1. Planning Investments: Capital Budgeting
Chapter 12
Planning Investments: Capital Budgeting
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. What are the Steps in the Capital Budgeting Process?
Identify the opportunity
Requests, opportunities, expansion
Select appropriate investments
Net present value analysis (other methods are available)
Determine how to finance the investments
Chapters 13 and 14
Accept or reject the opportunity

3. What are the Steps in the Net Present Value Method of Capital Budgeting?
Estimate the relevant cash inflows and cash outflows
Determine the present value of the future cash flows using the company’s weighted average cost of capital
Compute the net present value (NPV)
Accept or reject the proposal
If NPV is positive—accept (in general)
If NPV is negative—reject (in general)

4. What are the Sources of Cash Inflows?
Cash receipts from using the asset (net of tax)
Decrease in working capital requirements
Sale of old assets (net of tax)
Sale of new assets at the end of the project (net of tax)
Tax savings due to tax shield
NOTE: SAVINGS = INFLOW

5. What are the Sources of Cash Outflows?
Increase in working capital requirements
Cash expenditures from using the asset (net of tax)

6. What is included in the initial investment?
Purchase price Costs incurred to receive the asset Costs incurred to get the asset ready for its intended use (set up)
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7. How is the Weighted Average Cost of Capital Determined?
(% of company financed by debt * rate of interest on debt)
+ (% of company financed by owners’ equity * required rate of return on owners’ equity)

8. How is the NPV Determined?
(Sum of the present value of cash inflows and outflows) less the cost of the initial investment

9. How do we Determine Net of Tax Amounts?
Cash receipts and expenditures
Cash flow * (1 – tax rate)
Tax shield from depreciation
Depreciation amount * tax rate
Proceeds from sale of asset with gain
Proceeds – (gain * tax rate)
Proceeds from sale of asset with loss
Proceeds + (loss * tax rate)

10. What Other Factors should be Considered?
Human judgment
Goal incongruence
Uncertainty
Operating leverage
Qualitative factors
Balanced scorecard

11. Comprehensive example
Your company must determine whether it should purchase a machine costing $700,000 with a useful life of 20 years; it will be depreciated uniformly over its useful life. The new machine will require a working capital investment (inventory) of $80,000 that will be released at the end of the project. If the new machine is purchased, an old machine with a book value of $30,000 will be sold for $50,000. The new machine is expected to generate annual cash savings of $120,000. Your company’s cost of capital is 12% and its tax rate is 20%. Should you invest in the new machine?
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12. Answer
Initial investment $(700,000) Working capital (80,000) Sale of old machine Proceed $50,000 Book value 30,000 46,000 Gain on sale $20,000 Tax (20%) $ 4,000 Tax shield: $700,000/20 = 35,000 * .2 = 7,000 FV = 0, r = 12, c = 1, n = 20, ANN = 7,000, PV = 52,286 Annual savings: $120,000 * .8 = 96,000 FV = 0, r = 12, c = 1, n = 20, ANN = 96,000, PV = 717,067 Release of working capital FV = 80,000, r = 12, c = 1, n = 20, ANN = 0, PV = 8,293 NPV $ 43,646
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