1. Chapter 7 Cash Flow of Capital Budgeting

2. Will the machine be profitable?
Capital Budgeting: The process of planning for purchases of long-term assets.
For 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. 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
1) Evaluate Cash Flows
Terminal
Cash flow
Initial
outlay 1 2 3 4 5 n 6
. . .
Annual Cash Flows

6. Capital Budgeting Steps
2) Evaluate the Risk of the Project
We’ll get to this in the next chapter.
For now, we’ll assume that the risk of the project is the same as the risk of the overall firm.
If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.

7. Capital Budgeting Steps
3) Accept or Reject the Project

8. 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

9. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

10. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

11. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

12. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

13. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ (20,000)
(147,000)
+ (4,000)
Net Initial Outlay

14. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(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

15. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(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

16. Step 1: Evaluate Cash Flows
b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

17. For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

18. For Years 1 - 5: Incremental revenue - Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

19. For Years 1 - 5: 85,000 - Incremental costs - Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

20. For Years 1 - 5: 85,000 (29,750) - Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

21. For Years 1 - 5:
85,000
(29,750)
(29,400)
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

22. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

23. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

24. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
+ Depreciation reversal
Annual Cash Flow

25. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow

26. For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow

27. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

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

29. Tax Effects of Sale of Asset:
Salvage value = $50,000.
Book value = depreciable asset - total amount depreciated.
Book value = $147,000 - $147,000
= $0.
Capital gain = SV - BV
= 50, = $50,000.
Tax payment = 50,000 x .34 = ($17,000).

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

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

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

33. Project NPV: CF(0) = -151,000. CF(1 - 4) = 46,461.
Discount rate = 14%.
NPV = $27,721.
We would accept the project.

34. Capital Rationing
Suppose that you have evaluated five 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?

35. Capital Rationing
You could rank the projects by IRR:

36. Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15%
20%
25% $
Our budget is limited
so we accept only
projects 1, 2, and 3. 1 2 3 4 5 $X

37. Capital Rationing You could rank the projects by IRR: IRR 5% 10% 15%
20%
25% $
Our budget is limited
so we accept only
projects 1, 2, and 3. 1 2 3 $X

38. Capital Rationing
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.

39. 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.

40. Size Disparity Example
Project A
year cash flow
0 (135,000)
,000
,000
,000
required return = 12%
IRR = 15.89%
NPV = $9,110
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

41. Problems with Project Ranking
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.

42. 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

43. Mutually Exclusive Investments with Unequal Lives
Suppose our firm is planning to expand and we have to select one of two machines.
They differ in terms of economic life and capacity.
How do we decide which machine to select?

44. 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%.

45. 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!