Chapter 7Cash Flow of

Capital Budgeting

Capital Budgeting: The process of planning for purchases of long-term assets.

For example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide?

• Will the machine be profitable?• Will our firm earn a high rate of

return on the investment?• The relevant project information

follows:

• The cost of the new machine is $127,000. • Installation will cost $20,000.• $4,000 in net working capital will be needed at the

time of installation.• The project will increase revenues by $85,000 per

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.

Capital Budgeting Steps

1) Evaluate Cash FlowsLook at all incremental cash flows occurring as a result of the project.

• Initial outlay•Differential Cash Flows over the

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

•Terminal Cash Flows

Capital Budgeting Steps

1) Evaluate Cash Flows

0 1 2 3 4 5 n6 . . .

TerminalCash flow

Annual Cash Flows

Initialoutlay

2) Evaluate the Risk of the Project

• We’ll get to this in the next chapter.

• For now, we’ll assume that the risk of the project is the same as the risk of the overall firm.

• If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.

Capital Budgeting Steps

3) Accept or Reject the Project

Capital Budgeting Steps

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(Purchase price of the asset)+ (shipping and installation costs) (Depreciable asset)+ (Investment in working capital) + After-tax proceeds from sale of

old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(127,000)+ (shipping and installation costs) (Depreciable asset)+ (Investment in working capital) + After-tax proceeds from sale of

old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(127,000)+ ( 20,000) (Depreciable asset)+ (Investment in working capital) + After-tax proceeds from sale of

old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(127,000)+ ( 20,000) (147,000)+ (Investment in working capital) + After-tax proceeds from sale

of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(127,000)+ (20,000) (147,000)+ (4,000) + After-tax proceeds from sale

of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(127,000)+ (20,000) (147,000)+ (4,000) + 0 Net Initial Outlay

Step 1: Evaluate Cash Flows

• a) Initial Outlay: What is the cash flow at “time 0?”

(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

old asset ($151,000) Net initial outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at “time 0?”

(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 old

asset ($151,000) Net initial outlay

Step 1: Evaluate Cash Flows

b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

Incremental revenue- Incremental costs- Depreciation on project Incremental earnings before taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal Annual Cash Flow

For Each Year, Calculate:

Incremental revenue- Incremental costs- Depreciation on project

Incremental earnings before taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal Annual Cash Flow

For Years 1 - 5:

85,000- Incremental costs- Depreciation on project

Incremental earnings before taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750)- Depreciation on project

Incremental earnings before

taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750) (29,400) Incremental earnings before taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750) (29,400) 25,850- Tax on incremental EBT Incremental earnings after taxes+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750) (29,400) 25,850 (8,789) 17,061+ Depreciation reversal

Annual Cash Flow

For Years 1 - 5:

85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400

Annual Cash Flow

For Years 1 - 5:

85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789) Taxes 17,061 EAT 29,400 Depreciation

reversal 46,461 = Annual Cash Flow

For Years 1 - 5:

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

Salvage value+/- Tax effects of capital gain/loss+ Recapture of net working capital Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

50,000 Salvage value+/- Tax effects of capital gain/loss+ Recapture of net working

capital Terminal Cash Flow

Tax Effects of Sale of Asset:

• 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).

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

50,000 Salvage value (17,000) Tax on capital gain Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC Terminal Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

50,000 Salvage value (17,000) Tax on capital gain 4,000 Recapture of NWC 37,000 Terminal Cash Flow

Project NPV:

•CF(0) = -151,000.•CF(1 - 4) = 46,461.•CF(5) = 46,461 + 37,000 =

83,461.•Discount rate = 14%.•NPV = $27,721.•We would accept the

project.

Capital Rationing•Suppose that you have

evaluated five capital investment projects for your company.

•Suppose that the VP of Finance has given you a limited capital budget.

•How do you decide which projects to select?

Capital Rationing

•You could rank the projects by IRR:

Capital Rationing

•You could rank the projects by IRR:

IRR

5%

10%

15%

20%

25%

$

11 22 33 44 55

$X

Our budget is limitedso we accept only projects 1, 2, and 3.

Capital Rationing

•You could rank the projects by IRR:

IRR

5%

10%

15%

20%

25%

$

11 22 33

$X

Our budget is limitedso we accept only projects 1, 2, and 3.

Capital Rationing

•Ranking projects by IRR is not always the best way to deal with a limited capital budget.

• It’s better to pick the largest NPVs.

•Let’s try ranking projects by NPV.

Problems with Project Ranking

1) Mutually exclusive projects of unequal size (the size disparity problem)

• The NPV decision may not agree with IRR or PI.

• Solution: select the project with the largest NPV.

Size Disparity ExampleProject B

year cash flow 0 (30,000) 1 15,000 2 15,000 3 15,000required return = 12%IRR = 23.38%NPV = $6,027PI = 1.20

Project A year cash flow 0 (135,000) 1 60,000 2 60,000 3 60,000required return = 12%IRR = 15.89%NPV = $9,110PI = 1.07

Problems with Project Ranking

2) The time disparity problem with mutually exclusive projects.

• NPV and PI assume cash flows are reinvested at the required rate of return for the project.

• IRR assumes cash flows are reinvested at the IRR.

• The NPV or PI decision may not agree with the IRR.

• Solution: select the largest NPV.

Time Disparity ExampleProject B

year cash flow 0 (46,500) 1 36,500 2 24,000 3 2,400 4 2,400required return = 12%

IRR = 25.51%NPV = $8,455PI = 1.18

Project A year cash flow 0 (48,000) 1 1,200 2 2,400 3 39,000 4 42,000required return = 12%

IRR = 18.10%NPV = $9,436PI = 1.20

Mutually Exclusive Investments with Unequal Lives

•Suppose our firm is planning to expand and we have to select one of two machines.

•They differ in terms of economic life and capacity.

•How do we decide which machine to select?

The after-tax cash flows are:Year Machine 1 Machine 2 0 (45,000) (45,000) 1 20,000 12,000 2 20,000 12,000 3 20,000 12,000 4 12,000 5 12,000 6 12,000Assume a required return of 14%.

Step 1: Calculate NPV

•NPV1 = $1,433•NPV2 = $1,664

•So, does this mean #2 is better?

•No! The two NPVs can’t be compared!