Section E
Investment Decision
Capital Budgeting
The firm’s objective in using capital budgeting to select projects is to
maximize the value of its equity and thus maximize shareholder
wealth. In evaluating a potential investment, capital budgeting focuses
on the entire life of the project. It considers all expected cash inflows
as well as all expected cash outflows that should result from investing
in the project. Therefore, capital budgeting is not concerned with only
one year’s or one accounting period’s expected results from an
investment in a project. Instead, capital budgeting is a “life-cycle” or
“cradle-to-grave” approach to selecting, implementing and monitoring
the results of long-term investments.
All the revenues expected to be received during the life of the project
are included. Costs include everything from the initial investment to
research and development, manufacturing, and even anticipated after-
sale costs, such as customer service costs and warranty costs—for as
long as the project is ongoing.
Stages in Capital Budgeting
There are six stages that need to be followed in the process of making
capital investment decisions. They are:
1) Identification Stage – This stage indicates which types of capital
expenditure projects are necessary for the company to accomplish its
organizational objectives.
2)Search Stage – During this stage, the company explores alternative
capital investments that will achieve the organizational objectives.
Various technologies and other alternatives are researched. Investigate
investments and search for alternatives
3)Information-Acquisition Stage/ Evaluation Stage – The company
then must consider the expected costs and benefits (quantitative and
qualitative) of alternative capital investments. There are four main
steps in this stage for determining net cash flows for each potential
project it has identified:
* Determine the net investment and initial-cost cash outflow, which
are the net cash outflows associated with the increase in long-term
assets needed for the project(s) under consideration, as well as the
initial cash outflows for things such as advertising, employee training,
and research and development.
* Determine additional net working capital requirements, which is the
increase in net current assets (current assets minus current liabilities)
that will result from the investment decision. In the information-
acquisition stage, the additional net working capital that is required
must be treated as an investment because it represents short-term
assets that are not available for other purposes for the company.
* Determine the estimated subsequent net operating cash flows for
each future period that will result from using the assets that are
acquired. To do this, we need to have reliable estimates of revenues
and expenses and tax savings.
* Determine the net cash flows at the end of the project relating to
disposal of the long-term assets and release of working capital.
4) Selection Stage– At this stage the company chooses projects for
implementation on the basis of financial analysis and nonfinancial
considerations.
5) Financing Stage – The company obtains the necessary project
funding.
6) Implementation and Control Stage – This is the final stage in which
the project is implemented and monitored over time.
Capital Budgeting Applications
* Expansion projects - new assets (machines, buildings, etc.) bought
with the purpose of expanding business operations
* Replacement projects - Replacement of existing machines and
equipment
* Mandatory (compliance) project - Required by law to maintain
safety in the workplace, safety of consumers, or to protect the
environment
* Other projects - Allocations for R&D for new products and/or the
expansion of existing products as well as various other long-term
investments for buildings, land, patents, and the like
The cash flow amount that will be used in the capital budgeting
analysis for each year is the expected cash flow, or the weighted
average of all the possible cash flows, weighted according to their
probabilities.
All expected cash flows in a capital budgeting analysis are treated as
though they are received at the end of the year to which they are
assigned, even though in actuality, they will be received throughout
the year. Therefore, if an exam question says that a particular cash
flow is received at the beginning of a year, we treat it as if it is
received at the end of the previous year for capital budgeting
purposes.
Initial Cash Flow
Expected Cash Flows at the Beginning of the Project (Year 0)
The expected cash flows at the beginning of the project are the cash
outflows and inflows that are expected to occur at Day Zero or shortly
thereafter, when a new project is first implemented. They relate to the
net initial investment. In capital budgeting analysis, the date of the
initial investment may be referred to as either “Year 0” or “Time 0.”
Cash flows at the beginning of the project that relate to the net initial
investment consist of three components:
1) Initial investment:The initial investment is the cash outflow that is
used to purchase the new machinery or make the initial investment
into the project. The initial investment includes any setup, testing or
other related costs. Essentially, all of the costs necessary to get the
project operating are included as the initial investment.
