Capital budgeting focuses on cash flows rather than accounting profits. It is important to consider the timing and amounts of incremental cash inflows and outflows of a potential investment. Financing costs should be excluded from cash flow analyses. Non-cash expenses like depreciation affect cash flows through tax savings, so these tax impacts should be included. Terminal value calculations are also important to capture long-term value beyond the initial forecast period.

1. Cash Flow
And Capital Budgeting

2. 2
Capital budgeting is concerned with cash flow,
not accounting profit.
To evaluate a capital investment, we must know:
Incremental cash outflows of the investment
(marginal cost of investment), and
Incremental cash inflows of the investment
(marginal benefit of investment).
The timing and magnitude of cash flows and
accounting profits can differ dramatically.
Cash Flow Versus Accounting Profit

3. 3
Financing costs are captured in the process of
discounting future cash flows.
Both interest expense from debt financing and
dividend payments to equity investors should
be excluded.
Financing costs should be excluded when evaluating
a project’s cash flows.
Cash Flows: Financing Costs and Taxes
Only after-tax cash flows are relevant as only
such cash flows can be distributed to investors.

4. 4
Cash Flows: Noncash Expenses
• Noncash expenses include depreciation, amortization,
and depletion.
• Accountants charge depreciation to spread a fixed
asset’s costs over time to match its benefits.
• Capital budgeting analysis focuses on cash inflows and
outflows when they occur.
• Non-cash expenses affect cash flow through their impact
on taxes:
– Compute after-tax net income and add depreciation back, or
– Ignore depreciation expense but add back its tax savings.

5. 5
Assume a firm purchases a fixed asset today for
$30,000.
Plans to depreciate over 3 years using straight-line
method.
Firm pays taxes at 40% marginal rate.
Cash Flows: Noncash Expenses
Firm will produce
10,000 units/year
Costs $1/unit
Sells for $3/unit

6. 6
Cash Flows: Noncash Expenses
$6,000
Net income after
tax
$16,000
Cash flow
= NI + deprec
(4,000)
Taxes (40%)
$10,000
Pre-tax income
(10,000)
Depreciation
$20,000
Gross profits
(10,000)
Cost of goods
$30,000
Sales
Adding non-cash expenses back to
after-tax earnings
Method 1
$4,000
Depreciation tax
savings
$16,000
Cash Flow
$12,000
Aft-tax income
(8,000)
Taxes (40%)
$20,000
Pre-tax income
(10,000)
Cost of goods
$30,000
Sales
Find after-tax profits, add back
non-cash deduction tax savings
Method 2

7. 7
• Accelerated depreciation methods, such as the modified
accelerated cost recovery system (MACRS), increase the
present value of an investment’s tax benefits.
• Relative to MACRS, straight-line depreciation results in
higher reported earnings early in an investment’s life.
Because depreciation only affects cash flow through
taxes, we consider only the depreciation method
that a firm uses for tax purposes when determining
project cash flows.
Many countries allow one depreciation method for
tax purposes and another for reporting purposes.
Depreciation

8. 8
Table 9.1 U.S. Tax Depreciation Allowed for
Various MACRS Asset Classes.

9. 9
• Initial cash flows:
• Cash outflow to acquire/install fixed assets
• Cash inflow from selling old equipment
• Cash inflow (outflow) if selling old equipment below
(above) tax basis generates tax savings (liability)
An example....
Tax rate = 40%
New equipment costs $10 million,
$0.5 million to install
Old equipment fully depreciated,
sold for $1 million
Initial investment: Outflow of $10.5 million, and
after-tax inflow of $0.60 million
from selling the old equipment
Fixed Asset Expenditures

10. 10
• Many capital investments require additions to working
capital.
• Net working capital (NWC) = current assets
– current liabilities
• Increase in NWC is a cash outflow; decrease in NWC is a
cash inflow.
• An example…
• Operate booth from November 1 to January 31
• Order $15,000 calendars on credit, delivery by Nov 1
• Must pay suppliers $5,000/month, beginning Dec 1
• Expect to sell 30% of inventory (for cash) in Nov; 60%
in Dec; 10% in Jan
• Always want to have $500 cash on hand
Working Capital Expenditures

