Lesson 10

Chapter 4
Capital Budgeting
Unit 2
Long-term investment decisions
After reading this lesson you will be able to: -

Understand what capital investments are -- and what the capital budgeting
decision process involves.
Understanding the different types of project.
Be able to understand and explain the process to generate project proposals
within the firm.
Determine initial, interim, and terminal period after-tax incremental
operating cash flows associated with a capital investment project.
Understand why cash, not income, flows are the most relevant.
Our main focus in this lesson is identifying relevant cash flows

In the previous session we discussed the basics of capital budgeting. In this session our
discussion will be mainly on identifying relevant cash flows.

Let me introduce you to the topic with a brief discussion

As you know that the funds available with the firm are always limited and it is not
possible to invest funds in all the proposals at a time. Therefore, it is very essential to
select from amongst the various competing proposals, those which give the highest
benefit. A firm may face a situation where more investment proposals may be available
than investible funds. Some proposals may be good, some moderate and some may be
poor. The management has to select the most profitable project or to take up the most
profitable project first. There are many considerations, economic as well as non-
economic, which influence the capital budgeting decisions. Because of the utmost
importance of the capital budgeting decision, a sound appraisal method should be
adopted to measure the economic worth of each investment project. Capital expenditures
represent long-term commitment in the sense that current investment yields benefits in
future. As discussed the capital expenditure decisions assume great importance for the
future development of the concern. The important factor that influences the capital
budgeting decision is the profitability of the prospective investment. The risk involved in
the proposal cannot be ignored because profitability and risk are directly related, that is,
higher the profitability, the greater the risk and vice-versa. The goal of financial
management of a firm is the worth maximisation of the firm, and in order to achieve this
goal, the management must select those projects deserve first priority in terms of their
profitability. While evaluating, two basic principles are kept in mind, namely, the bigger
benefits are always preferable to small ones and early benefits are always better than the
deferred ones. The essential property of sound evaluation technique is that it should
maximise the shareholders' wealth.

How you as an individual will make an investment decision & how will you evaluate
it?

What do you think should be the characteristics of a Sound Investment Evaluation

Criterion?

• It should provide a means of distinguishing between acceptable and non-

acceptable projects.
• It should provide clear-cut ranking of .the projects in order of the profitability or
desirability.
• It should also solve the problem of choosing among alternative projects.
• It should be a criterion, which is applicable to any conceivable investment
project
• It should emphasize upon early and bigger cash benefits in comparison to distant
 and smaller benefits.
• The method should be suitable according to the nature and size of capital project
be evaluated.

For evaluating the project there is a need of a data. The data required is basically
the cash flows, inflows as well as outflows. Your understanding of cash flows needs
to be very clear, before you start with the evaluation.

ESTIMATION OF PROJECT CASH FLOWS

IMPORTANT

For evaluation purpose we will consider cash flow of a conventional type

only.

I. Conventional Cash flow

300 250 300 325 350

Cash inflows 1 2 3 4 5

Cash outflows (0)

Rs 1,500

II. Accounting profit vs. cash flows

In the capital budgeting procedure, the first step required is the estimation of cost and
benefits of different proposals being considered for decision-making. The estimation of
cost and benefits may be made on the basis of input data being provided by production,
marketing, accounting or any other department. What is required is the synchronization
of this data and to make an attempt to forecast the costs and benefits of a proposal. But
the question at this stage is how to measure the cost and benefits of a proposal?
Usually, two alternatives are suggested for measuring the 'Cost and benefits of a
proposal i.e., the accounting profits and the cash flows.

