FUNDAMENTALS OF CAPITAL

BUDGETING
 Corporate Capital Budgeting
• Capital budgeting is the process of analyzing investment opportunities
and making long term investment decisions.
• Numerous types of investment decisions that involve capital
expenditures.
• Capital expenditure is an outlay whose benefits are expected to
extend beyond one year.
• They are important to the firm because they often require substantial
expenditures that affect the firm’s profitability and future direction.
• These decisions have long term effect and once made are not easily
reversed.
• Sound capital investment decision can improve firm’s stock prices
which help the firm achieve its goal of maximizing shareholder wealth.
 Capital Budgeting Process
• It is a system of interrelated steps for making long term investment
decisions.
• Capital budgeting decisions logically flow from the firm’s business
strategy.
• Business strategy is the plan by which the firm hopes to achieve its
goals in a changing environment.
• Meeting some of these goals require capital expenditures, thus
business strategy often necessitates the capital budgeting process.
• Potential investment projects must pass a strategic test of
acceptability or compatibility with a firm’s business strategy.
• All strategically acceptable projects must then survive an economic
appraisal as well as other qualitative considerations.
• Capital budgeting process requires gathering
and analyzing information.
• Capital budgeting is a dynamic process because
firm’s changing environment may affect the
desirability of current or proposed investments.
• Information is needed throughout the process
to ensure that the process is operating
effectively.
• The information gathered and analyzed
includes not only new information but also
feedback on previous activities.
5 Major Steps in Capital Budgeting Process

• Generating project proposals

• Estimating cash flows
• Evaluating project proposals
• Selecting projects
• Implementing and reviewing projects
 Generating project proposals
• First step is to generate proposals for the
capital investment.
• Ideas come from many sources both inside
and outside the firm, good proposals do not
just appear.
Two approaches for generating proposals

• Under a top down approach proposal

originate with top mgt and information is
filtered down to the lower levels. Project
recommendations come from senior
managers and typically involve strategic
decisions which are non routine decisions and
involve many resources. They also require
authority to approve large capital outlays.
• Under a bottom up approach proposals
originate from below and are reported to
senior levels. Lower level managers make
proposals that require only operating
decisions which are routine in nature and
involve little capital. Administrative decisions
are made by middle managers and involve
projects requiring moderate resources such as
replacing manufacturing equipment.
• Investment projects are classified in to four
major categories:
• Expansion projects.
• Replacement projects.
• Modernization projects.
• Safety or environmental projects.
 Estimating Cash flows
• Next step is estimating cash flows.
• Net cash flow is the difference between inflows and outflows
of cash that result from a firm undertaking a project.
• Deriving accurate estimates is the most difficult task.
• This step is important because no later stage can overcome
inaccurate or unreliable information generated by this step.
• In a dynamic business environment projecting the cash flows
of a particular product is difficult.
• Past experience may help financial managers identify factors
that affect cash flows of some projects.
 Cash flows differ from accounting profit
• Accounting profit is not necessarily based on cash receipts or
payments.
• Income Tax Reform Act 1986 provides that certain taxpayers
including most corporations must use the accrual method of
accounting for federal income tax purposes.
• Under the accrual basis revenue is recognized as it is earned and
expenses are recognized as they are incurred, not when cash
changes hands.
• Although certain non cash items including depreciation and
amortization are treated as expenses.
• Depreciation expense permits the firm to reduce its tax burden, no
actual payment of cash is involved.
 Only incremental after tax cash flows are
relevant
• Incremental after tax cash flows include all changes in
the firm’s cash inflows and cash outflows that result
from undertaking an investment project.
• Cash flows that are not attributable to the investment
are not relevant.
• Cash flows that occur before the investment decisions
are sunk costs.
• Sunk costs are not relevant because they are
unrecoverable costs & do not change with the
acceptance or rejection of the project.
• Costs associated with financing a project
involve actual cash outflows but are excluded
from the project’s cash flows.
• The financial flows are incorporated in to the
firm’s cost of capital or required rate of return
which is the discount rate used for evaluating
projects.
 Cash flows of a project falls in to three
categories
• Net investment is the initial cash outlay needed to acquire
a specific investment project.
• Most projects require significant initial outlay before they
generate cash inflows.
• The net investment is calculated by subtracting any initial
cash inflows that occur in placing an assets in to service
from the amount of the initial cash outflows required by
the project.
• The net investment is assumed to occur at time period zero
although the cash inflows and outflows constituting the net
investment may occur at several points of time.
Purchase price of new asset
+ Installation and transportation costs
+ Additional net working capital
- Proceeds from sale of old assets
+ Tax effects on disposal of old asset and or the
purchase of new one
= Net investment
• The initial cash outflows include the purchase price of
the new asset, outlays for installation and
transportation, additional net working capital and any
other cost incurred to put the assets in to service (Net
working capital is the excess of current assets over
increased current liabilities required to support the
project).
• The initial cash inflows include the proceeds from the
disposal of existing assets if the investment proposal
involves replacing an old asset with a new one. The
tax impact of selling a depreciable asset can produce
an increase or decrease in the firm’s income tax
liability.
• The effects of the sale of an existing asset on
the net investment in a new asset depend on
the selling price, its original cost, and the
current book value.
TRANSACTION TAX EFFECT
Sale of a plant or equipment at its None
book value
Sale of plant or equipment at less (SP – BV) x MT = (8,000 – 10,000) x
than its book value 0.34 = -680 = Tax Saving