11. 11
($5,000)
($5,000)
($5,000)
$0
Payments
($500)
Net cash flow
$1,500
[10%]
$9,000
[60%]
$4,500
[30%]
$0
Reduction in
inventory
Jan 1 to
Feb 1
Dec 1 to
Jan 1
Nov 1 to
Dec 1
Oct 1 to
Nov 1
Payments and
inventory
($500) +$4,000 ($3,000)
(4,000)
+500
+500
NA
Monthly  in WC
(3,000)
1,000
500
0
Net WC
5,000
10,000
15,000
0
Accts payable
0
1,500
10,500
15,000
0
Inventory
$0
$500
$500
$500
$0
Cash
Feb 1
Jan 1
Dec 1
Nov 1
Oct 1
0
0
+3,000
Working Capital for Calendar Sales Booth

12. 12
When evaluating an investment with indefinite life-
span, the project’s terminal value is calculated:
Construct cash-flow
forecasts for 5 to 10
years
Forecasts more than 5 to
10 years have high
margin of error; use
terminal value instead.
• The terminal value is intended to reflect the value
of a project at a given future point in time.
• The terminal value is usually large relative to all
the other cash flows of the project.
Terminal Value

13. 13
Different ways to calculate terminal values:
• Use final year cash flow projections and assume that
all future cash flow grow at a constant rate;
• Multiply final cash flow estimate by a market multiple, or
• Use investment’s book value or liquidation value.
$3.25 Billion
$2.5 Billion
$1.75 Billion
$1.0 Billion
$0.5 Billion
Year 5
Year 4
Year 3
Year 2
Year 1
JDS Uniphase cash flow projections for acquisition
of SDL Inc.
Terminal Value

14. 14
$68.2
0.05
0.10
$3.41
PV
or
,
g
r
CF
PV 5
1
t
t 



 
• Assume that cash flow continues to grow at 5% per year
(g = 5%, r = 10%, cash flow for year 6 is $3.41 billion):
67
.
48
$
1
.
1
2
.
68
$
1
.
1
25
.
3
$
1
.
1
5
.
2
$
1
.
1
75
.
1
$
1
.
1
1
$
1
.
1
5
.
0
$
5
5
4
3
2
1






• Terminal value is $68.2 billion; value of entire project is:
$42.4 billion of total $48.7 billion is from terminal value!
• Using price-to-cash-flow ratio of 20 for companies in the
same industry as SDL to compute terminal value:
• Terminal Value = $3.25 x 20 = $65 billion
• Caveat: market multiples fluctuate over time
Terminal Value of SDL Acquisition

15. 15
Incremental cash flows versus sunk costs:
Capital budgeting analysis should include only
incremental costs.
• An example…
• Norman Paul’s current salary is $60,000 per year and he
expects it to increase at 5% each year.
• Norm pays taxes at flat rate of 35%.
• Sunk costs: $1,000 for GMAT course and $2,000 for
visiting various programs
• Room and board expenses are not incremental to the
decision to go back to school
Incremental Cash Flow

16. 16
• At end of two years assume that Norm receives a salary
offer of $90,000, which increases at 8% per year
• Expected tuition, fees and textbook expenses for each of
the next two years while studying for MBA: $35,000
• If Norm had worked at his current job for two years, his
salary would have increased to $60,000 x 1.052 = $66,150
• Yr 2 net cash inflow: $90,000 - $66,150 = $23,850
• After-tax inflow: $23,850 x (1-0.35) = $15,503
• Yr 3 cash inflow: ($90,000x1.08 - $60,000x1.053)x(1-0.35)
= $18,032
• MBA has substantial positive NPV value for 30 yr analysis
period
What about Norm’s opportunity cost?
Incremental Cash Flow

17. 17
Cash flows from alternative investment
opportunities, forgone when one investment is
undertaken.
NPV of a project could fall substantially if
opportunity costs are recognized!
First year: $60,000
($39,000 after taxes)
Second Year: $63,000
($40,950 after taxes)
If Norm did not attend MBA program, he would have
earned:
Opportunity Costs

18. 18
Cannibalization
• Cannibalization refers to the loss of sales
of an existing product when a new
product is introduced.
• Cannibalization is a “substitution” effect.

