Capital Budgeting Cash

Flows
11.1) PROJECT CASH FLOWS
Net Cash Flows
The net (or the sum of) incremental after-tax cash flows over a project’s life
Incremental Cash Flows
The additional after-tax cash flows—outflows or inflows—that will occur only if the investment is made

Major Cash Flow Types

Initial Investment
The incremental cash flows for a project at time zero
Operating Cash Flows
The net incremental after-tax cash flows occurring each period during the project’s life
Terminal Cash Flows
The net after-tax cash flow occurring in the final year of the project
 Replacement Decisions
Replacement Replacement decisions are per- Expansion Decisions
versus haps even more common
The firm must decide whether to re- Expansion decisions include in-
Expansion place some asset that it already owns
with a new asset
vestments designed to increase the
capacity of a factory, to launch a
Decisions Identifying incremental cash flows for product in a new market, or to open
a new location identifying incremen-
these sorts of investment projects
is more complicated because the tal cash flows along with developing
firm must compare the cash flows net cash flow estimates is rel-
that result from the new investment atively straightforward
to the cash flows that would have
occurred if no investment had been
made
FIGURE 11.2 RELEVANT NET CASH FLOWS FOR
REPLACEMENT DECISIONS
SUNK COSTS AND OPPORTUNITY COSTS

Sunk Costs

• Cash outlays that have already been made (past out-

lays) and cannot be recovered, whether or not the firm
follows through and makes an investment

• Sunk costs are irrelevant and should not be in-

cluded in a project’s incremental cash flows

Opportunity Costs

• Cash flows that could have been realized from the best alter-
native use of an owned asset

• Opportunity costs are relevant and should be included as part

of the cash flow projections when determining a project’s net
cash flows
EXAMPLE:

Jankow Equipment is considering enhancing its drill press X12, which it purchased 3 years earlier for
$237,000, by retrofitting it with the computerized control system from an obsolete piece of equip-
ment it owns. The obsolete equipment could be sold today for $42,000, but without its computerized
control system, it would be worth nothing. Jankow is in the process of estimating the labor and ma-
terials costs of retrofitting the system to drill press X12 and the benefits expected from the retrofit.
The $237,000 cost of drill press X12 is a sunk cost because it represents an earlier cash outlay.it would
not be included as a cash outflow when determining the cash flows relevant to the retrofit decision.

However, if Jankow uses the computerized control system of the obsolete machine, then Jankow will
have an opportunity cost of $42,000, which is the cash the company could have received by selling the
obsolete equipment in its current condition. By retrofitting the drill press, Jankow gives up the oppor-
tunity to sell the old equipment for $42,000. This opportunity cost would be included as a cash outflow
associated with using the computerized control system.
 11.2) Finding the Initial Investment
TABLE 11.1 THE BASIC FORMAT FOR DETERMINING
INITIAL INVESTMENT
(1) Installed cost of the new asset =
Cost of the new asset
+ Installation costs
(2) After-tax proceeds from the sale of the old asset =
Proceeds from the sale of the old asset
±Tax on the sale of the old asset
(3) Change in net working capital
Initial Investment = (1) − (2) ± (3)
Installed Cost of the New Asset
Cost of the New Asset
The cash outflow necessary to acquire a new asset
Installation Costs
Any added costs that are necessary to place the new asset into operation
Installed Cost of the New Asset
The cost of the new asset plus its installation costs; equals the asset’s deprecia-
ble value
After-Tax Proceeds from the Sale of the Old Asset
Proceeds from the Sale of the Old Asset
The before-tax cash inflow net of any removal costs that results from the sale of the old asset and is
normally subject to some type of tax treatment
Tax on the Sale of the Old Asset
Tax that depends on the relationship between the old asset’s sale price and its book value and on existing
government tax rules

Book Value
The asset’s value on the firm’s balance sheet as determined by accounting principles
Book Value = Installed Cost of New Asset – Accumulated Depreciation (11.1)