Accounting profit:

The benefits of a proposal may be measure in terms of the profit generated by it or in

terms of a measure based on accounting profits. However, the accounting profit, which
otherwise is a good estimate of judging the efficiency of any firm, may not be a good
measure to estimate the value/benefit created by a proposal. The accounting profit as a,
measure of benefits of a proposal is discarded on the following grounds:

a) The accounting profit is, to a large extent, affected by the accounting policies
being followed by the terms. These policies, which usually differ from one firm to
another or from one period to another, may be depreciation policy, inventory
valuation policy, capital expenditure and revenue expense policy etc. Thus, the
accounting profit is not a standard figure.

b). So many non-cash items such as depreciation, writing off the accumulated
losses etc, affect the accounting profit. The balancing profit figure after these
items is not a true measure of benefits contributed by a proposal.

c) The accounting profit measures the profit of any particular year in terms of the
money of that year. However, the cost and benefits of a proposal may occur over
a period of number of year. The benefits if measured in terms of accounting
profit, are expressed in monies of different time period and are not comparable.
Similarly, if two mutually exclusive proposals have different economic lives, then
the accounting profits emerging over different periods are not comparable.
 d) The accounting profit is based on the accrual concepts. For example, the sales
revenue and the expenses, both are recorded for the period in which they occur
instead of the period in which they are actually received or paid.

Thus, in view of these serious flows, the accounting profit as a measure of benefits of a
proposal is out rightly rejected. Instead, the cost and benefits are measured in terms of
cash flows.

Cash Flows:

In capital budgeting, the cost and benefits of a proposal are measured in terms of cash
flows. The term cash flow is used to describe the cash oriented measures of return
generated by a proposal. Though it may not be possible to obtain exact cash-effect meas-
urement, it is possible to generate useful approximations based on available accounting
data. The costs are denoted as cash outflows whereas the benefits are denoted as cash
inflows. It maybe noted that the cash outflows represent outflows of purchasing power
and cash inflow is an inflow of purchasing power. The cash outflows and inflows are
used to denote the cost and benefit of a proposal.

It may be noted that the accounting profit figure is the resultant figure on the basis of sev-
eral accounting concepts and policies. Some of the costs, which are deducted from the
sales revenue to arrive at the profit figure, do not involve any cash flow. These charges
against profit are simply book entries. For example, depreciation, provision for bad and
doubtful debts; writing off the goodwill etc. do not involve any cash flow Similarly, a
capital expenditure though involving a cash payment is not considered as the cost for the
period and hence is not deducted from the sales revenue. Therefore, there is a difference
between accounting profit and cash flow. This difference arises because of non-cash
transactions: This can be substantiated as follows:

The following is the income statement of a firm:

 Amt. (Rs.) Amt. (Rs.)

Sales Revenue 1,00, 000

- Cost of production 60,000
- Depreciation 15,000
75,000
Profit before Tax 25,000
- Tax @ 40% 10,000
Profit after Tax 15000

Now, presuming that all the sales, expenses and taxes have been affected in cash, the cash
flow position of the firm can be expressed as follows:

Amt. (Rs.) Amt.

(Rs.)
Cash realized from sales 1,00, 000
- Cost of production 60,000
- Taxes paid 10,000 70,000
Cash increase (i.e., cash
inflow) 30,000

Note the difference between the profit after tax (i.e., Rs. 15,000) and cash inflow (i.e., Rs.
30,000). This difference is due to the existence of non-cash expense of depreciation of
Rs. 15,000. On the basis of this example, the cash flow may be stated as follows:

Cash flow = Profit after Tax (PAT) + Non cash expenses (N/C exp.)

Further, if the firm has spent Rs. 5,000 on capital expenditure (Cap. Expd.), then this will
not affect the profit figure but Rs. 5,000 will reduce the cash flow as follows:

Cash flow = PAT + N/C Exp. - Capital Expenditures (1)

 = 15,000 + 15,000 - 5,000
= Rs. 25,000

Equation 1 above depicts that even if sales and operating expenses are affected in cash,
the profit of the firm and the cash flows may be different. The reason for this difference is
the non-cash expenses and the existence of capital expenditure.

Example

The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which, it would
be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBT) is
estimated to be Rs. 1,75,000 p.a. Find out the yearly cash flow from the plant. (Given the
tax rate @ 30%).

