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Chapter 12
Capital Budgeting and Estimating Cash Flows 12.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 12,
you should be able to: 1. 2. 3. 4. 5.
6. 7.
12.2
Define capital budgeting and identify the steps involved in the
capital budgeting process. Explain the procedure to generate long-term project proposals within the firm. Justify why cash, not income, flows are the most relevant to capital budgeting decisions. Summarize in a checklist the major concerns to keep in mind as one prepares to determine relevant capital budgeting cash flows. Define the terms sunk cost and opportunity cost and explain why sunk costs must be ignored, while opportunity costs must be included, in capital budgeting analysis. Explain how tax considerations, as well as depreciation for tax purposes, affects capital budgeting cash flows. Determine initial, interim, and terminal period after-tax, incremental, operating cash flows associated with a capital investment project. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Budgeting and
Estimating Cash Flows
12.3
The Capital Budgeting Process
Generating Investment Project Proposals Estimating Project After-Tax Incremental Operating Cash Flows Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. 12.4
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Capital Budgeting Process
12.5
Generate investment proposals
consistent with the firms strategic objectives. Estimate after-tax incremental operating cash flows for the investment projects. Evaluate project incremental cash flows. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Capital Budgeting Process
Select projects based on a valuemaximizing acceptance criterion.
Reevaluate implemented investment projects continually and perform postaudits for completed projects.
12.6
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Classification of Investment Project Proposals 1. New products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related) 12.7
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Screening Proposals and Decision Making 1. 2. 3. 4.
Section Chiefs Advancement Plant Managers to the next VP for Operations level depends Capital Expenditures on cost Committee and strategic importance. 5. President 6. Board of Directors 12.8
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Incremental flows Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Estimating After-Tax Incremental Cash Flows Principles that must be adhered to in the estimation
12.10
Ignore sunk costs
Include opportunity costs
Include project-driven changes in
working capital net of spontaneous changes in current liabilities
Include effects of inflation
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Tax Considerations and Depreciation Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Generally, profitable firms prefer to use an accelerated method for tax reporting purposes (MACRS). 12.11
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Depreciation and the
MACRS Method
Everything else equal, the greater the
depreciation charges, the lower the taxes paid by the firm.
Depreciation is a noncash expense.
Assets are depreciated (MACRS) on one
of eight different property classes.
Generally, the half-year convention is
used for MACRS.
12.12
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 12.14
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalized Expenditures Capitalized Expenditures are expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred.
Examples: Shipping and installation
12.15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Sale or Disposal of a Depreciable Asset Generally, the sale of a capital asset (as defined by the IRS) generates a capital gain (asset sells for more than book value) or capital loss (asset sells for less than book value).
12.16
Often historically, capital gains income
has received more favorable US tax treatment than operating income. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Corporate Capital Gains / Losses Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 35%.
12.17
Capital losses are deductible only
against capital gains.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
Terminal-year incremental net cash
flows the final periods net cash flow.
12.18
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash Outflow
a) Cost of new assets b) + Capitalized expenditures c) + ()
Increased (decreased) NWC
d) Net proceeds from sale of
asset(s) if replacement
old
e) + () Taxes (savings) due to the sale of old asset(s) if replacement f) = 12.19
Initial cash outflow
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Incremental Cash Flows
a) Net incr. (decr.) in operating revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr. b) (+)
Net incr. (decr.) in tax depreciation
c) = Net change in income before taxes
d) (+)
Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + ()
Net incr. (decr.) in tax depr. charges
g) = Incremental net cash flow for period
12.20
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Terminal-Year Incremental Cash Flows a) Calculate the incremental net cash flow for the terminal period b) + () Salvage value (disposal/reclamation costs) of any sold or disposed assets c) (+) Taxes (tax savings) due to asset sale or disposal of new assets d) + () Decreased (increased) level of net working capital e) = Terminal year incremental net cash flow 12.21
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 revenues will increase by $110,000 for each of the next 4 years and will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket. 12.22
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash Outflow
a)
$50,000
b)
20,000
c)
5,000
d)
0 (not a replacement)
e)
+ ()
0 (not a replacement)
f)
$75,000* * Note that we have calculated this value as a positive because it is a cash OUTFLOW (negative).
12.23
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Incremental Cash Flows
Year 1 a)
Year 2
Year 3
Year 4
$40,000
$40,000
$40,000
$40,000
23,331
31,115
10,367
5,187
c) = $16,669
$ 8,885
$29,633
$34,813
6,668
3,554
11,853
13,925
e) = $10,001
$ 5,331
$17,780
$20,888
23,331
31,115
10,367
5,187
g) = $33,332
$36,446
$28,147
$26,075
b) d) f) +
12.24
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Terminal-Year Incremental Cash Flows a) $26,075 The incremental cash flow from the previous slide in Year 4. b) +
10,000
Salvage Value.
c) 4,000 .40*($10,000 - 0) Note, the asset is fully depreciated at the end of Year 4. d) +
5,000
e) = $37,075 flow.
12.25
NWC - Project ends.
Terminal-year incremental cash
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of Project Net Cash Flows Asset Expansion Year 0
Year 1
$75,000* $33,332
Year 2
Year 3
Year 4
$36,446
$28,147
$37,075
* Notice again that this value is a negative
cash flow as we calculated it as the initial cash OUTFLOW in slide 12-23. 12.26
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember, you can use
Excel - Very Valuable!! Refer to the spreadsheet VW13E12b.xlsx on the New Asset tab for this spreadsheet. Try changing information in the spreadsheet to see the impact! 12.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 straight-line 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). 12.28
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Initial Cash Outflow
a) $50,000 b) +
20,000
c) +
5,000
d) e) f) =
12.29
6,000 (sale of old asset)
(tax savings from 2,400 <---loss on sale of $66,600 old asset) Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculation of the Change in Depreciation Year 1 a)
Year 2
Year 3
Year 4
$23,331
$31,115
$10,367
$ 5,187
6,000
6,000
c) = $17,331
$25,115
$10,367
$ 5,187
b)
a) Represent the depreciation on the new
project. b) Represent the remaining depreciation on the old project. c) Net change in tax depreciation charges. 12.30
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Terminal-Year Incremental Cash Flows a) $ 8,075 The incremental cash flow from the previous slide in Year 4. b) +
10,000
Salvage Value.
c) 4,000 (.40)*($10,000 0). Note, the asset is fully depreciated at the end of Year 4. d) +
5,000
e) = $19,075 flow.
12.32
Return of added NWC.
Terminal-year incremental cash
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember, you can use
Excel - Very Valuable!! Refer to the spreadsheet VW13E12b.xlsx on the Asset Replacement tab for this spreadsheet. Try changing information in the spreadsheet to see the impact! 12.33
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
12.34
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
