Capital Budgeting
Budgeting
&
&
Estimating
Estimating Cash
Cash Flows
Flows
What
What is
is Capital
Capital Budgeting?
Budgeting?
Investment is made on
Assets/Resource
Current asset/short
term Asset
The
The Capital
Capital Budgeting
Budgeting Process
Process
Step 1
Generating Ideas
Step 2
Collect information
Estimate aftertax incremental operating cash flows for the
investment projects.
Select projects based on a valuemaximizing acceptance criterion.
Step 3
Analyze the fit of the proposed projects with the companys strategy
Step 4
Classifying projects
Replacement
Projects
Expansion
Projects
Regulatory,
Safety, and
Environmental
Projects
New Products
and Services
Other
The timing of
cash flows is
crucial.
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
AfterTax
Operating
Cash Flow
AfterTax
Operating
Cash Flow
AfterTax
Operating
Cash Flow
AfterTax
Operating
Cash Flow
AfterTax
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 nextbest 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
Tax Considerations
and Depreciation
Depreciation is a noncash expense.
Depreciation will not be considered
in the cash flow calculation.
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
3Year
5Year
33.33%
20.00%
44.45
32.00
14.81
19.20
7.41
11.52
11.52
5.76
7Year
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
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.
Terminalyear 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.
() 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
Example11.4 436 page
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
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
The
The Capital
Capital Budgeting
Budgeting Estimation
Estimation of
of Operating
Operating Cash
Cash
Flow
Flow
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)
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 3year MACRS class. NWC will rise by
$5,000.
Lisa Miller forecasts that
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)
TerminalYear
Incremental Cash
Flows
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 3year MACRS class. NWC will rise by
$5,000.
Lisa Miller forecasts that
TerminalYear
Incremental Cash
Flows
a)
b)
c)
+

d)
e)
+
=
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
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 straightline over five
years ($6,000 per year). The machine has two
years of depreciation and four years of useful
life remaining. 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).
$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
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)
TerminalYear
Incremental Cash
Flows
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