Capital Budgeting

MF 807 Corporate Finance

Professor Thomas Chemmanur

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 Computing Cash Flows in Capital Budgeting
Cash flows are the difference between the dollars received and the
dollars paid at the point in time when the actual transaction
takes place.
E.g. if a bulldozer is bought at the start of a project, the
negative cash flow of, say, $100,000 would be recorded at t = 0
The accounting approach involves depreciating the cost over the
useful life of the asset
E.g. straight-line depreciation expense of $20,000 over 5 years
These different approaches would yield a different NPV.
Thus, accounting figures, if used, are only a starting point for the
cash flow analysis.
Keep in mind that we estimate cash flows on an incremental,
after-tax basis. Incremental cash flows are the inflows and
outflows that occur if and only if the project is undertaken. 2
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 Computing Cash Flows in Capital Budgeting

Principles to keep in mind when computing cash flows:

1. Do not confuse incremental cash flows with average cash

flows. E.g. if you hire an employee because of a project, his
salary and any additional salary paid to existing employees
because of this project become a part of the project. You would
not use the average labor cost for all of the firms projects.
2. Include all incidental effects. E.g. if taking on a project
requires the installation of a new sewage disposal system, its cost
should be included in the cash flows of the project.
3. Remember additional working capital requirements due to
the project. Net working capital (sometimes just working
capital) is the difference between current assets and current
liabilities.
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Computing Cash Flows in Capital Budgeting

4. Forget sunk costs. Any costs that have already been

incurred are excluded. E.g. the cost of a marketing study to
estimate the market size for a new product is left out of the
decision to introduce the new product.

5. Include opportunity costs. These are the foregone cash

flows that could have been generated from existing assets if
they had not been allocated to the project.

6. Beware of allocated overheads. E.g. the salary of the

company Chairman should not be apportioned to the project, if
he would have been paid the same salary without the project.
This point is related to point 1: only include incremental cash
flows.
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 Calculating Depreciation

Depreciation is relevant to cash flow estimation because it impacts

the incremental cash flows of the project by affecting the firms
tax bill.
When a portion of an investment can be expensed every year as
depreciation, this means the taxable income of the firm is reduced
by the same amount.
The benefit to the firm is called the depreciation tax shield. (Again
remember we only consider the incremental depreciation.)
Incremental depreciation tax shield in year t = Tc * Dt , where
Dt is the incremental depreciation due to the project in year t,
and Tc is the firms marginal corporate tax rate (i.e. tax on the
next dollar earned).

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 Calculating Depreciation
1. Straight Line Depreciation:
Investment - Salvage value
Dt =
N
where N is the number of years over which the capital
equipment involved can be depreciated under the tax code
2. Accelerated Depreciation:
Dt = Investment * ACRS factor for year t, corresponding to the
ACRS depreciation class of the equipment, per the tax code.
Note: The ACRS factor is available in Table 6-5, page 102,
Brealy and Myers. On an exam, I will specify these factors in
any problems I give.
Accelerated depreciation results in larger present values for
projects than straight line depreciation, because the present value
of tax shields is higher.
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 Calculating Depreciation

Accelerated depreciation results in larger present values for

projects than straight line depreciation, because the present value
of tax shields is higher. That is, the sooner we can capture the tax
shield from depreciation the better.
3. Different kinds of project cash flows

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 Different kinds of project cash flows

Sometimes it is useful to categorize project cash flows into three

groups:
1. Initial Cash Flows. These are cash flows which occur at the
beginning of the project. E.g. initial investment, additional
working capital requirements
2. Operating Cash Flows. These occur during the regular
operation of the project.
OC t = (R t - C t )(1 - Tc ) + Tc D t
Rt = Incremental Revenues due to the project in year t
Ct = Incremental Costs due to the project in year t.
Dt = Incremental Depreciation available in year t.
Note: Tc Dt is the tax shield in year t due to the project.
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 Different kinds of project cash flows

3. Terminal Cash Flows. These are cash flows that occur

while the project is being wound up. Examples are salvage
value, return of additional working capital, etc.
Note: Any amount of the salvage value in excess of the book
value is subject to some taxation. (The book value of any
capital equipment is the original cost of the equipment minus
the sum of the various amounts written off as depreciation Dt
over the life of the project.)
If the tax rate applicable to any salvage value in excess of book
value is t, then the cash flow related to the salvage is:
Book value + (1 t)(Salvage value Book value)
In problems, I will specify if you need to take into account the
taxation of salvage value, and what tax rate to use.

