1. Presentation
Chapter 9
Capital Budgeting
Cash Flows

2. Two Sides of an Investment Decision
Likely Return. Forecast the expected return from the investment. Compare an expenditure of cash and with a stream of cash inflows.
Required Return. Determine the required return given the level of risk.
If an investment requires a 20% return after taxes, the proposal must offer such a likely return.

3. After-tax Cash Flows
A cash flow stream identifies all cash outlays and inflows matched with the time periods in which they occur.
Money is invested in a project.
Money comes back from the investment.
Only cash is considered in the analysis.

4. Cash Flow Stream
Outlay: $6 million at the start of a year and $4 million at the end.
Annual inflows: $1 million.
Residual value: $8 million at end of year 4.
Year –1 Year 0 Year 1 Year 2 Year 3 Year 4
-6, , , ,000 +1, ,000

5. Accounting Calculations
Limited to 3 areas:
Income Tax Effects. If any.
Balance Sheet Effects. Avoid upsetting creditors or investors.
Future Earnings. Stability of earnings as a result of impact on net income.

6. Planning Horizon
A time period for the evaluating a capital investment.
Four to seven years is common.
An investment is made in year zero.
Its market value is estimated at the end of the planning horizon.
All cash effects during the period are considered.

7. Question
A four to seven year planning horizon is adequate to assess the investment in a $40 million ocean-going vessel, even though it has a 20-year service life. Do you agree?

8. Answer
Agree. The key is to include an ending value for the project estimated based on construction costs and the availability of other vessels.

9. Developing a Cash Flow Stream (1)
Seven steps:
#1. Net Cash Outlay. All money spent to begin a capital project.
#2. Depreciation Schedule. Used for tax calculation.
#3. Amortization Schedule. Use for cash effects of interest and principal and tax calculation at end of planning horizon.

10. Developing a Cash Flow Stream (2)
#4. Tax Calculation. Used for tax effects.
#5. Project Cash Flows. The after-tax cash flows.
#6. Residual Cash Flows. Cash effects from selling the asset at the end of the planning horizon.
#7. After-tax Cash Flow Stream. Brings all the cash effects together.

11. Net Cash Outlay (NCO)
The first item in a cash flow stream is the total cash to start a project. Two cash items are:
Purchase Price. Asset cost with timing of cash flows.
Fees and Other Costs. Legal, accounting, and other fees.

12. NCO: Capitalized Costs
Capitalization means NCO fixed asset costs are added to the asset base rather than expensed when occurred. The expense is recognized over the life of the project.

13. NCO: Funds Tied Up
Funds tied up during the planning horizon that are not spent would be available at the end of the planning horizon.
Funds tied up are treated as an outlay at the start and an inflow at the end.
This adjusts for the time value of money using a discounted cash flow technique.

14. NCO: Debt Financing
Funds provided by lenders reduces the NCO.

15. NCO: Accrued Interest
While preparing for operation, a project will not generate revenues to make interest and principal payments on debt. In many cases, the interest will accrue until start-up.

16. NCO Calculation
The net cash outlay equals:
Present Value of Purchase Price (outflow)
Plus Fees (outflow)
Plus Capitalized Costs (outflow)
Plus Funds Tied Up (outflow)
Less Debt (inflow)

17. NCO: Disbursements Over Time
Projects often require money to be invested in advance of the start of operations.
A time value of money is recognized for early capital expenditures.
Since the funds are outflows, they are viewed as having a low risk.
A borrowing rate is usually used as the time value factor.

18. NCO: Time Value Formula
Year Zero is the start of operations. Year –1 is one year earlier. Invested funds are moved forward to year zero.
FV = PV*(1+$TV)^N
Where PV = the disbursement of cash.
i = the time value factor.
n = periods from disbursement to start-up.

19. Answer
The formula (FV = PV*(1+$TV)^N) is nothing more than compounding over time.
PV $TV N FV % % % %

20. Net Cash Outlay (NCO)
This is all startup monies adjusted for time value to year zero. Possibilities are:
Cash Disbursements. For the project.
Fees. For design, architecture, accounting, legal, or other.
Capitalized Costs. Assets that will be depreciated over time.
Funds Tied Up. That will be returned in the future.

21. Debt in the Net Cash Outlay
Any debt used to finance a project reduces the net cash outlay. Care must be taken for debt financing:
Accrued Interest. If it accrues prior to year 0, add it to the starting loan.
Pay-as-you-Go Interest. If it is paid prior to year 0, add it to the NCO.
Repayment. Create an appropriate amortization schedule after year 0.

22. Question
A company invests $2 million three times, all one year apart. Upon making the third investment, a project becomes operational. The time value of investing funds is 7 percent. What is the net cash outlay?

23. Answer Year –2 Year –1 Year 0 Cash invested 2000 2000 2000
Time Value of Money % %
Cash Expended
Net Cash Outlay