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  • 1. © 2004 by Nelson, a division of Thomson Canada LimitedContemporary Financial ManagementChapter 9:Capital Budgeting and Cash FlowAnalysis
  • 2. © 2004 by Nelson, a division of Thomson Canada LimitedIntroduction• This chapter discusses capital budgeting andcapital expenditures• It deals with the financial management of theassets on a firm’s balance sheet
  • 3. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting• The process of planning for purchases of assetswhose useful lives are expected to continuebeyond a year• Capital Expenditure• A cash outlay expected to generate a flow offuture cash benefits for more than one year• Capital budgeting decisions can be among themost complex decisions facing management
  • 4. © 2004 by Nelson, a division of Thomson Canada LimitedExamples of Capital Expenditures• Expand an existing product line• Increase or decrease working capital• Refund an issue of debt• Leasing versus buying an asset• Mergers and acquisitions• Enter a new line of business• Repair versus replacing a machine• Advertising campaigns• Research and Development activities
  • 5. © 2004 by Nelson, a division of Thomson Canada LimitedTypes of Investment Projects• Growth opportunities• Cost reduction opportunities• Required to meet legal requirements• Required to meet health and safety standards
  • 6. © 2004 by Nelson, a division of Thomson Canada LimitedHow Projects are Classified• Independent• Acceptance or rejection has no effect on otherprojects• Mutually Exclusive• Acceptance of one automatically rejects theothers (replace versus repair)• Contingent• Acceptance of one project is dependent uponthe selection of another
  • 7. © 2004 by Nelson, a division of Thomson Canada LimitedCost of Capital• Firm’s overall cost of funds, often referred toWACC or Weighted Average Cost of Capital• Equal to a weighted average of the investors’required rates of return• The discount rate used to analysis capitalbudgeting proposals
  • 8. © 2004 by Nelson, a division of Thomson Canada Limited• Expand output until marginal revenue equalsmarginal cost• Invest in the most profitable projects first• Continue accepting projects as long as the rateof return exceeds the marginal cost of capital(MCC)Optimal Capital Budget
  • 9. © 2004 by Nelson, a division of Thomson Canada LimitedThe Optimal Capital BudgetFunding availableMCCRateReturnexceeds costCost exceedsreturnFund these projectsProject Return
  • 10. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting Problems• All projects may not be known at one time• Changing markets, technology, and corporatestrategies can quickly make current projectsobsolete and make new ones profitable• Difficulty in determining the behavior of themarginal cost of capital (MCC)• Estimates of project cash flows have varyingdegrees of uncertainty
  • 11. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting Process• Step 1: Generate proposals• Step 2: Estimate the cash flows• Step 3: Evaluate alternatives and selectprojects• Step 4: Review prior decisions
  • 12. © 2004 by Nelson, a division of Thomson Canada LimitedEstimating Cash Flows• Calculate only the incremental cash flows.• Measure on an after-tax basis.• All indirect effects should be included.• Sunk costs should not be considered• Value of resources should be measured interms of their opportunity cost rather than theiractual cost.
