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

0 1 2 3 4 5 n6 . . .

TerminalCash flow

Annual Cash Flows

Initialoutlay

2) Evaluate the Risk of the Project We’ll get to this in the next chapter. For now, we’ll 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 firm’s cost of capital as the discount rate for capital investment projects.

Capital Budgeting Steps

3) Accept or Reject the Project

Capital Budgeting Steps

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) 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

Step 1: Evaluate Cash Flows

b) 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

For Each Year, Calculate:

85,000 Revenue

(29,750) Costs

(29,400) Depreciation

25,850 EBT

(8,789) Taxes

17,061 EAT

29,400 Depreciation reversal

46,461 = Annual Cash Flow

For Years 1 - 5:

Step 1: Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s 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 project’s life?

50,000 Salvage value

(17,000) Tax on capital gain

4,000 Recapture of NWC

37,000 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: 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

Problem 1aInitial Outlay:

(400,000)Cost of asset

+ ( 20,000)Shipping & installation

(420,000)Depreciable asset

+ ( 25,000)Investment in NWC

($445,000) Net Initial Outlay

220,000 Increased revenue

10,000 Decreased defects

(30,000) Increased operating costs

(84,000) Increased depreciation ($420,000/5)

116,000 EBT

(39,440) Taxes (34%)

76,560 EAT

84,000 Depreciation reversal

160,560 = Annual Cash Flow

For Years 1 - 3: Problem 1a

Terminal Cash Flow:

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capital

Terminal Cash Flow

Problem 1a

Terminal Cash Flow:

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 Salvage value

(10,880) Tax on capital gain

25,000 Recapture of NWC

214,120 Terminal Cash Flow

Problem 1a

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!

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 Salvage value

23,120 Tax on capital gain

25,000 Recapture of NWC

148,120 Terminal Cash Flow

Problem 1b

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 value-

old asset salvage value) on project’s cash flow depreciation and salvage value.

Pay attention to “old asset current selling price”( use to calculate capital gain tax) & old asset salvage value at the end of project life (use to calculate incremental salvage value)

Replacement Project:

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%.

Problem 3

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. Salvage value after year 5 is $650,000. Cost of capital = 14%, marginal tax rate = 34%.

Problem 3

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.

Problem 3Initial Outlay:

(1,750,000) Cost of new machine

+ ( 56,000) Shipping & installation

(1,806,000) Depreciable asset

+ ( 68,000) NWC investment

+ 456,875 After-tax proceeds (sold old machine)

(1,417,125) Net Initial Outlay

385,000 Increased sales & cost savings

(248,700) Extra depreciation ( new machine depreciation- old machine depreciation; $361,200-$112,500)

136,300 EBT

(47,705) Taxes (35%)

88,595 EAT

248,700 Depreciation reversal

337,295 = Differential Cash Flow

For Years 1 - 5:Problem 3

Terminal Cash Flow:

500,000 Extra salvage value (SV of new machine-SV of old machine = $650,000- $150,000)

(175,000) Tax on capital gain

68,000 Recapture of NWC

393,000 Terminal Cash Flow

Problem 3

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!