1. Cash Flows and Other Topics in Capital Budgeting
Cash Flow estimation
Problems in Capital Budgeting
Capital Rationing
Problems with Project Ranking
Size disparity problem
Time disparity problem
Mutually exclusive investment with unequal lives

2. Capital Budgeting Example
Capital Budgeting: the process of planning for purchases of long-term assets.
Example:
Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on the investment?
The relevant project information follows:

3. Capital Budgeting Example (Continued)
The cost of the new machine is $127,000
Installation will cost $20,000
$4,000 in net working capital will be needed at the time of installation
The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase
Simplified straight line depreciation is used
Class life is 5 years, and the firm is planning to keep the project for 5 years
Salvage value at the end of year 5 will be $50,000
14% cost of capital; 34% marginal tax rate

4. Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows occurring as a result of the project.
Initial outlay
Differential Cash Flows over the life of the project (also referred to as annual cash flows)
Terminal Cash Flows

5. Capital Budgeting Steps (Continued)
2) Evaluate the risk of the project
For now, we’ll assume that the risk of the project is the same as the risk of the overall firm if not we would require a greater return
If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects. We’ll cover cost of capital in Chapter 12
3) Accept or Reject the Project

6. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
– Purchase price of the asset
+ – Shipping and installation costs
= – Depreciable asset
+ – Investment in working capital
+ After-tax proceeds from sale of old asset
= – Net Initial Outlay

7. Step 1: Evaluate Cash Flows (Continued)
a) Initial Outlay: What is the cash flow at “time 0?” Note amounts in parentheses are negative
–127,000 Purchase price of asset
+ –20,000 Shipping and installation
= –147,000 Depreciable asset
+ –4,000 Net working capital
Proceeds from sale of old asset
= –151,000 Net initial outlay

8. Step 1: Evaluate Cash Flows (Continued)
b) Annual Cash Flows: What incremental cash flows occur over the life of the project?
Incremental revenue
– Incremental costs
– Depreciation on project
= Incremental earnings before taxes
– Tax on incremental EBT (Based on marginal tax rate)
= Incremental earnings after taxes
+ Depreciation reversal (Because it is not an actual cash flow)
= Annual Cash Flow

9. Step 1: Evaluate Cash Flows (Continued)
85,000 Revenue
–29,750 Costs (35% of revenues)
–29,400 Depreciation (Straight-line over 5 years, 147K/5)
25,850 EBT
–8,789 Taxes (34 marginal tax rate)
17,061 EAT
29,400 Depreciation reversal
46,461 Annual Cash Flow

10. Step 1: Evaluate Cash Flows (Continued)
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50,000 Salvage value
+/ – Tax effects of capital gain/loss
+ Recapture of net working capital
= Terminal Cash Flow

11. Tax Effects of Sale
Salvage value (SV) = $50,000
Book value (BV) = depreciable asset – total amount depreciated.
Book value = $147,000 – $147,000 = $0
Capital gain = SV – BV = 50,000 – 0 = $50,000
Tax payment = 50,000 x 0.34 = $17,000

12. Step 1: Evaluate Cash Flows (Continued)
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50,000 Salvage value
–17,000 Tax on capital gain
4,000 Recapture of NWC
37,000 Terminal Cash Flow

13. Project NPV
CF(0) = –151,000
CF(1 – 4) = 46,461
CF(5) = 46, ,000 = 83,461
Discount rate = 14%
NPV = $27,721
We would accept the project

14. Problems in Capital Budgeting: Capital Rationing
Suppose that you have evaluated 5 capital investment projects for your company
Suppose that the VP of Finance has given you a limited capital budget
How do you decide which projects to select?
Ranking projects by IRR is not always the best way to deal with a limited capital budget
It’s better to pick the largest NPVs
Let’s try ranking projects by NPV

15. Problems with Project Ranking
1) Mutually exclusive projects of unequal size (the size disparity problem)
The NPV decision may not agree with IRR or PI
Solution: select the project with the largest NPV

16. Size Disparity – Example
Project A
year cash flow
0 (135,000)
,000
,000
,000
required return = 12%
IRR = 15.89%
NPV = 9,1100
PI = 1.07
Project B
year cash flow
0 (30,000)
,000
,000
,000
required return = 12%
IRR = 23.38%
NPV = 6,027
PI = 1.20

17. Problems with Project Ranking (Continued)
2) The time disparity problem with mutually exclusive projects
NPV and PI assume cash flows are reinvested at the required rate of return for the project
IRR assumes cash flows are reinvested at the IRR
The NPV or PI decision may not agree with the IRR
Solution: select the largest NPV

18. Time Disparity – Example
Project A
year cash flow
0 (48,000)
,200
,400
,000
,000
required return = 12%
IRR = 18.10%
NPV = $9,436
PI = 1.20
Project B
year cash flow
0 (46,500)
,500
,000
,400
,400
required return = 12%
IRR = 25.51%
NPV = $8,455
PI = 1.18

19. Problems with Project Ranking (Continued)
3) Mutually exclusive investments with unequal lives
Suppose our firm is planning to expand and we have to select 1 of 2 machines
They differ in terms of economic life and capacity
How do we decide which machine to select?

20. Mutually Exclusive Investments with Unequal Lives
The after-tax cash flows are:
Year Machine Machine 2
(45,000) (45,000)
, ,000
, ,000
, ,000
,000
,000
,000
Assume a required return of 14%

21. Step 1: Calculate NPV
NPV1 = $1,433
NPV2 = $1,664
So, does this mean #2 is better?
No! The two NPVs can’t be compared!

22. Step 2: Equivalent Annual Annuity (EAA) Method
If we assume that each project will be replaced an infinite number of times in the future, we can convert each NPV to an annuity
The projects’ EAAs can be compared to determine which is the best project!
EAA: Simply annualize the NPV over the project’s life

23. EAA with your Calculator
Simply “spread the NPV over the life of the project”
Machine 1: PV = –1,433, N = 3, I = 14,
Solve: PMT =
Machine 2: PV = –1,664, N = 6, I = 14,
Solve: PMT =

24. EAA Decision Rule EAA1 = $617 EAA2 = $428 This tells us that:
NPV1 = annuity of $617 per year
NPV2 = annuity of $428 per year
So, we’ve reduced a problem with different time horizons to a couple of annuities
Decision Rule: Select the highest EAA. We would choose machine #1

25. EAA Decision Rule
Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return
NPV∞,1 = 617 / 0.14 = $4,407
NPV∞,2 = 428 / 0.14 = $3,057
This doesn’t change the answer, of course; it just converts EAA to a NPV that can be compared