CASH FLOWS IN CAPITAL BUDGETING

TOPIC 6

Capital Budgeting StepsThe CFs of any project may include three (3) basic components:

1. Initial investment: the relevant cash outflow for a proposed project at time zero.

2. Operating cash inflows: the incremental after-tax cash inflows resulting from implementation of a project during its life.

3. Terminal CF: the after-tax non-operating CF occurring in the final year of a project. It is usually attributable to liquidation of the project.

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Relevant Cash Flows: Expansion vs. Replacement Decisions

Developing relevant CF estimates is most straightforward in the case of expansion decisions.

Identifying relevant CFs for replacement decisions is more complicated, because the firm must identify the incremental cash outflow and inflows that would result from the proposed replacement.

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4INITIAL OUTLAYInitial Outlay-What is the CF at time 0?

The immediate cash outflow necessary to purchase the asset and put it in operating order.

May include: Purchase cost, Set-up cost, Installation, Shipping/Freight, increased working-capital requirements, tax implications (if the project replaces an existing project/asset)

Purchase price of an asset X

+ Shipping, modification and installation costs X

+ Depreciable asset/Installed cost of new asset XX

Proceeds from sale of old asset X

- Tax on sale of old asset (X)

- After-tax proceeds from sale of old asset (XX)

+ Investment in net working capital XX

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After tax proceeds from sale of old assets

If the sale is different from the book value of the asset, then there is a tax effect.

Book value = initial cost accumulated depreciation

After-tax sale = sale T(sale book value)

Exercise 1

Blue Jay Industries is considering the purchase of a new machine to replace the old machine. At the end of the project, the old machine can be sold for RM50,000. The machine is 8 years old, cost RM200,000, had a 10-year useful life, and is being depreciated to zero using the straight-line method. Blue Jay's income tax rate is 35%. What is the after-tax proceeds from sale of the old machine? (A: RM46,500)

Initial Outlay

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Example 1 An Expansion (Ninja Farm)

After the long drought of 2011, the manager of Ninja Farm isconsidering the installation of an irrigation system. The system has an invoice price of $100,000 and will cost an additional $15,000 to install. It is estimated that it will increase revenues by $20,000 annually, and operating expenses will also increase by $5,000. The system will be depreciated straight-line over its depreciable life (5 years) to a zero salvage value. The system can actually be sold for an estimated $25,000 at the end of 5 years. Tax rate is 40% and the firms required rate of return is 16%. Should the firm purchase the new system?

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Initial Outlay-Example

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Example 2 A Replacement (Carrot Water)

Carrot Water Co. is considering replacing a canning machine. The old machine is being depreciated by the straight-line method over a 10-year recovery period from a depreciable cost basis of $120,000. The old machine has 5 years of remaining usable live, at which time its salvage value is expected to be zero, and it can be sold now for $40,000. The purchase price of the new machine is $250,000 and it will have shipping and installation costs of $12,500. It has a 5-year life and an expected salvage value of $25,000. Annual savings of electricity, labor and materials from use of the new machine are estimated at $40,000. The new machine will require an additional inventory of spare parts of $30,000. The company has 40% tax, and its cost of capital is 16%. What should the firm do?

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Initial Outlay-Example

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Initial Outlay-ExampleInitial Outlay Example 1-Ninja Farm (Year 0)

Initial Outlay Example 2-Carrot Water (Year 0)

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9ANNUAL CASH FLOWWhat incremental CFs occur over the life of the project? Annual free CF is the incremental after-tax CF resulting from the

project being considered. (Note, depreciation is a non-cash expense but influences the CFs through impact on taxes)For Years 1 n:

*If a replacement problem, Depreciation = Depreciation of New Equipment Depreciation of Old

Equipment

Incremental revenue (New sales Old sales)

- Incremental costs (OR + Decremental costs)

Earnings before depreciation, interest and taxes (EBDIT)

- Depreciation on project*

Earnings before interest and taxes (EBIT)

- Tax on EBIT

Earnings after taxes (EAT)+ Depreciation reversal

ANNUAL (OPERATING) CASH FLOWS

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Annual Cash Flow-ExampleAnnual CF Example 1-Ninja Farm (Year 1-5)

Annual CF Example 1-Carrot Water (Year 1-5)

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TERMINAL CASH FLOW

What is the CF at the end of the projects life?

The CF resulting from termination and liquidation of a project at the end of its economic life.

It represents the after-tax cash flow, exclusive of operating cash inflows, that occurs in the final year of the project.

The proceeds from sale of the new and the old asset, often called salvage value, represent the amount net of any removal or cleanup costs expected upon termination of the project.

net proceeds from the sale > book value tax payment (outflow)

net proceeds from the sale < book value tax rebate

(inflow)

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Terminal Cash Flow NWC represents the reversion of any initial NWC investment.

(reduction in net working capital).

With termination of the project, the need for the increased net working capital investment is assumed to end.

*If a replacement problem,

Salvage Value = Salvage Value of New Equipment Salvage Value of Old

Equipment12

Salvage Value*

Proceeds from SV of new asset X

-/+ Tax on SV of new asset X

After-tax proceeds from SV of new asset XX

Proceeds from SV of old asset X

-/+ Tax on SV of old asset X

- After-tax proceeds from SV of old asset (XX)

+ Recapture net working capital XX

TERMINAL CASH FLOW XXX

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Terminal Cash Flow-ExampleTerminal CF Example 1-Ninja Farm (Year 1-5)

Terminal CF Example 1-Carrot Water (Year 1-5)

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