AF3313 Business Finance

Lecture 4
Chapter 6
Capital Budgeting
Chapter 6 Capital Budgeting
❑ What does Capital Budgeting do
❑ Incremental Cash Flows

❑ Cash Flow Computation

❑ Operating Cash Flow
❑ Depreciation
❑ Net Working Capital

❑ Examples of Discounted Cash Flow Analysis

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Copyright © 2016 by McGraw-Hill Education. All rights reserved
What does Capital Budgeting do
❑The main purpose of capital budgeting
decisions is to select projects that are
beneficial to the corporation.
❑For example,
❑should we buy a new machine to for
production?
❑should we introduce a new product / service by
making a new investment?

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Capital Budgeting
❑ Why do we have to do capital budgeting?
❑ It helps us to make decisions objectively with regard to
maximizing corporation values.
❑ Among all the methodologies, managers should use Net
Present Value (NPV) for making decisions.
❑ There are steps that you should follow in order to arrive at
the NPV correctly.
❑ In order to calculate NPV of a project, a pro-forma model
should be built.

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Pro forma models
❑The pro forma models the anticipated results of the
transaction, with particular emphasis on the projected
cash flows, net revenues and taxes.

❑Consequently, pro forma statements summarize the

projected future status (future cash flow) of a company,
based on the current financial statements.

(Source: https://en.wikipedia.org/wiki/Pro_forma)

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Relevant Cash Flows
❑The cash flows that should be included in a
capital budgeting (NPV) analysis are those that
will only occur if the project is accepted
❑These cash flows are called incremental cash
flows
❑This allows us to analyze each project in
isolation from the firm simply by focusing on
incremental cash flows

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Asking the Right Question

❑You should always ask yourself “Will this cash flow

occur ONLY if we accept the project?”
❑If the answer is “ yes ”, it should be included in the
analysis because it is incremental
❑If the answer is “ no ”, it should not be included in
the analysis because it will occur anyway
❑If the answer is “part of it”, then we should include
the part that occurs because of the project

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Common Types of Cash Flows

❑Sunk costs – costs that have accrued in the past

❑Opportunity costs – costs forgone
❑Side effects
❑Positive side effects – benefits to other projects
❑Negative side effects – costs to other projects
Changes in net working capital
❑Financing costs
❑Taxes

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Sunk Costs (Irrelevant)
❑Costs that has already occurred
❑They cannot be changed by the decision of accepting or
rejecting the project.
❑Example:
❑ABC company wants to evaluate a new project and pays
$100,000 to a consulting firm to perform a market analysis.
Should the ABC include this $100,000 in its capital budgeting
decision?
❑No, since such cost is irrecoverable. It is only relevant
before it was sunk

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Opportunity Costs (Relevant)
❑Opportunities or benefits that a firm need to forgo if
project was accepted. It is relevant cash flow in NPV
analysis.
❑Example:
❑Should I go to University?
❑You expect higher salary after graduation and you
need to pay tuition now also.
❑What is your opportunity cost here?
❑You could have worked these three years and earn salary and
three years of salary is your opportunity cost

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Side Effects - Relevant
❑ What are the side effects of the proposed project on the other parts
of the firm?
❑Erosion: Erosion is a bad thing. If our new product will decrease
the demand of current products, we need to recognize that.
❑If a Toyota was considering to develop a new convertible sport
car, it will reduce the sales of existing sport cars.
❑Synergy: Synergy is a good thing. It can stimulate the current
sales.
❑Toyota wanted to start a racing team for F-1 racing and would
cost $35mil. However, because of publicity, its sales grew by
$65mil. Therefore, the NPV of the racing team would be
($65mil-$35mil) = $30 mil.