Sale of plant or equipment at more (SP – BV) x MT = (10,000 – 8,000) x

than its book value but less than or 0.34 = 680 = Tax Liability
equal to its original cost

Sale of plant or equipment at more (OC-BV) x MT + (SP – OC ) x MT =

than its original cost (9,000-8000) x 0.34 + (10,000-
SP = 10,000 9,000) x 0.34
OC = 9,000
BV = 8,000
 Replacement Proposal
Net Investment
NCF = Outflows - Inflows

Purchase price of new asset = $20,000

+ Installation and transportation costs =$2,000
+ Additional net working capital =$5,000
- Proceeds from sale of old assets = $10,000
+ Tax liability on the disposal of old asset = 680
= Net investment = $17,680
 Net Operating Cash flows
• Net operating cash flows are the incremental
changes in a firm’s cash flows that result from
investing in a project.
• It may vary over the project’s life and the
timing of these varying flows may also vary
during the year.
• They are generally assumed to occur at the
end of a given year.
Revenues (Cash)
- Operating expenses (Cash)
- Depreciation expenses (Non Cash)
Taxable income
- Income taxes (Cash)
Net income
+ Depreciation expenses (Non cash)
Net operating cash flows
• 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 3-year 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.
 Depreciation Calculation
• 1st year’s Annual Dep amount = Dep Basis x Dep
rate
• = 70,000 x 0.3333
• = 23,331
• 2nd year’s ann dep amt = 70,000 x 0.4445 = 31,115
• 3rd year’s ann dep amt = 70,000 x 0.1481 = 10,367
• 4th year’s ann dep amt = 70,000 x 0.0741 = 5,187
 Expansionary Proposal
Net Investment
Purchase price of new asset = 50,000
+ Installation and transportation costs = 20,000
+ Additional net working capital = 5,000
- Proceeds from sale of old assets = 0
+ Tax effects on disposal of old asset and or the
purchase of new one = 0
= Net investment = $75,000
 Net Operating Cash Flow
Revenues (Cash) = 110,000
- Operating expenses (Cash) = 70,000
- Depreciation expenses (Non Cash) = 23,331
Taxable income = 16,669
- Income taxes (Cash) = 6,668
Net income = 10,001
+ Depreciation expenses (Non cash) = 23,331
Net operating cash flows = 33,332
 Net Operating Cash Flow
Revenues (Cash) = 110,000
- Operating expenses (Cash) = 70,000
- Depreciation expenses (Non Cash) = 31,115
Taxable income = 8,885
- Income taxes (Cash) = 3,554
Net income = 5,331
+ Depreciation expenses (Non cash) = 31,115
Net operating cash flows = 36,446
 Net Operating Cash Flow
Revenues (Cash) = 110,000
- Operating expenses (Cash) = 70,000
- Depreciation expenses (Non Cash) = 10,367
Taxable income = 29,633
- Income taxes (Cash) = 11,853.2
Net income = 17,779.8
+ Depreciation expenses (Non cash) = 10,367
Net operating cash flows = 28,146.8
 Net Operating Cash Flow
Revenues (Cash) = 110,000
- Operating expenses (Cash) = 70,000
- Depreciation expenses (Non Cash) = 5,187
Taxable income = 34,813
- Income taxes (Cash) = 13,925.2
Net income = 20,887.8
+ Depreciation expenses (Non cash) = 5,187
Net operating cash flows = 26,074.8
 Net terminal cash flow
• Is the net cash flow resulting from ending a project.
• The financial manager must decide when the project will be terminated.
• At the end of the final year, the firm receives cash inflows in the form of
salvage valuation on the sale of the asset plus the release of any working
capital as a result of termination.
• Net working capital is a cash inflow because it is assumed to be
liquidated and returned to the firm as cash.
• No tax consequences are associated with the changes in net working
capital.
• The terminal cash inflows are reduced by any removal costs as they are
