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Chapter 10 - Cash Flows and
Other Topics in Capital Budgeting
2005, Pearson Prentice Hall
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Capital Budgeting: The process ofplanning for purchases of long-term
assets.For example: Our firm must decide
whether to purchase a new plastic
molding machine for $127,000. How dowe decide?
Will the machine be profitable?
Will our firm earn a high rate of return onthe investment?
The relevant project information follows:
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The cost of the new machine is $127,000.
Installation will cost $20,000.
$4,000 in net working capital will be needed atthe time of installation.
The project will increase revenues by $85,000per 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.
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Capital BudgetingSteps
1) Evaluate Cash FlowsLook at all incremental cashflows occurring as a result of the
project. Initial outlay
Differential Cash Flowsover the
life of the project (also referred toas annual cash flows).
Terminal Cash Flows
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Capital BudgetingSteps
1) Evaluate Cash Flows
0 1 2 3 4 5 n6 . . .
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Capital BudgetingSteps
1) Evaluate Cash Flows
0 1 2 3 4 5 n6 . . .
Initial
outlay
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Capital BudgetingSteps
1) Evaluate Cash Flows
0 1 2 3 4 5 n6 . . .
Annual Cash Flows
Initial
outlay
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Capital BudgetingSteps
1) Evaluate Cash Flows
0 1 2 3 4 5 n6 . . .
Terminal
Cash flow
Annual Cash Flows
Initial
outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of oldasset
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of oldasset
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(127,000)
+ ( 20,000)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of oldasset
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ After-tax proceeds from sale of oldasset
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 0?
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ 0
Net Initial Outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 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 oldasset
($151,000) Net initial outlay
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ep : va ua e asFlows
a) Initial Outlay: What is the cash flow attime 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 oldasset
($151,000) Net initial outlay
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ep : va ua e asFlows
b) Annual Cash Flows: Whatincremental cash flows occur overthe life of the project?
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For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings beforetaxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings beforetaxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
- Incremental costs
- Depreciation on project
Incremental earnings beforetaxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
- Depreciation on project
Incremental earnings beforetaxes
- Tax on incremental EBT
Incremental earnings aftertaxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
(29,400)
Incremental earnings beforetaxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850- Tax on incremental EBT
Incremental earnings aftertaxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850(8,789)
Incremental earnings aftertaxes
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850(8,789)
17,061
+ Depreciation reversal
Annual Cash Flow
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For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850(8,789)
17,061
29,400
Annual Cash Flow
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For Years 1 - 5:
85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT(8,789) Taxes
17,061 EAT
29,400 Depreciationreversal
46,461 = Annual Cash Flow
St 1 E l t C h
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Step 1: Evaluate CashFlows
c) Terminal Cash Flow: What is the cashflow at the end of the projects life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
St 1 E l t C h
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Step 1: Evaluate CashFlows
c) Terminal Cash Flow: What is the cashflow at the end of the projects life?
50,000 Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
T Eff t f S l f
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Tax Effects of Sale ofAsset:
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).
St 1 E l t C h
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Step 1: Evaluate CashFlows
c) Terminal Cash Flow: What is the cashflow at the end of the projects life?
50,000 Salvage value
(17,000) Tax on capital gain
Recapture of NWC
Terminal Cash Flow
Step 1 E al ate Cash
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Step 1: Evaluate CashFlows
c) Terminal Cash Flow: What is the cashflow at the end of the projects life?
50,000 Salvage value
(17,000) Tax on capital gain
4,000 Recapture of NWC
Terminal Cash Flow
Step 1 Evaluate Cash
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Step 1: Evaluate CashFlows
c) Terminal Cash Flow: What is the cashflow at the end of the projects life?
50,000 Salvage value
(17,000) Tax on capital gain
4,000 Recapture of NWC
37,000 Terminal Cash Flow
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2)Evaluate the Risk of the Project
Well get to this in the next chapter.
For now, well assume that the risk ofthe project is the same as the risk of theoverall firm.
If we do this, we can use the firms costof capital as the discount rate for capitalinvestment projects.
Capital Budgeting Steps
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3) Accept or Reject the Project IRR
NPV
PI
Capital Budgeting Steps