financial mgmt

1. © 2004 by Nelson, a division of Thomson Canada Limited
Contemporary Financial Management
Chapter 9:
Capital Budgeting and Cash Flow
Analysis

2. © 2004 by Nelson, a division of Thomson Canada Limited
Introduction
• This chapter discusses capital budgeting and
capital expenditures
• It deals with the financial management of the
assets on a firm’s balance sheet

3. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting
• The process of planning for purchases of assets
whose useful lives are expected to continue
beyond a year
• Capital Expenditure
• A cash outlay expected to generate a flow of
future cash benefits for more than one year
• Capital budgeting decisions can be among the
most complex decisions facing management

4. © 2004 by Nelson, a division of Thomson Canada Limited
Examples 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 Limited
Types of Investment Projects
• Growth opportunities
• Cost reduction opportunities
• Required to meet legal requirements
• Required to meet health and safety standards

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How Projects are Classified
• Independent
• Acceptance or rejection has no effect on other
projects
• Mutually Exclusive
• Acceptance of one automatically rejects the
others (replace versus repair)
• Contingent
• Acceptance of one project is dependent upon
the selection of another

7. © 2004 by Nelson, a division of Thomson Canada Limited
Cost of Capital
• Firm’s overall cost of funds, often referred to
WACC or Weighted Average Cost of Capital
• Equal to a weighted average of the investors’
required rates of return
• The discount rate used to analysis capital
budgeting proposals

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• Expand output until marginal revenue equals
marginal cost
• Invest in the most profitable projects first
• Continue accepting projects as long as the rate
of return exceeds the marginal cost of capital
(MCC)
Optimal Capital Budget

9. © 2004 by Nelson, a division of Thomson Canada Limited
The Optimal Capital Budget
Funding available
MCC
Rate
Return
exceeds cost
Cost exceeds
returnFund these projects
Project Return

10. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting Problems
• All projects may not be known at one time
• Changing markets, technology, and corporate
strategies can quickly make current projects
obsolete and make new ones profitable
• Difficulty in determining the behavior of the
marginal cost of capital (MCC)
• Estimates of project cash flows have varying
degrees of uncertainty

11. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting Process
• Step 1: Generate proposals
• Step 2: Estimate the cash flows
• Step 3: Evaluate alternatives and select
projects
• Step 4: Review prior decisions

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Estimating 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 in
terms of their opportunity cost rather than their
actual cost.

13. © 2004 by Nelson, a division of Thomson Canada Limited
The Capital Budgeting Decision
• The capital budgeting decision involves six
steps:
1 Calculate initial investment
2 Calculate PV of the annual after-tax cashflows
attributable to the new asset
3 Calculate PV of the tax-shield due to Capital
Cost Allowance (CCA)
4 Calculate PV of salvage value
5 Calculate PV of the tax shield lost due to
salvage
6 Calculate PV of any changes in working capital

14. © 2004 by Nelson, a division of Thomson Canada Limited
1: 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 old
asset
• If expenditures on the new asset occur over a
period of time, present value all costs back to
time period zero

15. © 2004 by Nelson, a division of Thomson Canada Limited
2: PV of Annual After-Tax CFs
( ) ( )
( )
∑
N
Cash Flow t
t=1
Revenue - Expenses 1 - T
PV =
1 + k
T = corporate marginal tax rate
k = WACC or discount rate
t = year 1 through year N

16. © 2004 by Nelson, a division of Thomson Canada Limited
3: PV of Tax Shield due to CCA
   
   
   
CapitalCost
Allowance
dT 1 + 0.5k
PV Tax Shield = UCC
d + k 1 + k
UCC = Undepreciated capital cost (cost - trade-in received)
d = Capital cost allowance rate
T = Corporate tax rate
k = Firm’s cost of capital

17. © 2004 by Nelson, a division of Thomson Canada Limited
4: Calcuate PV of Salvage
( )
Salvage t
Salvage
PV =
1 + k
Salvage = the expected future salvage value
k = the WACC or discount rate
t = the number of years until the asset is salvaged

18. © 2004 by Nelson, a division of Thomson Canada Limited
5: PV of Tax Shield Lost from Salvage
( )
  
 ÷   ÷   
Tax-shield t
Lost due to
Salvage
dT 1
PV = -Salvage Value
d + k 1 + k
d = CCA rate
T = Corporate tax rate
k = WACC or discount rate
t = number of years

19. © 2004 by Nelson, a division of Thomson Canada Limited
6: PV of Change in Working Capital
↓
↑
Change in
Working
Capital
Change in
Working
Capital
PV = +PV WorkingCapital
PV = - PV WorkingCapital
Working Capital = Current assets - current liabilities
↑ = Increase in working capital
↓ = Decrease in working capital
or

20. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Example
• Alki Dyes Ltd. buys a new tank for $18,000,
including installation. The estimated salvage
value at the end of its 3-year useful life is
$1,000. CCA is charged at a 50% rate. The
tank is expected to increase the firm’s pre-tax
cash flows by $10,000/year for the three years
of useful life. Working capital is expected to
increase 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 new
investment?

21. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
Step 1: Initial investment
Cash flow from tank purchase: -$18,000
Step 2: PV of annual cash flows
( ) ( )
( )
( )
( )
( )
( )
( )
( )
=
− − −
= + +
=
∑
N
Cash Flow t
t=1
2 3
Revenue - Expenses 1 - T
PV
1 + k
10,000 1 0.46 10,000 1 0.46 10,000 1 0.46
1.14 1.14 1.14
12,536.81

22. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
( ) ( ) ( )
   
=    
   
   +
=    
+   
=
CapitalCost
Allowance
dT 1 + 0.5k
PV Tax Shield UCC
d + k 1 + k
0.50 0.46 1 0.5 0.14
18,000
0.50 0.14 1.14
$6,071.55
Step 3: PV of tax-shield due to CCA

23. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
Step 4: PV of salvage
( )
( )
=
=
=
Salvage t
3
Salvage
PV
1 + k
1,000
1.14
674.97

24. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
Step 5: PV of the tax-shield lost due to salvage
( )
( ) ( )
( )
  
 ÷   ÷   
  
 ÷= −  
 ÷+   
= −
Tax-shield t
Lost due to
Salvage
3
dT 1
PV = -Salvage Value
d + k 1 + k
0.50 0.46 1
1,000
0.50 0.14 1.14
$242.57

25. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
Step 6: PV of the change in Working Capital
( )
= − ↑
= −
= −
Change in
Working
Capital
PV PV WorkingCapital
1,000
1.14
877.19

26. © 2004 by Nelson, a division of Thomson Canada Limited
Capital Budgeting: Solution
-$18,000.00
+$12,536.81
+$6,071.55
+$674.97
-$242.57
-$877.19
+$163.57
Step 1:
Step 2:
Step 3:
Step 4:
Step 5:
Step 6:
NPV

27. © 2004 by Nelson, a division of Thomson Canada Limited
Ethical Issues: Biased CF Estimates
• The outcome of any capital budgeting exercise
is 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 Limited
Major Points
• Firms make investment decisions using a capital
budgeting framework.
• The capital budgeting process captures all of the
incremental costs and benefits of undertaking a
project.
• If capital is unlimited, the firm will accept all
positive NPV projects and reject all negative NPV
projects.