cash flows & other topics in capital budgeting

7/31/2019 Cash Flows & Other Topics in Capital Budgeting

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Chapter 10 - Cash Flows and

Other Topics in Capital Budgeting

2005, Pearson Prentice Hall


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Capital Budgeting: The process ofplanning for purchases of long-term

assets.For example: Our firm must decide

whether to purchase a new plastic

molding machine for $127,000. How dowe decide?

Will the machine be profitable?

Will our firm earn a high rate of return onthe investment?

The relevant project information follows:


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The cost of the new machine is $127,000.

Installation will cost $20,000.

$4,000 in net working capital will be needed atthe time of installation.

The project will increase revenues by $85,000per year, but operating costs will increase by

35% of the revenue increase.

Simplified straight line depreciation is used.

Class life is 5 years, and the firm is planning to

keep the project for 5 years. Salvage value at the end of year 5 will be

$50,000.

14% cost of capital; 34% marginal tax rate.


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Capital BudgetingSteps

1) Evaluate Cash FlowsLook at all incremental cashflows occurring as a result of the

project. Initial outlay

Differential Cash Flowsover the

life of the project (also referred toas annual cash flows).

Terminal Cash Flows


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1) Evaluate Cash Flows

0 1 2 3 4 5 n6 . . .


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0 1 2 3 4 5 n6 . . .

Initial

outlay


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0 1 2 3 4 5 n6 . . .

Annual Cash Flows

Initial

outlay


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0 1 2 3 4 5 n6 . . .

Terminal

Cash flow

Annual Cash Flows

Initial

outlay


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ep : va ua e asFlows

a) Initial Outlay: What is the cash flow attime 0?

(Purchase price of the asset)

+ (shipping and installation costs)

(Depreciable asset)

+ (Investment in working capital)

+ After-tax proceeds from sale of oldasset

Net Initial Outlay


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(127,000)

+ (shipping and installation costs)

(Depreciable asset)



Net Initial Outlay


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(127,000)

+ ( 20,000)

(Depreciable asset)


+ After-tax proceeds from sale of old asset

Net Initial Outlay


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(127,000)

+ ( 20,000)

(147,000)



Net Initial Outlay


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(127,000)

+ (20,000)

(147,000)

+ (4,000)


Net Initial Outlay


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(127,000)

+ (20,000)

(147,000)

+ (4,000)

+ 0

Net Initial Outlay


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(127,000) Purchase price of asset

+ (20,000) Shipping and installation

(147,000) Depreciable asset

+ (4,000) Net working capital

+ 0 Proceeds from sale of oldasset

($151,000) Net initial outlay


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(127,000) Purchase price of asset

+ (20,000) Shipping and installation

(147,000) Depreciable asset

+ (4,000) Net working capital

+ 0 Proceeds from sale of oldasset

($151,000) Net initial outlay


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b) Annual Cash Flows: Whatincremental cash flows occur overthe life of the project?


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For Each Year, Calculate:

Incremental revenue

- Incremental costs

- Depreciation on project

Incremental earnings beforetaxes

- Tax on incremental EBT

Incremental earnings after taxes

+ Depreciation reversal

Annual Cash Flow


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For Years 1 - 5:

Incremental revenue

- Incremental costs






Annual Cash Flow


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For Years 1 - 5:

85,000

- Incremental costs






Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)




Incremental earnings aftertaxes


Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)

(29,400)





Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)

(29,400)

25,850- Tax on incremental EBT



Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)

(29,400)

25,850(8,789)



Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)

(29,400)

25,850(8,789)

17,061


Annual Cash Flow


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For Years 1 - 5:

85,000

(29,750)

(29,400)

25,850(8,789)

17,061

29,400

Annual Cash Flow


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For Years 1 - 5:

85,000 Revenue

(29,750) Costs

(29,400) Depreciation

25,850 EBT(8,789) Taxes

17,061 EAT

29,400 Depreciationreversal

46,461 = Annual Cash Flow

St 1 E l t C h


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Step 1: Evaluate CashFlows

c) Terminal Cash Flow: What is the cashflow at the end of the projects life?

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capital

Terminal Cash Flow

St 1 E l t C h


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50,000 Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capital

Terminal Cash Flow

T Eff t f S l f


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Tax Effects of Sale ofAsset:

Salvage value = $50,000. Book value = depreciable asset -

total amount depreciated.

Book value = $147,000 - $147,000= $0.

Capital gain = SV - BV

= 50,000 - 0 = $50,000. Tax payment = 50,000 x .34 =

($17,000).

St 1 E l t C h


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(17,000) Tax on capital gain

Recapture of NWC

Terminal Cash Flow

Step 1 E al ate Cash


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4,000 Recapture of NWC

Terminal Cash Flow

Step 1 Evaluate Cash


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4,000 Recapture of NWC

37,000 Terminal Cash Flow


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2)Evaluate the Risk of the Project

Well get to this in the next chapter.

For now, well assume that the risk ofthe project is the same as the risk of theoverall firm.

If we do this, we can use the firms costof capital as the discount rate for capitalinvestment projects.

Capital Budgeting Steps


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3) Accept or Reject the Project IRR

NPV

PI

Capital Budgeting Steps

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