capital budgeting and estimation of cash flows

capital budgeting and estimation of cash flows

1. 1
Capital Budgeting and
Estimating Cash Flows

2. 2
What is Capital Budgeting?
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.

3. 3
The Capital
Budgeting Process
Generate investment proposals
consistent with the firm’s strategic
objectives.
Estimate after-tax incremental
operating cash flows for the
investment projects.
Evaluate project incremental cash
flows.

4. 4
The Capital
Budgeting Process
Select projects based on a value-
maximizing acceptance criterion.
Reevaluate implemented
investment projects continually and
perform postaudits for completed
projects.

5. 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)

6. 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
Advancement
to the next
level depends
on cost
and strategic
importance.

7. 7
Estimating After-Tax
Incremental Cash Flows
Cash(not accounting income) flows
Operating(not financing) flows
After-tax flows
Incremental flows
Basic characteristics of relevant
project flows

8. 8
Estimating After-Tax
Incremental Cash Flows
Ignoresunk costs
Includeopportunity costs
Includeproject-driven changes in
working capital net of spontaneous
changes in current liabilities
Includeeffects of inflation
Principles that must be adhered to
in the estimation

9. 9
Tax Considerations
and Depreciation
Generally, profitable firms prefer to use
an accelerated method for tax reporting
purposes.
Depreciationrepresents the systematic
allocation of the cost of a capital asset
over a period of time for financial
reporting purposes, tax purposes, or
both.

10. 10
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

11. 11
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 andinstallation

12. 12
Sale or Disposal of a
Depreciable Asset
Often historically, capital gains
income has received more favorable
tax treatment than operating income.
Generally, the sale of a “capital asset” (as
defined by the IT Dept) generates a
capital gain (asset sells for more than
book value) or capital loss (asset sells for
less than book value).

13. 13
Corporate Capital Gains /
Losses
Capital losses are deductible only
against capital gains.
Currently, capital gains are taxed
at 20%, if indexed value is used for
corporations, or 10% on historical
cost.

14. 14
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 period’s cash flow.
Terminal-year incremental net cash flows
--the final period’s net cash flow.

15. 15
Initial Cash Outflow
a) Cost of “new” assets
b)+ Capitalized expenditures
c)+ (-)Increased (decreased) NWC
d)- Net proceeds from sale of
“old” asset(s) if replacement
e)+ (-)Taxes (savings) due to the sale
of “old” asset(s) if replacement
f)= Initial cash outflow

16. 16
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

17. 17
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

18. 18
Example of an Asset
Expansion Project
XLDhabaisconsideringthepurchaseofanew
juiceextractingmachine.Themachinewillcost
110,000plus10000forshippingandinstallation.
NWCwillriseby15,000.Companyforecaststhat
revenueswillincreaseby110,000foreachofthe
next4yearsandwillthenbesold(scrapped)for
10,000attheendofthefourthyear,whenthelifeof
themachineends.Operatingcostswillriseby
70,000foreachofthenextfouryears.XLDhabais
inthe30%taxbracket.

19. 19
Initial Cash flow
a)- 110,000
b)- 10,000
c)- 15,000
d)+ 0 (not a replacement)
e)-(+) 0 (not a replacement)
f)= -135,000

20. 20
Depreciation Calculation
Initial Investment-Salvage Value
Depreciation= -------------------------------------------------
Economic Life
110000-10000
= ------------------------------= 25000
4

21. 21
Incremental Cash Flows
Year 1Year 2Year 3Year 4
a) 40,000 40,000 40,000 40,000
b)- 25,000 25,000 25,000 25,000
c)= 15,000 15,000 15,000 15,000
d)- 4,500 4,500 4,500 4,500
e)= 11,500 11,500 11,500 11,500
f)+ 25,000 25,000 25,000 25,000
g)= 36,500 36,500 36,500 36,500

22. 22
Terminal-Year Incremental
Cash Flows
a) 36,500 The incremental cash flow
from the previous slide in
Year 4.
b)+ 10,000Salvage Value.
c)- 0
d)+ 15,000NWC -Project ends.
e)= 51,500 Terminal-year incremental
cash flow.

