1

TOPIC 6:

CASH FLOWS IN
CAPITAL
BUDGETING

The Capital Budgeting Decision

Process

Capital Budgeting is the process of

identifying, evaluating, and implementing a
firms investment opportunities whose
returns (cash flows) are expected to extend
beyond one year.

It

seeks to identify investments that will

enhance a firms competitive advantage
and increase shareholder wealth.
The typical capital budgeting decision
involves a large up-front investment
followed by a series of smaller cash inflows.
Poor capital budgeting decisions can
ultimately result in company bankruptcy.

3
Motives
of making capital
expenditure

GUIDELINES FOR CAPITAL

BUDGETING

Use cash flows rather than accounting profits.

Incremental after-tax cash flows
Use incremental cash flows and incremental costs
Sunk costs are not incremental cash flows
Ignores interest payments and financing flows
Account for opportunity costs
Beware of cash flows diverted from existing
products
Looks for other effects
Work in working capital requirements

TAX CONSIDERATIONS AND

DEPRECIATION
Depreciation
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
straight line
method.
Everything else equal, the greater the
depreciation
5
charges, the lower the taxes paid by the
firm.
Depreciation is a noncash expense.

DEPRECIABLE BASIS
COST OF ASSET + CAPITALIZED

EXPENDITURES

CAPITALIZED EXPENDITURES ARE

EXPENDITURES THAT MAY PROVIDE BENEFITS

INTO THE FUTURE AND THEREFORE ARE
TREATED AS CAPITAL OUTLAYS AND NOT AS
EXPENSES OF THE PERIOD IN WHICH THEY WERE
6
INCURRED.

Calculating the cash flows

Determining Cash Flows

Look at all incremental cash flows occurring as
result of the project.

Initial outlay - the initial net cash

investment.
Differential Cash Flows over the life of
the
project but not including the final periods
cash
flow (also referred to as annual cash flows).
Terminal Cash Flows - the final periods
net cash flow.

Cash Flow Components

1. DETERMINING
INITIAL OUTLAY

Initial outlay is the immediate cash outflow

necessary to purchase the asset and put it in
operating order
May include:

Purchase cost
Installation/Modification
Shipping/Freight
Renovation
Set-up cost
Non-expense cash outlays
increased working-capital
requirements

10Initial

Outlay :What is the cash flow

at time 0

(Purchase price of the new asset)

+ (Capitalized expenditure- shipping and
installation costs)
=
(Depreciable asset)
+/- Increased/decreased in NWC (Investment
in
working capital)
+/- After-tax proceeds from sale of old asset
(if replacement- #net proceed from sell of
old
asset [+/- taxes [saving] )
Net Initial Outlay

2. DETERMINING ANNUAL
CASH cash
FLOWS
Differential
flows over the project's life
11

include the incremental after-tax flows over

the life of the project , for example :
1. Added revenue for the proposal
2. Any labor and/or material savings incurred
3. Increases in overhead incurred
4. Changes in taxes, depreciation
5. Change in net working capital.
6. Change in capital spending.
8. Do not to include financing charges
(such as interest or preferred stock
dividends)

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Annual Cash Flows: What incremental cash flows
occur over the life of the project?
Incremental revenue
- Incremental costs
- Depreciation on project
= Incremental earnings before taxes
- Tax on incremental EBT
= Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

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3. DETERMINING TERMINAL
CASH FLOWS

Terminal

cash flows include any incremental

cash flows that result at the termination of the
project, for example:
1. The project's salvage value plus (or minus)
any taxable gains or losses associated with the
project
2. Any terminal cash flow needed, perhaps
disposal of obsolete equipment
3.
Recovery of any non-expense cash outlays
associated with the project, such as recovery of
increased working-capital needs associated

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TAX TREATMENT ON SALES

OF ASSETS

Form of
taxable
income

Definition

Tax
treatment

Gain on
sale of
assets

If the selling
price is
greater than
book value

All gains
above book
value are
taxed.