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 Example 1

Initial Cash Flows:

Price (100,000)
Modification (20,000)
Net Working Capital (5,000)
Total - 125,000
Operating Cash Flows:
Year 1 Year 2 Year 3
After tax savings 25,600 25,600 25,600
Depreciation 39,996 53,340 17,772
T Dt 14,398.56 19,202.40 6,397.92
Total 39,998.56 44,802.4 31,997.2

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 Example 1

Terminal Cash Flows:

Salvage Value 50,000
Return of NWC 5,000
Total 55,000

NPV = -125,000 + 39,998.56 (PVIF 10%, 1 yrs) +

44,802.4 (PVIF 10%, 2 yrs) + 31,997.2 (PVIF 10%, 3yrs)
+ 55,000 (PVIF 10%, 3yrs)
= -125,000 + 138, 748.38
= 13,748.38 > 0 , So Accept.

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 How Should We Handle Inflation?

There is a positive rate of inflation in most real world economies.

We can define the inflation rate, denoted by p, as:
price of a basket of goods in the period
p= -1
price of the same basket in the current period
The inflation rate is already built into the nominal (or money)
discounting rate, which is what we observe. The relationship
between the nominal (or money) rate of return r, the inflation rate
p, and the real rate of return rc is given by:
(1 + r) = (1 + rc)(1 + p)
If we use the nominal rate of return to discount a given cash flow
stream, we should also adjust the cash flows we use in our
investment analysis for inflation.
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 How Should We Handle Inflation?

This adjustment is particularly important in the case of projects

lasting for longer periods, where this can make a significant
difference in our accept / reject decision.
Denote by CFt the cash flow at date t in current prices (I.e., cash
flows which are not adjusted for inflation)
Then the cash flows adjusted for inflation for date t, denoted by
ACFt, is given by:
ACFt = CFt (1 + p)t
The NPV of the project is:
n
ACFt n
CFt (1 p) t
NPV = =
t = 0 (1 r)
t t
t=0 (1 r)

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 How Should We Handle Inflation?

Sometimes, it is convenient to adjust the interest rate at which the

cash flows are discounted, keeping the cash flows at current
prices. To see how to do this, replace the nominal discount rate in
the previous expression for NPV by the real discount rate.
n
CFt (1 p) t n
CFt (1 p) t n
CFt

t = 0 [(1 rc )(1 + p)]
t
=
t = 0 (1 rc ) (1 + p)
t t
=
t=0 (1 r ) t
c

Thus, another way to handle inflation is to discount cash flows at

current prices at the real discount rate (i.e., use unadjusted cash
flows, but adjust the discount rate).

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 Example 2

Sales = 1000(138) 138,000

Cost = 1000(105) 105,000
Net before tax 33,000
Net income after tax 33,000 ( 1 0.36)
21,120
Cost of capital = 15% in nominal terms
Inflation rate = 6%
(1 + i) = (1 + ir)(1 + p)
ir = 1.15/1.06 - 1 = 0.0849 8.5%
As a perpetuity, PV of benefit = 21,120 / 0.0849 = 248,763.25
NPV = 248,763.25 150,000 = 98,763.25
Note: this project will have negative NPV if we ignore inflation
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 Project Interactions

So far, we have assumed that the investment opportunities

available to the company are cleanly separable, and that we can
analyze each project separately. This is a simplification.
Furthermore, a decision involving a project may not be one of
accept / reject but accept / reject / delay.
Cases of project interaction:
Optional timing of an investment: Net future valuet at date t
(1 + r)
Choosing between projects with unequal lives.
When to replace a machine.

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 Project Interactions

Optimal timing examples:

E.g. a drilling project might not be currently profitable because
of low oil prices, but the NPV could turn positive at higher
prices in the future. The right choice may be to buy an option
on the land (and thus the NPV of buying the land and
potentially drilling in the future is positive, given the
probability distribution of future oil prices).
E.g. the problem of when to harvest a crop of timber, given that
trees are growing and there will be more over time. (Assume
for simplicity that timber prices are constant). The answer here
is not to wait forever, since there is a time value for money, but
to harvest the timber at a certain optimal point in time.

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 Project Interactions

An example of two mutually exclusive projects with unequal

lives:
Consider a company having to decide between two machines,
one having a life of five years and the other seven years.
Assume further that the NPV of buying the machine with a
shorter life is larger. The solution here is not necessarily to buy
the first machine, if it also means the company has to buy a
new machine sooner (after 5 years).
The concept of equivalent annual cost is useful in solving this
problem. The EAC is the annual amount of an annuity with the
same present value as that of the project under consideration.
The firm should buy the machine with the lower equivalent
annual cost.
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 Example 3

PV of A = - 40,000 + {-10,000(PVIFA 6%, 3 yrs)}

= - 40,000 + -10,000(2.6730) = - 66,730
Equivalent Annual Cost (EAC)
EACA [PVIFA 6%, 3 yrs] = -66,730
EACA = 66,730/2.6730 = -24,964

PV of B = -50,000 + {-8,000(PVIFA 6%, 4 yrs)}

EACB [PVIFA 6%, 4 yrs] = -77,720
EACB = -77,720 / [PVIFA 6%, 4 yrs] = -22,430

Buy machine B, since the EAC is lower.

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