19. 19
Classicaltunes.com is considering adding jazz
recordings to its offerings.
• Firm uses 10% discount rate to calculate NPV and 40% tax
rate.
• The average selling price of Classicaltunes CD’s is $13.50;
price is expected remain constant indefinitely.
• Sales expected to begin when new fiscal year begins.
Initial
investment
transactions:
$50,000 for computer equipment
(MACRS 5-year)
$4,500 for inventory
($2,500 of which is purchased on credit)
$1,000 increase in cash balances
Initial Investment for Classicaltunes.com

20. 20
Projections
for
Jazz
CD
Proposal

21. 21
Annual Net Cash Flow Estimates for Classicaltunes.com
Projections for Jazz CD Proposal

22. 22
• Initial cash outlay of $50,000 for computer equipment
• Changes in working capital are result of following
transactions:
• Purchase of $4,500 in inventory and increase cash balance by
$1000
• an inflow of $2,500 from an increase in trade credit (Account
Receivable)
Increase in gross fixed assets - $50,000
Change in working capital - $3,000
Net cash flow - $53,000
Net Cash Flow:
Year Zero Cash Flow
Invest $3000 in working capital

23. 23
• In year 1, the project earns after-tax income of $561.
• No new investment in fixed asset.
• Add back the non-cash depreciation charge of $10,000.
• Net working capital for year one is:
• NWC = Current Assets – Current Liabilities
= $2,000 + 5,063 + 7,594 - $4,374 = $10,282
• NWC = NWCyear1 – NWCyear0 = $10,282 - $3,000 = $7,282
• Increase in NWC from year zero: $7,282
net cash flow from working capital: -$7,282
net cash flow: $561 + 10,000 – 7,282 = $3,279
Year One Cash Flow

24. 24
Depreciation $10,000
Invest in working capital (cash outflow) -$7,282
Net income $561
Net cash flow $3,279
Net Cash Flow:
Year One Cash Flow

25. 25
Depreciation $10,000
Increase in working capital - $10,623
Net income +$8,580
Net cash flow $7,957
Net Cash Flow:
• In year 2, net income equals $8,580.
• To that, add back the $10,000 non-cash depreciation deduction.
• Next, determine the change in working capital: The working capital
balance increased from $10,282 in year 1 to $20,905 in year 2, so
this represents a cash outflow of 10,623.
• As in year 1, there are no new investments in fixed assets to
consider.
Year Two Cash Flow

26. 26
• If we assume that cash flow continue to grow at 4% per
year at and beyond year 6 (g = 4%, r = 15%,):
 
327
,
325
$
04
.
0
15
.
0
786
,
35
$
or
,
786
,
35
$
410
,
34
$
04
.
1
1
6
1
1













PV
g
r
CF
PV
CF
g
CF
t
t
t
t
Terminal Value for Jazz CD Proposal
• Second approach: use the book value at end of year six:
• Plant and Equipment (P&E) at end of year six is $0.
• The firm liquidates total current assets (cash 3,500, accounts
receivable 28,125, inventory 42,188) and pays off current debts
(accounts payable 24,300):
• Terminal value = $73,813 - $24,300 = $49,513.

27. 27
• Using assumption that cash flow grow at a steady rate past
year 6:
475
,
153
$
15
.
1
327
,
325
$
410
,
34
$
15
.
1
211
,
35
$
15
.
1
833
,
24
$
15
.
1
785
,
15
$
15
.
1
957
,
7
$
15
.
1
279
,
3
$
000
,
53
$
6
6
4
3
2
1










NPV
233
,
34
$
15
.
1
513
,
49
$
410
,
34
$
15
.
1
211
,
35
$
15
.
1
833
,
24
$
15
.
1
785
,
15
$
15
.
1
957
,
7
$
15
.
1
279
,
3
$
000
,
53
$
6
5
4
3
2
1











NPV
NPV for Jazz CD Proposal
• Using book value assumption for terminal value:
• NPV is positive with both methods: investing in Jazz CD
project increases shareholders wealth.