Loss on
sale of
asset

If the selling
price is less
than book
value

Assumed
tax rate

25% of
capital gain.

If the asset
is
depreciable,
loss is
25% of
deducted
capital loss
from
(tax refund)
ordinary

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Terminal Cash Flow: What is the cash

flow at the end of the projects life?
Salvage value
+/- Tax effects of capital gain/loss
(taxes (tax saving) due to asset sale or
disposed asset)

+/- Recapture
(increased/decreased)
level of net working capital
Terminal Cash Flow

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Cost

EXAMPLE 1:

of new machine is RM127,000.

Installation cost = RM20,000.
Net working capital of RM4,000 required at the
time of installation.
This project will increase annual return by
RM85,000, but the operation cost also will
increase by 35% of return incremental.
Use simplified straight line depreciation method.
Life of the machine is 5 year and life of the
project also 5 year.
Salvage value of the machine at the end of life =
RM50,000.
Cost of capital =14% & tax rate = 34%

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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

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a)

EXAMPLE 1
(CONT)
Initial Outlay : What is the cash
flow at time 0?
127,000
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of
old asset
Net Initial Outlay

19
a)

EXAMPLE 1
(CONT)
Initial Outlay : What is the cash
flow at time 0?
127,000
+
20,000
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of
old asset
Net Initial Outlay

20
a)

EXAMPLE 1
(CONT)
Initial Outlay : What is the cash
flow at time 0?
127,000
+
20,000
147,000
+ (Investment in working capital)
+ After-tax proceeds from sale of
old asset
Net Initial Outlay

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a)

EXAMPLE 1
(CONT)
Initial Outlay : What is the cash
flow at time 0?
127,000
+
20,000
147,000
+
4,000
+ After-tax proceeds from sale of
old asset
Net Initial Outlay

22
a)

EXAMPLE 1
(CONT)

Initial Outlay : What is the cash

flow at time 0?
127,000
+
20,000
147,000
+
4,000
+
0
Net Initial Outlay

23
a)

EXAMPLE 1
(CONT)

Initial Outlay : What is the cash

flow at time 0?
127,000
+
20,000
147,000
+
4,000
+
0
151,000

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a)

EXAMPLE 1
(CONT)
Initial Outlay : What is the cash
flow at time 0?
127,000
Purchase price of asset
+
20,000
Shipping and installation
147,000
Depreciable asset
+
4,000
Net working capital
+
0
Proceeds from sale of old asset
151,000
Net initial outlay

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b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

26
b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
85,000
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

27
b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the
life ofx .35
the project?
= 85,000
= 29,750
85,000
- 29,750
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

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b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
Depreciable asset / useful life
= 147,000 /5
85,000
= 29,400
- 29,750
- 29,400
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

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b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
85,000
- 29,750
- 29,400
25,850
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

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b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
85,000
- 29,750
25,850 x 0.34
= 8,789
- 29,400
25,850
- 8,789
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

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b)

For Years 1 What incremental cash5:

Annual Cash Flows:

flows occur over the life of the project?
85,000
- 29,750
25,850 x 0.34
= 8,789
- 29,400
25,850
- 8,789
17,061
+ Depreciation reversal
Annual Cash Flow

For Years 1 What incremental cash5:

32
b)

Annual Cash Flows:

flows occur over the life of the project?
85,000
- 29,750
- 29,400
25,850
- 8,789
17,061
+ 29,400
Annual Cash Flow

For Years 1 What incremental cash5:

33
b)

Annual Cash Flows:

flows occur over the life of the project?
85,000
- 29,750
- 29,400
25,850
- 8,789
17,061
+ 29,400
46,461

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85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
reversal

FOR YEARS 1 5:

Revenue
Costs
Depreciation
EBT
Taxes
EAT
Depreciation

46,461 = Annual Cash

Flow

35

EXAMPLE 1
(CONT)

c) Terminal Cash Flow: What is

the cash flow at the end of the
projects life?
Salvage value
+/- Tax effects of capital
gain/loss
+ Recapture of net
working capital
Terminal Cash Flow

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EXAMPLE 1
(CONT)

c) Terminal Cash Flow: What is

the cash flow at the end of the
projects life?