Solution

Annual depreciation charge (Rs. 5,00,000/5) 1,00,000

Profit before depreciation, interest and taxes 1,75,000
-Depreciation. 1,00,000
Profit before Tax 75,000
Tax @ 30% 22,500
Profit after Tax 52,500
+ Depreciation (added back) 1,00,000
Therefore, cash flow 1,52,500
Example

ABC Ltd. Is evaluating a capital budgeting proposal for which relevant figures are as
follows:

Cost of the plant (Rs.) 11,00,000

Installation cost (Rs.) 3,400
Economic life 7 years
Scrap value (Rs.) 30,000
Profit before depreciation and tax (Rs.) 2,00,000
Tax rate 50%

Solution:
Annual depreciation charge
(Rs. 11,03,400 – Rs. 30,000)/7 1,53,343

Profit before depreciation and taxes 2,00,000

- Depreciation 1,53,343

Profit before tax 46,657

- Tax @50% 23,329
Profit after tax 23,328
+ Depreciation (added back) 1,53,343
Cash inflow (yearly) 1,76,671

The plant has an initial cash outflow of Rs. 11,03,400 (Rs. 11,00,000 + Rs. 3,400), and its
annual cash inflows for 7 year will be Rs. 1,76,671 p.a. however, in the 7th year, there
will be an additional cash inflow of Rs. 30,000 i.e., the scrap value. Therefore, in year,
the total cash inflow will be Rs. 2,06,671.
In the above two examples all the sales and expenses have been effected in cash.
However, in practice there is a time gap between the occurrence of sales and expenses
and their incidence on cash flow. Thus, each transaction of sales and expenses need to be
analyzed to find out the cash flow associated with it. Similarly, pattern of receipts from
receivables (debtors and bill) and the pattern of payments to payable (creditors and bills)
should also be analyzed to assess the effect on cash flow. But this is too difficult and
rather impossible to apply. Moreover, in capital budgeting, the emphasis is on yearly
basis cash flows rather than on intra-year cash flows. Therefore, in capital budgeting,
only the total cash flows are relevant and so, the profit figure is adjusted only for non-
cash items.

Cash Flows versus Accounting Profit: In a capital budgeting decision situation, the
measurement of cost and benefits should result in identical estimates irrespective of the
person making the estimates, but the vagaries of accounting always do not permit this.
The accounting policies relating to depreciation, inventory valuation, and allocation of
indirect costs may cause wide discrepancies in accounting profit in identical situation.
These problems may all be overcome by focusing on the cash flows, which will be
identical irrespective of the person making estimation thereof. The concept of cash flows
as a measure of evaluating the cost and benefits of a proposal is better than the concept of
accounting profit in more than one ways as follows:

a) The accounting profit ignores the concept of time value of money, whereas the
cash flow technique incorporates the time value of money also.

b) In capital budgeting, a finance manager is concerned with measuring the

economic value created by a decision, rather than book entry value. In cash flow
analysis, the cost and benefits are measured in terms of actual cash inflows and
outflows rather than an imaginary profit figure.
 c) The accounting profit may be influenced and affected by adopting one or the
other accounting policy, however the cash flows are the actual flows and therefore
are not affected by any such discretionary policy of the, firm.

Thus, it is clear that the cash flows, as a measure of cost and benefits of a proposal is a
better technique to evaluate a proposal.

III. Components of cash flows

It may be further noted that the cash flows associated with a proposal may be classified
into
(i) Original or Initial cash outflow (Initial investment)
(ii) Subsequent cash in flows (Annual cash inflows)
(iii) Terminal cash flow.

Computation of Cash flows will depend on the nature of proposal. Projects can be
categorized into:
Single Proposal
Replacement situations
Mutually exclusive

We will discuss components of cash flow keeping in mind above categories of Capital
projects

(1). ORIGINAL OR INITIAL CASH OUTFLOW: All the capital projects require a
sizeable initial cash outflow before any future inflow is realized. This initial cash outflow
is needed to get a project operational. In most of the capital budgeting proposals, the
initial cost of the project i.e., the initial investment cost in the cash outflow occurring in
the initial stages of the projects. Since the investment cost occurs in the beginning of the
project, it is relatively easy to identify the initial cash outflows. It reflects the cash spent
to acquire the asset.
Case A: Single Proposal / New Project
In case of a new project the calculation of outflow is quite easy. It is presented below

Cash outflow of New Project {(Beginning of the period at zero time (t=0)}
1. Cost of new project
2. (+) Installation cost
3. (+/-) Working capital

1. Cost of new project

This is the amount spent on purchase of machinery.

