Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 8 Capital Budgeting Cash Flows

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-2 Learning Goals 1.Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. 2.Define basic capital budgeting terminology. 3.Discuss relevant cash flows, expansion versus replacement decisions, sunk costs and opportunity costs, and international capital budgeting.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-3 Learning Goals (cont.) 4.Calculate the initial investment associated with a proposed capital expenditure. 5.Find the relevant operating cash inflows associated with a proposed capital expenditure. 6.Determine the terminal cash flow associated with a proposed capital expenditure.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-4 The Capital Budgeting Decision Process Capital Budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. It seeks to identify investments that will enhance a firm’s competitive advantage and increase shareholder wealth. The typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. Poor capital budgeting decisions can ultimately result in company bankruptcy.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-5 Table 8.1 Key Motives for Making Capital Expenditures

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-6 Basic Terminology: Independent versus Mutually Exclusive Projects Independent Projects, on the other hand, do not compete with the firm’s resources. A company can select one, or the other, or both—so long as they meet minimum profitability thresholds. Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can select one or another but not both.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-7 Basic Terminology: Unlimited Funds versus Capital Rationing If 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. However, 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-8 Basic Terminology: Accept-Reject versus Ranking Approaches The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria. The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8-9 Basic Terminology: Conventional versus Nonconventional Cash Flows Figure 8.1 Conventional Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved Basic Terminology: Conventional versus Nonconventional Cash Flows (cont.) Figure 8.2 Nonconventional Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved For 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. The Relevant Cash Flows Incremental cash flows: –are cash flows specifically associated with the investment, and –their effect on the firms other investments (both positive and negative) must also be considered.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Relevant Cash Flows: Major Cash Flow Components Figure 8.3 Cash Flow Components

Copyright © 2009 Pearson Prentice Hall. All rights reserved Relevant Cash Flows: Expansion Versus Replacement Decisions Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Figure 8.4 Relevant Cash Flows for Replacement Decisions

Copyright © 2009 Pearson Prentice Hall. All rights reserved Relevant Cash Flows: Sunk Costs Versus Opportunity Costs Note that cash outlays already made (sunk costs) are irrelevant to the decision process. However, opportunity costs, which are cash flows that could be realized from the best alternative use of the asset, are relevant.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Initial Investment Table 8.2 The Basic Format for Determining Initial Investment

Copyright © 2009 Pearson Prentice Hall. All rights reserved Book Value = $100,000 - $52,000 = $48,000 Hudson Industries, a small electronics company, 2 years ago acquired a machine tool with an installed cost of $100,000. The asset was being depreciated under MACRS using a 5-year recovery period. Thus 52% of the cost (20% + 32%) would represent accumulated depreciation at the end of year two. Finding the Initial Investment (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved If Hudson sells the old asset for $110,000, it realizes a gain of $62,000 ($110,000 - $48,000). Technically, the difference between the cost and book value ($52,000) is called recaptured depreciation and the difference between the sales price and purchase price ($10,000) is called a capital gain. Under current corporate tax laws, the firm must pay taxes on both the gain and recaptured depreciation at its marginal tax rate. Finding the Initial Investment Sale of the Asset for More Than Its Purchase Price

Copyright © 2009 Pearson Prentice Hall. All rights reserved If Hudson sells the old asset for $70,000, it realizes a gain in the form of recaptured depreciation of $22,000 ($70,000–$48,000) which is taxed at the firm’s marginal tax rate. Finding the Initial Investment (cont.) Sale of the Asset for More Than Its Book Value but Less than Its Purchase Price

Copyright © 2009 Pearson Prentice Hall. All rights reserved If Hudson sells the old asset for its book value of $48,000, there is no gain or loss and therefore no tax implications from the sale. Finding the Initial Investment (cont.) Sale of the Asset for Its Book Value

Copyright © 2009 Pearson Prentice Hall. All rights reserved If Hudson sells the old asset for $30,000 which is less than its book value of $48,000, it experiences a loss of $18,000 ($48,000 - $30,000). If this is a depreciable asset used in the business, the loss may be used to offset ordinary operating income. If it is not depreciable or used in the business, the loss can only e used to offset capital gains. Finding the Initial Investment (cont.) Sale of the Asset for Less Than Its Book Value

Copyright © 2009 Pearson Prentice Hall. All rights reserved Danson Company, a metal products manufacturer, is contemplating expanding operations. Financial analysts expect that the changes in current accounts summarized in Table 8.4 on the following slide will occur and will be maintained over the life of the expansion. Finding the Initial Investment (cont.) Change in Net Working Capital

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Initial Investment (cont.) Table 8.4 Calculation of Change in Net Working Capital for Danson Company

Copyright © 2009 Pearson Prentice Hall. All rights reserved Powell Corporation, a large diversified manufacturer of aircraft components, is trying to determine the initial investment required to replace an old machine with a new, more sophisticated model. The machine’s purchase price is $380,000 and an additional $20,000 will be necessary to install it. It will be depreciated under MACRS using a 5-year recovery period. The firm has found a buyer willing to pay $280,000 for the present machine and remove it at the buyers expense. The firm expects that a $35,000 increase in current assets and an $18,000 increase in current liabilities will accompany the replacement. Both ordinary income and capital gains are taxed at 40%. Finding the Initial Investment (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Initial Investment (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Powell Corporation’s estimates of its revenues and expenses (excluding depreciation and interest), with and without the new machine described in the preceding example, are given in Table 8.5. Note that both the expected usable life of the proposed machine and the remaining usable life of the existing machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380,000 and the installation costs of $20,000. Finding the Operating Cash Inflows

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Operating Cash Inflows (cont.) Table 8.5 Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines

Copyright © 2009 Pearson Prentice Hall. All rights reserved Table 8.6 Depreciation Expense for Proposed and Present Machines for Powell Corporation

Copyright © 2009 Pearson Prentice Hall. All rights reserved Table 8.7 Calculation of Operating Cash Inflows Using the Income Statement Format

Copyright © 2009 Pearson Prentice Hall. All rights reserved Table 8.8 Calculation of Operating Cash Inflows for Powell Corporation’s Proposed and Present Machines

Copyright © 2009 Pearson Prentice Hall. All rights reserved Table 8.9 Incremental (Relevant) Operating Cash Inflows for Powell Corporation

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Terminal Cash Flow Table 8.10 The Basic Format for Determining Terminal Cash Flow

Copyright © 2009 Pearson Prentice Hall. All rights reserved Continuing with the Powell Corporation example, assume that the firm expects to be able to liquidate the new machine at the end of its 5-year useable life to net $50,000 after paying removal and cleanup costs. The old machine can be liquidated at the end of the 5 years to net $10,000. The firm expects to recover its $17,000 net working capital investment upon termination of the project. Again, the tax rate is 40%. Finding the Terminal Cash Flow (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Finding the Terminal Cash Flow (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Summarizing the Relevant Cash Flows