28. 28
Can a firm accept all investment projects with
positive NPV?
Reasons why a company would not accept all
projects:
Limited availability of skilled personnel to be
involved with all the projects;
Financing may not be available for all projects.
Companies are reluctant to issue new shares to
finance new projects because of the negative signal
this action may convey to the market.
Capital Rationing

29. 29
Capital rationing: project combination that
maximizes shareholder wealth subject to funding
constraints
1. Rank the projects using Profitability Index (PI)
2. Select the investment with the highest PI
3. If funds are still available, select the second-
highest PI, and so on, until the capital is exhausted.
The steps above ensure that managers select the
combination of projects with the highest NPV.
Capital Rationing

30. 30
• A firm must purchase an electronic control device:
• First alternative: cheaper device, higher maintenance costs,
shorter period of utilization
• Second device: more expensive, smaller maintenance costs,
longer life span
• Expected cash outflows:
Device A’s cash outflow < Device B’s cash outflow
 select A?
Equipment Replacement and Unequal Lives
• Using real discount rate of 7%:

31. 31
Table 9.4 Capital Rationing and the
Profitability Index (12% required return)

32. 32
Table 9.5 Operating and Replacement Cash
Flows for Two Devices (all values are outflows)

33. 33
• EAC converts lifetime costs to a level annuity; eliminates
the problem of unequal lives .
1. Compute NPV for operating devices A and B for their
respective lifetimes:
• NPV of device A = $15,936
• NPV of device B = $18,065
2. Compute annual expenditure (annuity cost) to make NPV
of annuity equal to NPV of operating device:
$6,072
X
07
.
1
07
.
1
07
.
1
936
,
15
$ 3
2
1




X
X
X
Device A
$5,333
Y
07
.
1
07
.
1
07
.
1
07
.
1
065
,
18
$ 4
3
2
1





Y
Y
Y
Y
Device B
• Since Device B’s annuity cost is lower, choose Device B.
Equivalent Annual Cost (EAC)

34. 34
• Excess capacity is not a free asset as traditionally regarded
by managers.
• Company has excess capacity in a distribution center warehouse.
• In two years, the firm will invest $2,000,000 to expand the
warehouse.
• The firm could lease the excess space for $125,000 per year
(at the beginning of each year) for the next two years.
• Expansion plans should begin immediately in this case to hold
inventory for new stores coming on line in a few months.
• Incremental cost: investing $2,000,000 at present vs. two years
from today
• Incremental cash inflow: $125,000 (at the beginning of the year)
Excess Capacity

35. 35
• NPV of leasing excess capacity (assume 10% discount rate):
471
,
108
$
1
.
1
000
,
000
,
2
10
.
1
000
,
125
000
,
000
,
2
000
,
125 2






NPV
0
1
.
1
000
,
000
,
2
10
.
1
000
,
000
,
2 2





X
X
NPV
Excess Capacity
- X = $181,818 (at the beginning of the year)
- Leasing the excess capacity for a price above $181,818 would
increase shareholders wealth.
• NPV negative: reject leasing excess capacity at $125,000
per year.
• The firm could compute the value of the lease that would
allow break even.

36. 36
The Human Face of Capital Budgeting
• Managers must be aware of optimistic bias in the
assumptions made by project supporters.
• Companies should have control measures in place to
remove bias:
– Investment analysis should be done by a group independent of
individual or group proposing the project.
– Project analysts must have a sense of what is reasonable when
forecasting a project’s profit margin and its growth potential.
• Storytelling: The best analysts not only provide numbers
to highlight a good investment, but also can explain why
the investment makes sense.

37. 37
• Certain types of cash flows are common to many
investments
• Opportunity costs should be included in cash
flow projections
• Consider human factors in capital budgeting
Cash Flow and Capital Budgeting