50,000 Salvage value

+/- Tax effects of capital
gain/loss
+ Recapture of net
working capital
Terminal Cash Flow

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TAX EFFECTS OF SALE

OF ASSET:

Salvage value= $50,000

Book value
= depreciable asset total
amount depreciated.
= $147,000 - $147,000
= $0.
Capital gain = SV - BV
= 29,400 x 5
= 50,000 - 0 = $50,000
Tax payment = 50,000 x .34 = ($17,000)

38

EXAMPLE 1
(CONT)

c) Terminal Cash Flow: What is

the cash flow at the end of the
projects life?

50,000 Salvage value

(17,000) Tax effects of capital
gain/loss
+ Recapture of net
working capital
Terminal Cash Flow

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EXAMPLE 1
(CONT)

c) Terminal Cash Flow: What is

the cash flow at the end of the
projects life?
50,000 Salvage value
(17,000) Tax effects of capital
gain/loss
4,000 Recapture of net
working capital
37,000 Terminal Cash

40

Example 1
(cont)

PROJECTS NPV:

CF(0) = -151,000
CF(1 - 4) = 46,461
CF(5) = 46,461 + 37,000 =
83,461
Discount rate = 14%
NPV = ??
Decision = Accept OR Reject ??

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Project Information:
Cost

EXAMPLE
2

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 machine 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%

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Initial

EXAMPLE 2
(CONT)

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

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FOR YEARS 1 - 3:Example 2

(cont)
Increased revenue

220,000
10,000 Decreased defects
(30,000) Increased operating
costs
(84,000) Increased
depreciation
116,000 EBT
(39,440) Taxes (34%)
76,560
EAT
84,000
Depreciation reversal
160,560 = Annual Cash Flow

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EXAMPLE 2
(CONT)

Terminal Cash Flow:

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

45

EXAMPLE 2
(CONT)

Terminal Cash Flow:

Salvage value= $200,000
Book value
= depreciable asset total amount depreciate
= 420,000 252,000
= $168,000.
Capital gain = SV - BV = $32,000
= 84,000 x 3
Tax payment = 32,000 x .34 = ($10,880)

EXAMPLE 2
(CONT)

46

Terminal Cash Flow:

200,000
(10,880)
gain
25,000
NWC
214,120
Flow

Salvage value
Tax on capital
Recapture of
Terminal Cash

47

EXAMPLE 2
(CONT)

Find projects NPV and IRR:

CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160,560 + 214,120
= 374,680
Discount rate = 12%
IRR = ??
NPV = ??

48

EXAMPLE 2
(CONT)

Find projects NPV and IRR:

CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160,560 + 214,120 =
374,680
Discount rate = 12%
IRR = 22.1%
NPV = $93,044.42 Accept the
project!

49

Replacement Project:

Example
3

Old Asset (5 years old):

Cost of equipment = $1,125,000.
10-year project life, 10-year class life.
Simplified straight line depreciation.
Current salvage value is $400,000.
Cost of capital = 14%,
Tax rate = 35%.

50

Example 3
(cont)

Replacement Project:
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.
Already paid $15,000 for training program.
Salvage value after year 5 is $500,000.
Cost of capital = 14%, marginal tax rate = 35%.

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EXAMPLE 3: SELL THE

OLD ASSET
Salvage value = $400,000.
Book

value

= depreciable asset - total amount

depreciated.
Book value
= $1,125,000 - $562,500
= $562,500.
Capital gain
= SV - BV
= 400,000 - 562,500 = ($162,500).
Tax refund
= 162,500 x .35 = $56,875.