an operating expenses, the taxes on the sale of the asset are determined
after subtracting removal costs.
Salvage value = 10,000
- Removal costs = 0
Salvage value before taxes = 10,000
- Income taxes = 4,000
Net salvage value = 6,000
+ Release of net working capital = 5,000
= Terminal cash flow = $11,000
 Time line
•
• 0 1 2 3 4
-75,000 33,332 36,446 28,146.8 $37,074.8
 Cash flow’s two patterns
• A conventional cash flow is a time series that
contains only one change in sign.
• A non conventional cash flow is a time series
of net cash flows that contains more than one
change in sign. Investment projects with con
conventional cash flows may produce
contradictory evaluations.
 Evaluating Project Proposals
• After the projection of cash flows, the next step is
evaluating project proposals.
• Capital investments are evaluated under risk or certainty.
• Under certainty the exact values associated with the
investment are known in advance.
• In practice few financial variables are known in advance
with certainty.
• Under risk, variables required for evaluating investment
proposals are not certain and involve a margin of error.
• Numerous techniques are available for this.
 Selecting Projects
• The final selection of the project depends on three major factors:
project type, availability of funds, and decision criteria.
• Capital expenditure decisions may be classified as independent and
mutually exclusive.
• An independent project is one having a distinct function.
• A mutually exclusive project is an alternate way of performing the
same function as other projects under consideration.
• The availability of funds affect capital budgeting decisions. Unlimited
funds allow a firm to operate with no constraints on its capital
expenditures.
• A firm with no capital constraints should accept all projects that
meet its selection criteria.
• Capital rationing occurs when a firm places an upper limit on its capital
expenditures.
• Under capital rationing a firm may not maximize shareholder wealth because it
may reject profitable projects.
• A firm that rations funds should allocate the funds in a way that maximizes
long run return within the budget constraints.
• Decision criteria are established to rank projects and to provide a cutoff point
for capital expenditures.
• Frequently there are more proposals for projects than the firm is able or willing
to finance.
• Ranking techniques are used to select the best subset of acceptable projects
from a larger set that cannot be fully funded.
• Projects are ranked according to a prescribed hurdle rate or minimum
acceptable rate of return.
• Capital budgeting techniques provide a useful quantitative basis for project
selection.
• Qualitative factors such as personal preferences of decision makers, ethics,
and social responsibility also serve as inputs in the selection process.
 Implementing and Reviewing Projects
• Final step is implementing and reviewing accepted projects.
• Decision to accept or reject a project must be communicated to its
originator and to others in the firm.
• Acceptable projects must be implemented in a timely and efficient
manner.
• The implementation stage involves developing formal procedures
for authorizing the expenditures of funds for capital projects.
• The review stage involves analyzing projects that have been
adopted in order to determine if they should be continued,
modified, or terminated.
• After a project is completed, a post audit is conducted in which
comparisons are made between earlier estimates and actual data.