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Capital budgeting and estimating cash flows

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  • 1. 2-1 Capital BudgetingCapital Budgeting and Estimatingand Estimating Cash FlowsCash Flows
  • 2. 2-2 ObjectivesObjectives Define “capital budgeting” and identify the steps involved in the capital budgeting process. Explain the procedure to generate long-term project proposals within the firm. Justify why cash, not income, flows are the most relevant to capital budgeting decisions. Summarize in a “checklist” the major concerns to keep in mind as one prepares to determine relevant capital budgeting cash flows. Define the terms “sunk cost” and “opportunity cost” and explain why sunk costs must be ignored, while opportunity costs must be included, in capital budgeting analysis. Explain how tax considerations, as well as depreciation for tax purposes, affects capital budgeting cash flows. Determine initial, interim, and terminal period “after-tax, incremental, operating cash flows” associated with a capital investment project.
  • 3. 2-3 Capital Budgeting andCapital Budgeting and Estimating Cash FlowsEstimating Cash Flows The Capital Budgeting Process Generating Investment Project Proposals Estimating Project “After-Tax Incremental Operating Cash Flows”
  • 4. 2-4 What isWhat is Capital Budgeting?Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
  • 5. 2-5 The CapitalThe Capital Budgeting ProcessBudgeting 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.
  • 6. 2-6 The CapitalThe Capital Budgeting ProcessBudgeting Process Select projects based on a value- maximizing acceptance criterion – or the use of capital budgeting techniques
  • 7. 2-7 Classification of InvestmentClassification of Investment Project ProposalsProject 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)
  • 8. 2-8 Estimating After-TaxEstimating After-Tax Incremental Cash FlowsIncremental Cash Flows  CashCash (not accounting income) flowsflows  OperatingOperating (not financing) flowsflows  After-tax flowsAfter-tax flows  Incremental flowsIncremental flows Basic characteristics ofBasic characteristics of relevant project flowsrelevant project flows
  • 9. 2-9 Estimating After-TaxEstimating After-Tax Incremental Cash FlowsIncremental Cash Flows  Ignore sunk costssunk costs  Include opportunity costsopportunity costs  Include project-driven changes inchanges in working capitalworking capital net of spontaneous changes in current liabilities  Include effects of inflationeffects of inflation Principles that must be adheredPrinciples that must be adhered to in the estimationto in the estimation
  • 10. 2-10 Tax ConsiderationsTax Considerations and Depreciationand Depreciation Generally, profitable firms prefer to use an accelerated method for tax reporting purposes DepreciationDepreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.
  • 11. 2-11 Depreciation and taxesDepreciation and taxes Everything else equal, the greater the depreciation charges, the lower the taxes paid by the firm. Depreciation is a noncash expense.
  • 12. 2-12 Depreciable BasisDepreciable 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 BasisDepreciable Basis = Cost of AssetCost of Asset + CapitalizedCapitalized ExpendituresExpenditures
  • 13. 2-13 CapitalizedCapitalized ExpendituresExpenditures Capitalized ExpendituresCapitalized 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
  • 14. 2-14 Sale or Disposal ofSale or Disposal of a Depreciable Asseta 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).
  • 15. 2-15 Corporate CapitalCorporate Capital Gains / LossesGains / Losses Capital losses are deductible only against capital gains. Currently, capital gains are taxed at ordinary income tax rates for corporations, or a maximum 30%.
  • 16. 2-16 Calculating theCalculating the Incremental Cash FlowsIncremental Cash Flows Initial cash outflowInitial cash outflow -- the initial net cash investment. Interim incremental net cash flowsInterim incremental net cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow. Terminal-year incremental net cashTerminal-year incremental net cash flowsflows -- the final period’s net cash flow.
  • 17. 2-17 Initial Cash OutflowInitial Cash Outflow a) Cost of “new” assetsCost 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 cashInitial cash outflowoutflow
  • 18. 2-18 Incremental Cash FlowsIncremental Cash Flows a) Net incr. (decr.) in operating revenue less (plus) any net incr. (decr.) in operating expenses, excluding depr. b) - (+) Net incr. (decr.) in tax depreciation c) = Net change in income before taxes d) - (+) Net incr. (decr.) in taxes e) = Net change in income after taxes f) + (-) Net incr. (decr.) in tax depr. charges g) == Incremental net cash flow for periodIncremental net cash flow for period
  • 19. 2-19 Terminal-YearTerminal-Year Incremental Cash FlowsIncremental Cash Flows a) Calculate the incremental net cashincremental net cash flowflow for the terminal periodterminal 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) == Terminal year incremental net cash flowTerminal year incremental net cash flow

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