After-Tax Proceeds from the Sale of the Old Asset

The difference between the old asset’s sale proceeds and any applicable tax liability or refund re-
lated to its sale
EXAMPLE:
The old asset purchased 2 years ago for $100,000 by Hudson Industries has a current
book value of $48,000. What will happen if the firm now decides to sell the asset and re-
place it?
The tax consequences depend on the sale price. Figure 11.3 depicts the taxable income
resulting from four possible sale prices in light of the asset’s initial purchase price of
$100,000 and its current book value of $48,000. The tax consequences of each of these sale
prices are described in the following summary.
TABLE 11.2 TAX TREATMENTS FOR THE SALES OF
ASSETS
Tax case Definition Tax treatment
Gain on the sale Portion of the sale price All gains above book value are taxed as
of asset that is greater than book ordinary income.
value
Loss on the sale Amount by which sale If the asset is depreciable and used in
of asset price is less than book business, then loss is deducted from
value ordinary income
 Blank Blank If the asset is not depreciable or is not used in
business, then loss is deductible only against
capital gains.
PURCHASING PRICE FROM 2 YEARS =
100,000

30,000 48,000 70,000 110,000

BV = 48,000
BV = 48,000 Diff= 110,000 –
Diff= 30,000 – BV = 48,000 48,000
48,000 Diff= 48,000 – BV = 48,000 Profit = 62,000
Loss = 18,000 48,000 Diff= 70,000 – Gain = 10,000
Tax Refund No Loss / No 48,000 Captured de-
= 18,000 x 21% gain Profit = 22,000 preciation
= 3,780 Tax Paid =52,000
No Taxes = 22000 x 21% Tax Paid
= 4,620 = 62000 x 21%
= 13,020

Four scenarios for different selling Prices and the tax treatment
LET’S EXPLAIN THE TAX CONSEQUENCES

The sale of the asset for more than its book value If Hudson sells the old asset for $110,000, it
realizes a gain of $62,000 ($110,000 − $48,000). Technically, this gain is made up of two parts: a cap-
ital gain and recaptured depreciation, which is the portion of the sale price that is above book value
and below the initial purchase price.
For Hudson, the capital gain is $10,000 ($110,000 sale price − $100,000 initial purchase price); re-
captured depreciation is $52,000 (the $100,000 initial purchase price − $48,000 book value).
The tax treatment of capital gains can be quite complex, so to keep things simple we assume that the
total gain above book value of $62,000 is taxed at Hudson’s ordinary corporate income tax rate
of 21%, resulting in taxes of $13,020 (0.21 × $62,000). Hudson would not have paid these taxes had
they not replaced the old equipment, so the taxes are part of the incremental cash flows at time zero.
That is, the taxes constitute a portion of the replacement project’s initial investment. In effect, the taxes
raise the amount of the firm’s initial investment in the new asset by reducing the proceeds from the
sale of the old asset.
If Hudson instead sells the old asset for $70,000, it experiences a gain above book value (in the form of recap-
tured depreciation) of $22,000 ($70,000 − $48,000), as shown under the $70,000 sale price in Figure 11.3.
This gain is taxed as ordinary income. Because the firm is in the 21% tax bracket, the taxes on the $22,000 gain
are $4,620 (0.21 × $22,000). This amount in taxes should be used in calculating the initial investment in the new
asset.
The sale of the asset for its book value If Hudson sells the old asset for $48,000, there is no gain or loss on the
sale, as Figure 11.3 shows. Because there is no gain or loss, there is no incremental tax effect of the sale.

The sale of the asset for less than its book value If Hudson sells the asset for $30,000, it experiences a loss of
$18,000 ($48,000 − $30,000), as shown under the $30,000 sale price in Figure 11.3. The firm may use the loss to
offset ordinary operating income, which saves the firm $3,780 (0.21 × $18,000) in taxes. And, if current operating
earnings are not sufficient to offset the loss, the firm may be able to apply these losses to prior or future years’
taxes.
CALCULATING CHANGE IN NET WORKING CAPITAL
Net Working Capital
The difference between the firm’s current assets and its current liabilities
Change in Net Working Capital
The difference between the change in current assets and the change in current liabilities

Danson Company is expanding. Analysts

expect that the changes summarized in Table
11.3 will occur and will be maintained over
the life of the expansion. Current assets will
increase by $22,000, and current liabilities
will increase by $9,000, resulting in a
$13,000 increase in net working capital. This
increase in net working capital is part of
the initial cash outflow required to begin
the expansion project, so we treat it as a
cash outflow in calculating the initial invest-
ment.
THE MAIN EXAMPLE

Powell Corporation is trying to determine the initial investment required to replace an old
machine with a new one. The new machine costs $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 old machine was purchased 3 years ago at a cost of $240,000 and was being
depreciated under MACRS, using a 5-year recovery period.

