3. Capital-Investment and Estimation of Cash Flows

8/12/2019 3. Capital-Investment and Estimation of Cash Flows

http://slidepdf.com/reader/full/3-capital-investment-and-estimation-of-cash-flows 1/35

“Principles of Capital

Investment”

Capital Budgeting andEstimating Cash Flows



Capital Budgeting?

The process of identifying,analyzing, and selecting

investment projects whose returns(cash flows) are expected toextend beyond one year.e.g. Purchase of Fixed Assets,

Investment in R&D



When a business firm makes a capitalinvestment, it incurs current cash outlayfor benefits to be realized in future.

Proposed investment is judged by theexpected return

How close will it come to RRR by the

investors.



The Capital

Budgeting Process

Generate investment proposalsconsistent with the firm’s strategic

objectives. Estimate after-tax incremental operating

cash flows for the investment projects.

Evaluate project incremental cashflows.



The Capital

Budgeting Process

Select projects based on a value-maximizing acceptance criterion. i.e.Whether proposed project will add valueto firm

Reevaluate implemented investment

projects continually and perform post-audits for completed projects.



Classification of Investment

Project Proposals

1. New products or expansion of existingproducts

2. Replacement of existing equipment orbuildings

3. Research and development

4. Exploration

5. Other (e.g., safety or pollution related)



Estimating After-Tax

Incremental Cash Flows

Cash flows (not accounting income)

Operating flows (not financing)

After-tax flows Incremental flows

Basic characteristics of relevant

project flows



Estimating After-Tax Incremental CFs

Ignore sunk costs (the only concerned isincremental cost & benefits, recovery ofpast cost is irrelevant).

Include opportunity costs. (certain cost

do not involve cash, e.g. un-usedbuilding used for new project) Include project-driven changes in

working capital net of spontaneous

changes in current liabilities. (additionalcash, A/R, Inv. Required, and it is assumed itwill be recovered during the life of project.

Include effects of inflation

Principles that must be adhered to in the estimation



Tax Considerations

and Depreciation

Generally, profitable firms prefer to use anaccelerated method for tax reportingpurposes (MACRS).

Depreciation represents the systematic

allocation of the cost of a capital asset

over a period of time for financialreporting purposes, tax purposes, or

both.



MACRS Sample Schedule

Recovery Property Class

Year 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%2 44.45 32.00 24.49

3 14.81 19.20 17.49

4 7.41 11.52 12.49

5 11.52 8.936 5.76 8.92

7 8.93

8 4.46



Deprec iab le Bas is

In tax accounting, the fully installed cost ofan asset. This is the amount that, by law,

may be written off over time for taxpurposes.

Depreciable Basis =

Cost of Asset + Capitalized Expenditures



Capital ized

Expendi tures

Capitalized Expenditures areexpenditures that may provide benefits

into the future and therefore are treatedas capital outlays and not as expenses of

the period in which they were incurred.

Examples: Shipping and installation



Sale or Disposal of

a Depreciable Asset

capital gain :Tax is implemented on Excessamount,

capital loss : So tax saving results on lossamount → cash saving

Generally, the sale of a “capital asset”

generates a capital gain (asset sells for

more than book value) or capital loss(asset sells for less than book value).



Calcu lat ing the

Inc remental Cash Flows

1. Initial cash outflow -- the initial net cashinvestment.

2. Interim incremental net cash flows --those net cash flows occurring after theinitial cash investment but not includingthe final period’s cash flow.

3. Terminal-year incremental net cashflows -- the final period’s net cash flow.



In i t ial Cash Outf low

a) Cost of “new” assets b) + Capitalized expendituresc) + (-) Increased (decreased) NWCd) - Net proceeds from sale of

“old” asset(s) if replacement e) + (-) Taxes (savings) due to the sale

of “old” asset(s) if replacement f) = Initial cash outflow

Depreciable Basis: (a) + (b)



1. Net operating C/F or Saving

(include inflation, if any)

2. (-) Depreciation (net)3. = CF_BT (EBT)

4. (-/+) Taxes

5. = CF_AT (EAT)

6. = Incremental C/F (1-4) or (2+5)

Incremental Cash Flows



Terminal-Year


a) Calculate the incremental net cashflow for the terminal period

b) + (-) Salvage value (disposal/reclamationcosts) of any sold or disposed assets

c) - (+) Taxes (tax savings) due to asset saleor disposal of “new” assets

d) + (-) Decreased (increased) level of “net”working capital

e) = Terminal year incremental net cash flow



Example 1: an Asset Expansion Project

ABC Co. is considering the purchase of a newequipment. The equipment will cost $90,000 plus$10,000 for shipping and installation.

Falls under the 3-year MACRS class.

No NWC requirements. It is forecasted that revenues for the next 4 years :35167, 36250, 55725, 32,258.

The used equipment will then be sold (scrapped)

for $16,500 at the end of the fourth year, when theproject ends. It is in the 40% tax bracket.





Example 1: an Asset

Expansion Projectyear 1 year 2 year 3 year 4

a) Net C/F 35167 36250 55725 32258

b)

- Depr.

