The document discusses capital budgeting and cash flow estimation. It defines capital budgeting as identifying, analyzing and selecting long-term investment projects. The capital budgeting process involves generating investment proposals, estimating after-tax cash flows, evaluating projects, selecting projects, and reevaluating implemented projects. Methods for estimating initial cash outflows, incremental cash flows, and terminal year cash flows are also presented. Two examples of asset expansion and replacement projects are provided to illustrate the capital budgeting concepts and calculations.

1. 12-1
CChhaapptteerr 1122
CCaappiittaall BBuuddggeettiinngg
aanndd EEssttiimmaattiinngg
CCaasshh FFlloowwss

2. 12-2
WWhhaatt iiss
CCaappiittaall BBuuddggeettiinngg??
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.

3. 12-3
TThhee CCaappiittaall
BBuuddggeettiinngg PPrroocceessss
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.

4. 12-4
TThhee CCaappiittaall
BBuuddggeettiinngg PPrroocceessss
Select projects based on a value-maximizing
acceptance criterion.
Reevaluate implemented
investment projects continually
and perform postaudits for
completed projects.

5. 12-5
CCllaassssiiffiiccaattiioonn ooff IInnvveessttmmeenntt
PPrroojjeecctt PPrrooppoossaallss
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)

6. 12-6
SSccrreeeenniinngg PPrrooppoossaallss
aanndd DDeecciissiioonn MMaakkiinngg
1. Section Chiefs
2. Plant Managers
3. VP for Operations
4. Capital Expenditures
Committee
5. President
6. Board of Directors
AAddvvaanncceemmeenntt
ttoo tthhee nneexxtt
lleevveell ddeeppeennddss
oonn ccoosstt
aanndd ssttrraatteeggiicc
iimmppoorrttaannccee..

7. 12-7
EEssttiimmaattiinngg AAfftteerr--TTaaxx
IInnccrreemmeennttaall CCaasshh FFlloowwss
BBaassiicc cchhaarraacctteerriissttiiccss ooff
rreelleevvaanntt pprroojjeecctt fflloowwss
 CCaasshh (not accounting income) fflloowwss
 OOppeerraattiinngg (not financing) fflloowwss
 AAfftteerr--ttaaxx fflloowwss
 IInnccrreemmeennttaall fflloowwss

8. 12-8
EEssttiimmaattiinngg AAfftteerr--TTaaxx
IInnccrreemmeennttaall CCaasshh FFlloowwss
PPrriinncciipplleess tthhaatt mmuusstt bbee aaddhheerreedd
ttoo iinn tthhee eessttiimmaattiioonn
 Ignore ssuunnkk ccoossttss
 Include ooppppoorrttuunniittyy ccoossttss
 Include project-driven cchhaannggeess iinn
wwoorrkkiinngg ccaappiittaall net of spontaneous
changes in current liabilities
 Include eeffffeeccttss ooff iinnffllaattiioonn

9. 12-9
TTaaxx CCoonnssiiddeerraattiioonnss
aanndd DDeepprreecciiaattiioonn
DDeepprreecciiaattiioonn represents the systematic
allocation of the cost of a capital asset
over a period of time for financial
reporting purposes, tax purposes, or
both.
Generally, profitable firms prefer to use
an accelerated method for tax
reporting purposes (MACRS).

10. 12-10
DDeepprreecciiaattiioonn aanndd tthhee
MMAACCRRSS MMeetthhoodd
Everything else equal, the greater the
depreciation charges, the lower the
taxes paid by the firm.
Depreciation is a noncash expense.
Assets are depreciated (MACRS) on one
of eight different property classes.
Generally, the half-year convention is
used for MACRS.

11. 12-11
MMAACCRRSS SSaammppllee SScchheedduullee
Recovery Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46

12. 12-12
CCaallccuullaattiinngg tthhee
IInnccrreemmeennttaall CCaasshh FFlloowwss
IInniittiiaall ccaasshh oouuttffllooww -- the initial net cash
investment.
IInntteerriimm iinnccrreemmeennttaall nneett ccaasshh fflloowwss --
those net cash flows occurring after the
initial cash investment but not including
the final period’s cash flow.
TTeerrmmiinnaall--yyeeaarr iinnccrreemmeennttaall nneett ccaasshh
fflloowwss -- the final period’s net cash flow.