2. Installation cost:
The initial cash outflow includes the total cost of the project in order to bring it in
workable condition. Thus, the initial cash outflow includes the cost of plant, but also the
transportation cost, installation cost and any other incidental cost.

3.Additional working capital requirement:

Another item that needs consideration to ascertain the initial cash outflow is the working
capital required for the proposal or more precisely, the change in working capital due to
the proposal. Since the change in working capital affects the cash flows, it is important
that the working capital requirement of every alternative proposal be analyzed and
considered for the capital budgeting decision.

Almost every investment proposal requires an additional investment in all or any of the
three main components of working capital. The proposal if accepted would require
increase in minimum cash balance to be maintained, higher’ inventory level and more
receivables. Though, every firm tries to keep its investment in working capital to the
minimum level, yet the new project, if undertaken, would require the firm (i) to extend
additional credit to its customers, (ii) to carry additional inventory to serve customer
orders, and (iii) to enlarge its cash balance to meet its enlarged transactions.
Generally speaking, the working capital requirement of a proposal will be a function of
the expected growth in revenues and expenses from that project, although the exact
linkage will vary from business to business. Thus, if the firm undertakes the projects, it
requires additional working capital to support the operations of the project and therefore,
this additional working capital required is the additional investment to be made in the
project, and is therefore, also included in the initial cash outflows of the project.

Any additional investment in working capital cannot be used elsewhere and is similar to
an investment in building or plant or furniture etc. It has to be viewed as a cash outflow
when it is made. On the similar lines, any decrease in working capital resulting from
the proposal can be viewed as a release of working capital or cash inflow.

However, it may be noted that the additional working capital is required only for the
period equal to the life of the proposal. At the end of the proposal, this additional
working capital being invested now will be released and recaptured by the firm. Thus the
cash inflow for the last year of the life of the project would also include the working
capital released by the project.

Failure to consider the working capital needs in the capital budgeting decision may have
two consequences i.e., (i) the cash flows will be over-estimated and (ii) even if working
capital is salvaged fully at the end of the project life, the net present value of the cash
flows created by change of working capital will be negative and hence the capital
budgeting decision may be taken wrongly.

Case B: Replacement situations

In case of replacement situation we are replacing the old machinery by the new one. We
will be selling the old machinery therefore our outflows in form of purchase price will be
reduced.
Cash outflow in a replacement situation {(Beginning of the period at zero time (t=0)}
1. Cost of new project
2. (+) Installation cost
3. (+/-) Working capital
4. (-) Sale proceeds of existing machine
5. (+/-) Taxes (tax savings) due to the sale of “old” asset(s) if the investment is a
replacement decision

Case C: Mutually Exclusive projects

Cash outflow in a mutually Exclusive projects {(Beginning of the period at zero time
(t=0)} is same as that in case of replacement situation.
Mutually exclusive means the selection of one proposal precludes the choice of other(s).

(2). SUBSEQUENT CASH IN FLOWS (ANNUAL CASH INFLOWS):

The original investment cost or the initial cash outflow of the proposal is expected to
generate a series of cash inflows in the form of cash profits contributed by the project.
These cash inflows may be same every year throughout the life of the project or may vary
from one year to another. The timings of the inflows may also be different. The cash
inflows mostly occur annually, but in some cases may occur half yearly or biannually
also. These cash inflows generated during the life of the project may also be called
operating cash flows. These are positive cash flows for most of the conventional revenue
generating proposals, however, in case of cost reduction proposals these cash flows may
be negative.

Sometimes, the project may require some subsequent cash outflows also in the form of
periodic intensive repair, periodic shunting cost etc. All these cash inflows and outflows
are to be considered for the capital budgeting decision.

Similarly, if additional working capital is required by the proposal in any of the

subsequent years then it should be considered as outflow for that year. However, if the
working capital is released in any of the subsequent years, then it should be considered as
cash inflow for that year.

