3. 2-3What isWhat isCapital Budgeting?Capital Budgeting?The process of identifying,analyzing, and selectinginvestment projects whosereturns (cash flows) areexpected to extend beyondone year.The process of identifying,analyzing, and selectinginvestment projects whosereturns (cash flows) areexpected to extend beyondone year.
4. 2-4The CapitalThe CapitalBudgeting ProcessBudgeting ProcessGenerate investment proposalsconsistent with the firm’s strategicobjectives.Estimate after-tax incrementaloperating cash flows for theinvestment projects.Evaluate project incremental cashflows.
5. 2-5The CapitalThe CapitalBudgeting ProcessBudgeting ProcessSelect projects based on a value-maximizing acceptance criterion.Reevaluate implementedinvestment projects continuallyand perform postaudits forcompleted projects.
6. 2-6Classification of InvestmentClassification of InvestmentProject ProposalsProject Proposals1. New products or expansion ofexisting products2. Replacement of existing equipment orbuildings3. Research and development4. Exploration5. Other (e.g., safety or pollution related)
7. 2-7Screening ProposalsScreening Proposalsand Decision Makingand Decision Making1. Section Chiefs2. Plant Managers3. VP for Operations4. Capital ExpendituresCommittee5. President6. Board of DirectorsAdvancementAdvancementto the nextto the nextlevel dependslevel dependson coston costand strategicand strategicimportance.importance.
9. 2-9Estimating After-TaxEstimating After-TaxIncremental Cash FlowsIncremental Cash Flows Ignore sunk costssunk costs Include opportunity costsopportunity costs Include project-driven changes inchanges inworking capitalworking capital net of spontaneouschanges in current liabilities Include effects of inflationeffects of inflationPrinciples that must be adheredPrinciples that must be adheredto in the estimationto in the estimation
10. 2-10Tax ConsiderationsTax Considerationsand Depreciationand DepreciationGenerally, profitable firms prefer to usean accelerated method for taxreporting purposes (MACRS).DepreciationDepreciation represents the systematicallocation of the cost of a capital assetover a period of time for financialreporting purposes, tax purposes, orboth.
11. 2-11Depreciation and theDepreciation and theMACRS MethodMACRS MethodEverything else equal, the greater thedepreciation charges, the lower thetaxes paid by the firm.Depreciation is a noncash expense.Assets are depreciated (MACRS) on oneof eight different property classes.Generally, the half-year convention isused for MACRS.
13. 2-13Depreciable BasisDepreciable BasisIn tax accounting, the fully installedcost of an asset. This is theamount that, by law, may be writtenoff over time for tax purposes.Depreciable BasisDepreciable Basis =Cost of AssetCost of Asset + CapitalizedCapitalizedExpendituresExpenditures
14. 2-14CapitalizedCapitalizedExpendituresExpendituresCapitalized ExpendituresCapitalized Expenditures areexpenditures that may providebenefits into the future and thereforeare treated as capital outlays and notas expenses of the period in whichthey were incurred.Examples: Shipping and installation
15. 2-15Sale or Disposal ofSale or Disposal ofa Depreciable Asseta Depreciable AssetOften historically, capital gains incomehas received more favorable U.S. taxtreatment than operating income.Generally, the sale of a “capital asset”(as defined by the IRS) generates acapital gain (asset sells for more thanbook value) or capital loss (asset sellsfor less than book value).
16. 2-16Corporate CapitalCorporate CapitalGains / LossesGains / LossesCapital losses are deductible onlyagainst capital gains.Currently, capital gains are taxedat ordinary income tax rates forcorporations, or a maximum 35%.
17. 2-17Calculating theCalculating theIncremental Cash FlowsIncremental Cash FlowsInitial cash outflowInitial cash outflow -- the initial net cashinvestment.Interim incremental net cash flowsInterim incremental net cash flows --those net cash flows occurring after theinitial cash investment but not includingthe final period’s cash flow.Terminal-year incremental net cashTerminal-year incremental net cashflowsflows -- the final period’s net cash flow.
