Chapter 8. Capital Budgeting Cash Flow

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1 Chapter 8 Capital Budgeting Cash Flow

2 Learning Goals 1. Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. 2. Define basic capital budgeting terminology. 3. Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity costs, and international capital budgeting. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-2

3 Learning Goals (cont.) 4. Calculate the initial investment associated with a proposed capital expenditure. 5. Find the relevant operating cash inflows associated with a proposed capital expenditure. 6. Determine the terminal cash flow associated with a proposed capital expenditure. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-3

4 The Capital Budgeting Decision Capital Budgeting is the process of identifying, evaluating, and implementing a firm s investment opportunities. It seeks to identify investments that will enhance a firm s competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-4

Motives for Capital Expenditures Copyright 2006

7 Basic Terminology: Independent versus Mutually Exclusive Projects Independent Projects, on the other hand, do not compete with the firm s resources. A company can select one, or the other, or both so long as they meet minimum profitability thresholds. Mutually Exclusive Projects are investments that compete in some way for a company s resources a firm can select one or another but not both. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-7

8 Basic Terminology: Unlimited Funds versus Capital Rationing If the firm has unlimited funds for making investments, then all independent projects that provide returns greater than some specified level can be accepted and implemented. However, in most cases firms face capital rationing restrictions since they only have a given amount of funds to invest in potential investment projects at any given time. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-8

9 Basic Terminology: Accept-Reject versus Ranking Approaches The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm s minimum acceptance criteria. The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-9

12 The Relevant Cash Flows Incremental cash flows: are cash flows specifically associated with the investment, and their effect on the firms other investments (both positive and negative) must also be considered. For example, if a day-care center decides to open another facility, the impact of customers who decide to move from one facility to the new facility must be considered. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-12

14 Relevant Cash Flows: Expansion Versus Replacement Decisions Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-14

16 Relevant Cash Flows: Sunk Costs Versus Opportunity Costs Note that cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-16

17 Relevant Cash Flows: International Capital Budgeting International capital budgeting analysis differs from purely domestic analysis because: cash inflows and outflows occur in a foreign currency, and foreign investments potentially face significant political risks Despite these risks, the pace of foreign direct investment has accelerated significantly since the end of WWII. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-17

20 Finding the Initial Investment (cont.) Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. The asset was being depreciated under MACRS using a 5-year recovery period. Thus 52% of the cost (20% + 32%) would represent accumulated depreciation at the end of year two. Book Value = $100,000 - $52,000 = $48,000 Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-20

21 Finding the Initial Investment Sale of the Asset for More Than Its Purchase Price If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 - $48,000). Technically, the difference between the cost and book value ($52,000) is called recaptured depreciation and the difference between the sales price and purchase price ($10,000) is called a capital gain. Under current corporate tax laws, the firm must pay taxes on both the gain and recaptured depreciation at its marginal tax rate. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-21

22 Finding the Initial Investment (cont.) Sale of the Asset for More Than Its Book Value but Less than Its Purchase Price If Hudson sells the old asset for $70,000, it realizes a gain in the form of recaptured depreciation of $22,000 ($70,000 $48,000) which is taxed at the firm s marginal tax rate. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-22

23 Finding the Initial Investment (cont.) Sale of the Asset for Its Book Value If Hudson sells the old asset for its book value of $48,000, there is no gain or loss and therefore no tax implications from the sale. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-23

24 Finding the Initial Investment (cont.) Sale of the Asset for Less Than Its Book Value If Hudson sells the old asset for $30,000 which is less than its book value of $48,000, it experiences a loss of $18,000 ($48,000 - $30,000). If this is a depreciable asset used in the business, the loss may be used to offset ordinary operating income. If it is not depreciable or used in the business, the loss can only e used to offset capital gains. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-24

26 Finding the Initial Investment (cont.) Change in Net Working Capital Danson Company, a metal products manufacturer, is contemplating expanding operations. Financial analysts expect that the changes in current accounts summarized in Table 8.4 on the following slide will occur and will be maintained over the life of the expansion. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-26

28 Finding the Initial Investment (cont.) Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine s purchase price is $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 firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyers expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-28

30 Finding the Operating Cash Inflows Powell Corporation s estimates of its revenues and expenses (excluding depreciation and interest), with and without the new machine described in the preceding example, are given in Table 8.5. Note that both the expected usable life of the proposed machine and the remaining usable life of the existing machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380,000 and the installation costs of $20,000. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-30

Finding the Operating Cash Inflows (cont.

Finding the Terminal Cash Flow Copyright 2006

37 Finding the Terminal Cash Flow (cont.) Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5-year useable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Again, the tax rate is 40%. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-37

Chapter 6 Making Capital Investment Decisions

Chapter 6 Making Capital Investment Decisions Making Capital Investment Decisions Solutions to Even-Numbered Problems and Cases 6.2 Manitoba Railroad Limited (MRL) (a) Discount Rate 7% Cash Cash Net Cash Cumulative Year Outflows Inflows Flows Cash