capital budgeting analysis.
An opportunity cost is what would be earned on the next-best use
of the assets.
An incremental cash flow is the difference in a companys cash
flows with and without the project.
An externality is an effect that the investment project has on
something else, whether inside or outside of the company.
Cannibalization is an externality in which the investment
reduces cash flows elsewhere in the company (e.g., takes sales
from an existing company project).

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of cash
cash flow
flow

Ignore sunk costs


Include opportunity costs
Include project-driven changes in
working capital net of spontaneous
changes in current liabilities
Include effects of inflation

Tax Considerations
and Depreciation
Depreciation is a noncash expense.
Depreciation will not be considered
in the cash flow calculation.

Generally, profitable firms prefer to


use an accelerated method for tax
reporting purposes (MACRS)(page
117)

Depreciation and
the MACRS Method
Everything else equal, the greater the
depreciation charges, the lower the
taxes paid by the firm.
Assets are depreciated (MACRS) on
one of eight different property
classes.

MACRS Sample
Schedule
Recovery
Year
1
2
3
4
5
6
7
8

Property Class
3-Year
5-Year
33.33%
20.00%
44.45
32.00
14.81
19.20
7.41
11.52
11.52
5.76

7-Year
14.29%
24.49
17.49
12.49
8.93
8.92
8.93
4.46

Depreciable Basis
In tax accounting, the fully installed
cost of an asset. This is the amount
that, by law, may be written off over
time for tax purposes.
Depreciable Basis =
Cost of Asset + Capitalized
Expenditures
Shipping and
installation

Sale or Disposal of
a Depreciable
Asset

Generally, the sale of a capital


asset (as defined by the IRS)
generates a capital gain (asset sells
for more than book value) or capital
loss (asset sells for less than book
value).

Calculating the
Incremental Cash
Flows
Initial cash outflow -- the initial net
cash investment.
Interim incremental net cash flows -those net cash flows occurring after
the initial cash investment but not
including the final periods cash flow.
Terminal-year incremental net cash
flows -- the final periods net cash
flow.

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Initial
Initial Investment
Investment
cash
cash out
out flow/
flow/ Initial
Initial Project
Project cost
cost

Installed cost=
New asset purchase price
(+) Capitalized expenditure/ shipping,
installation cost.

(-) After tax proceed from sale of old


asset
Proceeds from sale of old asset(s) if
replacement
(-) tax on sale of old asset

() change in NWC
= Initial cash outflow

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Initial
Initial Investment
Investment
cash
cash out
out flow/
flow/ Initial
Initial Project
Project cost
cost

() change in NWC
Example-11.4 -436 page

Example of an Asset Expansion Project without


replacement

Basket Wonders (BW) is considering the


purchase of a new basket weaving machine.
The machine will cost $50,000 plus $20,000
for shipping and installation and falls under
the 3-year MACRS class. NWC will rise by
$5,000. Lisa Miller forecasts that revenues will
increase by $110,000 for each of the next 4
years and will then be sold (scrapped) for
$10,000 at the end of the fourth year, when
the project ends. Operating costs will rise by
$70,000 for each of the next four years. BW is
in the 40% tax bracket.

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Initial
Initial Investment
Investment
cash
cash out
out flow/
flow/ Initial
Initial Project
Project cost
cost

Installed cost

-70000
New asset purchase price = -$50,000
(+) Capitalized expenditure/ = -$20000
shipping, installation cost.

5000

() change in NWC= Initial cash outflow


= -75000

Example of an Asset Expansion Project with


replacement
New machine

Basket Wonders (BW) is considering the purchase of a


new basket weaving machine. The machine will cost
$50,000 plus $20,000 for shipping and installation and
falls under the 3-year MACRS class. NWC will rise by
$5,000. Lisa Miller forecasts that revenues will increase
by
Old machine

The original basis of the machine was $30,000 and


depreciated using straight-line over five years ($6,000
per year). BW can sell the current machine for $6,000.
NWC will rise to $10,000 from $5,000 (old). next four years.
BW is in the 40% tax bracket.

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Initial
Initial Investment
Investment
cash
cash out
out flow/
flow/ Initial
Initial Project
Project cost
cost

Installed cost

= -70000

New asset purchase price = -$50,000


(+) Capitalized expenditure/ = -$20000
shipping, installation cost.
(-) After tax proceed from =3600
sale of old asset
Proceeds from sale of old = $6000
asset(s) if replacement
(-) tax on sale of old asset = -$2400

() change in NWC=- 5000


Initial cash outflow
= -71400

The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Operating
Operating Cash
Cash
Flow
Flow

Those net cash flows occurring after


the initial cash investment but not
including the final periods cash flow.
Incremental and
After tax
Interest expense will not be included
here.

a)
b)
c)
d)
e)
f)