  • 13. © 2004 by Nelson, a division of Thomson Canada LimitedThe Capital Budgeting Decision• The capital budgeting decision involves sixsteps:1 Calculate initial investment2 Calculate PV of the annual after-tax cashflowsattributable to the new asset3 Calculate PV of the tax-shield due to CapitalCost Allowance (CCA)4 Calculate PV of salvage value5 Calculate PV of the tax shield lost due tosalvage6 Calculate PV of any changes in working capital
  • 14. © 2004 by Nelson, a division of Thomson Canada Limited1: Calculate Initial Investment• The initial investment includes:• The cost of the new asset• Plus shipping & installation costs• Less any trade-in value received from an oldasset• If expenditures on the new asset occur over aperiod of time, present value all costs back totime period zero
  • 15. © 2004 by Nelson, a division of Thomson Canada Limited2: PV of Annual After-Tax CFs( ) ( )( )∑NCash Flow tt=1Revenue - Expenses 1 - TPV =1 + kT = corporate marginal tax ratek = WACC or discount ratet = year 1 through year N
  • 16. © 2004 by Nelson, a division of Thomson Canada Limited3: PV of Tax Shield due to CCA         CapitalCostAllowancedT 1 + 0.5kPV Tax Shield = UCCd + k 1 + kUCC = Undepreciated capital cost (cost - trade-in received)d = Capital cost allowance rateT = Corporate tax ratek = Firm’s cost of capital
  • 17. © 2004 by Nelson, a division of Thomson Canada Limited4: Calcuate PV of Salvage( )Salvage tSalvagePV =1 + kSalvage = the expected future salvage valuek = the WACC or discount ratet = the number of years until the asset is salvaged
  • 18. © 2004 by Nelson, a division of Thomson Canada Limited5: PV of Tax Shield Lost from Salvage( )   ÷   ÷   Tax-shield tLost due toSalvagedT 1PV = -Salvage Valued + k 1 + kd = CCA rateT = Corporate tax ratek = WACC or discount ratet = number of years
  • 19. © 2004 by Nelson, a division of Thomson Canada Limited6: PV of Change in Working Capital↓↑Change inWorkingCapitalChange inWorkingCapitalPV = +PV WorkingCapitalPV = - PV WorkingCapitalWorking Capital = Current assets - current liabilities↑ = Increase in working capital↓ = Decrease in working capitalor
  • 20. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: Example• Alki Dyes Ltd. buys a new tank for $18,000,including installation. The estimated salvagevalue at the end of its 3-year useful life is$1,000. CCA is charged at a 50% rate. Thetank is expected to increase the firm’s pre-taxcash flows by $10,000/year for the three yearsof useful life. Working capital is expected toincrease by $1,000 at the end of the first year.The firm’s tax rate and WACC are 46% and 14%respectively. What is the NPV of the newinvestment?
  • 21. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: SolutionStep 1: Initial investmentCash flow from tank purchase: -$18,000Step 2: PV of annual cash flows( ) ( )( )( )( )( )( )( )( )=− − −= + +=∑NCash Flow tt=12 3Revenue - Expenses 1 - TPV1 + k10,000 1 0.46 10,000 1 0.46 10,000 1 0.461.14 1.14 1.1412,536.81
  • 22. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: Solution( ) ( ) ( )   =          +=    +   =CapitalCostAllowancedT 1 + 0.5kPV Tax Shield UCCd + k 1 + k0.50 0.46 1 0.5 0.1418,0000.50 0.14 1.14$6,071.55Step 3: PV of tax-shield due to CCA
  • 23. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: SolutionStep 4: PV of salvage( )( )===Salvage t3SalvagePV1 + k1,0001.14674.97
  • 24. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: SolutionStep 5: PV of the tax-shield lost due to salvage( )( ) ( )( )   ÷   ÷      ÷= −   ÷+   = −Tax-shield tLost due toSalvage3dT 1PV = -Salvage Valued + k 1 + k0.50 0.46 11,0000.50 0.14 1.14$242.57
  • 25. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: SolutionStep 6: PV of the change in Working Capital( )= − ↑= −= −Change inWorkingCapitalPV PV WorkingCapital1,0001.14877.19
  • 26. © 2004 by Nelson, a division of Thomson Canada LimitedCapital Budgeting: Solution-$18,000.00+$12,536.81+$6,071.55+$674.97-$242.57-$877.19+$163.57Step 1:Step 2:Step 3:Step 4:Step 5:Step 6:NPV
  • 27. © 2004 by Nelson, a division of Thomson Canada LimitedEthical Issues: Biased CF Estimates• The outcome of any capital budgeting exerciseis only as good as the estimates used as inputs.Problems may arise from:• Overestimated revenues• Underestimated costs• Unrealistic salvage values• Ignoring necessary changes in working capital
  • 28. © 2004 by Nelson, a division of Thomson Canada LimitedMajor Points• Firms make investment decisions using a capitalbudgeting framework.• The capital budgeting process captures all of theincremental costs and benefits of undertaking aproject.• If capital is unlimited, the firm will accept allpositive NPV projects and reject all negative NPVprojects.