23. 23
Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1Year 2Year 3Year 4
-135,00036,500 36,500 36,500 51,500

24. 24
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 50,000 and depreciated using
straight-line over five years (10,000 per year). The
machine has three years of depreciation and four years
of useful life remaining. XL Dhaba can sell the current
machine for 15,000. 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 20,000 from 5,000 (old).

25. 25
Initial Cash Outflow
a) 110,000
b)+ 10,000
c)+ 15,000
d)- 15,000 (sale of “old” asset)
e)- 4,500 <----
f)=115,500
(tax savings from
loss on sale of
“old” asset)

26. 26
Calculation of the Change
in Depreciation
Year 1Year 2Year 3Year 4
a) 25,000 25,000 25,000 25,000
b)- 10,000 10,000 10000 0
0
c)= 15,000 15,000 15,000 25,000
a)Represent the depreciation on the “new”
project.
b)Represent the remaining depreciation on the
“old” project.
c)Net changein tax depreciation charges.

27. 27
Incremental Cash Flows
Year 1Year 2Year 3Year 4
a) 10,000 10,000 10,000 10,000
b)- 15,00015,000 15,000 25,000
c)= -5,000 -5000 -5000 -15,000
d)- -1,500 -1,500 -1,500 4,500
e)= -3,500 -3,500 -3,500 -11,500
f)+ 15,00015,000 15,000 25,000
g)= 11,500 11,500 11,500 13,500

28. 28
Terminal-Year Incremental
Cash Flows
a) 13,500The incremental cash flow
from the previous slide in
Year 4.
b)+ 10,000Salvage Value.
c)- 0
d)+ 15,000Return of “added” NWC.
e)= 38,500 Terminal-year incremental
cash flow.

29. 29
Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1Year 2Year 3Year 4
-135,00036,500 36,500 36,500 51,500
Asset Replacement
Year 0 Year 1Year 2Year 3Year 4
-115,50011,500 11,500 11,500 38,500

30. 30
Problem: 1(Purchase of a
New Asset)
SarafFinialFabricatingWoksisconsideringautomatingitsexisting
finialcastingandassemblydepartment.Theplantmanagerhas
accumulatedthefollowinginformationforyou:
•TheautomationproposalwouldresultinreducedlabourcostsofRs.
1500000peryear.
•ThecostofdefectsisexpectedtoremainatRs.50000evenifthe
automationproposalisaccepted.
•NewequipmentcostingRs.5000000wouldneedtobepurchased.For
taxpurposes,theequipmentwillbedepreciatedonastraight-linebasis
overitsusefulfour-yearlife.Theestimatedfinalsalvagevalueofthenew
equipmentisRs.500000.
•AnnualmaintenancecostswillincreasefromRs.20000toRs.80000if
thenewequipmentispurchased.
•Thecompanyissubjecttomarginaltaxrateof30percent.
Whataretherelevantincrementalcashinflowsovertheproposal’suseful
lifeandwhatistheincrementalcashoutflowattime0?

31. 31
Problem: 2(Replacement
of an Old Asset)
SahaandAssociatesisconsideringthereplacementoftwomachinesthat
arethreeyearsoldwithanew,moreefficientmachine.Theoldmachines
couldbesoldcurrentlyforatotalofRs.70000inthesecondarymarket,
buttheywouldhavezerosalvagevalueifheldtotheendoftheir
remainingusefullife.TheiroriginaldepreciablebasistotaledRs.300000.
Theyhaveadepreciatedtaxbookvalueof86400,andaremaininguseful
lifeofeightyears.Thenewmachinecanbepurchasedandinstalledfor
Rs.480000.Ithasausefullifeofeightyears,attheendofwhicha
salvagevalueof40000isexpected.Duetogreaterefficiency,thenew
machineisexpectedtoresultinincrementalannualoperatingsavingsof
Rs.100000.Thecompany’scorporatetaxrateis40percent,andisaloss
occursinanyyearontheproject,itisassumedthatthecompanycan
offsetthelossagainstothercompanyincome.Whataretheincremental
cashinflowsovertheeightyears,andwhatistheincrementalcash
outflowattime0?