13. 12-13
IInniittiiaall CCaasshh OOuuttffllooww
a) CCoosstt ooff ““nneeww”” aasssseettss
b) + Capitalized expenditures
c) + Increased 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) == IInniittiiaall ccaasshh oouuttffllooww

14. 12-14
IInnccrreemmeennttaall CCaasshh FFlloowwss
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) == IInnccrreemmeennttaall nneett ccaasshh ffllooww ffoorr ppeerriioodd

15. 12-15
TTeerrmmiinnaall--YYeeaarr
IInnccrreemmeennttaall CCaasshh FFlloowwss
a) Calculate the iinnccrreemmeennttaall nneett ccaasshh
ffllooww for the tteerrmmiinnaall ppeerriioodd
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) == TTeerrmmiinnaall yyeeaarr iinnccrreemmeennttaall nneett ccaasshh ffllooww

16. 12-16
Example 1: aann AAsssseett EExxppaannssiioonn PPrroojjeecctt
 ABC Co. is considering the purchase of a new
equipment. The equipment will cost $90,000 plus
$10,000 for shipping and installation.
 Falls under the 3-year MACRS class.
 No NWC requirements.
 It is forecasted that revenues for the next 4 years :
35167, 36250, 55725, 32,258.
 The used equipment will then be sold (scrapped) for
$16,500 at the end of the fourth year, when the project
ends.
 It is in the 40% tax bracket.

17. 12-17
IInniittiiaall CCaasshh OOuuttffllooww
a) $90,000
b) + 10,000
c) + 0
d - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) == $$110000,,000000

18. 12-18
EExxaammppllee 11:: aann AAsssseett
EExxppaannssiioonn PPrroojjeecctt
year 1 year 2 year 3 year 4
a) Net C/F 35167 36250 55725 32258
b) - Depr. 33330 44450 14810 7410
c) = CF_BT 1837 (8200) 40915 24848
d) - Tax 735 (3280) 16366 9939
e) = CF_AT 1102 (4920) 24549 14909
f) + Depr. 33330 44450 14810 7410
g) Incr. C/F 34432 39530 39359 22319
or (a) - (d) 34432 39530 39359 22319

19. TTeerrmmiinnaall--YYeeaarr IInnccrreemmeennttaall CC//FF
12-19
a) $$2222,,331199 The iinnccrreemmeennttaall ccaasshh ffllooww
from the previous slide in Year 4.
b) + 16,500 Salvage Value.
c) - 6,600 .40*($16,500 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
d) + 0 NWC - Project ends.
e) == $$3322,,221199 TTeerrmmiinnaall--yyeeaarr iinnccrreemmeennttaall
ccaasshh ffllooww..

20. 12-20
SSuummmmaarryy ooff PPrroojjeecctt NNeett CCaasshh
FFlloowwss
Asset Expansion
Year 0 Year 1 Year 2 Year 3
Year 4
--$$110000,,000000 $$3344,,443322 $$3399,,553300 $$3399,,335599
$$3322,,221199

21. 12-21
SSuummmmaarryy ooff PPrroojjeecctt
year 1 year 2 year 3 year 4
a) Net C/F 35167 36250 55725 32258
b) - Depr. 33330 44450 14810 7410
c) = CF_BT 1837 (8200) 40915 24848
d) - Tax 735 (3280) 16366 9939
(a) - (d) 34432 39530 39359 22319
Terminal Year CF = (16,500*.6)=9,900 32,219
(100000) 34,432 39,530 39,359 32,219

22. EExxaammppllee 22:: aann AAsssseett EExxppaannssiioonn PPrroojjeecctt
BW Co. is considering the purchase of a new machine.
The machine will cost $50,000 plus $20,000 for shipping
and installation.
Falls under the 3-year MACRS class.
NWC will rise by $5,000.
FM forecasts that revenues will increase by $110,000 for
each of the next 4 years and will then be sold (scrapped)
for $10,000 at the end of the fourth year, when the project
ends. Operating costs will rise by $70,000 for each of the
next four years.
BW is in the 40% tax bracket.
12-22

23. 12-23
IInniittiiaall CCaasshh OOuuttffllooww
a) $50,000
b) + 20,000
c) + 5,000
d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) == $$7755,,000000

24. 12-24
IInnccrreemmeennttaall CCaasshh FFlloowwss
Year 1 Year 2 Year 3 Year 4
a) Net C/F $40,000 $40,000 $40,000 $40,000
b) - Depr. 23,331 31,115 10,367 5,187
c) = CF_BT $16,669 $ 8,885 $29,633 $34,813
d) - Tax 6,668 3,554 11,853 13,925
e) = CF_AT $10,001 $ 5,331 $17,780 $20,888
f) + 23,331 31,115 10,367 5,187
g) == $$3333,,333322 $$3366,,444466 $$2288,,114477 $$2266,,007755