Tax Effect: There is no immediate tax effect in respect to the initial
investment. Any tax benefits that may arise will occur over the life of
the project as the machinery or equipment is depreciated.
2) Initial working capital investment - “Working capital” (also called
“net working capital”) is defined as total current assets minus total
current liabilities.it means that we expect accounts receivable and
inventory to increase because of the project under consideration. Raw
materials inventory may need to be purchased. Accounts receivable
will increase as soon as sales are made. We also expect that accounts
payable related to the purchased inventory will increase. However, the
increase in accounts payable will not be as large as the increases in
accounts receivable and inventory. Thus, working capital will
increase incrementally by the amount of the increase in current assets
(accounts receivable and inventory) minus the amount of increase in
current liabilities (accounts payable). This incremental increase in
working capital requires cash, needed to purchase inventory.
This increase in working capital is a cash outflow at the beginning of
the project. Remember that if a new machine is replacing an old one,
the initial working capital investment will be the difference between
the working capital investment required to operate the new machine
and the working capital investment that was required to operate the
old machine. In the case of a new machine replacing an old one, the
initial working capital investment would be an incremental amount.
Tax Effect: There is no tax effect related to working capital.
Therefore, the amount that needs to be included in the capital
budgeting analysis is the actual amount of the increase in working
capital that the company expects to occur.
3)Cash received from the disposal of the old machine if there is an old
machine to be disposed of:
Cash received from the disposal of the old machine is a cash inflow
and therefore reduces the initial investment for the new machine.
Tax Effect: When the old machine is sold, there will be a tax effect
related to the gain or loss on the sale. The amount of the gain or loss
is calculated as the difference between the tax basis (the asset’s book
value for tax purposes) of the asset and the cash received from the
sale of the asset. If there is a gain, this gain will be taxed. The effect
of this tax is a reduction of the cash inflow by the amount of taxes
paid on the gain. Gain Tax shield is treated as Cash Outflow
If there is a loss, this loss will be a reduction of net taxable income
because the loss will be deducted. The effect of this deductible loss is
that the company pays less in taxes in total, which saves them money.
Therefore, the loss on the disposal of the old equipment creates a cash
“inflow” in the form of lower taxes. It is considered a cash inflow
because it is a decrease in cash outflow. The amount of this tax
savings is a cash inflow that increases the cash received from the sale
of the asset for the capital budgeting calculation. Loss Tax shield is
treated as cash inflow
OATCF / Ongoing Annual Net Cash Flows from Operations
After the project has started, the company will have cash flows that
occur on an annual basis. The annual cash flows used may be the
same each year during the project, or they may be different. The
operating cash inflows may result from one or both of two sources:
1) Increased sales. As a result of having made this investment, the
company should experience an increase in sales, which will lead to an
increase in profits. The cash inflow for capital budgeting purposes is
the amount of the increased operating cash flows (cash inflows minus
cash outflows) that result each year from this investment.
2) Decreased operating expenses. While decreased operating expenses
will also lead to increased profits, it comes about from the other side
of the process. The new equipment may be more efficient than the old
equipment, leading to lower operating costs. The amount of the
decreased operating expenses that result from the investment are a
cash inflow for capital budgeting purposes.
Tax Effect: The company will need to pay taxes as a result of either
increased sales and profits or decreased operating costs. Therefore,
the cash flows related to these items need to be reduced for the taxes
that will be paid as a result.
OATCF
Sales Revenue
-Variable Cost
= Contribution Margin
-Fixed cost
= operating pre tax cash flow
-tax rate
= OATCF
Depreciation Tax Shield – A Cash Inflow
The tax effect of the asset is received as the asset is depreciated.
Depreciation is an expense, so it increases expenses and decreases net
taxable income on the firm’s tax return. The tax benefit is received in
the form of reduced taxes due to the decreased taxable income. The
calculated amount of tax-deductible depreciation will be a reduction
of the company’s taxable income, because depreciation expense is a
tax-deductible expense. The amount of tax-deductible depreciation
will cause an equal reduction in the company’s taxable income. That
will, in turn, cause a reduction in the amount of tax that will be due.