33330 44450 14810 7410c) = CF_BT 1837 (8200) 40915 24848

d) - Tax 735 (3280) 16366 9939

e) = CF_AT 1102 (4920) 24549 14909

f) + Depr. 33330 44450 14810 7410

g) Incr. C/F 34432 39530 39359 22319

or (a) - (d) 34432 39530 39359 22319



Terminal-Year Incremental C/F

a) $22,319 The incremental cash flowfrom the previous slide inYear 4.

b) + 16,500 Salvage Value.

c) - 6,600 .40*($16,500 - 0) Note, theasset is fully depreciated atthe end of Year 4.

d) + 0 NWC - Project ends.e) = $32,219 Terminal-year incremental

cash flow.



Summary of Project Net Cash

Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3

Year 4-$100,000 $34,432 $39,530

$39,359 $32,219



Summary of Project

year 1 year 2 year 3 year 4 a) Net C/F 35167 36250 55725 32258

b) - Depr. 33330 44450 14810 7410

c) = CF_BT 1837 (8200) 40915 24848

d) - Tax 735 (3280) 16366 9939

(a) - (d)

34432 39530 39359 22319Terminal Year CF = (16,500*.6)=9,900 32,219 (100000) 34,432 39,530 39,359 32,219



Example 2: an Asset Expans ion Project

BW Co. is considering the purchase of a new

machine. The machine will cost $50,000 plus$20,000 for shipping and installation.Falls under the 3-year MACRS class.NWC will rise by $5,000.

FM forecasts that revenues will increase by$110,000 for each of the next 4 years and will thenbe sold (scrapped) for $10,000 at the end of thefourth year, when the project ends. Operating costswill rise by $70,000 for each of the next four years.BW is in the 40% tax bracket.




a) $50,000

b) + 20,000

c) + 5,000d) - 0 (not a replacement)

e) + (-) 0 (not a replacement)

f) = $75,000




Year 1 Year 2 Year 3 Year 4

a) Net C/F $40,000 $40,000 $40,000 $40,000

b) - Depr. 23,331 31,115 10,367 5,187

c) = CF_BT $16,669 $ 8,885 $29,633 $34,813

d) - Tax 6,668 3,554 11,853 13,925

e) = CF_AT $10,001 $ 5,331 $17,780 $20,888

f) + 23,331 31,115 10,367 5,187g) = $33,332 $36,446 $28,147 $26,075



Terminal-Year


a) $26,075 The incremental cash flowfrom the previous slide inYear 4.

b) + 10,000 Salvage Value.c) - 4,000 .40*($10,000 - 0) Note, the

asset is fully depreciated at

the end of Year 4.d) + 5,000 NWC - Project ends.

e) = $37,075 Terminal-year incrementalcash flow.



Summary o f Project

Net Cash Flows

Asset Expansion Year 0 Year 1 Year 2 Year 3 Year 4

-$75,000* $33,332 $36,446 $28,147 $37,075

* Notice again that this value is a negative cashflow as we calculated it as the initial cash OUTFLOW



Example of an Asset Replacement Project

Let us assume that previous asset expansion project

is actually an asset replacement project.The new machine will cost $50,000 plus $20,000 forshipping and installation and falls under the 3-yearMACRS class.

The original basis of the old machine was $30,000and depreciated using straight-line over five years($6,000 per year). The machine has two years ofdepreciation and four years of useful life remaining.BW can sell the current machine for $6,000. The newmachine will save $10,000 per year.NWC are $5,000.40% tax bracket.




a) $50,000 Cost

b) + 20,000 Shipping + installation

= $70,000 Depreciable basisc) + 5,000 NWC

d) - 6,000 (sale of “old” asset)

e) - 2,400 <---f) = $66,600 (tax savings

from

loss on sale of

“old” asset)



Depreciable Basis (old) 30000 Remaining life 4 years Remaining depr. 2 years

Acc. Depr. (3-yaers) 18000 Book Value 12000 Sold for 6000 Loss on disposal 6000 Tax saving 2400



Calcu lat ion o f the

Change in Deprec iat ion


a) $23,331 $31,115 $10,367 $ 5,187

b) - 6,000 6,000 0 0

c) = $17,331 $25,115 $10,367 $ 5,187

a) Represent the depreciation on the “new”

project.

b) Represent the remaining depreciation on the“old” project.

c) Net change in tax depreciation charges.





a) Net C/F $10,000 $10,000 $10,000 $10,000

b) - Depr. (net) 17,331 25,115 10,367 5,187

c) = CF_BT $ -7,331 -$15,115 $ -367 $ 4,813

d) - tax -2,932 -6,046 -147 1,925

g) = $12,932 $16,046 $10,147 $ 8,075



Terminal-Year


a) $ 8,075 The incremental cash flowfrom the previous slide inYear 4.

b) + 10,000 Salvage Value.c) - 4,000 (.40)*($10,000). Note, the

asset is fully depreciated at

the end of Year 4.d) + 5,000 Return of “added” NWC.

e) = $19,075 Terminal-year incrementalcash flow.



Documents

3. Capital-Investment and Estimation of Cash Flows