Capital Budgeting

Process of identifying, evaluating, and selecting capital projects

Capital projects involve the purchase of a long-term (fixed) asset

Part of the “Investment Decision” from Chapter 1 – What assets should the firm own?

Types of Projects

Replacement of existing assets Expansion of existing products or

services Addition of new product lines or

services Government mandated projects

Steps in Capital Budgeting Process

1) Generate ideas for projects 2) Estimate incremental cash flows for

proposed project 3) Evaluate riskiness of incremental

cash flows 4) Select projects that will increase

shareholder wealth 5) Monitor outcome of accepted projects

Step 2: Estimating Incremental Cash Flows

Incremental means that we only look at those cash flows that will CHANGE if we proceed with the project

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

1. Net Investment Cash Outflow (NICO) = initial cash outlay at start of project

2. Operating Cash Inflows (OCFs) = annual cash flows from using the new assets

3. Disposal Cash Flow (DCF) = special cash flows associated with ending the project

Watch Out For …

Sunk Costs – (money has already been spent) - NOT incremental

Opportunity Costs – (is there an alternate use for an asset?) - ARE incremental

Side Effects – (Acceptance of project has effect on existing project) - ARE incremental

Net Investment Cash Outflow (NICO)

Initial cash outlay at beginning of project Cash outlay obviously based on new

asset’s cost, but other factors must be considered as well

Look for 6 possible items to include in NICO estimate

NICO Checklist

1. Cost of new asset(s) = outflow 2. Extra charges (shipping, handling,

freight, delivery, installation, modification, etc.) = outflow

Note that for IRS purposes, the extra charges are included in the new asset’s depreciable base

NICO Checklist continued

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

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

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.

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

4. cont. Look for changes in CA and/or in CL. Net out the changes using NWC = CA – CL.

An increase in NWC is a cash outflow. A decrease in NWC is a cash inflow.

NICO Checklist Continued

5. Proceeds from sale (disposal) of old asset = inflow

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

Compare Market Value (MV) to Book Value (BV)

Book Value = original cost still on books; unclaimed depreciation

If MV > BV, gain on disposal; must pay taxes on gain.

Taxes owed = gain x tax rate (outflow)

Tax Effects continued

If MV < BV, loss on disposal. Do not pay taxes on losses. Loss creates tax savings.

Tax savings = Loss x tax rate (Inflow) If MV = BV, no gain or loss on disposal.

(No tax effect)

Summary of NICO

From your list of 6 possible items, net the outflows against the inflows.

NOTE that not all problems will have all 6 times – some just have one or two!

You should have one final outflow estimate of what it costs to get the project started

Save this number to use in project selection analysis

Operating Cash Inflows (OCFs)

Net the proposed project’s revenues and expenses for each year of the project’s useful life using the following equation:

OCF = (S – TVC – TFC – D)(1 – T) + D

Definitions of Terms in OCF Equation

S = Sales = Price per unit x # units TVC = Total Variable Costs = VC per

unit x # units TFC = Total Fixed Costs = Lump Sum D = Depreciation (see next slide) T = Marginal Tax Rate

Depreciation

Follow IRS rules for depreciating long-term (fixed) assets

IRS-approved method = Modified Accelerated Cost Recovery System (MACRS)

To calculate annual depreciation expense, determine depreciable base and class life

Look in text p. 218 at MACRS table for % to apply against base

D = Base x %

Summary of OCFs

Calculate the OCF equation for each year that the new asset is being used

Keep a list of all of the OCFs – don’t add them all together (they occur in different time periods!)

Save OCFs to use in project selection analysis

Disposal Cash Flow (DCF)

1. Proceeds from disposal of “new” asset (now old) = inflow

2. Tax effects of disposal of “new” asset (Follow rules listed earlier in NICO section) (outflow or inflow)

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.

Increase in NWC under NICO = inflow for DCF Decrease in NWC under NICO = outflow for DCF

Summary of DCF

Net outflows and inflows to get one disposal cash flow

This disposal cash flow will be added to the final year’s OCF when we get to project selection analysis.

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