Chapter 9 Introduction Capital budgeting is the decision-making process used in the acquisition of long-term physical assets. Traditional capital budgeting projects include decisions to invest in the following: A new hotel A casino expansion Addition of a bar to a restaurant Replacement of a sprinkler system at a hotel

Chapter 9 Introduction Capital budgeting decisions are crucial to a firm’s long-term financial health. Successful capital budgeting projects usually generate a positive cash flow for a long period of time. Unsuccessful capital budgeting projects do not return sufficient cash flow to justify the investment. Such projects usually continue to generate losses or are liquidated for a large one-time loss. Capital budgeting decisions set a firm’s future course by determining what services will be offered, how they will be offered, and where they will be offered.

Organization of Chapter 9 Different types of capital budgeting projects; classification of projects by purpose and by type of analysis Project cash flows and principles of cash flow estimation Project cost—net investment estimation

Organization of Chapter 9 A project’s future cash inflows—net cash flow estimation Project termination—after-tax salvage value estimation Project depreciation and its impact on cash flow

Classifying Capital Budgeting Projects The purpose of a project may be to: Grow the firm causing future sales, profits, and cash flows to increase; includes typical expansion projects. Reduce the firm’s future operating costs causing future profits and cash flows to increase; examples include new, more efficient air conditioners or new kitchen equipment requiring less maintenance. Meet legal requirements or satisfy ethical considerations; examples include fire alarm and fire suppression systems.

Classifying Capital Budgeting Projects Independent versus mutually exclusive projects. An independent project requires a stand-alone decision. The project is analyzed in isolation and not compared to other projects. An example is a proposal to add a new 200-room tower to a hotel.

Classifying Capital Budgeting Projects Mutually exclusive projects require a choice between two or more projects. For example, a decision to replace the air conditioning system with brand x, brand y, or brand z is a mutually exclusive decision. If you decide to invest in a new air conditioning system by brand x, then brands y and z have been excluded!

Project Cash Flows Estimating a project’s impact on a firm’s future cash flows is a crucial part of the investment decision. Some basic principles need to be followed when estimating a project’s cash flows: An incremental basis An after-tax basis Indirect effects should be included Costs should be measured as opportunity costs and not based upon historical or sunk costs

Project Cash Flows The capital budgeting decision is essentially based upon a cost/benefit analysis. The cost of a project is called the net investment. The benefits from a project are the future cash flows generated. We call these the net cash flows.

Net Investment The net cash outflows required to ready a project for its basic operation; the net investment includes: Cost of any assets + Delivery costs + Installation costs + Any required increase in net working capital – After-tax salvage value from replaced assets

Net Cash Flows These are the future cash flows generated from a project once it commences operation. The net cash flows are expected to continue throughout the project’s economic life. The net cash flow for each year is:  Earnings before taxes x (1 – t) +  Depreciation -  Net working capital

Net Cash Flows And  Earnings before taxes is estimated by:  Sales revenue –  Operating expenses –  Depreciation Interest expense is generally not included in the net cash flows since it will be taken into account later through the firm’s required rate of return.

Terminal Nonoperating Cash Flow These are special one-time cash flows that only occur at the end of a project’s life. They are added to a project’s last net cash flow. They include: After-tax salvage value of the project’s assets Return of any increased net working capital

Computation of After-Tax Salvage Values Taxes owed on salvage value depend upon the salvage price relative to the asset’s book value. As asset’s book value is the asset’s original acquisition cost minus all depreciation taken on the asset (accumulated depreciation).

Computation of After-Tax Salvage Values If an asset is sold for its book value then no taxes are owed. If an asset is sold for more than book value, then taxes are owed on this excess. If an asset is sold for less than book value, then taxes are reduced. The loss acts as a tax shelter, reducing taxes by an amount equal to the firm’s marginal tax rate times the deficit.

Depreciation The depreciation actually affecting cash flow is MACRS depreciation used for taxes. MACRS depreciation varies by type of asset but always depreciates to a zero value, not an estimated salvage value. Here we will simplify by assuming straight-line depreciation to a zero value.

Depreciation Depreciation shelters income from taxes. Thus, greater depreciation reduces taxes. Depreciation is not an out-of-pocket expense. Thus an increase in depreciation will reduce profit but increase cash flow.

Summary of Chapter 9 Topics The significance of good capital budgeting decisions to a firm’s long-term financial health Projects can be classified according to: Purpose Independent versus mutually exclusive decisions

Summary of Chapter 9 Topics The cash flows associated with a project are crucial to the investment decision. They include: Net investment Net cash flows Terminal nonoperating cash flows