Capital Budgeting
Ross Ch. 9 & 10
MAKING CAPITAL INVESTMENT DECISION
3 key areas of Financial Management
• How to manage its short-term activities (Ch.18-20)
• How to finance its operation (Ch.4,14-16,17)
• What fixed asset we should buy (Ch.9-11)
What is Relevant Cashflows for a
project?
Incremental CF = the difference between a firm’s
future cashflows WITH a project and those WITHOUT
the project
1 2 ?
Stand-alone principle:
• Evaluation of a project based on the project’s
incremental CF
• A kind of “mini firm”
• Its own CF
How to find (or calculate) incremental CF
Sunk Cost: expense we have already paid for or have
incurred the liability to pay (cannot be removed)
Opportunity Cost: the most valuable alternative that
is given up if investment is undertaken
Side Effect:
• Negative impact on CF/erosion (cannibal)
• Positive impact (synergy)
Non-cash Expenses: Depreciation, Amortization
How to find (or calculate) incremental CF
Net Working Capital: normally a project will need
additional Cash, A/R, inventories, etc.
Current Assets
Current Liabilities
Net Working Cap
Financing Cost: already taken into consideration in
the DISCOUNTING PROCESS
Taxes: it is “after-tax incremental CF” not Net Income
nor EAT
Components of Total CF
Operating Cash Flow = EBIT – Taxes + Depr.
Capital Spending
Change in Net Working Capital
Beginning Ending
Current A/R $ 100 $ 110
Assets Inventory $ 100 $ 80
Current
A/P $ 100 $ 70 Increase by
Liability
$ 100 $ 120 $ 20
Total CF = - Capital Spending + OCF – Change in NWC
OCF = EBIT – Taxes + Depr.
Sales (50.000 units at $4/unit) $ 200,000
Variable Costs ($2.50/unit) - 125,000
$ 75,000
Fixed Costs - 12,000
Depreciation - 30,000
EBIT $ 33,000
Taxes (34%) - 11,220
Net Income $ 21,780
OCF = $ 21,780 + $ 30,000 = $ 51,780
Total CF = OCF – Capital Spending – Change in NWC
Capital Spending = $ 90,000
Old machine
Sell
Removal
New machine
Buy
Construction
Training
Etc. (-) (+)
Change in NWC = $ 20,000
0 N
How to find OCF?
Sales = $ 1,500
}
Cost = $ 700 →VC + FC EBIT = Sales – Costs – Depr.
Depr = $ 600
Taxes = EBIT*T (T = corporate tax rate)
1. OCF = EBIT – Taxes + Depr.
2. BOTTOM-UP Approach, (Project) Net Income = EBIT –
Taxes, OCF = NI + Depr.
3. TOP-DOWN Approach, OCF = Sales – Cost – Taxes
4. TAX SHIELD Approach, OCF = (Sales – Cost)(1 – T) +
Depr.(T).
Investment Criteria
PV Present Value of future OCF
1. NPV -I0 Capital Spending + Change in NWC
NPV
- ∆NWC + ∆NWC
-I0 +OCF +OCF +OCF +OCF
0 1 2 3 4
2. Payback period
3. Discounted Payback period
4. Average Accounting Return
5. Internal Rate of Return (IRR)
6. Modified IRR → non-conventional CF
7. Profitability Index → capital rationing
Comprehensive Problem: new
business
− We think we can sell 6.000 units per year at $1,000 each.
Variable costs will run about $400 per unit.
− The product should have a four-year life
− Fixed costs will run $450,000 per year
− We will need to invest $1,250,000 in mfg. equipment
− Using a straight line method and five year depreciation
− In four years, the equipment will be worth about half of
what we paid for
− We will have to invest $1,150,000 in net working capital at
the start; after that, NWC requirements will be 25% of sales.
Steps to solve the problem
− First, prepare a pro forma income statement for
each year
− Next calculate operating cash flow
− Finish the problem by determining total cash flow
and then calculating NPV assuming 28 percent
required return.
− Use a 34 percent tax rate throughout
Depreciation calculation
Year Depr % Depr Ending book
value
1 20% $ 250,000 $ 1,000,000
2 20 250,000 750,000
3 20 250,000 500,000
4 20 250,000 250,000
Projected Income Statement
Year
1 2 3 4
Sales $6,000,000 $6,000,000 $6,000,000 $6,000,000
VC 2,400,000 2,400,000 2,400,000 2,400,000
FC 450,000 450,000 450,000 450,000
Depreciation 250,000 250,000 250,000 250,000
EBIT $2,900,000 $2,900,000 $2,900,000 $2,900,000
Taxes (34%) 986,000 986,000 986,000 986,000
Net Income $1,914,000 $1,914,000 $1,914,000 $1,914,000
Operating cash flows
Year
1 2 3 4
EBIT $2,900,000 $2,900,000 $2,900,000 $2,900,000
Depreciation 250,000 250,000 250,000 250,000
Taxes 986,000 986,000 986,000 986,000
Operating cash
2,164,000 2,164,000 2,164,000 2,164,000
flow
Projected Cash Flows
Year
0 1 2 3 4
OCF 2,164,000 2,164,000 2,164,000 2,164,000
∆ NWC
-$1,150,000 - $350,000 1,500,000
Capital
-$1,250,000 497,500
Spending
Total CF
-$2,400,000 $1,814,000 $2,164,000 $2,164,000 $4,261,500
Is it profitable (feasible)?
NPV = - $2,400,000 + 1,814,000/1.28 +
2,164,000/1.282 + 2,164,000/1,283 + 4,261,500/1.284
= $ 2,956,396