The firm can sell the old machine for $280,000. The firm expects that a $35,000 in-
crease in current assets and an $18,000 increase in current liabilities will accompany
the replacement, resulting in a $17,000 ($35,000 − $18,000) increase in net working capital.
The firm’s tax rate is 21%.
 Solution

Draft:
Acc dep.= (0.2+0.32+
0.19) X $240,000
= 170,400
Bv = 240,000 – 170,400
= 69,600
Profit =280,000- 69,600
= 210,400
Taxes = 210,000x21%
= 44,184
11.3 FINDING THE OPERATING CASH FLOWS
All costs and benefits expected from a proposed project must be measured on a cash flow
basis
• Cash outflows represent costs incurred by the firm, and cash inflows repre-
sent dollars that the firm receives and can then spend
• Cash flows generally are not equal to accounting profits

• Cash flows that result from investment projects must be measured on an after-tax
basis because the firm will not have the use of any cash flows until it has both satis-
fied the government’s tax claims and captured the government’s tax re-
funds, credits, or other tax breaks

• Firms can use only the after-tax cash flows to pay returns to lenders and share-
holders, so when making investment decisions, analysts must take care to mea-
sure incremental cash flows after taxes
A simple technique • The calculation requires adding depreciation and
can convert after- any other noncash charges (amortization and de-
tax net profits into pletion) deducted as expenses on the firm’s in-
operating cash come statement back to net profits after taxes
flows • Adding depreciation to profit simply recognizes that
the profit calculation requires firms to deduct
an expense not tied to a specific cash outlay

• Adding depreciation to after-tax profit “corrects” this

issue and provides a number that better matches the
actual cash inflows and outflows
THE MAIN EXAMPLE (CON’T)

Powell Corporation’s estimates of its revenue and expenses (excluding depreciation and in-
terest), with and without the proposed new machine described in the following table (table
1). Note that both the expected usable life of the new machine and the remaining usable life
of the old machine are 5 years. The new machine’s depreciable value is the sum of the
$380,000 purchase price and the $20,000 installation cost. The firm calculates annual de-
preciation deductions on the new machine, using the MACRS percentages based on a 5-
year recovery period. The resulting depreciation on this machine for each of the 6 years, as
well as the remaining 3 years of depreciation (years 4, 5, and 6) on the old machine, are
calculated in Table 2
 Bl

With new machine With old machine

an
k

Expenses (excl. depr. Expenses

Year Revenue and int.) Year Revenue (excl. depr. and int.)
1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,000
2 2,520,000 2,300,000 2 2,300,000 2,110,000
3 2,520,000 2,300,000 3 2,400,000 2,230,000
4 2,520,000 2,300,000 4 2,400,000 2,250,000
5 2,520,000 2,300,000 5 2,250,000 2,120,000

Table 1
 Table 2

SECTION BREAK
Insert the title of your subtitle Here

Depreciation Expense for New and Old Machines for Powell Corporation
CALCULATION OF OPERATING CASH FLOWS USING THE INCOME
STATEMENT FORMAT

Revenue
− Expenses (excluding depreciation and interest)
Earnings before interest, taxes, depreciation, and amortization (EBITDA)

− Depreciation
Earnings before interest and taxes (EBIT)
− Taxes (rate = T)
Net operating profit after taxes [NOPAT = EBIT × (1 − T)]
+ Depreciation
Operating cash flows (OCF)
CALCULATION OF OPERATING CASH FLOWS FOR POWELL
CORPORATION’S NEW MACHINES
CALCULATION OF OPERATING CASH FLOWS FOR POWELL
CORPORATION’S OLD MACHINES
FINDING THE OPERATING CASH FLOWS

- The final step in estimating

the net operating cash flows for
a proposed replacement project
is to calculate the incremen-
tal cash flows

- The differences in cash

flows that occur with the new
machines compared to cash
flows that occurred with the
old machine are incremental
cash flows
EXPLANATION