18. 2-18Initial Cash OutflowInitial Cash Outflowa) Cost of “new” assetsCost of “new” assetsb) + Capitalized expendituresc) + (-) Increased (decreased) NWCd) - Net proceeds from sale of“old” asset(s) if replacemente) + (-) Taxes (savings) due to the saleof “old” asset(s) if replacementf) == Initial cashInitial cash outflowoutflow
19. 2-19Incremental Cash FlowsIncremental Cash Flowsa) Net incr. (decr.) in operating revenueless (plus) any net incr. (decr.) inoperating expenses, excluding depr.b) - (+) Net incr. (decr.) in tax depreciationc) = Net change in income before taxesd) - (+) Net incr. (decr.) in taxese) = Net change in income after taxesf) + (-) Net incr. (decr.) in tax depr. chargesg) == Incremental net cash flow for periodIncremental net cash flow for period
20. 2-20Terminal-YearTerminal-YearIncremental Cash FlowsIncremental Cash Flowsa) Calculate the incremental net cashincremental net cashflowflow for the terminal periodterminal periodb) + (-) Salvage value (disposal/reclamationcosts) of any sold or disposed assetsc) - (+) Taxes (tax savings) due to asset saleor disposal of “new” assetsd) + (-) Decreased (increased) level of “net”working capitale) == Terminal year incremental net cash flowTerminal year incremental net cash flow
21. 2-21Example of an AssetExample of an AssetExpansion ProjectExpansion ProjectBasket Wonders (BW) is considering thepurchase of a new basket weaving machine. Themachine will cost $50,000 plus $20,000 forshipping and installation and falls under the 3-year MACRS class. NWC will rise by $5,000. LisaMiller forecasts that revenues will increase by$110,000 for each of the next 4 years and willthen be sold (scrapped) for $10,000 at the end ofthe fourth year, when the project ends. Operatingcosts will rise by $70,000 for each of the next fouryears. BW is in the 40% tax bracket.
22. 2-22Initial Cash OutflowInitial Cash Outflowa) $50,000b) + 20,000c) + 5,000d) - 0 (not a replacement)e) + (-) 0 (not a replacement)f) == $75,000*$75,000** Note that we have calculated this value as a“positive” because it is a cash OUTFLOW (negative).
24. 2-24Terminal-YearTerminal-YearIncremental Cash FlowsIncremental Cash Flowsa) $26,075$26,075 The incremental cash flowincremental cash flowfrom the previous slide inYear 4.b) + 10,000 Salvage Value.c) - 4,000 .40*($10,000 - 0) Note, theasset is fully depreciated atthe end of Year 4.d) + 5,000 NWC - Project ends.e) == $37,075$37,075 Terminal-year incrementalTerminal-year incrementalcash flow.cash flow.
25. 2-25Summary of ProjectSummary of ProjectNet Cash FlowsNet Cash FlowsAsset ExpansionYear 0 Year 1 Year 2 Year 3 Year 4-$75,000*-$75,000* $33,332$33,332 $36,446 $28,147$36,446 $28,147 $37,075$37,075* Notice again that this value is a negativenegativecash flow as we calculated it as the initialcash OUTFLOW in slide 12-18.
26. 2-26Example of an AssetExample of an AssetReplacement ProjectReplacement ProjectLet us assume that previous asset expansionproject is actually an asset replacement project.The original basis of the machine was $30,000 anddepreciated using straight-line over five years($6,000 per year). The machine has two years ofdepreciation and four years of useful life remain-ing. BW can sell the current machine for $6,000.The new machine will not increase revenues(remain at $110,000) but it decreases operatingexpenses by $10,000 per year (old = $80,000). NWCwill rise to $10,000 from $5,000 (old).
27. 2-27Initial Cash OutflowInitial Cash Outflowa) $50,000b) + 20,000c) + 5,000d) - 6,000 (sale of “old” asset)e) - 2,400 <----f) == $66,600$66,600(tax savings fromloss on sale of“old” asset)
28. 2-28Calculation of theCalculation of theChange in DepreciationChange in DepreciationYear 1 Year 2 Year 3 Year 4a) $23,331 $31,115 $10,367 $ 5,187b) - 6,000 6,000 0 0c) = $17,331 $25,115 $10,367 $ 5,187$17,331 $25,115 $10,367 $ 5,187a) Represent the depreciation on the “new”project.b) Represent the remaining depreciation on the“old” project.c) Net changechange in tax depreciation charges.
30. 2-30Terminal-YearTerminal-YearIncremental Cash FlowsIncremental Cash Flowsa) $ 8,075$ 8,075 The incremental cash flowincremental cash flowfrom the previous slide inYear 4.b) + 10,000 Salvage Value.c) - 4,000 (.40)*($10,000 - 0). Note, theasset is fully depreciated atthe end of Year 4.d) + 5,000 Return of “added” NWC.e) == $19,075$19,075 Terminal-year incrementalTerminal-year incrementalcash flow.cash flow.
31. 2-31Summary of ProjectSummary of ProjectNet Cash FlowsNet Cash FlowsAsset ExpansionYear 0 Year 1 Year 2 Year 3 Year 4-$75,000-$75,000 $33,332$33,332 $36,446 $28,147$36,446 $28,147 $37,075$37,075Asset ReplacementYear 0 Year 1 Year 2 Year 3 Year 4-$66,600-$66,600 $12,933$12,933 $16,046 $10,147$16,046 $10,147 $19,075$19,075