This tax reduction will not represent an actual cash inflow, but it
reduces the cash outflow of the company for taxes. Therefore, the
amount of tax savings that occurs as a result of the depreciation
expense is treated as a cash inflow for capital budgeting purposes.
The amount of tax savings that results from the depreciation is called
the depreciation tax shield.
The amount of depreciation that will be deductible for tax purposes
will depend upon the depreciation method being used for tax
purposes.
Note: Salvage (or residual) value is not taken into account when
calculating the depreciation for the depreciation tax shield in capital
budgeting regardless of which depreciation method is being used—
even if straight line depreciation is being used. Regardless of what
method of depreciation is being used for tax purposes, the depreciable
base for tax purposes is always 100% of the asset’s cost, according to
U.S. tax regulations.
Note: If the new machine is replacing an old machine that still is
usable and is not yet fully depreciated, the only relevant depreciation
amount to use here is the amount of change in each year’s
depreciation expense between the new machine and the machine it
will replace. Note that this amount of change in the annual
depreciation expense may be different in different years of the project,
since the depreciation on the old machine (if kept) might have ended
before the useful life of the new machine ends.
Outflow
The company may have cash outflows in years after the initial
investment is made. There are two potential sources of cash outflows
in the following years:
1) Another cash investment It is possible that a follow-up investment
must be made after some period of time, or that there will be a capital
investment that needs to be made with the equipment to maintain it
after a certain number of years. These would both be treated as cash
outflows for the amount that is paid in the year it is to be paid.
Tax Effect: The tax effect of additional investments will be treated in
the same manner as the original investment. The tax savings will be
received (and the cash inflow received) when the asset is depreciated.
2) Further working capital investment The company may need
another increase in its working capital later in the project’s life. This
additional increase is treated in the same manner is the increase in
working capital at the start of the project, except it occurs in a later
year. Additional w.cap is treated as an cash outflow.
Tax Effect: As was the case with the original investment in working
capital, any increase in working capital in subsequent periods also
does not have a tax effect.
Cash Flows at the Disposal or Completion of the Project
When the project is terminated, there are number of potential cash
flows related to this event. These potential cash flows are:
1) Cash received from the disposal of equipment. The cash received
from the sale of any assets (equipment, machines or the investment
project itself) is a cash inflow in the final year of the project.
Tax Effect: If the sale of the assets results in a gain or loss, there will
be a tax effect from this gain or loss. The gain or loss is calculated by
comparing the tax basis (or book value, if the tax basis is not given)
with the cash received. Remember that the tax basis is the full cost of
the asset minus accumulated depreciation on the sale date.
If there is a gain, the cash inflow will be reduced by the taxes paid on
the gain. Gain tax sheild is treated as a cash outflow If there is a loss,
the loss will be tax deductible and the resulting tax savings will be
added to the cash received from the sale to calculate the cash inflow.
This tax treatment is the same as the treatment of the gain or loss on
the sale of the old equipment at the start of the project.
2) Recovery of working capital The initial incremental investment in
working capital and any subsequent investments in working capital
are usually fully recouped at the end of the project. The final accounts
receivable will be collected and not replaced with other accounts
receivable (for this project), the inventory associated with the project
will have been sold, and all the related accounts payable paid. It is
also possible for an investment in working capital to be recovered
before the end of the project. Whenever working capital is recovered,
it is a cash inflow in that year with no tax effect.
Tax Effect: There is no tax effect related to working capital because
working capital is neither an income nor an expense. Therefore, the
amount that needs to be included in the capital budgeting analysis is
the actual amount of the working capital that is recovered at the end
of the project
Note: The calculation of the taxable gain or loss should use the tax
basis of the asset. The tax basis is the equipment's book value for tax
purposes, which may be different from the equipment's book value for
book purposes. In some questions on the exam, however, the book
value of the asset may be given instead of the tax basis. If only the
book value is given, you should simply use the book value to
calculate the gain or loss. But if both the book value and the tax basis
are given, use the tax basis.
It is possible that a problem will tell you that the company's tax rate
for capital gains is different from its tax rate for cash flows from
operations. If that occurs, use the tax rate for capital gains to calculate
the tax effect of the gain or loss.