Lecture 2

Principles of Capital Investment

- Capital Budgeting and

Estimating Cash Flows
Presented by
Muhammad Khalid Sohail

What is
Capital Budgeting?
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond one
year.
e.g. Purchase of Fixed Assets,
Investment in R&D
2

When a business firm makes a

capital investment, it incurs
current cash outlay for benefits
to be realized in future.

Proposed investment is judged

by the expected return

How

close will it come to RRR by

the investors.

The Capital
Budgeting Process

Generate investment proposals

consistent with the firms strategic
objectives.

Estimate after-tax incremental

operating cash flows for the
investment projects.

Evaluate project incremental cash

flows.

The Capital
Budgeting Process

Select projects based on a valuemaximizing acceptance criterion. i.e.

Whether proposed project will add
value to firm

Reevaluate implemented investment

projects continually and perform
postaudits for completed projects.

Classification of Investment
Project Proposals
1. New products or expansion of
existing products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related)
6

Screening Proposals
and Decision Making
1.
2.
3.
4.
5.

Section Chiefs
Plant Managers
VP for Operations
Capital Expenditures Committee
Advancement
President
to the next
6.
Board of Directors
level depends
( for proposal acceptance it
depends upon the size, if bigon cost
and strategic
size then the project is
importance.
approved by higher level
authority)

Estimating After-Tax
Incremental Cash Flows
Basic characteristics of
relevant project flows

Cash flows (not accounting income)

Operating flows (not financing)

After-tax flows

Incremental flows

Estimating After-Tax Incremental CFs

Principles that must be adhered to in the estimation

Ignore sunk costs (the only concerned

is incremental cost & benefits,
recovery of past cost is irrelevant).
Include opportunity costs. (certain
cost do not involve cash, e.g. un-used
building used for new project)
Include project-driven changes in
working capital net of spontaneous
changes in current liabilities.
(additional cash, A/R, Inv. Required, and it
is assumed it will be recovered during the
life of project.

Include effects of inflation

Tax Considerations
and Depreciation
Depreciation

represents the systematic

allocation of the cost of a capital asset
over a period of time for financial
reporting purposes, tax purposes, or
both.
Generally, profitable firms prefer to use
an accelerated method for tax
reporting purposes (MACRS).
10

Salvage value is ignored.

MACRS Sample Schedule

Recovery
Year
1
2
3
4
5
6
7
8
11

Property Class
3-Year
5-Year
33.33%
20.00%
44.45
32.00
14.81
19.20
7.41
11.52
11.52
5.76

7-Year
14.29%
24.49
17.49
12.49
8.93
8.92
8.93
4.46

Depreciable Basis
In tax accounting, the fully installed
cost of an asset. This is the
amount that, by law, may be written
off over time for tax purposes.
Depreciable Basis =
Cost of Asset + Capitalized
Expenditures
12

Capitalized
Expenditures
Capitalized Expenditures are
expenditures that may provide
benefits into the future and therefore
are treated as capital outlays and not
as expenses of the period in which
they were incurred.

Examples: Shipping and

installation
13

Sale or Disposal of
a Depreciable Asset

Generally, the sale of a capital asset

generates a capital gain (asset sells for
more than book value) or capital loss
(asset sells for less than book value).

capital gain :Tax is implemented on Excess

capital loss : So tax saving results on loss

14

amount, So earlier tax benefit received

becomes less.

amount cash saving other income in

the form of cash.

Calculating the
Incremental Cash Flows
1. Initial cash outflow -- the initial net cash
investment.
2. Interim incremental net cash flows -those net cash flows occurring after the
initial cash investment but not including
the final periods cash flow.
3. Terminal-year incremental net cash flows
-- the final periods net cash flow.

15

Initial Cash Outflow

a)

Cost of new assets

b) +
Capitalized expenditures
c) + (-)
Increased (decreased) NWC
d) Net proceeds from sale of
old asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of old asset(s) if replacement
f)
=
Initial cash outflow
Depreciable Basis: (a) + (b)
16

Incremental Cash Flows

a)
b)
c)
d)
e)
f)
g)
17

Net incr. (decr.) in operating revenue

less (plus) any net incr. (decr.) in
operating expenses, excluding depr.
- (+) Net incr. (decr.) in tax depreciation
=
Net change in income before taxes
- (+) Net incr. (decr.) in taxes
=
Net change in income after taxes
+ (-) Net incr. (decr.) in tax depr. charges
=
Incremental net cash flow for period

Terminal-Year
Incremental Cash Flows
a)

Calculate the incremental net cash

flow for the terminal period

b)

+ (-) Salvage value (disposal/reclamation

costs) of any sold or disposed assets

c)

- (+) Taxes (tax savings) due to asset sale

or disposal of new assets

d)

+ (-) Decreased (increased) level of net

working capital

e)

18

Terminal year incremental net cash flow

1. Net operating C/F or Saving

(include inflation, if any)
2. (-)

Depreciation (net)

3.

