chapt 8 capital budgeting cash flows

8/4/2019 Chapt 8 Capital Budgeting Cash Flows

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Copyright 2009 Pearson Prentice Hall . All rights reserved.

Chapter 8

CapitalBudgetingCash Flows


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Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-2

Learning Goals

1. Understand the motives for key capitalbudgeting expenditures and the steps in thecapital budgeting process.

2. Define basic capital budgeting terminology.

3. Discuss relevant cash flows, expansion versusreplacement decisions, sunk costs and

opportunity costs, and international capitalbudgeting.


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Learning Goals (cont.)

4. Calculate the initial investment associated with

a proposed capital expenditure.

5. Find the relevant operating cash inflowsassociated with a proposed capital expenditure.

6. Determine the terminal cash flow associated

with a proposed capital expenditure.


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The Capital Budgeting Decision Process

Capital Budgeting is the process of identifying,evaluating, and implementing a firms investmentopportunities.

It seeks to identify investments that will enhance afirms competitive advantage and increaseshareholder wealth.

The typical capital budgeting decision involves a

large up-front investment followed by a series ofsmaller cash inflows.

Poor capital budgeting decisions can ultimately resultin company bankruptcy.


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Table 8.1 Key Motives for MakingCapital Expenditures


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1. Proposal Generation

2. Review and Analysis

3. Decision Making

4. Implementation

5. Follow-up

Our Focus ison Step 2 and 3

Steps in the Process


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Basic Terminology: Independent versusMutually Exclusive Projects

Independent Projects, on the other hand, do not

compete with the firms resources. A company can

select one, or the other, or bothso long as they meet

minimum profitability thresholds.

Mutually Exclusive Projects are investments that

compete in some way for a companys resourcesa

firm can select one or another but not both.


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Basic Terminology: Unlimited Fundsversus Capital Rationing

If the firm has unlimited funds for makinginvestments, then all independent projects thatprovide returns greater than some specified levelcan be accepted and implemented.

However, in most cases firms face capitalrationing restrictions since they only have a

given amount of funds to invest in potentialinvestment projects at any given time.


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Basic Terminology: Accept-Reject versusRanking Approaches

The accept-reject approach involves theevaluation of capital expenditure proposals todetermine whether they meet the firmsminimum acceptance criteria.

The ranking approach involves the ranking ofcapital expenditures on the basis of some

predetermined measure, such as the rate ofreturn.


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Basic Terminology: Conventional versusNonconventional Cash Flows

Figure 8.1 Conventional Cash Flow


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Basic Terminology: Conventional versusNonconventional Cash Flows (cont.)

Figure 8.2 NonconventionalCash Flow


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For example, if a day-care center decides to open another

facility, the impact of customers who decide to move from

one facility to the new facility must be considered.

The Relevant Cash Flows

Incremental cash flows:

are cash flows specifically associated with the

investment, and

their effect on the firms other investments (both

positive and negative) must also be considered.


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Relevant Cash Flows:Major Cash Flow Components

Figure 8.3 Cash Flow Components


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Relevant Cash Flows: Expansion VersusReplacement Decisions

Estimating incremental cash flows is relativelystraightforward in the case ofexpansionprojects, but not so in the case ofreplacementprojects.

With replacement projects, incremental cashflows must be computed by subtracting existing

project cash flows from those expected from thenew project.


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Figure 8.4 Relevant Cash Flows forReplacement Decisions


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Relevant Cash Flows: Sunk CostsVersus Opportunity Costs

Note that cash outlays already made (sunk

costs) are irrelevant to the decision process.

However, opportunity costs, which are cashflows that could be realized from the best

alternative use of the asset, are relevant.


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Relevant Cash Flows: InternationalCapital Budgeting

International capital budgeting analysis differs from

purely domestic analysis because:

cash inflows and outflows occur in a foreign

currency, and

foreign investments potentially face significant political risks

Despite these risks, the pace of foreign direct

investment has accelerated significantly since the endof WWII.


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Finding the Initial Investment

Table 8.2 The Basic Format for DeterminingInitial Investment


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Finding the Initial Investment (cont.)

