1. Planning Investments: Capital Budgeting
Chapter 12
Planning Investments: Capital Budgeting

2. 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

3. 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

4. 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

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

6. 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)

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

8. 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.)

9. 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)

10. 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

11. 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

12. 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

13. 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.

14. 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.

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