CF_BT (EBT)

4. (-/+) Taxes
5.

CF_AT (EAT)

6.

Incremental C/F (1-4) or (2+5)

7.
19

Last year C/F + rec. of WC + Salvage

Value * (1 tax rate)

Example 1: an Asset Expansion Project

20

ABC Co. is considering the purchase of a new

equipment. The equipment will cost $90,000
plus $10,000 for shipping and installation.
Falls under the 3-year MACRS class.
No NWC requirements.
It is forecasted that revenues for the next 4
years : 35167, 36250, 55725, 32,258.
The used equipment will then be sold
(scrapped) for $16,500 at the end of the fourth
year, when the project ends.
It is in the 40% tax bracket.

Initial Cash Outflow

a)

21

$90,000

b)

10,000

c)

d
e)
f)

0 (not a replacement)
+ (-)
0 (not a replacement)
=
$100,000

Example 1: an Asset
Expansion Project
year 1

22

year 2

year 3

year 4

a)

Net C/F

35167

36250

55725

32258

b)

- Depr.

33330

44450

14810

7410

c)

= CF_BT

1837

(8200)

40915

24848

d)

- Tax

735

(3280)

16366

9939

e)

= CF_AT

1102

(4920)

24549

14909

f)

+ Depr.

33330

44450

14810

7410

g)
or

Incr. C/F
(a) - (d)

34432
34432

39530
39530

39359
39359

22319
22319

Another Look
1
35,167
14,067
21,100
33,330
13,332
34,432

2
36,250
14,500
21,750
44,450
17,780
39,530

3
55,725
22,290
33,435
14,810
5,924
39,359

Net_OP_Rev

35,167

36,250

55,725

32,258

Net_OP_Rev_AT

21,100

21,750

33,435

19,355

Depr

33,330

44,450

14,810

7,410

Tax Saving on Depr

13,332

17,780

5,924

2,964

CF_AT

34,432

39,530

39,359

22,319

Net_OP_Rev
Taxes
Net_OP_Rev_AT
Depr
Tax Saving on Depr
CF_AT

23

4
32,258
12,903
19,355
7,410
2,964
22,319

Terminal-Year Incremental C/F

a)

b)
c)

d)
e)
24

$22,319 The incremental cash flow

from the previous slide in
Year 4.
+ 16,500 Salvage Value.
- 6,600 .40*($16,500 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
+
0
NWC - Project ends.
= $32,219 Terminal-year incremental
cash flow.

Summary of Project Net

Cash Flows
Asset Expansion
Year 0
Year 1
Year 4
-$100,000 $34,432
$32,219

25

Year 2

Year 3

$39,530

$39,359

Summary of Project
year 1

year 2

year 3

year 4

a)

Net C/F

35167

36250

55725

32258

b)

- Depr.

33330

44450

14810

7410

c)

= CF_BT

1837

(8200)

40915

24848

d)

- Tax

735

(3280)

16366

9939

34432
39530
39359
Terminal Year CF = (16,500*.6)=9,900

22319
32,219

(a) - (d)

(100000)
26

34,432

39,530

39,359

32,219

Example 2: an Asset Expansion Project

BW

Co. is considering the purchase of a new

machine. The machine will cost $50,000 plus
$20,000 for shipping and installation.
Falls under the 3-year MACRS class.
NWC will rise by $5,000.
FM forecasts that revenues will increase by
$110,000 for each of the next 4 years and
Operating costs will rise by $70,000 for each of
the next four years. Asset will then be sold
(scrapped) for $10,000 at the end of the fourth
year, when the project ends.
BW is in the 40% tax bracket.
27

Initial Cash Outflow

a)
b)
c)
d)
e)
f)
28

$50,000
+
20,000
+
5,000
0 (not a replacement)
+ (-)
0 (not a replacement)
=
$75,000

Incremental Cash Flows

Year 1

Year 2

Year 3

Year 4

Net C/F

$40,000

$40,000

$40,000

$40,000

b) - Depr.