These net operating cash flows represent the amounts by which each respective year’s
operating cash flow will change as a result of the replacement project.
For example, in year 1, Powell Corporation’s operating cash flow would increase by
$18,652 if the proposed project were undertaken. These are the relevant cash flows that
analysts should consider when evaluating the benefits of making a capital budgeting
decision regarding the replacement of the old machine with the new machine.
11.4 FINDING THE TERMINAL CASH FLOW
A project’s terminal cash flow is the cash flow resulting from termination and liquidation of a
project at the end of its economic life
It represents the after-tax cash flow, exclusive of operating cash flows, that occurs in the final
year of the project
For replacement projects, analysts must take into account the proceeds from both the new
asset and the old asset
The proceeds from the sale of the new and the old asset, often called “salvage value,”
represent the amount net of any removal costs expected on termination of the project
For expansion types of investment projects, the proceeds from the old asset are zero
THE BASIC FORMAT FOR DETERMINING TERMINAL
CASH FLOW
(1) After-tax proceeds from the sale of the new asset =
Blank

Proceeds from the sale of the new asset

Bl

± Tax on the sale of the new asset

an
k

(2) After-tax proceeds from the sale of the old asset =

Blank

Proceeds from the sale of the old asset

Blank

± Tax on the sale of the old asset

(3) Change in net working capital
Bl

Terminal cash flow = (1) − (2) ± (3)

an
k
• After-Tax Proceeds from the Sale of the New and Old Assets
When the investment being analyzed involves replacing an old asset with a new one, two
elements are key in finding the terminal cash flow.

First, at the end of the project’s life, the firm will dispose of the new asset, possibly by sell-
ing it, so the after-tax proceeds from selling the new asset represent an incremental
cash inflow

However, remember that if the firm had not replaced the old asset, the firm would have
received proceeds from the sale of the old asset at the end of the project (rather than
counting those after-tax proceeds at the beginning of the project timeline as part of
the initial investment)
Remember:
If the net proceeds from the sale exceed book value, a tax payment shown as an
outflow will occur
When the net proceeds from the sale fall short of book value, a tax benefit shown
as a cash inflow will result
 CHANGE IN NET WORKING CAPITAL

When we calculated the initial investment, we took into account any change in net working capital that is at-
tributable to the new asset

- Now, when we calculate the terminal cash flow, the change in net working capital represents the rever-
sion of any initial net working capital investment.

- Most often, this will show up as a cash inflow due to the reduction in net working capital; with termi-
nation of the project, the need for the increased net working capital investment usually ends

- As long as no changes in working capital occur after the initial investment, the amount recovered at ter-
mination will equal the amount shown in the calculation of the initial investment.
THE MAIN EXAMPLE (CON’T)
Continuing with the Powell Corporation example, assume that the firm expects to liqui-
date the new machine at the end of its 5-year usable life, to net $50,000 after paying re-
moval and cleanup costs. Had the new machine not replaced the old machine, the old
machine would have been liquidated after 5 years to net $10,000. The firm expects to re-
cover its $17,000 net working capital investment upon termination of the project.
The firm pays taxes at a rate of 21%.
 Solution

Draft:
book value of $20,000
(equal to the year-6 depre-
ciation) after 5 years.
Profit = 30,000
Taxes = 0.21 × $30,000=
6,300

Old machine:
Taxes: 0.21 × $10,000
(profit) = 2,100
11.5 SUMMARIZING THE NET CASH FLOWS

• The initial investment, operating cash flows, and terminal cash flow together repre-
sent a project’s net cash flows
• We can view these cash flows as the net after-tax cash flows attributable to the proposed
project
• They represent, in a cash flow sense, how much better or worse off the firm will be if it
chooses to implement the proposal
• With the cash flow estimates in hand, a financial manager could then calculate the in-
vestment’s NPV or IRR using the techniques covered in the previous topic.
Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering
replacing an existing piece of equipment with a more sophisticated machine. The following
information is given.

MACRS depreciation: 20% in year 1; 32% in year 2; 19% in year 3 and 12% in year 4 and 12 %
in year 5.
The proposed machine will be disposed of at the end of its usable life of five years at an estimated
sale price of $ 30,000. The old machine will be with no value at the end of the project. Net working
capital is expected to decline by $5,000
The firm pays 40 percent taxes on ordinary income and capital gains. The firm has 15%cost of
capital.
a) Compute the initial investment
b) Compute the incremental cash flows
c) Compute the payback period
d) Compute the terminal cash flow
e) Compute the Net present value. Should the project be accepted?