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Computing Cash Flows

Cash Flow from Assets (CFFA) = OCF – Net

Capital Spending (NCS) – ↑ in Net Working Capital
(NWC)

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Computing Cash Flows

❑Operating Cash Flow (OCF)

❑Bottom-Up Approach = EBIT + depreciation – taxes
❑Top-Down Approach = Sales – Costs – Taxes
❑Tax Shield Approach
= (Sales – Cost) x (1-Taxe rate) + depreciation x (Taxe rate)

Tax Shield

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Example: Operating Cash Flow (OCF)
Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
OCF $ 51780
OCF = Net income + depreciation

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Net Working Capital (NWC)

❑Net Working Capital ≡

Current Assets – Current Liabilities

❑NWC usually grows with the firm

Change in NWC

$252m = $707- $455

2013 2012 2013 2012
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to$104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460 $275 million in 2013 from
Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 $252 million
Stockholder's equity: in 2012.
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
$23 million
Common stock ($1 par value) 55 32
Capital surplus 347 327
$275m = $761m- $486m This increase
Accumulated of $23 million
retained earnings 390 347
Less treasury stock (26) (20)
isTotal
anequity
investment of the $805firm.
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity
$1,879 $1,742
Change in NWC
❑Why do we have to consider changes in NWC
separately?
❑GAAP requires that sales be recorded on the income
statement when made, not when cash is received
❑GAAP also requires that we record cost of goods sold
when the corresponding sales are made, whether we
have actually paid our suppliers yet
❑Finally, we have to buy inventory to support sales
although we haven’t collected cash yet

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Change in NWC

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Net Capital Spending
Net Capital spending
❑ Acquisitions of fixed assets minus sales of fixed
assets
Net Capital Spending
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital Spending
Capital spending -173 Purchase of fixed assets $198
(Acquisitions of fixed assets
minus sales of fixed assets) Sales of fixed assets -$25
Additions to net working capital -23
Total $42 Capital Spending $173
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
Why do we have a tax shield?
❑What is depreciation?
❑It reflects the accountant’s estimation of the cost of
equipment being used up in the production process.
❑For example, an asset with a five-year life and no
resale value is purchased for $1000. If straight line
depreciation is used, each year you will estimate a
depreciation expense of $200 ($1000/5).

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Depreciation
❑The depreciation expense used for capital budgeting
should be the depreciation schedule required by the
government for tax purposes
❑Depreciation itself is a non-cash expense;
consequently, it is only relevant because it affects
taxes
❑Depreciation tax shield = D × T
▪ D = depreciation expense
▪ T = marginal tax rate

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Computing Depreciation
❑Straight-line depreciation
▪ D = (Initial cost – Salvage (book) value) / number of years
▪ Very few assets are depreciated straight-line for tax purposes

❑MACRS (Modified Accelerated Cost Recovery System)

▪ Need to know which asset class is appropriate for tax
purposes
▪ Multiply percentage given in table by the initial cost
▪ Depreciate to zero
▪ Allows greater accelerated depreciation over the life of the
asset

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Example: 3-year MACRS

Annual depreciation

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 Example
The Best Manufacturing Company is considering a new investment. Financial
projections for the investment are tabulated here. The corporate tax rate is 34
percent. Assume all sales revenue is received in cash, all operating costs and
income taxes are paid in cash, and all cash flows occur at the end of the year. All
net working capital is recovered at the end of the project.

Change in NWC

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Example
Year 1 Year 2 Year 3 Year 4
Sales $12,500 $13,000 $13,500 $10,500
Costs 2,700 2,800 2,900 2,100
Depreciation 6,000 6,000 6,000 6,000
EBT $3,800 $4,200 $4,600 $2,400
Tax 1,292 1,428 1,564 816
Net income $2,508 $2,772 $3,036 $1,584

OCF 0 $8,508 $8,772 $9,036 $7,584

Capital spending –$24,000 0 0 0 0
Change in NWC –300 –350 –400 –300 1,350

Incremental cash flow –$24,300 $8,158 $8,372 $8,736 $8,934

The NPV for the project is:

