Chapter 10: Capital Budgeting: Cash Flow Principles Learning Goals

Understand the key capital expenditure motives and the steps in the capital budgeting process. Define basic capital budgeting terminology. Discuss the major components of relevant cash flows, expansion versus replacement cash flows, and international capital budgeting and long-term investments. Calculate the initial investment associated with a proposed capital expenditure. Determine the relevant operating cash inflows using the income statement format. ind the terminal cash flow.

Introduction
Capital budgeting is the process of identifying, evaluating, and implementing a firm!s investment opportunities.

"t seeks to identify investments that will enhance a firm!s competitive advantage and increase shareholder wealth.

#he typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows.

$oor capital budgeting decisions can ultimately result in company bankruptcy.

Key Motives or Capital !"penditures

Capital expenditures are made for many reasons.

#he basic motives for capital expenditures are to expand, replace, or renew fixed assets or to obtain some other less tangible benefit over a long period.

%pecific examples of key motives are shown on the following slide. Details with regard to these motives can be found on the book!s web site&
http&''www.awl.com' gitman(madura.

)xamples
*eplacing worn out or obsolete assets "mproving business efficiency +c,uiring assets for expansion into new products or markets +c,uiring another business Complying with legal re,uirements %atisfying work-force demands )nvironmental re,uirements

#teps in the Process

%tep -& $roposal .eneration

/ow are projects initiated0 /ow much is available to spend0

%tep 1& *eview and +nalysis

$reliminary project review #echnically feasible0 Compatible with corporate strategy0

%tep 2& Decision 3aking

4hat are the costs and benefits0 4hat is the project!s return0

4hat are the risks involved0

%tep 5& "mplementation

4hen to implement0 /ow to implement0

%tep 6& ollow-Up

"s the project within budget0 4hat lessons can be drawn0

Independent versus Mutually !"clusive Pro$ects

3utually exclusive projects are investments that compete in some way for a company!s resources. + firm can select one or another but not both.

"ndependent projects, on the other hand, do not compete with the firm!s resources. + company can select one, or the other, or both7so long as they meet minimum profitability thresholds.

%nli&ited Funds versus Capital 'ationing

"f 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.

/owever, 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.

(ccept)'e$ect versus 'an*ing (pproaches

#wo basic approaches to capital budgeting decisions are available.
#he accept-reject approach involves evaluating capital expenditure proposals to determine whether they meet the firm!s minimum acceptance criterion.

 #he ranking approach involves ranking projects on the basis of some predetermined measure, such as the rate of return.

Conventional versus +onconventional Cash Flow Patterns

+ conventional cash flow pattern consists of an initial outflow followed only by a series of inflows as shown in igure -8.-.

+ nonconventional cash flow pattern is one in which an initial outflow is followed by a series of inflows and outflows as shown in igure -8.1.

Difficulties often arise in evaluating projects with nonconventional cash flow patterns9 we will limit our discussion in this book to conventional projects.

,he 'elevant Cash Flows

"ncremental Cash lows

:nly cash flows associated with the investment.

)ffects on the firm!s other investments ;both positive and negative< must also be considered.

or 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.
:nly cash flows associated with the investment.

)ffects on the firms other investments ;both positive and negative< must also be considered.

=ote that cash outlays already made ;sunk costs< are irrelevant to the decision process.

/owever, opportunity costs, which are cash flows that could be reali>ed from the best alternative use of the asset, are relevant.

)stimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects.

4ith replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.

)xamples of relevant cash flows&

Cash inflows, outflows, and opportunity costs Changes in working capital "nstallation, removal and training costs #erminal values Depreciation )xisting asset effects

3ajor Cash low Components&

"nitial cash flows are cash flows resulting initially from the project. #hese are typically net negative outflows. :perating cash flows are the cash flows generated by the project during its operation. #hese cash flows typically are net positive cash flows. #erminal cash flows result from the disposition of the project. #hese are typically positive net cash flows.

International Capital Budgeting

"nternational capital budgeting analysis differs from purely domestic analysis because&
Cash inflows and outflows occur in a foreign currency. oreign investments potentially face significant political risks.

Despite these risks, the pace of foreign direct investment has accelerated significantly since the end of 4orld 4ar "".

Chapter !"a&ple
3orton Company, a large diversified manufacturer of electronics components, is trying to determine the initial investment re,uired to replace an old machine with a new, more sophisticated model. #he machine!s purchase price is ?2@8,888 and an additional ?18,888 will be needed to install it.

"t will be depreciated under the 3+C*% 6-year recovery period. #he old machine was purchased 2 years ago at a cost of ?158,888 and was also depreciated under the 3+C*% 6-year class rates.

3orton has found a buyer willing to pay ?1@8,888 for the present machine. 3orton expects that a ?26,888 increase in current assets and an ?-@,888 increase in current liabilities will be re,uired to support the new machine. 3orton is in the 58A tax bracket for both ordinary income and capital gains.

Finding -perating Cash In lows

3orton Company!s estimates of its revenues and expenses ;excluding depreciation<, with and without the proposed new machine described in the preceding example, are given in #able -8.5. =ote that both the expected life of the proposed machine and the remaining useful life of the present machine are 6 years.

#he amount to be depreciated with the proposed machine is calculated by summing the price of ?2@8,888 and the installation costs of ?18,888. #he proposed machine is to be depreciated under 3+C*% using a 6-year recovery period. #he resulting depreciation on this machine for each of the B years, as well as the remaining 2 years of depreciation ;years 5, 6, B< on the present machine, are calculated in #able -8.6 on the following two slides.

#he operating cash inflows in each year can be calculated using the income statement format as shown in #able -8.B below. #he results as applied to the 3orton Company are depicted in #able -8.C on the following two slides.

#able -8.@ demonstrates the calculation of 3orton Company!s incremental ;relevant< operating cash inflows for each year.

Finding the ,er&inal Cash Flows

#erminal cash flow is the cash flow resulting from termination and li,uidation of a project at the end of its economic life. #he general format for calculating terminal cash flow is shown in #able -8.D below.

Continuing with the 3orton Company example, assume that the firm expects to be able to li,uidate the new machine at the end of its 6-year usable life to net ?68,888 after paying removal and cleanup costs. #he old machine can be li,uidated at the end of the 6 years to net ?8 because it will then be completely obsolete. #he firm expects to recover its ?-C,888 net working capital investment upon termination of the project. Eoth ordinary income and capital gains are taxed at 58A.

#he proposed ;new< machine will have a book value of ?18,888 ;e,ual to the year B depreciation at the end of 6 years<. #he present ;old< machine will be fully depreciated and therefore have a book value of >ero at the end of 6 years. Eecause the sale price of ?68,888 for the new machine is greater than its ?18,888 book value, it will have to pay tax of ?28,888 on recaptured depreciation. +pplying the ordinary tax rate of 58A results in a tax of ?-1,888. Eecause the present machine would net ?8 at termination and its book value would also be ?8, its after-tax proceeds would also be ?8. %ubstituting these values in the format in #able -8.D results in a terminal cash flow of ?66,888.