23,331

31,115

10,367

5,187

c) = CF_BT $16,669

$ 8,885

$29,633

$34,813

6,668

3,554

11,853

13,925

e) = CF_AT $10,001

$ 5,331

$17,780

$20,888

a)

d) - Tax

29

f)

23,331

31,115

10,367

5,187

g)

$33,332

$36,446

$28,147

$26,075

Terminal-Year
Incremental Cash Flows
a)

$26,075

The incremental cash flow

from the previous slide in
Year 4.

b)

10,000

c)

4,000

.40*($10,000 - 0) Note, the

asset is fully depreciated at
the end of Year 4.

d)

5,000

NWC - Project ends.

e)

$37,075

30

Salvage Value.

Terminal-year incremental
cash flow.

Summary of Project
Net Cash Flows
Asset Expansion
Year 0

Year 1

Year 2

Year 3

Year 4

-$75,000*

$33,332

$36,446

$28,147

$37,075

* Notice again that this value is a negative

cash flow as we calculated it as the initial
cash OUTFLOW
31

Example of an Asset Replacement Project

Let

us assume that previous asset expansion

project is actually an asset replacement project.
The new machine will cost $50,000 plus $20,000
for shipping and installation and falls under the 3year MACRS class.
The original basis of the old machine was $30,000
and depreciated using straight-line over five years
($6,000 per year). The machine has four years of
useful life & two years of depreciation remaining.
BW can sell the current machine for $6,000. The
new machine will save $10,000 per year. Asset will
then be sold (scrapped) for $10,000 at the end of
the fourth year, when the project ends.
NWC are $5,000.
40% tax bracket.

32

Initial Cash Outflow

a)
b)

c)
d)
e)
f)
33

+
=
+
=

$50,000
Cost
20,000 Shipping + installation
$70,000 Depreciable basis
5,000
NWC
6,000 (sale of old asset)
(tax savings
2,400 <--from
$66,600
loss on sale of
old asset)

34

Depreciable Basis (old)

Remaining life

30000
4 years

Remaining depr.

2 years

Acc. Depr. (3-years)

18000

Book Value

12000

Sold for

6000

Loss on disposal

6000

Tax saving

2400

Calculation of the
Change in Depreciation
a)

Year 1

Year 2

Year 3

Year 4

$23,331

$31,115

$10,367

$ 5,187

b)

6,000

6,000

c)

$17,331

$25,115

$10,367

$ 5,187

a) Represent the depreciation on the new

project.
b) Represent the remaining depreciation on the
old project.
35

c) Net change in tax depreciation charges.

Incremental Cash Flows

a)
b)

Net C/F
- Depr. (net)

Year 1

Year 2

Year 3

Year 4

$10,000

$10,000

$10,000

$10,000

17,331

25,115

10,367

5,187

-367

$ 4,813

c) = CF_BT $ -7,331 -$15,115

d) - tax
g)

36

-2,932

-6,046

-147

1,925

$12,932

$16,046

$10,147

$ 8,075

Terminal-Year
Incremental Cash Flows
a)

$ 8,075

The incremental cash flow

from the previous slide in
Year 4.

b)

10,000

c)

4,000

(.40)*($10,000). Note, the

asset is fully depreciated at
the end of Year 4.

d)

5,000

Return of added NWC.

e)

$19,075

37

Salvage Value.

Terminal-year incremental
cash flow.

Summary of Project
Net Cash Flows
Asset Expansion
Year 0

Year 1

Year 2

Year 3

Year 4

-$75,000

$33,332

$36,446

$28,147

$37,075

Asset Replacement
Year 0

Year 1

Year 2

Year 3

Year 4

-$66,600

$12,933

$16,046

$10,147

$19,075

38

39

Old machine
Remaining useful life (years)
current salvage value (SV)
if held to its useful life, SV
Remaining Tax Book Value
(and Last year depr.)

40

New machine cost

SV
Saving / year

4
8000
2000
4520

60000
15000
12000

ICO

cost
sale of old
machine

Gain (not use in

calculation, its for
calculation of taxes)

41

Taxes
ICO
Depreciable
Basis

+60000
-8000
3480
+1392
53392
60000

42

saving

12000

12000

12000

12000

Depr (new)

19998

26670

8886

4446

Depr (old)

4520

Net Depr

15,478

26,670

8,886

4,446

Op_CF_BT

(3,478)

(14,670)

3,114

7,554

Taxex

(1,391)

(5,868)

1,246

3,022

CF_AT

13,391

17,868

10,754

8,978

Terminal Year Cash Flow

last year
8,978
SV (new)
15000
SV (old)
2000
Net SV
13000
Taxes
5200
net CF at year end
-53,392
0
43

13,391

16,778
17,868

10,754
2

16,778
3

P-6.3
year 1

year 2

year 3

year 4

year 5 year 6 year 7

a)

Net C/F

8000

8000

8000

8000

8000

8000

8000

b)

- Depr.