It is important to recognize the timing of these subsequent cash inflows and outflows, as
these are to be adjusted for the time value of money. The more quickly and earlier, occur,
the more valuable these are.

Case A: Single Proposal / New Project

In case of a new project the calculation of inflow is quite easy. It is presented below

Cash inflow of New Project [Time t = 1-N]

Years 1 2 3 …. N
Cash sales revenues
Less Cash operating cost
Cash inflows before taxes (CFBT)
Less Depreciation
Taxable income
Less tax
Earning after taxes
Plus Depreciation
Cash inflows after tax (CFAT)
Plus Salvage value (in nth year)
Plus Recovery of working capital (in nth year)

Case B: Replacement situations

In replacement situation we calculate incremental cash inflows, which will be discussed
little latter.

Case C: Mutually Exclusive projects

Cash inflow in mutually Exclusive projects is same as that in case of replacement
situation.
3.TERMINAL CASH INFLOWS: The cash inflows for the last year will terminal cash
flows in addition to annual cash inflows. Two common terminal cash inflows may occur
in the last year. First, as already noted, the estimated salvage or scrap value of the project
realizable at the end of the economic life of the project or at the time of its termination is
the cash inflow for the last year.
Second, as already noted, the working capital that was invested (tied up) in the beginning
will no longer be required as the project is being terminated. This working released will
be available back to the firm and is considered as a terminal cash inflow.

Tax effect of salvage value:

Salvage value is the market price of an investment at time of its sale. A company will
incur loss if an asset is sold for a price less than the asset’s book (depreciated) value.
On the other hand, the company will make a profit it the asset’s salvage value is more
than its book value. The profit on the sale of an asset may be divided into ordinary
income and capital gain. Capital gain is equal to salvage value minus original value of the
asset, and ordinary income is equal to original value minus book value of the asset.
Capital gains are generally taxed at a rate lower than the ordinary income. Does a
company pay tax on profit or get tax credit on loss on the sale of an asset? In a number of
countries the sale of an asset has implications. This was also a practice in India till
recently. But as per the changed Income Tax rules, the depreciable bases of the block of
assets are adjusted for the sale of assets and no taxes are computed.
Assuming tax implications of the sale of an asset, the net proceeds can be
calculated as follows:

1. SV < BV: LOSS

Net Proceeds = Salvage value + Tax credit on loss
Net proceeds = SV + T(SV – BV)

2. SV > BV but SV < OV: Ordinary Profit

 Net proceeds = Salvage value – Tax on profit
Net proceeds = SV – T (SV – BV)

3. SV > OV: Ordinary Profit and Capital Gain

Net proceeds = Salvage value – Tax on ordinary profit – Tax on capital gain
Net proceeds = SV – T (OV – BV) – Tc (SV – OV)
Where SV = salvage value; BV = book value; OV = original value; T = ordinary income
tax rate, and Tc = capital gain tax rate

IV. Incremental Approach To Cash Flows

In the capital budgeting, the cash flows are measured in the incremental terms i.e., only
those cash flows are considered, that differ or occur as a result of undertaking/accepting
the particular proposal. These refer to those cash flows, which can be associated and
attributed to adoption of a particular proposal.
What do we mean by incremental cash flows? Every investment involves a comparison
of alternatives. The problem of choice will arise only if there are at least two possibilities.
The minimum investment opportunity, which a company will always have, will be either
to invest or not to invest in a project. Assume that the question before a company is to
introduce a new product. The incremental cash flows in this case will be determined by
comparing cash flows resulting with and without the introduction of the new product. If,
for example, the company has to spend Rs. 50,000 initially to introduce the product, we
are implicitly comparing cash outlay for introducing the product with a zero cash outlay
of not introducing the product. When the incremental cash flows for an investment are
calculated by comparing with a hypothetical zero-cash-flow project, we call them
absolute cash flows.

