Planning Investments: Capital Budgeting Chapter 12 Planning Investments: Capital Budgeting

What are the Steps in the Capital Budgeting Process? Identify the opportunity Select appropriate investments Determine how to finance the investments Accept or reject the opportunity

What are the Steps in the Net Present Value Method of Capital Budgeting? Estimate the relevant cash inflows and cash outflows Determine the present value of the future cash flows using the company’s weighted average cost of capital Compute the net present value Accept or reject the proposal

What are the Sources of Cash Inflows? Cash receipts from using the asset (net of tax) Decrease in working capital requirements Sale of old assets (net of tax) Sale of new assets at the end of the project (net of tax) Tax savings due to tax shield

What are the Sources of Cash Outflows? Increase in working capital requirements Cash expenditures from using the asset (net of tax)

How is the Weighted Average Cost of Capital Determined? (% of company financed by debt * rate of interest on debt) + (% of company financed by owners’ equity * required rate of return on owners’ equity)

How is the NPV Determined? (Sum of the present value of cash inflows and outflows) less the initial investment

What Costs are Included in the Initial Investment Amount? All costs necessary to obtain and get the asset ready for its intended use. Cost of the asset itself Cost to receive the asset (freight, etc.) Cost to setup the asset (installation, etc.)

How do we Determine Net of Tax Amounts? Cash receipts and expenditures Cash flow * (1 – tax rate) Tax shield from depreciation Depreciation amount * tax rate Proceeds from sale of asset with gain Proceeds – (gain * tax rate) Proceeds from sale of asset with loss Proceeds + (loss * tax rate)

Net of Tax Examples Total cash inflows are $100,000 and the tax rate is 20%, what are the net cash inflows? $100,000 * 0.80 = $80,000; or $100,000 – ($100,000 * 0.20) = $80,000

Net of Tax Examples Continued Total cash outflows are $70,000 and the tax rate is 30%, what are the net cash outflows? $70,000 * 0.70 = $49,000; or $70,000 – ($70,000 * 0.30) = $49,000

Net of Tax Examples Continued An asset will cost $100,000 and be used for 10 years. It is depreciated uniformly over its life and the tax rate is 25%. What is the annual tax shield? $100,000 / 10 years = $10,000 depreciation $10,000 * 0.25 = $2,500 tax shield

Taxes and Gains An asset with a book value of $10,000 will be sold for $15,000. The tax rate is 35%. What is the after-tax cash inflow? Proceeds $15,000 – Book value $10,000 = Gain $5,000. Gain $5,000 * 0.35 = $1,750 Tax Paid on Gain. Cash inflow = $15,000 - $1,750 = $13,250.

Taxes and Losses An asset with a book value of $10,000 will be sold for $8,000. The tax rate is 20%. What is the after-tax cash inflow? Proceeds $8,000 – Book Value $10,000 = Loss $2,000. Loss $2,000 * 0.20 = $400 Tax Savings on Loss. Cash inflow = $8,000 + $400 = $8,400.

What Other Factors should be Considered? Human judgment Uncertainty Qualitative factors