Incremental Cash
Flows
Net increase in revenue
- Net increase in expenses (excluding
depreciation and interest)
= EBDIT
- Net incr in depreciation
=
EBIT
- Net incr. in tax
Operating profit after tax
+
Net incr in depreciation
[[

g)

= Incremental net operating cash flow


for period

Example of an Asset
Expansion Project
Basket Wonders (BW) is considering the
purchase of a new basket weaving machine.
The machine will cost $50,000 plus $20,000
for shipping and installation and falls under
the 3-year MACRS class. NWC will rise by
$5,000.
Lisa Miller forecasts that

revenues will increase by $110,000 for


each of the next 4 years. Operating
costs will rise by $70,000 for each of the
next four years. BW is in the 40% tax
bracket. then be sold (scrapped) for

Incremental Cash
Flows
Year 1
a)
$40,000
$40,000
b)
23,331
5,187
c)
= $16,669
$34,813
d)
6,668
13,925
e)
= $10,001
$20,888

Year 2
$40,000

Year 3
Year 4
$40,000

31,115

10,367

$ 8,885

$29,633

3,554

11,853

$ 5,331

$17,780

a)
b)
c)
d)
e)

Terminal-Year
Incremental Cash
Flows

Calculate the incremental net cash


flow for the terminal period
+ (-) Salvage value (disposal/reclamation
costs) of any sold or disposed assets
- (+) Taxes (tax savings) due to asset sale
or disposal of new assets
+ (-) Decreased (increased) level of net
working capital
= Terminal year incremental net cash flow

Example of an Asset
Expansion Project
Basket Wonders (BW) is considering the
purchase of a new basket weaving machine.
The machine will cost $50,000 plus $20,000
for shipping and installation and falls under
the 3-year MACRS class. NWC will rise by
$5,000.
Lisa Miller forecasts that

revenues will increase by $110,000 for


each of the next 4 years. Operating
costs will rise by $70,000 for each of the
next four years. BW is in the 40% tax
bracket. then be sold (scrapped) for

Terminal-Year
Incremental Cash
Flows

a)
b)
c)

+
-

d)
e)

+
=

$26,075 The incremental cash flow


from the previous slide in
Year 4.
10,000 Salvage Value.
4,000 .40*($10,000 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
5,000 NWC - Project ends.
$37,075 Terminal-year incremental
cash flow.

Summary of Project
Net Cash Flows
Asset Expansion
Year 0 Year 1
Year 2
Year 3
Year 4
-$75,000* $33,332 $36,446
$28,147
$37,075

* Notice again that this value is a


negative cash flow as we calculated it
as the initial cash OUTFLOW in slide 1218.

Example of an Asset
Replacement Project
Let us assume that previous asset expansion
project is actually an asset replacement project.
The original basis of the machine was $30,000
and depreciated using straight-line over five
years ($6,000 per year). The machine has two
years of depreciation and four years of useful
life remain-ing. BW can sell the current machine
for $6,000. The new machine will not increase
revenues (remain at $110,000) but it decreases
operating expenses by $10,000 per year (old =
$80,000). NWC will rise to $10,000 from $5,000
(old).

Initial Cash Outflow


a)
b)
c)
d)
e)
f)

$50,000
+
20,000
+
5,000
6,000 (sale of old asset)
2,400 <---(tax savings from
= $66,600
loss on sale of
old asset)

Calculation of the
Change in Depreciation
Year 1
a)
$23,331
5,187
b)
6,000
0
c)
= $17,331
5,187

Year 2
$31,115

Year 3
Year 4
$10,367
$

6,000

$25,115

$10,367

a) Represent the depreciation on the new


project.
b) Represent the remaining depreciation on
the old project.

Incremental Cash
Flows
Year 1
Year 2
Year 3
Year 4
a)
$10,000 $10,000 $10,000
$10,000
b)
17,331
25,115
10,367
5,187
c)
=
$ -7,331 -$15,115 $ -367 $
4,813
d)
-2,932
-6,046
-147
1,925
e)
= $ -4,399 $ -9,069 $ -220 $
2,888

a)
b)
c)
d)
e)

Terminal-Year
Incremental Cash
Flows

$ 8,075 The incremental cash flow


from the previous slide in
Year 4.
+ 10,000 Salvage Value.
4,000 (.40)*($10,000 - 0). Note, the
asset is fully depreciated at
the end of Year 4.
+
5,000 Return of added NWC.
= $19,075 Terminal-year incremental
cash flow.

Summary of Project
Net Cash Flows
Asset Expansion
Year 0 Year 1
Year 2
Year 3
Year 4
-$75,000 $33,332 $36,446
$28,147
$37,075

Asset Replacement
Year 0 Year 1
Year 2
Year 3
Year 4
-$66,600 $12,933 $16,046
$10,147
$19,075