Capital Budgeting n Process of identifying, evaluating, and selecting capital projects n Capital projects involve the purchase of a long-term (fixed) asset n Part of the “Investment Decision” from Chapter 1 – What assets should the firm own?

Types of Projects n Replacement of existing assets n Expansion of existing products or services n Addition of new product lines or services n Government mandated projects

Steps in Capital Budgeting Process n 1) Generate ideas for projects n 2) Estimate incremental cash flows for proposed project n 3) Evaluate riskiness of incremental cash flows n 4) Select projects that will increase shareholder wealth n 5) Monitor outcome of accepted projects

Step 2: Estimating Incremental Cash Flows n Incremental means that we only look at those cash flows that will CHANGE if we proceed with the project n Analyze the proposal as if the company is going to do the project – figure out which outflows and inflows will be affected and by how much

Types of Incremental Cash Flows n 1. Net Investment Cash Outflow (NICO) = initial cash outlay at start of project n 2. Operating Cash Inflows (OCFs) = annual cash flows from using the new assets n 3. Disposal Cash Flow (DCF) = special cash flows associated with ending the project

Watch Out For … n Sunk Costs – (money has already been spent) - NOT incremental n Opportunity Costs – (is there an alternate use for an asset?) - ARE incremental n Side Effects – (Acceptance of project has effect on existing project) - ARE incremental

Net Investment Cash Outflow (NICO) n Initial cash outlay at beginning of project n Cash outlay obviously based on new asset’s cost, but other factors must be considered as well n Look for 6 possible items to include in NICO estimate

NICO Checklist n 1. Cost of new asset(s) = outflow n 2. Extra charges (shipping, handling, freight, delivery, installation, modification, etc.) = outflow n Note that for IRS purposes, the extra charges are included in the new asset’s depreciable base

NICO Checklist continued n 3. Investment Tax Credit – sometimes an asset purchase will be eligible for a federal income tax credit; take % x cost to get amount of credit; credit = inflow n 4. Change in Net Working Capital – NWC = CA – CL; sometimes the purchase of a long-term asset results in a change in CA or CL

NICO Checklist continued n 4. cont. Suppose purchase of a new asset causes an increase or a decrease in spare parts inventory (a CA). This change wouldn’t have happened if we hadn’t bought the new long-term asset. n Any changes in CA or CL resulting from the purchase of a new long-term asset must be considered – it’s incremental!

NICO Checklist Continued n 4. cont. Look for changes in CA and/or in CL. Net out the changes using NWC = CA – CL. n An increase in NWC is a cash outflow. n A decrease in NWC is a cash inflow.

NICO Checklist Continued n 5. Proceeds from sale (disposal) of old asset = inflow n 6. Any time depreciable asset is sold, must look at tax effects (do you owe taxes on sale, create a tax savings with the sale, or have no tax effect from the sale?)

Tax Effects of Sale (Disposal) of a Depreciable Asset n Compare Market Value (MV) to Book Value (BV) n Book Value = original cost still on books; unclaimed depreciation n If MV > BV, gain on disposal; must pay taxes on gain. n Taxes owed = gain x tax rate (outflow)

Tax Effects continued n If MV < BV, loss on disposal. Do not pay taxes on losses. Loss creates tax savings. n Tax savings = Loss x tax rate (Inflow) n If MV = BV, no gain or loss on disposal. (No tax effect)

Summary of NICO n From your list of 6 possible items, net the outflows against the inflows. n NOTE that not all problems will have all 6 times – some just have one or two! n You should have one final outflow estimate of what it costs to get the project started n Save this number to use in project selection analysis

Operating Cash Inflows (OCFs) n Net the proposed project’s revenues and expenses for each year of the project’s useful life using the following equation: n OCF = (S – TVC – TFC – D)(1 – T) + D

Definitions of Terms in OCF Equation n S = Sales = Price per unit x # units n TVC = Total Variable Costs = VC per unit x # units n TFC = Total Fixed Costs = Lump Sum n D = Depreciation (see next slide) n T = Marginal Tax Rate

Depreciation n Follow IRS rules for depreciating long-term (fixed) assets n IRS-approved method = Modified Accelerated Cost Recovery System (MACRS) n To calculate annual depreciation expense, determine depreciable base and class life n Look in text p. 218 at MACRS table for % to apply against base n D = Base x %

Summary of OCFs n Calculate the OCF equation for each year that the new asset is being used n Keep a list of all of the OCFs – don’t add them all together (they occur in different time periods!) n Save OCFs to use in project selection analysis

Disposal Cash Flow (DCF) n 1. Proceeds from disposal of “new” asset (now old) = inflow n 2. Tax effects of disposal of “new” asset (Follow rules listed earlier in NICO section) (outflow or inflow) n 3. Recovery of Net Working Capital (NWC): If “new” asset is no longer being used, CA and CL are assumed to revert to their pre-project levels. n Increase in NWC under NICO = inflow for DCF n Decrease in NWC under NICO = outflow for DCF

Summary of DCF n Net outflows and inflows to get one disposal cash flow n This disposal cash flow will be added to the final year’s OCF when we get to project selection analysis. n 2 cash flows in last year of project: one from using it during the year and one from stopping it at the end of the year