Chapter 10 - Cash Flows and Other Topics in Capital Budgeting

2005, Pearson Prentice Hall

Capital Budgeting: The process of planning for purchases of long-term assets.

For example: Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? The relevant project information follows:

 The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at
the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate.

Capital Budgeting Steps

1) Evaluate Cash Flows Look at all incremental cash flows occurring as a result of the project. Initial outlay Differential Cash Flows over the life of the project (also referred to as annual cash flows). Terminal Cash Flows

Capital Budgeting Steps

1) Evaluate Cash Flows
Initial outlay Terminal Cash flow

...

Annual Cash Flows

Capital Budgeting Steps

2) Evaluate the Risk of the Project Well get to this in the next chapter. For now, well assume that the risk of the
project is the same as the risk of the overall firm. If we do this, we can use the firms cost of capital as the discount rate for capital investment projects.

Capital Budgeting Steps

3) Accept or Reject the Project

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (Purchase price of the asset) + (shipping and installation costs) (Depreciable asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Step 1: Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0? (127,000) + (20,000) (147,000) + (4,000) + 0 ($151,000) Purchase price of asset Shipping and installation Depreciable asset Net working capital Proceeds from sale of old asset Net initial outlay

Step 1: Evaluate Cash Flows

b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

For Each Year, Calculate:

Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 46,461 = Revenue Costs Depreciation EBT Taxes EAT Depreciation reversal Annual Cash Flow

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 old machine salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Tax Effects of Sale of Asset:

Salvage value = $50,000. Book value = depreciable asset - total
amount depreciated. Book value = $147,000 - $147,000 = $0. Capital gain = SV - BV = 50,000 - 0 = $50,000. Tax payment = 50,000 x .34 = ($17,000).

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 (17,000) 4,000 37,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Project NPV:

CF(0) = -151,000. CF(1 - 4) = 46,461. CF(5) = 46,461 + 37,000 = 83,461. Discount rate = 14%. NPV = 46,461(PVIFA 14%, 4) +
83,461/(1.14)5 151,000 $27,721. We would accept the project.

Practice Problems: Cash Flows & Other Topics in Capital Budgeting

Project Information: Problem 1a Cost of equipment = $400,000. Shipping & installation will be $20,000. $25,000 in net working capital required at setup. 3-year project life, 5-year class life. Simplified straight line depreciation. Revenues will increase by $220,000 per year. Defects costs will fall by $10,000 per year. Operating costs will rise by $30,000 per year. Salvage value after year 3 is $200,000. Cost of capital = 12%, marginal tax rate = 34%.

Problem 1a
Initial Outlay: (400,000) + ( 20,000) (420,000) + ( 25,000) ($445,000) Cost of asset Shipping & installation Depreciable asset Investment in NWC Net Initial Outlay

For Years 1 - 3:
220,000 10,000 (30,000) (84,000) 116,000 (39,440) 76,560 84,000 160,560 =

Problem 1a

Increased revenue Decreased defects Increased operating costs Increased depreciation ($420,000/5) EBT Taxes (34%) EAT Depreciation reversal Annual Cash Flow

Problem 1a
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Terminal Cash Flow:

Problem 1a

Salvage value = $200,000. Book value = depreciable asset - total

amount depreciated. = $420,000- ($84,000 x3) = $168,000. Capital gain = SV - BV = $32,000. Tax payment = 32,000 x .34 = ($10,880).

Problem 1a
Terminal Cash Flow: 200,000 (10,880) 25,000 214,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 1a Solution NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 214,120 = 374,680 Discount rate = 12% NPV = 160,560 (PVIFA 12%, 2) + 374,680/(1.12)3 445,000 NPV = $93,044. Accept the project!

Problem 1b
Project Information: For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. Calculate NPV for the project. Is it still acceptable?

Problem 1b
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

Problem 1b
Terminal Cash Flow:

Salvage value = $100,000. Book value = depreciable asset - total

amount depreciated. Book value = $168,000. Capital loss = SV - BV = ($68,000). Tax refund = 68,000 x .34 = $23,120.

Problem 1b
Terminal Cash Flow: 100,000 23,120 25,000 148,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 1b Solution NPV and IRR: CF(0) = -445,000. CF(1), (2) = 160,560. CF(3) = 160,560 + 148,120 = 308,680. Discount rate = 12%. NPV = $46,067. Accept the project!

Replacement project
The main difference between replacement project
and the previous examples are the calculation of cash flow, depreciation and salvage value. What matter in replacement analysis is the incremental effects of new machine (new asset
depreciation old asset depreciation; new asset salvage valueold asset salvage value) on

projects cash flow depreciation and salvage value.

Pay attention to old asset current selling price(

use to calculate capital gain tax) & incremental salvage value)

old asset salvage value at the end of project life (use to calculate

Replacement Project:

Problem 3

Old Asset (5 years old): Cost of equipment = $1,125,000. 10-year class life (remaining 5 years economic life) Simplified straight line depreciation. Can be sold for $400,000 today. The salvage value after 5 years is $150,000 Cost of capital = 14%, marginal tax rate = 35%.

Replacement Project:

Problem 3

New Asset: Cost of equipment = $1,750,000. Shipping & installation will be $56,000. $68,000 investment in net working capital. 5-year project life, 5-year class life. Simplified straight line depreciation. Will increase sales by $285,000 per year. Operating expenses will fall by $100,000 per year. Salvage value after year 5 is $650,000. Cost of capital = 14%, marginal tax rate = 34%.

Problem 3: Sell the Old Asset

Old asset sale price = $400,000. Book value = depreciable asset - total amount
depreciated. Book value = $1,125,000 ($1,125,000/10 x 5) = $1,125,000-$562,500 = $562,500 Capital gain = Sale price book value = 400,000 - 562,500 = ($162,500). Tax refund = 162,500 x .35 = $56,875.

Initial Outlay:
(1,750,000) + ( 56,000) (1,806,000) + ( 68,000) + 456,875

Problem 3

Cost of new machine Shipping & installation Depreciable asset NWC investment After-tax proceeds (sold old machine) (1,417,125) Net Initial Outlay

Problem 3

For Years 1 - 5:
385,000 (248,700) 136,300 (47,705) 88,595 248,700 337,295 = Increased sales & cost savings Extra depreciation ( new machine EBT Taxes (35%) EAT Depreciation reversal Differential Cash Flow

depreciation- old machine depreciation; $361,200-$112,500)

Problem 3
Terminal Cash Flow: 500,000 Extra salvage value (SV

of new machine-SV of old machine = $650,000- $150,000)

(175,000) 68,000 393,000

Tax on capital gain Recapture of NWC Terminal Cash Flow

Problem 3 Solution
NPV CF(0) = -1,417,125. CF(1 - 4) = 337,295. CF(5) = 337,295 + 393,000 = 730,295. Discount rate = 14%. NPV = 337,295(PVIFA 14%, 4) + 730,295/(1.14)5 1,417,125 = (55,052.07) We would not accept the project!