Table 8.3 Tax Treatment on Sales ofAssets


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Book Value = $100,000 - $52,000 = $48,000

Hudson Industries, a small electronics company, 2

years ago acquired a machine tool with an installed

cost of $100,000. The asset was being depreciatedunder MACRS using a 5-year recovery period. Thus

52% of the cost (20% + 32%) would represent

accumulated depreciation at the end of year two.



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If Hudson sells the old asset for $110,000, it realizes a

gain of $62,000 ($110,000 - $48,000). Technically, thedifference between the cost and book value ($52,000) is

called recaptured depreciation and the difference

between the sales price and purchase price ($10,000) is

called a capital gain. Under current corporate tax laws,

the firm must pay taxes on both the gain and recaptured

depreciation at its marginal tax rate.

Finding the Initial Investment

Sale of the Asset for More Than Its Purchase Price


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If Hudson sells the old asset for $70,000, it realizes

a gain in the form of recaptured depreciation of

$22,000 ($70,000$48,000) which is taxed at the

firms marginal tax rate.


Sale of the Asset for More Than Its Book Value but

Less than Its Purchase Price


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If Hudson sells the old asset for its book value of

$48,000, there is no gain or loss and therefore no tax

implications from the sale.


Sale of the Asset for Its Book Value


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If Hudson sells the old asset for $30,000 which is less thanits book value of $48,000, it experiences a loss of $18,000

($48,000 - $30,000). If this is a depreciable asset used in

the business, the loss may be used to offset ordinary

operating income. If it is not depreciable or used in the

business, the loss can only e used to offset capital gains.


Sale of the Asset for Less Than Its Book Value


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Figure 8.5 Taxable Income from Sale of Asset


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Danson Company, a metal products manufacturer, is

contemplating expanding operations. Financial analysts

expect that the changes in current accounts summarized

in Table 8.4 on the following slide will occur and will bemaintained over the life of the expansion.


Change in Net Working Capital


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Table 8.4 Calculation of Change in Net WorkingCapital for Danson Company


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Powell Corporation, a large diversified manufacturer of aircraft

components, is trying to determine the initial investment required

to replace an old machine with a new, more sophisticated model.

The machines purchase price is $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 firm has

found a buyer willing to pay $280,000 for the present machine

and remove it at the buyers expense. The firm expects that a

$35,000 increase in current assets and an $18,000 increase in

current liabilities will accompany the replacement. Both ordinary

income and capital gains are taxed at 40%.



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Powell Corporations estimates of its revenues and expenses

(excluding depreciation and interest), with and without the new

machine described in the preceding example, are given inTable 8.5. Note that both the expected usable life of the

proposed machine and the remaining usable life of the existing

machine are 5 years. The amount to be depreciated with the

proposed machine is calculated by summing the purchase

price of $380,000 and the installation costs of $20,000.

Finding the Operating Cash Inflows


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Finding the OperatingCash Inflows (cont.)

Table 8.5 Powell Corporations Revenue andExpenses (Excluding Depreciation and Interest)for Proposed and Present Machines

Table 8 6 Depreciation Expense for


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Table 8.6 Depreciation Expense forProposed and Present Machines for PowellCorporation


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Table 8.7 Calculation of Operating CashInflows Using the Income Statement Format

Table 8 8 Calculation of Operating Cash


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Table 8.8 Calculation of Operating CashInflows for Powell Corporations Proposedand Present Machines


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Table 8.9 Incremental (Relevant) OperatingCash Inflows for Powell Corporation


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Finding the Terminal Cash Flow

Table 8.10 The Basic Format for DeterminingTerminal Cash Flow


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Continuing with the Powell Corporation example, assume that

the firm expects to be able to liquidate the new machine at the

end of its 5-year useable life to net $50,000 after payingremoval and cleanup costs. The old machine can be

liquidated at the end of the 5 years to net $10,000. The firm

expects to recover its $17,000 net working capital investment

upon termination of the project. Again, the tax rate is 40%.

Finding the Terminal Cash Flow (cont.)


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Finding the Terminal Cash Flow (cont.)


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Summarizing the Relevant Cash Flows

chapt 8 capital budgeting cash flows

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