© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 9: Capital Budgeting and Cash Flow Analysis

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter discusses capital budgeting and capital expenditures  It deals with the financial management of the assets on a firm’s balance sheet

© 2004 by Nelson, a division of Thomson Canada Limited 3 Capital Budgeting  The process of planning for purchases of assets whose useful lives are expected to continue beyond a year  Capital Expenditure A cash outlay expected to generate a flow of future cash benefits for more than one year  Capital budgeting decisions can be among the most complex decisions facing management

© 2004 by Nelson, a division of Thomson Canada Limited 4 Examples of Capital Expenditures  Expand an existing product line  Increase or decrease working capital  Refund an issue of debt  Leasing versus buying an asset  Mergers and acquisitions  Enter a new line of business  Repair versus replacing a machine  Advertising campaigns  Research and Development activities

© 2004 by Nelson, a division of Thomson Canada Limited 5 Types of Investment Projects  Growth opportunities  Cost reduction opportunities  Required to meet legal requirements  Required to meet health and safety standards

© 2004 by Nelson, a division of Thomson Canada Limited 6 How Projects are Classified  Independent Acceptance or rejection has no effect on other projects  Mutually Exclusive Acceptance of one automatically rejects the others (replace versus repair)  Contingent Acceptance of one project is dependent upon the selection of another

© 2004 by Nelson, a division of Thomson Canada Limited 7 Cost of Capital  Firm’s overall cost of funds, often referred to WACC or Weighted Average Cost of Capital  Equal to a weighted average of the investors’ required rates of return  The discount rate used to analysis capital budgeting proposals

© 2004 by Nelson, a division of Thomson Canada Limited 8  Expand output until marginal revenue equals marginal cost  Invest in the most profitable projects first  Continue accepting projects as long as the rate of return exceeds the marginal cost of capital (MCC) Optimal Capital Budget

© 2004 by Nelson, a division of Thomson Canada Limited 9 The Optimal Capital Budget Funding available MCC Rate Return exceeds cost Cost exceeds return Fund these projects Project Return

© 2004 by Nelson, a division of Thomson Canada Limited 10 Capital Budgeting Problems  All projects may not be known at one time  Changing markets, technology, and corporate strategies can quickly make current projects obsolete and make new ones profitable  Difficulty in determining the behavior of the marginal cost of capital (MCC)  Estimates of project cash flows have varying degrees of uncertainty

© 2004 by Nelson, a division of Thomson Canada Limited 11 Capital Budgeting Process  Step 1: Generate proposals  Step 2: Estimate the cash flows  Step 3: Evaluate alternatives and select projects  Step 4: Review prior decisions

© 2004 by Nelson, a division of Thomson Canada Limited 12 Estimating Cash Flows  Calculate only the incremental cash flows.  Measure on an after-tax basis.  All indirect effects should be included.  Sunk costs should not be considered  Value of resources should be measured in terms of their opportunity cost rather than their actual cost.

© 2004 by Nelson, a division of Thomson Canada Limited 13 The Capital Budgeting Decision  The capital budgeting decision involves six steps: Calculate initial investment Calculate PV of the annual after-tax cashflows attributable to the new asset Calculate PV of the tax-shield due to Capital Cost Allowance (CCA) Calculate PV of salvage value Calculate PV of the tax shield lost due to salvage Calculate PV of any changes in working capital

© 2004 by Nelson, a division of Thomson Canada Limited 14 1: Calculate Initial Investment  The initial investment includes: The cost of the new asset Plus shipping & installation costs Less any trade-in value received from an old asset If expenditures on the new asset occur over a period of time, present value all costs back to time period zero

© 2004 by Nelson, a division of Thomson Canada Limited 15 2: PV of Annual After-Tax CFs T = corporate marginal tax rate k = WACC or discount rate t = year 1 through year N

© 2004 by Nelson, a division of Thomson Canada Limited 16 3: PV of Tax Shield due to CCA UCC = Undepreciated capital cost (cost - trade-in received) d = Capital cost allowance rate T = Corporate tax rate k = Firm’s cost of capital

© 2004 by Nelson, a division of Thomson Canada Limited 17 4: Calcuate PV of Salvage Salvage = the expected future salvage value k = the WACC or discount rate t = the number of years until the asset is salvaged

© 2004 by Nelson, a division of Thomson Canada Limited 18 5: PV of Tax Shield Lost from Salvage d = CCA rate T = Corporate tax rate k = WACC or discount rate t = number of years

© 2004 by Nelson, a division of Thomson Canada Limited 19 6: PV of Change in Working Capital Working Capital = Current assets - current liabilities  = Increase in working capital  = Decrease in working capital or

© 2004 by Nelson, a division of Thomson Canada Limited 20 Capital Budgeting: Example  Alki Dyes Ltd. buys a new tank for $18,000, including installation. The estimated salvage value at the end of its 3-year useful life is $1,000. CCA is charged at a 50% rate. The tank is expected to increase the firm’s pre-tax cash flows by $10,000/year for the three years of useful life. Working capital is expected to increase by $1,000 at the end of the first year. The firm’s tax rate and WACC are 46% and 14% respectively. What is the NPV of the new investment?

© 2004 by Nelson, a division of Thomson Canada Limited 21 Capital Budgeting: Solution Step 1: Initial investment Cash flow from tank purchase: -$18,000 Step 2: PV of annual cash flows

© 2004 by Nelson, a division of Thomson Canada Limited 22 Capital Budgeting: Solution Step 3: PV of tax-shield due to CCA

© 2004 by Nelson, a division of Thomson Canada Limited 23 Capital Budgeting: Solution Step 4: PV of salvage

© 2004 by Nelson, a division of Thomson Canada Limited 24 Capital Budgeting: Solution Step 5: PV of the tax-shield lost due to salvage

© 2004 by Nelson, a division of Thomson Canada Limited 25 Capital Budgeting: Solution Step 6: PV of the change in Working Capital

© 2004 by Nelson, a division of Thomson Canada Limited 26 Capital Budgeting: Solution -$18, $12, $6, $ $ $ $ Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: NPV

© 2004 by Nelson, a division of Thomson Canada Limited 27 Ethical Issues: Biased CF Estimates  The outcome of any capital budgeting exercise is only as good as the estimates used as inputs. Problems may arise from: Overestimated revenues Underestimated costs Unrealistic salvage values Ignoring necessary changes in working capital

© 2004 by Nelson, a division of Thomson Canada Limited 28 Major Points  Firms make investment decisions using a capital budgeting framework.  The capital budgeting process captures all of the incremental costs and benefits of undertaking a project.  If capital is unlimited, the firm will accept all positive NPV projects and reject all negative NPV projects.