Chapter 8

Capital
Budgeting
Cash Flows

Copyright © Copyright
2009 Pearson Prentice
© 2009 Pearson Hall.Hall.
Prentice All All
rights
rights reserved.
reserved.
Learning Goals

• Understand the motives for key capital

budgeting expenditures and the steps in the
capital budgeting process.
• Define basic capital budgeting terminology.
• Discuss relevant cash flows, expansion versus
replacement decisions, sunk costs and
opportunity costs, and international capital
budgeting.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-2

Learning Goals (cont.)

• Calculate the initial investment associated with

a proposed capital expenditure.
• Find the relevant operating cash inflows
associated with a proposed capital expenditure.
• Determine the terminal cash flow associated
with a proposed capital expenditure.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-3

The Capital Budgeting Decision Process

• Capital Budgeting is the process of identifying,

evaluating, and implementing a firm’s investment
opportunities.
• It seeks to identify investments that will enhance a
firm’s 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.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-4
Table 8.1 Key Motives for Making
Capital Expenditures

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-5

Steps in the Process

•Proposal Generation

•Review and Analysis

Our Focus is
on Step 2 and 3
•Decision Making

•Implementation

•Follow-up
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-6
Basic Terminology: Independent versus
Mutually Exclusive Projects

• Independent Projects, on the other hand, do not

compete with the firm’s resources. A company can
select one, or the other, or both—so long as they meet
minimum profitability thresholds.
• Mutually Exclusive Projects are investments that
compete in some way for a company’s resources—a
firm can select one or another but not both.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-7

 Basic Terminology: Unlimited Funds
versus Capital Rationing

• If the firm has unlimited funds for making

investments, then all independent projects that
provide returns greater than some specified level
can be accepted and implemented.
• However, in most cases firms face capital
rationing restrictions since they only have a
given amount of funds to invest in potential
investment projects at any given time.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-8
Basic Terminology: Accept-Reject versus
Ranking Approaches

• The accept-reject approach involves the

evaluation of capital expenditure proposals to
determine whether they meet the firm’s
minimum acceptance criteria.
• The ranking approach involves the ranking of
capital expenditures on the basis of some
predetermined measure, such as the rate of
return.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-9

Basic Terminology: Conventional versus
Nonconventional Cash Flows

Figure 8.1 Conventional Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-10

Basic Terminology: Conventional versus
Nonconventional Cash Flows (cont.)

Figure 8.2 Nonconventional

Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-11

The Relevant Cash Flows

• Incremental cash flows:

–are cash flows specifically associated with the
investment, and
–their effect on the firms other investments (both
positive and negative) must also be considered.

For example, if a day-care center decides to open another

facility, the impact of customers who decide to move from
one facility to the new facility must be considered.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-12

Relevant Cash Flows:
Major Cash Flow Components

Figure 8.3 Cash Flow Components

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-13

Relevant Cash Flows: Expansion Versus
Replacement Decisions

• Estimating incremental cash flows is relatively

straightforward in the case of expansion
projects, but not so in the case of replacement
projects.
• With replacement projects, incremental cash
flows must be computed by subtracting existing
project cash flows from those expected from the
new project.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-14

Figure 8.4 Relevant Cash Flows for
Replacement Decisions

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-15

Relevant Cash Flows: Sunk Costs
Versus Opportunity Costs

• Note that cash outlays already made (sunk

costs) are irrelevant to the decision process.
• However, opportunity costs, which are cash
flows that could be realized from the best
alternative use of the asset, are relevant.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-16

Finding the Initial Investment

Table 8.2 The Basic Format for Determining

Initial Investment

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-17

Finding the Initial Investment (cont.)

Table 8.3 Tax Treatment on Sales of

Assets

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-18

Finding the Initial Investment (cont.)

Hudson Industries, a small electronics company, 2

years ago acquired a machine tool with an installed
cost of $100,000. The asset was being depreciated
under MACRS using a 5-year recovery period. Thus
52% of the cost (20% + 32%) would represent
accumulated depreciation at the end of year two.

Book Value = $100,000 - $52,000 = $48,000

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-19

Finding the Initial Investment

• Sale of the Asset for More Than Its Purchase Price

If Hudson sells the old asset for $110,000, it realizes a

gain of $62,000 ($110,000 - $48,000). Technically, the
difference between the cost and book value ($52,000) is
called recaptured depreciation and the difference
between the sales price and purchase price ($10,000) is
called a capital gain. Under current corporate tax laws,
the firm must pay taxes on both the gain and recaptured
depreciation at its marginal tax rate.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-20
Finding the Initial Investment (cont.)

• Sale of the Asset for More Than Its Book Value but
Less than Its Purchase Price

If Hudson sells the old asset for $70,000, it realizes

a gain in the form of recaptured depreciation of
$22,000 ($70,000–$48,000) which is taxed at the
firm’s marginal tax rate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-21

Finding the Initial Investment (cont.)

• Sale of the Asset for Its Book Value

If Hudson sells the old asset for its book value of

$48,000, there is no gain or loss and therefore no tax
implications from the sale.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-22

Finding the Initial Investment (cont.)

• Sale of the Asset for Less Than Its Book Value

If Hudson sells the old asset for $30,000 which is less than
its book value of $48,000, it experiences a loss of $18,000
($48,000 - $30,000). If this is a depreciable asset used in
the business, the loss may be used to offset ordinary
operating income. If it is not depreciable or used in the
business, the loss can only e used to offset capital gains.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-23

Finding the Initial Investment (cont.)

Figure 8.5 Taxable Income from Sale of Asset

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-24

Finding the Initial Investment (cont.)

• Change in Net Working Capital

Danson Company, a metal products manufacturer, is

contemplating expanding operations. Financial analysts
expect that the changes in current accounts summarized
in Table 8.4 on the following slide will occur and will be
maintained over the life of the expansion.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-25

Finding the Initial Investment (cont.)

Table 8.4 Calculation of Change in Net Working

Capital for Danson Company

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-26

Finding the Initial Investment (cont.)

Powell Corporation, a large diversified manufacturer of aircraft

components, is trying to determine the initial investment required
to replace an old machine with a new, more sophisticated model.
The machine’s purchase price is $380,000 and an additional
$20,000 will be necessary to install it. It will be depreciated
under MACRS using a 5-year recovery period. The firm has
found a buyer willing to pay $280,000 for the present machine
and remove it at the buyers expense. The firm expects that a
$35,000 increase in current assets and an $18,000 increase in
current liabilities will accompany the replacement. Both ordinary
income and capital gains are taxed at 40%.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-27

Finding the Initial Investment (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-28

Table 8.7 Calculation of Operating Cash
Inflows Using the Income Statement Format

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-29

Table 8.8 Calculation of Operating Cash
Inflows for Powell Corporation’s Proposed
and Present Machines

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-30

Table 8.9 Incremental (Relevant) Operating
Cash Inflows for Powell Corporation

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-31

Finding the Terminal Cash Flow

Table 8.10 The Basic Format for Determining

Terminal Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-32

Finding the Terminal Cash Flow (cont.)

Continuing with the Powell Corporation example, assume that

the firm expects to be able to liquidate the new machine at the
end of its 5-year useable life to net $50,000 after paying
removal and cleanup costs. The old machine can be
liquidated at the end of the 5 years to net $10,000. The firm
expects to recover its $17,000 net working capital investment
upon termination of the project. Again, the tax rate is 40%.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-33

Finding the Terminal Cash Flow (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-34

Summarizing the Relevant Cash Flows

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-35