25. 12-25
TTeerrmmiinnaall--YYeeaarr
IInnccrreemmeennttaall CCaasshh FFlloowwss
a) $$2266,,007755 The iinnccrreemmeennttaall ccaasshh ffllooww
from the previous slide in
Year 4.
b) + 10,000 Salvage Value.
c) - 4,000 .40*($10,000 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
d) + 5,000 NWC - Project ends.
e) == $$3377,,007755 TTeerrmmiinnaall--yyeeaarr iinnccrreemmeennttaall
ccaasshh ffllooww..

26. 12-26
SSuummmmaarryy ooff PPrroojjeecctt
NNeett CCaasshh FFlloowwss
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
--$$7755,,000000** $$3333,,333322 $$3366,,444466 $$2288,,114477 $$3377,,007755
* Notice again that this value is a nneeggaattiivvee
cash flow as we calculated it as the initial
cash OUTFLOW

27. o Example off aann AAsssseett RReeppllaacceemmeenntt PPrroojjeecctt
Let us assume that previous asset expansion project is
actually an asset replacement project.
The new machine will cost $50,000 plus $20,000 for
shipping and installation and falls under the 3-year MACRS
class.
The original basis of the old machine was $30,000 and
depreciated using straight-line over five years ($6,000 per
year). The machine has two years of depreciation and four
years of useful life remaining. BW can sell the current
machine for $6,000. The new machine will save $10,000 per
year.
NWC are $5,000.
40% tax bracket.
12-27

28. 12-28
IInniittiiaall CCaasshh OOuuttffllooww
a) $50,000 Cost
b) + 20,000 Shipping + installation
= $$7700,,000000 DDeepprreecciiaabbllee bbaassiiss
c) + 5,000 NWC
d) - 6,000 (sale of “old” asset)
e) - 2,400 ---
(tax savings
f) == $$6666,,660000
from
loss on sale of
“old” asset)

29. 12-29
Depreciable Basis (old) 30000
Remaining life 4 years
Remaining depr. 2 years
Acc. Depr. (3-yaers) 18000
Book Value 12000
Sold for 6000
Loss on disposal 6000
Tax saving 2400

30. 12-30
CCaallccuullaattiioonn ooff tthhee
CChhaannggee iinn DDeepprreecciiaattiioonn
Year 1 Year 2 Year 3 Year 4
a) $23,331 $31,115 $10,367 $ 5,187
b) - 6,000 6,000 0 0
c) = $$1177,,333311 $$2255,,111155 $$1100,,336677 $$ 55,,118877
a) Represent the depreciation on the “new”
project.
b) Represent the remaining depreciation on the
“old” project.
c) Net cchhaannggee in tax depreciation charges.

31. 12-31
IInnccrreemmeennttaall CCaasshh FFlloowwss
Year 1 Year 2 Year 3 Year 4
a) Net C/F $10,000 $10,000 $10,000 $10,000
b) - Depr. (net) 1177,,333311 2255,,111155 1100,,336677 55,,118877
c) = CF_BT $ -7,331 -$15,115 $ -367 $ 4,813
d) - tax -2,932 -6,046 -147 1,925
g) == $$1122,,993322 $$1166,,004466 $$1100,,114477 $$ 88,,007755

32. 12-32
TTeerrmmiinnaall--YYeeaarr
IInnccrreemmeennttaall CCaasshh FFlloowwss
a) $$ 88,,007755 The iinnccrreemmeennttaall ccaasshh ffllooww
from the previous slide in
Year 4.
b) + 10,000 Salvage Value.
c) - 4,000 (.40)*($10,000). Note, the
asset is fully depreciated at
the end of Year 4.
d) + 5,000 Return of “added” NWC.
e) == $$1199,,007755 TTeerrmmiinnaall--yyeeaarr iinnccrreemmeennttaall
ccaasshh ffllooww.

33. 12-33
SSuummmmaarryy ooff PPrroojjeecctt
NNeett CCaasshh FFlloowwss
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
--$$7755,,000000 $$3333,,333322 $$3366,,444466 $$2288,,114477 $$3377,,007755
Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
--$$6666,,660000 $$1122,,993333 $$1166,,004466 $$1100,,114477 $$1199,,007755