Fundamentals of

Capital Budgeting
Estimating the Projects Cash Flows
What are the relevant cash flows for a project?
Include any and all changes in the Firms cash flows
that are a direct result of undertaking the project
What is the incremental Concept
An incremental cash flow is the change in a firms
cash flow attributable to an investment project. Use
incremental cash flows.

Estimating the Projects Cash Flows
What are some complications
Sunk Cost

Opportunity Cost

Externalities


Estimating the Projects Cash Flows
What are some complications - Continued
Inflation

Net Working Capital

Financing costs

Use After-Tax Cash Flows!



Estimating the Projects Cash Flows
Identify incremental cash flows for all phases of
the project:
Initial Investment Outlay: The incremental cash flow
that will occur only at the start of the project.
Initial Operating Cash Flow: The changes in day to
day cash flows that result from the project and
continue until the project ends.
Terminal Cash Flow: The net cash flow that occurs at
the end of the project
Cash Flow Versus Accounting Income:
An example:


For year 2001: Accounting Profits Cash Flows
Sales $ 1,000 $ 1,000
Costs Except Depreciation ( 500) ( 500)
Depreciation ( 300) -
Net Operating Income or Cash Flow 200 500
Taxes Based on Op. Income (@30%) ( 60) ( 60)
Net Income or Cash Flow $ 140 $ 440




Net Cash Flow = Net Income Plus Depreciation =

Cash Flow Versus Accounting Income:
An example:


For year 2002: Accounting Profits Cash Flows
Sales $ 1,000 $ 1,000
Costs Except Depreciation ( 500) ( 500)
Depreciation ( 100) -
Net Operating Income or Cash Flow 400 500
Taxes Based on Op. Income (@30%) ( 120) ( 120)
Net Income or Cash Flow $ 280 $ 380




Net Cash Flow = Net Income Plus Depreciation =

Cash Flow Versus Accounting Income (continued):
So we have the following equations for calculating
operating cash flows:

Net cash flow = Net income + Depreciation.

Incremental operating CFt = NI
t
+ Depr
t

= (S
t
- OC
t
) (1 T) + T ( Depr
t
).

Checking this for the example on the last page:
Salvage Value, Book Value, and Depreciation
Straight-line Depreciation versus Modified Accelerated Cost Recovery System
(MACRS) Depreciation (Appendix 7)
Straight-line: Depreciate the initial capital spending down to zero. Often used for
stockholder reporting purposes.
Modified Accelerated Cost Recovery System (MACRS): Depreciate ACCORDING TO
THE FASTEST RATE ACCORDED BY LAW for tax purposes.
Class Examples
3-year Equipment for research; some manufacturing tools.
5-year Autos, computers, etc.
7-year Most industrial equipment
(Longer See text.)
Example: (Use 7-year MACRS)
Year MACRS % Depreciation ($) Ending
Book Value
1 14
2 25
3 17
4 13

5 9
6 9
7 9
8 4
Salvage Value, Book Value, and Depreciation
Salvage Value versus Book Value: Tax Implication
If (Salvage Value) > (Book Value), then taxes are due on
(Salvage Value Book Value).
Reason: Excess depreciation must be recaptured!

If (Salvage Value) < (Book Value), then taxes savings are
credited on (Book Value Salvage Value).
Reason: Assets were under-depreciated!

Bottom Line:
After-tax Salvage Value = Salvage Value Taxes
= SV (SV BV) (T).
Example:
Solution to the Greatyear Tires Expansion Project Problem

Assumptions:
Initial Investment Outlay 120,000,000
Useful life (in years) 7
Salvage Value of Investment 60,000,000
Ending Book
Year MACRS % Depreciation Value
1 14% 16,800,000 103,200,000
2 25% 30,000,000 73,200,000
3 17% 20,400,000 52,800,000
4 13% 15,600,000 37,200,000 Last year of project
5 9% 10,800,000 26,400,000
6 9% 10,800,000 15,600,000
7 9% 10,800,000 4,800,000
8 4% 4,800,000 -
SuperTread price/unit in OEM market (year 1) 36.00 $
SuperTread price/unit in Replacement market (year 1) 59.00 $
SuperTread price/unit in OEM market (year 1) 18.00 $
Year 1 Marketing and Administrative Costs 25,000,000
Annual inflation rate 3.00%
Corporate tax rate 40.00%
Beta (from Value Line) 1.15
Risk-free rate (4-year U.S. Treasury note) 5.00%
Market return (S&P 500 30-year annual average) 13.50%
Required project return (from CAPM) 14.78%
Year 1 OEM Market ( 2 million new cars x 4 tires/car) 8,000,000
Forecast OEM market annual growth 2.50%
Forecast of SuperTread market share 11.00%
Year 1 Replacement Market 14,000,000
Forecast Replacement market annual growth 2.00%
Forecast of SuperTread market share 8.00%
Solution to the Greatyear Tires Expansion Project Problem (Cont)

