contemporary financial management

© 2004 by Nelson, a division of Thomson Canada Limited

Contemporary Financial Management

Chapter 9:Capital Budgeting and Cash Flow Analysis

© 2004 by Nelson, a division of Thomson Canada Limited2

Introduction

This chapter discusses capital budgeting and capital expenditures

It deals with the financial management of the assets on a firm’s balance sheet


Capital Budgeting

The process of planning for purchases of assets whose useful lives are expected to continue beyond a year

Capital Expenditure A cash outlay expected to generate a flow of

future cash benefits for more than one year

Capital budgeting decisions can be among the most complex decisions facing management


Examples of Capital Expenditures

Expand an existing product line

Increase or decrease working capital

Refund an issue of debt

Leasing versus buying an asset

Mergers and acquisitions

Enter a new line of business

Repair versus replacing a machine

Advertising campaigns

Research and Development activities


Types of Investment Projects

Growth opportunities

Cost reduction opportunities

Required to meet legal requirements

Required to meet health and safety standards


How Projects are Classified

Independent Acceptance or rejection has no effect on other

projects

Mutually Exclusive Acceptance of one automatically rejects the

others (replace versus repair)

Contingent Acceptance of one project is dependent upon

the selection of another


Cost of Capital

Firm’s overall cost of funds, often referred to WACC or Weighted Average Cost of Capital

Equal to a weighted average of the investors’ required rates of return

The discount rate used to analysis capital budgeting proposals


Expand output until marginal revenue equals marginal cost

Invest in the most profitable projects first

Continue accepting projects as long as the rate of return exceeds the marginal cost of capital (MCC)

Optimal Capital Budget


The Optimal Capital Budget

Funding available

MCC

Rate

Return exceeds cost

Cost exceeds returnFund these projects

Project Return


Capital Budgeting Problems

All projects may not be known at one time

Changing markets, technology, and corporate strategies can quickly make current projects obsolete and make new ones profitable

Difficulty in determining the behavior of the marginal cost of capital (MCC)

Estimates of project cash flows have varying degrees of uncertainty


Capital Budgeting Process

Step 1: Generate proposals

Step 2: Estimate the cash flows

Step 3: Evaluate alternatives and select projects

Step 4: Review prior decisions


Estimating Cash Flows

Calculate only the incremental cash flows.

Measure on an after-tax basis.

All indirect effects should be included.

Sunk costs should not be considered

Value of resources should be measured in terms of their opportunity cost rather than their actual cost.


The Capital Budgeting Decision

The capital budgeting decision involves six steps:

Calculate initial investment

Calculate PV of the annual after-tax cashflows attributable to the new asset

Calculate PV of the tax-shield due to Capital Cost Allowance (CCA)

Calculate PV of salvage value

Calculate PV of the tax shield lost due to salvage

Calculate PV of any changes in working capital


1: Calculate Initial Investment

The initial investment includes:

The cost of the new asset Plus shipping & installation costs Less any trade-in value received from an old

asset If expenditures on the new asset occur over a

period of time, present value all costs back to time period zero


2: PV of Annual After-Tax CFs

N

Cash Flow tt=1

Revenue - Expenses 1 - TPV =

1 + k

T = corporate marginal tax rate

k = WACC or discount rate

t = year 1 through year N


3: PV of Tax Shield due to CCA

CapitalCostAllowance

dT 1 + 0.5kPV Tax Shield = UCC

d + k 1 + k

UCC = Undepreciated capital cost (cost - trade-in received)d = Capital cost allowance rateT = Corporate tax ratek = Firm’s cost of capital


4: Calcuate PV of Salvage

Salvage t

SalvagePV =

1 + k

Salvage = the expected future salvage valuek = the WACC or discount ratet = the number of years until the asset is salvaged


5: PV of Tax Shield Lost from Salvage

Tax-shield tLost due toSalvage

dT 1PV = -Salvage Value

d + k 1 + k

d = CCA rateT = Corporate tax ratek = WACC or discount ratet = number of years


6: PV of Change in Working Capital

Change inWorkingCapital


PV = +PV WorkingCapital

PV = - PV WorkingCapital

Working Capital = Current assets - current liabilities = Increase in working capital = Decrease in working capital

or


Capital Budgeting: Example

Alki Dyes Ltd. buys a new tank for $18,000, including installation. The estimated salvage value at the end of its 3-year useful life is $1,000. CCA is charged at a 50% rate. The tank is expected to increase the firm’s pre-tax cash flows by $10,000/year for the three years of useful life. Working capital is expected to increase by $1,000 at the end of the first year. The firm’s tax rate and WACC are 46% and 14% respectively. What is the NPV of the new investment?


Capital Budgeting: SolutionStep 1: Initial investment

Cash flow from tank purchase: -$18,000

Step 2: PV of annual cash flows

N

Cash Flow tt=1

2 3

Revenue - Expenses 1 - TPV

1 + k

10,000 1 0.46 10,000 1 0.46 10,000 1 0.46

1.14 1.14 1.14

12,536.81


Capital Budgeting: Solution

CapitalCostAllowance

dT 1 + 0.5kPV Tax Shield UCC

d + k 1 + k

0.50 0.46 1 0.5 0.1418,000

0.50 0.14 1.14

$6,071.55

Step 3: PV of tax-shield due to CCA



Step 4: PV of salvage

Salvage t

3

SalvagePV

1 + k

1,000

1.14

674.97



Step 5: PV of the tax-shield lost due to salvage

Tax-shield tLost due toSalvage

3

dT 1PV = -Salvage Value

d + k 1 + k

0.50 0.46 11,000

0.50 0.14 1.14

$242.57



Step 6: PV of the change in Working Capital


PV PV WorkingCapital

1,0001.14

877.19



-$18,000.00

+$12,536.81

+$6,071.55

+$674.97

-$242.57

-$877.19

+$163.57

Step 1:

Step 2:

Step 3:

Step 4:

Step 5:

Step 6:

NPV


Ethical Issues: Biased CF Estimates

The outcome of any capital budgeting exercise is only as good as the estimates used as inputs. Problems may arise from:

Overestimated revenues Underestimated costs Unrealistic salvage values Ignoring necessary changes in working capital


Major Points

Firms make investment decisions using a capital budgeting framework.

The capital budgeting process captures all of the incremental costs and benefits of undertaking a project.

If capital is unlimited, the firm will accept all positive NPV projects and reject all negative NPV projects.

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