2-1 Chapter 12 Capital Capital Budgeting Budgeting and and Estimating Estimating Cash Cash Flows Flows 2-2 What What is is Capital Capital Budgeting? Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year 2-3 The The Capital Capital Budgeting Budgeting Process Process  Generate investment proposals consistent with the firm’s strategic objectives  Estimate after-tax incremental operating cash flows for the investment projects  Evaluate project incremental cash flows 2-4 The The Capital Capital Budgeting Budgeting Process Process  Select projects based on a valuemaximizing acceptance criterion  Reevaluate implemented investment projects continually and perform postaudits for completed projects 2-5 Classification Classification of of Investment Investment Project Project Proposals Proposals New products or expansion of existing products Replacement of existing equipment or buildings Research and development Exploration Other (e.g., safety or pollution related) 2-6 Screening Screening Proposals Proposals and and Decision Decision Making Making Section Chiefs Plant Managers VP for Operations Capital Expenditures Committee President Board of Directors Advancement to the next level depends on cost and strategic importance 2-7 Estimating Estimating After-Tax After-Tax Incremental Incremental Cash Cash Flows Flows Basic characteristics of relevant project flows  Cash (not accounting income) flows  Operating (not financing) flows  After-tax flows  Incremental flows 2-8 Estimating Estimating After-Tax After-Tax Incremental Incremental Cash Cash Flows Flows Principles that must be adhered to in the estimation  Ignore sunk costs  Include opportunity costs  Include project-driven changes in working capital net of spontaneous changes in current liabilities  Include effects of inflation 2-9 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)  2-10 Depreciation and the MACRS Method  Everything else equal, the greater the depreciation charges, the lower the taxes paid by the firm  Depreciation is a noncash expense  Assets are depreciated (MACRS) on one of eight different property classes  Generally, the half-year convention is used for MACRS Terminal-Year Incremental C/F 2-19 a) $22,319 The incremental cash flow from the previous slide in Year b) + 16,500 c) - d) + 6,600 e) = $32,219 Salvage Value .40*($16,500 - 0) Note, the asset is fully depreciated at the end of Year NWC - Project ends Terminal-year incremental cash flow 2-20 Summary of Project Net Cash Flows Asset Expansion Year Year -$100,000 $34,432 $32,219 Year $39,530 Year $39,359 Year 2-21 Summary of Project year year year year     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 22319 (a) - (d) Terminal Year CF = (16,500*.6)=9,900   (100000) 34,432 39,530 32,219 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 years and will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends Operating costs will rise by $70,000 for each of the next four years BW is in the 40% tax bracket 2-22 2-23 Initial Cash Outflow a) $50,000 b)+ 20,000 c) + 5,000 d)- (not a replacement) e) + (-) f) = $75,000 (not a replacement) 2-24 Incremental Cash Flows Year Year Year Year 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 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 b) + 10,000 Salvage Value c) 4,000 40*($10,000 - 0) Note, the asset is fully depreciated at the end of Year d) + 5,000 e) = $37,075 flow 2-25 NWC - Project ends Terminal-year incremental cash Summary of Project Net Cash Flows Asset Expansion Year Year Year Year Year -$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 2-26 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 3-year 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 two years of depreciation and four years of useful life remaining BW can sell the current machine for $6,000 The new machine will save $10,000 per year NWC are $5,000 40% tax bracket 2-27 2-28 Initial Cash Outflow a) b) $50,000 Cost + 20,000 = $70,000 Depreciable basis 5,000 NWC c) + d) - e) - f) = Shipping + installation 6,000 (sale of “old” asset) (tax savings 2,400 < from $66,600 loss on sale of “old” asset) 2-29 Depreciable Basis (old) Remaining life 30000 years Remaining depr years Acc Depr (3-yaers) 18000 Book Value 12000 Sold for 6000 Loss on disposal 6000 Tax saving 2400 2-30 Calculation of the Change in Depreciation a) Year Year Year Year $23,331 $31,115 $10,367 $ 5,187 b) - 6,000 6,000 0 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 c) Net change in tax depreciation charges 2-31 Incremental Cash Flows a) b) Net C/F - Depr (net) c) = CF_BT d) - tax g) = Year Year Year Year $10,000 $10,000 $10,000 $10,000 17,331 25,115 $ -7,331 -$15,115 10,367 $ -367 5,187 $ 4,813 -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 b) + 10,000 Salvage Value c) 4,000 (.40)*($10,000) Note, the asset is fully depreciated at the end of Year d) + 5,000 e) = $19,075 flow 2-32 Return of “added” NWC Terminal-year incremental cash Summary of Project Net Cash Flows Asset Expansion Year Year Year Year Year -$75,000 $33,332 $36,446 $28,147 $37,075 Asset Replacement Year Year Year Year Year -$66,600 $12,933 $16,046 $10,147 $19,075 2-33 ... Calculating the Incremental Cash Flows  Initial cash outflow the initial net cash investment  Interim incremental net cash flows -those net cash flows occurring after the initial cash investment but... Flows Flows Basic characteristics of relevant project flows  Cash (not accounting income) flows  Operating (not financing) flows  After-tax flows  Incremental flows 2-8 Estimating Estimating... Incremental Cash Cash Flows Flows Principles that must be adhered to in the estimation  Ignore sunk costs  Include opportunity costs  Include project-driven changes in working capital net of spontaneous