Assume now that the question before a company is to invest either in Project A or
in Project B. One way of analysing can be to compute the absolute cash flows for each
project and determine their respective NPVs. Then, by comparing their NPVs, a choice
can be made. Alternatively, two projects can be compared directly. For example, we can
subtract (algebraically) cash flows of Project B from that of Project A (or vice versa) to
find out incremental cash flows (of Project A minus Project B). The positive difference in
a particular period will tell how much more cash flow is generated by Project A relative
to Project B. The incremental cash flows found out by such comparison between two real
alternatives can be called relative cash flows. NPV of this series of relative cash flows
will be equal to NPV of the absolute cash flows from Project A minus NPV of the
absolute cash flows from Project B. Thus, NPV (A-B) = NPV (A) – NPV (B). The
principle of incremental cash flows assumes greater importance in the case of
replacement decisions.
The principle of incremental cash flows in capital budgeting analysis is critical. A
finance manager while evaluating a proposal should note whether a particular cash flow
is incremental or not. Only the incremental cash flows should be considered for capital
budgeting. Any cash inflow or outflow hat can be directly or indirectly traced to a project
must be considered. Obviously, the incremental cash flows analysis also implies that any
reduction in cash inflow or outflow that occurs as a consequence of a project should also
be considered.

Let us take an example

Example
Ojus Enterprises is determining the cash flow for a project involving replacement of an
old machine by a new machine. The old machine bought a few years ago has a book
value of Rs. 400,000 and it can be sold to realize a post-tax salvage value of Rs 500,000.
It has a remaining life of five years after which its net salvage value is expected to be Rs
160,000. It is being depreciated annually at a rate of 25 per cent under the written down
value method. The working capital required for the old machine is Rs 400,000.

The new machine costs Rs 16,00,000. It is expected to fetch a net salvage of Rs

8,00,000 after 5 years when it will no longer be required. The depreciation rate applicable
to it is 25 per cent under the written down value method. The net working capital
required for the new machine is Rs 500,000. The new machine is expected to bring a
saving of Rs 300,000 annually in manufacturing costs (other than depreciation). The tax
rate applicable to the firm is 40 per cent.

Solution

Cash Flows for the Replacement Project

Rs in ‘000
Year 0 1 2 3 4 5
I. Investment Outlay
1. Cost of new asset (1600)
2. Salvage value of 500
old asset
3. Increase in (100)
working capital
4. Total net (1200)
investment (1-
2+3)
II. Operating Inflows
Over the Project Life
5. After-tax savings 180 180 180 180 180
in manufacturing
costs
6. Depreciation on 400 300 225 168.8 126.6
new machine
7. Depreciation on 100 75 56.3 42.2 31.6
old machine
8. Incremental 300 225 168.7 126.6 95
depreciation (6 –
7)
9. Tax savings on 120 90 67.5 50.6 38
incremental
depreciation (0.4 x
8)
10. Net operating cash 300 270 247.5 230.6 218
inflow (5+9)
III Terminal Cash Inflow
11. Net terminal value 800
of new machine
12. Net terminal value 160
of old machine
13. Recovery of 100
incremental
 working capital
14. Total terminal 740
cash inflow (11-
12+13)
IV. Net Cash Flow (1200) 300 270 247.5 230.6 958
(4+10+14)

Multiple Choice Questions

1. In proper capital budgeting analysis we evaluate incremental __________ cash flows.

i. Accounting
ii. Operating
iii. Before-tax
iv. Financing

2. The estimated benefits from a capital budgeting project are expected as cash flows
rather than income flows because __________.

i. It is more difficult to calculate income flows than cash flows

ii. It is cash, not accounting income that is central to the firm's capital budgeting
decision
iii. This is required by the accounting profession
iv. This is required by the government

3.In estimating "after-tax incremental operating cash flows" for a project, you should
include all of the following except __________.

i. Changes in costs due to a general appreciation in those costs

ii. The amount (net of taxes) that we could realize from selling a currently unused
building of ours that we intend to use for our project
 iii. Changes in working capital resulting from the project, net of spontaneous changes
in current liabilities
iv. Costs that have previously been incurred that are unrecoverable

4. All of the following influence capital budgeting cash flows except __________.

i. Choice of depreciation method for tax purposes

ii. Economic length of the project
iii. Projected sales (revenues) for the project
iv. Sunk costs of the project

5. The basic capital budgeting principles involved in determining relevant after-tax

incremental operating cash flows require us to __________.