Year 0 1 2 3 4
Sales:
in the OEM Market
Units 880,000 902,000 924,550 947,664
Price 36.00 37.44 38.94 40.50
Total OEM Market 31,680,000 33,770,880 35,999,758 38,375,742
in the Replacement Market
Units 1,120,000 1,142,400 1,165,248 1,188,553
Price 59.00 61.36 63.81 66.37
Total Replacement Market 66,080,000 70,097,664 74,359,602 78,880,666
Total Sales 97,760,000 103,868,544 110,359,360 117,256,408
Variable Costs
Units (OEM + Replacement) 2,000,000 2,044,400 2,089,798 2,136,217
Cost 18.00 18.72 19.47 20.25
Total Variable Costs 36,000,000 38,271,168 40,685,859 43,253,159
Marketing and Admin. Costs 25,000,000 25,750,000 26,522,500 27,318,175
Depreciation 16,800,000 30,000,000 20,400,000 15,600,000
Net Operating Income ("EBIT") 19,960,000 9,847,376 22,751,001 31,085,074
Tax (7,984,000) (3,938,950) (9,100,400) (12,434,030)
Net Income 11,976,000 5,908,426 13,650,600 18,651,044
Memo: NWC 11,000,000 14,664,000 15,580,282 16,553,904
NI + Depreciation 28,776,000 35,908,426 34,050,600 34,251,044
Change in NWC (11,000,000) (3,664,000) (916,282) (973,622) 16,553,904
Capital Spending (120,000,000) 50,880,000
Erosion Effects (5,000,000) (7,500,000) (10,000,000) (12,500,000)
Cash Flow (131,000,000) 20,112,000 27,492,144 23,076,978 89,184,948
Discounted CF (131,000,000) 17,522,980 20,869,594 15,262,899 51,392,809
NPV = (25,951,717)
IRR = 6.65%
Example:
You have been asked by the president of your company to evaluate the
proposed acquisition of a spectrometer for the firms R&D department. The
equipments base price is $140,000, and it would cost another $30,000 to
modify it. The spectrometer falls into the MACRS 3-year class, and would
be sold after 3 years for $60,000. Use of the equipment would require an
increase in net working capital (spare parts inventory) of $8,000. The
spectrometer would have no effect on revenues, but is expected to save the
firm $50,000 per year in before-tax operating costs, mainly labor. The firms
marginal tax rate is 40%.

Whats the initial investment outlay associated with this project? (That
is, what is the Year 0 net cash flow?)
Example:

What are the incremental operating cash flows in Years 1, 2, and 3?
Example:

What is the terminal cash flow in Year 3?
Example:

If the projects required rate of return is 12%, should the spectrometer
be purchased? (Calculate the projects NPV and make a
recommendation.)
Project Risk and Estimating the Projects
Required Rate of Return

Risk-adjusted discount rate approach:
Increase the discount rate for projects that are
riskier than the firms average projects, and

Decrease the discount rate for projects that are
less risky than the firms average projects.

Project Risk and Estimating the Projects
Required Rate of Return
Many firms use this approach.
Chevron Example:

Examples Opportunity Cost Rate*

High Risk Projects

Medium Risk Projects

Low Risk Projects

* This is the rate used for
1) The discount rate in NPV Calculations, and
2) The cutoff rate for IRR analysis
Analyzing the project:
Break even



Sensitivity Analysis



Scenario Analysis



Replacement analysis Example
The Gehr Company is considering the purchase of a new machine tool to
replace an obsolete one. The machine being used for the operation has
both a tax book value and market value of 0. It is in good working order,
however, and will physically last at least another 10 years. The proposed
replacement machine will perform the operation more efficiently with
estimated after-tax cash flows of $ 9,000 per year in labor savings and
depreciation. The new machine will cost $40,000 delivered and installed
and is expected to last 10 years. It will have zero salvage value. Should the
firm purchase the new machine? (Assume the firms required rate of return
is 10%.)