5600

8960

5376

3226

3226

1612

c)

=CF_BT

2400

(960)

2624

4774

4774

6388

8000

d)

- Tax

816

(326)

892

1623

1623

2172

2720

or

(a) - (d)

7184

8326

7108

6377

6377

5828

5280

28000

28000

28000

28000

28000

28000

28000

0.2

0.32

0.192

0.1152 0.1152 0.0576

cost
depr
rate

44

Thoma Pharmaceutical Company may buy DNAtesting equipment costing $60,000.

This equipment is expected to reduce labor costs of
the clinical staff by $20,000 annually.
The equipment has a useful life of ve years but falls
in the three-year property class for cost recovery
(depreciation) purposes.
No salvage value is expected at the end.
The corporate tax rate for Thoma (combined federal
and state) is 38 percent, and its required rate of
return is 15 percent. (If prots after taxes on the
project are negative in any year, the rm will offset
the loss against other rm income for that year.) On
the basis of this information, what are the relevant
45cash ows?

P-6.6 or
P12.1
year 1

year 2

year 3

year 4

year 5

a)

Net C/F

20000

20000

20000

20000

20000

b)

- Depr.

19998

26670

8886

4446

c)

= CF_BT

(6670)

11114

15554

20000

d)

- Tax

(2535)

4223

5911

7600

or

(a) - (d)

19999

22535

15777

14089

12400

cost

60000

60000

60000

60000

60000

depr rate

0.3333

0.4445

0.1481

0.0741

46

a)
b)
c)
d)
or

P.6.7-a
Net C/F
- Depr.
= CF_BT
- Tax
(a) - (d)

cost
inflation rate 6%,
(1+0.06)^n
Net C/F
47

year 1
20000
19998
2
1
19999

year 2
21200
26670
(5470)
(2079)
23279

year 3 year 4 year 5

22472 23820 25250
8886
4446
0
13586 19374 25250
5163
7362
9595
17309 16458 15655

0
1
2
20000 20000 20000

3
4
20000 20000
1.1910 1.2624
1
1.06 1.1236
16
77
20000 21200 22472 23820 25250

In Problem 1, suppose that 6 percent ination in

savings from labor costs is expected over
the last four years, so that savings in the rst
year are $20,000, savings in the second year
are $21,200, and so forth.
a. On the basis of this information, what are the
relevant cash ows?
b. If working capital of $10,000 were required in
addition to the cost of the equipment and
this additional investment were needed over the
life of the project, what would be the
effect on the relevant cash ows? (All other
things are the same as in Problem 2, Part (a).)
48

P-6.7 (b)

a)
b)
c)
d)
or

49

Net C/F
- Depr.
= CF_BT
- Tax
(a) - (d)
Salvage
Value
Rec. of WC
Op. C/F_AT

year 1 year 2 year 3 year 4 year 5

20000
21200
22472
23820 25250
19998
26670
8886
4446
0
2 (5470)
13586
19374 25250
1 (2079)
5163
7362
9595
19999
23279
17309
16458 15655

19999

23279

17309

16458

0
10000
25655

The City of San Jose must replace a number of its concrete-mixer trucks with new
trucks. It has received two bids and has evaluated closely the performance
characteristics of the various trucks. The Rockbuilt truck, which costs $74,000, is topof-the-line equipment. The truck has a life of eight years, assuming that the engine is
rebuilt in the fth year.
Maintenance costs of $2,000 a year are expected in the rst four years, followed by total
maintenance and rebuilding costs of $13,000 in the fth year. During the last three
years, maintenance costs are expected to be $4,000 a year. At the end of eight years the
truck will
have an estimated scrap value of $9,000.
A bid from Bulldog Trucks, Inc., is for $59,000 a truck. Maintenance costs for the truck
will be higher. In the rst year they are expected to be $3,000, and this amount is
expected
to increase by $1,500 a year through the eighth year. In the fourth year the engine will
need
to be rebuilt, and this will cost the company $15,000 in addition to maintenance costs in
that year. At the end of eight years the Bulldog truck will have an estimated scrap value
of
$5,000.
a. What are the relevant cash ows related to the trucks of each bidder? Ignore tax considerations because the City of San Jose pays no taxes.
b. Using the gures determined in Part (a), what are the cash-ow savings each year
that
can be obtained by going with the more expensive truck rather than the less expensive
one? (That is, calculate the periodic cash-ow differences between the two cash-ow
streams assume that any net cost savings are positive benets.)
50