Example 3
(cont)

52

Initial Outlay:
(1,750,000)
+ ( 56,000)
(1,806,000)
+ ( 68,000)
+ 456,875
(1,417,125)

Cost of new machine

Shipping & installation
Depreciable asset
NWC investment
After-tax proceeds (sold
old machine)
Net Initial Outlay

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FOR YEARS 1 5:

Example 3
(cont)

385,000 Increased sales & cost savings

(248,700) Extra depreciation
136,300 EBT
(47,705) Taxes (35%)
88,595 EAT
248,700 Depreciation reversal
337,295 Differential Cash Flow

54
Terminal Cash Flow:
500,000
(175,000)
68,000
393,000

Salvage value
Tax on capital gain
Recapture of NWC
Terminal Cash Flow

Example 3
(cont)

55

NPV and IRR:

Example 3
(cont)

CF(0) = -1,417,125.
CF(1 - 4) = 337,295.
CF(5) = 337,295 + 393,000 = 730,295.
Discount rate = 14%.
NPV = (55,052.07).
IRR = 12.55%.
We would not accept the project!

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EXERCIS
E 1:

Automation Project:
Cost of equipment = $550,000
Shipping & installation will be $25,000
$15,000 in net working capital required at setup
8-year project life, 5-year class life
Simplified straight line depreciation
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Salvage value after year 8 is $40,000
Cost of capital = 14%, marginal tax rate = 34%

57

(CONT)

Questions:
i) Calculate the projects initial outlay
ii) Calculate the annual cash flow
iii)Calculate the terminal cash flow
iv) If the discount rate is 14%, calculate the NPV. Would
you accept the project?

2.

EXERCIS
E 2:

XYZ company is considering replacing an old machine

with a new one. Two months ago their chief engineer
completed a training seminar on the new machines
operation and efficiency. The $4,000 cost for this training
session has already been paid. If the new machine is
purchased, it would require $5,000 in installation and
modification cost to make it suitable for operation in the
factory. The old machine originally cost $90,000 five
years ago and is being depreciated by $15,000 per year.
The new machine will cost $80,000 before installation
and modification. It will be depreciated by $5,000 per
year. The old machine can be sold today for $10,000. The
marginal tax rate for the firm is 40%. Compute the
relevant initial outlay in this capital budgeting decision.
Answer: ($73,000)

3.

EXERCIS
E 3:to
MM Fabric Shop is purchasing a new rivet machine

replace an existing one. The new machine costs $8,000

and will require an additional cost of $1,000 for
modification. It will be depreciated using simplified
straight line depreciation over five years. The new
machine operates much faster than the old machine and
with better quality. Consequently, sales are expected to
increase by $2,100 per year for the next five years. While
it is faster, it is fully automated and will result in and
increased electricity costs for the firm by $700 per year.
It will, however, save about $850 per year in labor costs.
The old machine is 20 years old and has already been
fully depreciated. If the firm tax rate is 28%, compute
the after tax incremental cash flows for the new machine
for years 1 through 5.
Answer: ($2,124)

EXERCIS
E 4:

4.

CC industries is considering the purchase of a new

machine that will cost $250,000, plus an additional
$10,000 to ship and install. The new machine is
expected to have a salvage value of $30,000 at the end
of year five. The company tax rate is 40%. The
additional net working capital from this project of
$50,000 is expected to be recaptured upon
termination. Calculate the terminal cash flow of the
new machine.
Answer: ($68,000)

EXERCIS
E 5:
5. The Director of Capital Budgeting of Capital Assets
Corp. is considering the acquisition of a new high
speed photocopy machine. The photocopy machine is
priced at $85,000 and would require $2,000 in
transportation costs and $4,000 for installation. The
equipment will have a useful life of 5 years. The
proposal will require that Capital Assets Corp. send
technician for training at a cost of $5,000. The firms
marginal tax rate is 40 percent. How much is the
initial cash outlay of the photocopy machine?
Answer: ($96,000)