i. Include sunk costs, but ignore opportunity costs

ii. Include opportunity costs, but ignore sunk costs
iii. Ignore both opportunity costs and sunk costs
iv. Include both opportunity and sunk costs

6. Place the following items in the proper order of completion regarding the capital
budgeting process. I. Perform a post audit for completed projects; II. Generate project
proposals; III. Estimate appropriate cash flows; IV. Select value maximizing projects; V.
Evaluate projects.

i. II, V, III, IV, and I.

ii. III, II, V, IV, and I.
iii. II, III, V, IV, and I.
iv. II, III, IV, V, and I.

7. The basic capital budgeting principles involved in determining relevant after-tax

incremental operating cash flows require us to __________.
 i. Include effects of inflation, but ignore project-driven changes in working capital
net of spontaneous changes in current liabilities
ii. Include effects of inflation, and include project-driven changes in working capital
net of spontaneous changes in current liabilities
iii. Ignore both the effects of inflation and project-driven changes in working capital
net of spontaneous changes in current liabilities
iv. Ignore the effects of inflation, but include project-driven changes in working
capital net of spontaneous changes in current liabilities

8. Interest payments, principal payments, and cash dividends are __________ the typical
budgeting cash-flow analysis because they are ________ flows.

i. Included in; financing

ii. Excluded from; financing
iii. Included in; operating
iv. Excluded from; operating

9. What is an example of a capitalized expenditure?

i. Funds spent last year to renovate a building that could be used to house a new
project that is currently being evaluated.
ii. Installation costs necessary to use a machine that was just purchased.
iii. The necessary increase in inventories needed to support a project that is currently
being implemented.
iv. All of the above are examples of capitalized expenditures.

Answers to above

1.Operating
2. It is cash, not accounting income that is central to the firm's capital budgeting decision
3. Costs that have previously been incurred that are unrecoverable
4. Sunk costs of the project
5. Include opportunity costs, but ignore sunk costs
6. The correct answer: II, III, V, IV, and I.
7. Include effects of inflation, and include project-driven changes in working capital net
of spontaneous changes in current liabilities
8.Excluded from; financing
9.Only the installation costs are considered capitalized expenditures.

True or False

1. The stream of cash flows produced by the project directly influences the value of a
capital expansion project.

2. Capital budgeting is the process of identifying, analyzing, and selecting investment

projects whose cash flows will all be received beyond one year.

3. Cash flow calculations require adding back depreciation to net income since it is a non-
cash expense.

4. A capital investment involves making a future cash outlay in the expectation of current
benefits.

Answers to above

1. TRUE
2. TRUE
3. TRUE
4. FALSE

ESSAY QUESTIONS

1. Adam Smith is considering automating his pen factory with the purchase of a $475,000
machine. Shipping and installation would cost $5,000. Smith has calculated that
automation would result in savings of $45,000 a year due to reduced scrap and $65,000 a
year due to reduced labor costs. The machine has a useful life of 4 years and falls in the
3-year property class for depreciation purposes. The estimated salvage value of the
machine at the end of four years is $120,000. The old machine is fully depreciated, but
has a salvage value today of $100,000. The firm's marginal tax rate is 34 percent.

What is the initial cash outflow at time period 0?

What would be the relevant incremental cash inflows over the machine's useful life?

2. Bug Busters of Antarctica, Inc., is considering replacing a machine with a new

machine that has a four-year life. The purchase of this new machine has a cost of
$700,000, shipping cost of $80,000, and an installation charge of $20,000. This machine
will not require any additional working capital. The "old" project can be salvaged for
$120,000 currently. The "old" machine has four years useful life remaining with a
depreciation expense of $20,000 for each of those years and was originally purchased six
years ago for $200,0000. The "new" project will not generate additional revenues, but
will decrease operating expenses by $90,000 for each year of the four-year project. The
company is subject to a marginal tax rate of 40%. The salvage value at the end of the
fourth year for the "new" project is expected to be $50,000.

What is the initial cash outflow?

What are the interim incremental net cash flows for each year?
What is the terminal year cash flow?