Chapter 12

Capital Budgeting
and Estimating
Cash Flows
12-1

2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

Capital Budgeting and

Estimating Cash Flows

12-2

The Capital Budgeting Process

Generating Investment Project

Proposals

Estimating Project After-Tax

Incremental Operating Cash
Flows

What is
Capital Budgeting?
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.
12-3

The Capital
Budgeting Process

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.

12-4

The Capital
Budgeting Process

Select projects based on a valuemaximizing acceptance criterion.

Reevaluate implemented
investment projects continually
and perform postaudits for
completed projects.

12-5

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)
12-6

Screening Proposals
and Decision Making
1. Section Chiefs
2. Plant Managers
3. VP for Operations
4. Capital Expenditures
Committee
5. President
6. Board of Directors
12-7

Advancement
to the next
level depends
on cost
and strategic
importance.

Estimating After-Tax
Incremental Cash Flows
Basic characteristics of
relevant project flows

12-8

Cash (not accounting income) flows

Operating (not financing) flows

After-tax flows

Incremental flows

Estimating After-Tax
Incremental Cash Flows
Principles that must be adhered
to in the estimation

12-9

Ignore sunk costs

Include opportunity costs

Include project-driven changes in

working capital net of spontaneous
changes in current liabilities

Include effects of inflation

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).

12-10

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.

12-11

MACRS Sample Schedule

Recovery
Year
1
2
3
4
5
6
7
8
12-12

Property Class
3-Year
5-Year
33.33%
20.00%
44.45
32.00
14.81
19.20
7.41
11.52
11.52
5.76

7-Year
14.29%
24.49
17.49
12.49
8.93
8.92
8.93
4.46

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
12-13

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

12-14

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).

Often historically, capital gains income

has received more favorable U.S. tax
treatment than operating income.

12-15

Corporate Capital
Gains / Losses

Currently, capital gains are taxed

at ordinary income tax rates for
corporations, or a maximum 35%.

Capital losses are deductible only

against capital gains.

12-16

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.

12-17

Initial Cash Outflow

a)

Cost of new assets

Capitalized expenditures

b)

c)

+ (-) Increased (decreased) NWC

d)

e)

+ (-) Taxes (savings) due to the sale

of old asset(s) if replacement

f)

12-18

Net proceeds from sale of

old asset(s) if replacement

Initial cash outflow

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)

d)

- (+) Net incr. (decr.) in taxes

e)

f)

+ (-) Net incr. (decr.) in tax depr. charges

g)

12-19

Net change in income before taxes

Net change in income after taxes
Incremental net cash flow for period

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)

12-20

Terminal year incremental net cash flow

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.

12-21

Initial Cash Outflow

a)

$50,000

b)

20,000

c)

5,000

d)

0 (not a replacement)

e)

+ (-)

0 (not a replacement)

f)

12-22

$75,000*
* Note that we have calculated this value as a
positive because it is a cash OUTFLOW (negative).

Incremental Cash Flows

a)

Year 1

Year 2

Year 3

Year 4

$40,000

$40,000

$40,000

$40,000

b)

23,331

31,115

10,367

5,187

c)

$16,669

$ 8,885

$29,633

$34,813

d)

6,668

3,554

11,853

13,925

e)

$10,001

$ 5,331

$17,780

$20,888

f)

23,331

31,115

10,367

5,187

g)

$33,332

$36,446

$28,147

$26,075

12-23

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.
12-24

NWC - Project ends.

Terminal-year incremental cash

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

* Notice again that this value is a negative

cash flow as we calculated it as the initial
cash OUTFLOW in slide 12-18.
12-25

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).

12-26

Initial Cash Outflow

a)

$50,000

b)

20,000

c)

5,000

d)

e)

f)

12-27

6,000 (sale of old asset)

2,400 <---- (tax savings from
loss
on
sale
of
$66,600
old asset)

Calculation of the
Change in Depreciation
a)

Year 1

Year 2

Year 3

Year 4

$23,331

$31,115

$10,367

$ 5,187

b)

6,000

6,000

c)

$17,331

$25,115

$10,367

$ 5,187

a) Represent the depreciation on the new

project.
b) Represent the remaining depreciation on the
old project.
12-28

c) Net change in tax depreciation charges.

Incremental Cash Flows

a)

Year 1

Year 2

Year 3

Year 4

$10,000

$10,000

$10,000

$10,000

17,331
25,115
$ -7,331 -$15,115

10,367
$ -367

5,187
$ 4,813

-147

1,925

-220

$ 2,888

10,367
$10,147

5,187
$ 8,075

b)

c)

d)

-2,932

-6,046

e)

$ -4,399

$ -9,069

f)

g)

17,331
25,115
$12,932 $16,046

12-29

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.
12-30

Return of added NWC.

Terminal-year incremental cash

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

12-31