NPV = –$24,300 + $8,158 / 1.12 + $8,372 / 1.122 + $8,736 / 1.123 + $8,934 / 1.124
NPV = $1,553.87
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After-tax Salvage
❑If the salvage (market) value* (that’s a second-hand
resell market value of fixed asset) is different from
the book value of the asset, then there is a tax effect
❑Book value = initial cost – accumulated depreciation
❑After-tax salvage:
= Salvage value – Tax rate X (salvage value – book value)

*It is also called scrap value

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Example: Depreciation and
After-tax Salvage
❑You purchase a machine for $100,000, and it costs
$10,000 to have it delivered and installed. This machine
will be depreciated straight-line to zero over the
project's six-year life. Based on past information, you
believe that you can sell the equipment for $17,000
when you are done with it in 6 years. No salvage
(book) value
❑The company’s marginal tax rate is 40%.
❑What is the depreciation expense each year and the
after-tax salvage in year 6 for each of the following
situations?

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Example: Straight-line

❑Suppose the appropriate depreciation schedule is

straight-line
▪ D = (110,000) / 6 = 18,333 every year for 6 years
▪ BV in year 6 = 110,000 – 6(18,333) = 0
▪ Assume a salvage (market) value of 17,000 in year 6
▪ After-tax salvage = 17,000 - 0.4(17,000 – 0)
= 10,200

10-30
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Example: 3-year MACRS

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Example: 7-year MACRS

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Equivalent Annual Cost
(EAC) Analysis
❑ There are times when application of the NPV rule can lead to
the wrong decision.
❑ Consider a factory that must have an air cleaner that is
mandated by law. There are two choices:
❑The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100, and lasts 10 years.
❑The “Cheapskate cleaner” costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.

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Investments of Unequal Lives
❑ Assuming a 10% discount rate, which one should we
choose?
❑NPV of total cost (Cadillac, 10-year life ) = -4,614
❑NPV of total cost (Cheapskate, 5-year life ) = -2,895
❑ This overlooks the fact that the Cadillac cleaner lasts
twice as long.
❑ When we incorporate the difference in lives, the Cadillac
cleaner is actually cheaper (i.e., has a lower EAC).
❑ EAC is used to find the per year cost using the PV of
annuity formula.
C  1 
PV = 1 − (1 + r ) T 
r  
 Example: Equivalent Annual Cost (EAC) Analysis
❑ NPV of total cost (Cadillac, 10-year life) = -4,000 -$100(PVIFA10%,10) = -4,614
❑ NPV of total cost (Cheapskate, 5 life ) = -1,000 -$500(PVIFA10%,5) = -2,895
❑ Which one incur a higher cost?
❑ However, they have different useful life. One way to compare them is to apply
EAC. EAC is used to find the per year cost using the PV of annuity formula,
given below.
EAC 1 1
−4,614 = 𝐶 −
10% 10%(1 + 10%)10
1 1 
Cost = C  −  𝐶 = −$750
 r r (1 + r )
T
 −2,895 = 𝐶
1
−
1
10% 10%(1 + 10%)5
PV of total cost 𝐶 = −$763
So, we should select Cadillac air cleaner as it has a
lower EAC.

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Equivalent Annual Cost (EAC) Analysis

A constant stream of cash flows with a fixed maturity

EAC EAC EAC EAC

0 1 2 3 T
C C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) T
PV of Annuity: Example
EAC of Cheapskate cleaner

$EAC $EAC $EAC $EAC

0 1 2 3 5

▪PV of total cost: -$2,895

▪-$2,895 = EAC[1 – 1 / 1.15] / 0.1
▪EAC = -$763
C  1 
PV of annuity PV = 1 − T 
formula r  (1 + r ) 
Inflation

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Cash Flow and Inflation
❑Two kinds of Cash Flow
❑1. Nominal Cash Flow – actual dollars to be received or paid
out.
❑2. Real Cash Flow – refers to the cash flow’s purchasing
power.
❑When performing NPV analysis, you have to keep
consistency between cash flows and discount rates.
❑As long as you are consistent, you should get the same
result under the two approaches.
❑So which one should you use?
❑Use the one that involves less computations

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