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Capital Budgeting Cash Flows

Capital Budgeting Cash Flows. Prepared by Keldon Bauer FIL 240. Capital Budgeting Decision. Capital Budgeting: The process of evaluating and selecting long-term investments. Capital Expenditure: An outlay expected to benefit the firm over at least 1 year.

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Capital Budgeting Cash Flows

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  1. Capital Budgeting Cash Flows Prepared by Keldon Bauer FIL 240

  2. Capital Budgeting Decision • Capital Budgeting: • The process of evaluating and selecting long-term investments. • Capital Expenditure: • An outlay expected to benefit the firm over at least 1 year. • Operating expenditures benefit the firm over a period less than 1 year.

  3. Capital Budgeting Decision • Steps in the Process: • Proposal generation. • Review and analysis. • Decision making. • Implementation. • Follow-up.

  4. Basic Terminology • Independent versus Mutually Exclusive. • Unlimited Funds versus Capital Rationing. • Accept-Reject versus Ranking . • Conventional versus Non-Conventional Cash Flow Patterns.

  5. Relevant Cash Flows • Incremental Cash Flows: • Marginal cash flow associated with adopting the proposed “project.” • Major Cash Flow Components: • Initial Cash Flow • Operating Cash Flow • Terminal Cash Flow

  6. Relevant Cash Flows • Expansion versus Replacement Decisions. • Sunk Costs and Opportunity Costs. • Sunk costs are ignored (incremental costs are zero). • Opportunity costs are included, since they represent costs (or revenues) forgone.

  7. Clicker Question Set-up • Given the following costs related to a proposed project, identify whether each of these should be treated as a sunk or opportunity cost associated with that replacement decision:

  8. 1. Initial Cash Flow • Cost of New Asset: • Include shipping and installation. • After-tax Proceeds from Sale of Old Asset: • Removal/Sale • Cleanup costs • Net of tax effect • Book value, tax profit (recaptured depreciation.

  9. 1. Initial Cash Flow • Change in Net Working Capital. • Summary: Installed cost of new assets After-tax proceeds from sale of old assets. Change in net working capital Initial Cash Flow

  10. Example • Germantown Manufacturing is considering replacing one machine with another. The old machine was purchased 3 years ago for an installed cost of $10,000. The firm is depreciating the machine under MACRS, using a 5 year recovery period. The new machine costs $24,000 in installation costs. The firm’s marginal tax rate is 40%. What is the initial cash flow if the old machine sells for $7,000?

  11. Example

  12. Example

  13. Example

  14. 2. Operating Cash Flows • After-tax Incremental Cash Flows from Operations. • Be careful, especially under replacement decisions. • Usually compared to not replacing now. • After-tax usually is “earnings” less the depreciation shielded tax. • Generally assume accelerated depreciation. • See page 73 (chapter 4) for MACRS table.

  15. 2. Operating Cash Flows • Summary: • Operating Cash Flow = NOPAT + Deprec. • If relevant, find the incremental cash flow, by finding the difference between the OCF for the proposed project and the OCF of the best alternative (what you are currently doing).

  16. Example • A replacement machine will reduce operating expenses by $16,000 per year for each of the 5 years the new machine is expected to last. Although the old machine has zero book value, it can be used for 5 more years. The depreciable value of the new machine is $48,000. The firm will depreciate the machine under MACRS using a five year recovery period, and is subject to a 40% tax rate.

  17. Example

  18. Example

  19. 3. Terminal Cash Flow • Proceeds from Sale of Assets • Net of sale, removal and cleanup. • Taxes on Sale of Assets • Book value and profit. • Change in Net Working Capital • Typically, setting net working capital back the way it was.

  20. Example • A new machine costs $160,000 and requires $20,000 in installation. Purchase of this machine is expected to result in an increase in net working capital of $30,000 to support the expanded level of operations. The firm plans to depreciate the machine under MACRS using a 5-year period, and expects to sell the machine in 5 years for a net of $10,000 before taxes. Assume a 40% tax rate.

  21. Example

  22. Example

  23. Summarizing Relevant CFs • Use a cash flow timeline. • Rather than using the format presented in the text, bring net inflows and outflows down: • Make outflows negative, • Make inflows positive.

  24. Example • If all the examples presented so far were for one project (which they aren’t):

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