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© 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
© 2004 by Nelson, a division of Thomson Canada Limited3
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
© 2004 by Nelson, a division of Thomson Canada Limited4
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
© 2004 by Nelson, a division of Thomson Canada Limited5
Types of Investment Projects
Growth opportunities
Cost reduction opportunities
Required to meet legal requirements
Required to meet health and safety standards
© 2004 by Nelson, a division of Thomson Canada Limited6
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
© 2004 by Nelson, a division of Thomson Canada Limited7
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
© 2004 by Nelson, a division of Thomson Canada Limited8
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
© 2004 by Nelson, a division of Thomson Canada Limited9
The Optimal Capital Budget
Funding available
MCC
Rate
Return exceeds cost
Cost exceeds returnFund these projects
Project Return
© 2004 by Nelson, a division of Thomson Canada Limited10
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
© 2004 by Nelson, a division of Thomson Canada Limited11
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
© 2004 by Nelson, a division of Thomson Canada Limited12
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.
© 2004 by Nelson, a division of Thomson Canada Limited13
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
© 2004 by Nelson, a division of Thomson Canada Limited14
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
© 2004 by Nelson, a division of Thomson Canada Limited15
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
© 2004 by Nelson, a division of Thomson Canada Limited16
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
© 2004 by Nelson, a division of Thomson Canada Limited17
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
© 2004 by Nelson, a division of Thomson Canada Limited18
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
© 2004 by Nelson, a division of Thomson Canada Limited19
6: PV of Change in Working Capital
Change inWorkingCapital
Change inWorkingCapital
PV = +PV WorkingCapital
PV = - PV WorkingCapital
Working Capital = Current assets - current liabilities = Increase in working capital = Decrease in working capital
or
© 2004 by Nelson, a division of Thomson Canada Limited20
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?
© 2004 by Nelson, a division of Thomson Canada Limited21
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
© 2004 by Nelson, a division of Thomson Canada Limited22
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
© 2004 by Nelson, a division of Thomson Canada Limited23
Capital Budgeting: Solution
Step 4: PV of salvage
Salvage t
3
SalvagePV
1 + k
1,000
1.14
674.97
© 2004 by Nelson, a division of Thomson Canada Limited24
Capital Budgeting: Solution
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
© 2004 by Nelson, a division of Thomson Canada Limited25
Capital Budgeting: Solution
Step 6: PV of the change in Working Capital
Change inWorkingCapital
PV PV WorkingCapital
1,0001.14
877.19
© 2004 by Nelson, a division of Thomson Canada Limited26
Capital Budgeting: Solution
-$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
© 2004 by Nelson, a division of Thomson Canada Limited27
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
© 2004 by Nelson, a division of Thomson Canada Limited28
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.