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Chapter 8

Capital Budgeting Cash Flows

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Learning Goals

1. Basic capital budgeting terminology.2. Relevant cash flows.

4. Calculate the initial investment.

5. Calculate the annual operating cash flows.

6. Calculate the terminal cash flow.

Introduction

• Most organizations have an operating budget and a capital budget.

– Operating budget includes production costs, sales and administrative expense, maintenance, etc.

– Capital budget includes planned purchases of plant and equipment. Purchases can be replacement or expansion.

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The Capital Budgeting Decision Process

• Capital Budgeting involves identifying, evaluating, and implementing projects to be included in the capital budget.

• The typical capital budgeting decision involves a large commitment of funds for a long time.

• Poor capital budgeting decisions result in missed opportunities or possibly company bankruptcy.

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Basic Terminology: Independent versus Mutually Exclusive Projects

• Independent Projects do not compete with each other. A company can select one or both.

• Mutually Exclusive Projects compete in some way for a company’s resources—a firm can select only one.

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Basic Terminology: Unlimited Funds versus Capital Rationing

• If the firm has sufficient financing for making investments, then all acceptable independent projects can be accepted and implemented.

• However, some firms have a limited amount of funds to invest in potential investment projects at any given time, a situation referred to as capital rationing.

The Relevant Cash Flows

• To evaluate a capital budgeting project, we need to identify the incremental after-tax cash flows:

• Incremental cash flows:

– cash flows that result if the project is accepted and implemented that will not occur if the project is rejected

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Categories of Cash Flows:

1. Initial investment

2. Annual operating cash flows

3. Terminal cash flows

Relevant Cash Flows

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Price of equipment

+ Delivery & installation

- After-tax proceeds from sale of existing asset*

+ Change in net working capital

Initial investment

*Only if the project is replacing an existing asset

Remember: the initial investment is a negative cash

flow

Initial Investment

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After-tax proceeds from asset sale

Sale price

-book value

Gain (loss)

xTax rate

Taxes

Sale price

-tax

After-tax proceeds

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Operating Cash Flows

There are two techniques to find the annual operating CFs:

Pro forma income statement:

Op CF = EBIT - Tax + Depr Exp

= NOPAT + Depr Exp

Equation:

Op CF = (Rev – Cash exp)(1 – T) + (Depr Exp)(T)

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Terminal Cash Flow

After-tax proceeds from sale of new asset

-After-tax proceeds from sale of old asset (if replacement

project)

+ Change in net working capital

Terminal Cash Flow (CFT)

The values for each of these are as of termination of the new

asset. In other words, for the 2d line, we determine the AT

proceeds from the sale of the old asset if it were kept.

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